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« Fallout from the 'Strategic Failure of a Whole Generation of Economists, Bankers, and Policymakers' | Main | The Fed Fails to Change Reality »

December 10, 2007

String-Pushers

Many stock market bulls view each Fed easing with the same sense of anticipation as a heroin addict looking forward to his (or her) next hit of smack.

Unfortunately, in an environment where the body -- or, in this case, the economy and the financial markets -- has begun to suffer the ill effects of long-term misuse and abuse, each new high seems to produce less and less of the desired result.

When it comes to lower rates, in particular, it's always worth remembering that the "high" doesn't actually come from the injection of cheap "money," but from the addition of low-priced credit.

However, if things get so bad that people are maxed out financially and don't really want to borrow, then you get what BusinessWeek writes about in "The Fed: 'Pushing on a String'."

The Federal Reserve's expected rate cut won't necessarily stimulate growth and protect the U.S. economy from the threat of recession

The Federal Reserve's rate-setting committee is widely expected to cut the target federal funds rate by a quarter percentage point on Dec. 11, to 4.25%, but it's not clear how effective the move will be in keeping the U.S. economy from sliding into recession.

Four years ago, an economist from the Federal Reserve Bank of St. Louis, Jeremy Piger, demonstrated the problem that's giving Fed Chairman Ben Bernanke and his crew such a tough time. Piger showed that it's a lot harder for the Fed to boost growth by cutting interest rates (as it seeks to do now) than it is for the Fed to slow growth by raising rates (as it tries to do when the economy is overheating).

Specifically, Piger found that in the two years following a one-percentage-point increase in the federal funds rate, quarterly GDP growth fell 1.21 percentage points. In the two years following a one-percentage-point cut in the funds rate, quarterly growth rose 0.53 percentage points.

Slowing growth? Easy. Stimulating it? Hard.

Stringy Economics

The problem is, the Fed can make more money available in the financial system, but it can't force lenders to lend it out—or borrowers to borrow it. Economists refer to this problem as "pushing on a string." You can push and push, but the string just collects in a pile. Nothing happens.

Pushing on a string is more of a problem than usual because in the current credit crisis, lenders are unusually afraid that if they make loans, they won't be repaid. Even the loans that banks make to each other are getting more expensive. William Gross, chief investment officer of giant bond manager PIMCO Bonds, said in his December newsletter, "Fed ease has lowered Treasury yields, but for the rest of the market—the segment that influences the bottom line of U.S. corporations, homeowners, and consumers—not much has changed."

Gross concludes that the Fed "may need to eventually go down to 3% or lower" on the federal funds rate before money will be cheap enough to give the economy some real stimulus.

Solid Job Market?

Luckily for Bernanke & Co., the job market has held up remarkably well in spite of the credit crunch. On Dec. 7, the Labor Dept. announced that the economy created 94,000 jobs in November, and the unemployment rate held steady at 4.7%. That good news lessened the chance that the Fed would cut the funds rate by a half percentage point, which would be seen as something close to an emergency move. Instead, the market is expecting a quarter-point cut.

But the job market is hardly immune from the credit problems. Thomas Higgins, chief economist of Payden & Rygel, wrote Dec. 7 that the six-month moving average of payroll gains fell from 190,000 at the end of 2006 to less than half that this November. Also, initial claims for unemployment insurance have been increasing. Higgins said "the unemployment rate is poised to rise."

It's looking like the Dec. 11 rate cut, assuming it happens, won't be the last one.

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Comments

Very true! In economic-speak, this means that "the level of interest rates will not tell you whether money is “tight” or “loose.” The only way to find out is to check out the rate of growth (or contraction) of money." (see What makes monetary policy ‘loose’ or ‘tight?' @ http://cij.inspiriting.com/?p=151).

The central bankers can stuff as much credit down the throat of the economy, but if the economy refuses to borrow, the supply of money and credit will not expand. Put simply, you can lead a horse to the water, but you can't force it to drink.

For a year of so I have been diligently trying to learn how to invest/trade on my own. The most salient tidbit gleaned from my efforts is that making money on Wall Street is much easier when markets are uptrending. Duh!, of course. Being prudent, I have been too scared to make many moves of late.
I do understand the concept "dead cat bounce" and oversold conditions, but WHY O WHY? would someone please tell me why is the market going higher?(with consideration of much readily available data indicating ...at the very least, a lot of uncertainty, if not an OUTRIGHT CRISIS of large proportion.

To: dubious neophyte
Yes, it is a crisis, but it is yet to be reflected in the averages. As for the why, there are a million reasons, but greed and stupidity are probably the two main ones.

"When in doubt just stay out"

I don't think many of us can even begin to comprehend the depth and scope of this mess. Things will get a lot worse before they get any better.

I wonder how much "real" growth there has been in the USA for the past 10 years or so? How much real excess have we produced?

Hi dubious neophyte!

> "would someone please tell me why is the market going higher?(with consideration of much
> readily available data indicating ...at the very least, a lot of uncertainty, if not an
> OUTRIGHT CRISIS of large proportion."

A very simple way to explain this is that stock prices are soaring due to monetary inflation (i.e. 'printing' of money). In "Are stocks good value?" @ http://cij.inspiriting.com/?p=65, it says:

"... there is still too much liquidity (money, credit, etc) in the financial system. And this liquidity is the driving force behind the stock markets’ performance. Sure, stocks can continue to rise in 2007 due to the sheer weight of money sloshing around the globe... You can make the Dow climb as high as you want as long as you print enough money (that is, provide enough liquidity). In fact, if you run the printing press hot enough, anything that you ‘invest’ in will increase in price."

That explains why Zimbabwe has got the world's 'best performing' stock market even though its economy is close to collapse with hyper-inflation.

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