The Fed Is Still Behind the Curve

by: Babak March 20, 2008    

Babak

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So the Fed has had a busy week. On Sunday they cut the discount rate by a quarter percent to 3.25% and Tuesday, they cut the Fed Funds rate by 75 basis points to 2.25%. The market almost unanimously rejoiced and rushed to buy with both hands, even though the Fed Funds futures indicated most were expecting a full 1% cut.

Is that enough? Are we out of trouble now?

I don’t think so (just yet).

One of the theories of why we are in such a fine financial mess today is that we’ve had lax monetary policy. I’d like to propose another, without necessarily disagreeing or disproving that school of thought.

It goes something like this: while lax monetary policy is bad, what we are dealing with now isn’t just the after-tremors of the Greenspan bubble era. Since his first days as Chairman, Bernanke has refused to listen to the bond market.

By ignoring it, he has compounded the problems that were there to begin with. And instead of giving the economy the flexibility it needs to go through a short transition period to “fix” itself, he has in effect, extended this painful process (indefinitely).

I’m referring to Bernanke’s insistence to remain, month after month, firmly behind the 3-month Treasury Bill rates. This is something that I noticed last summer, when I wrote that the Fed should cut rates immediately.

And if you take a look at this long term chart of the Fed funds rate compared to the 90 T-Bill rate, you can easily compare the Bernanke Fed to the Greenspan Fed. Greenspan let the market lead him by the nose. His talent was in making every one believe he was in charge… the Maestro, orchestrating the economic symphony, while in fact, he was just flailing his arms around randomly.

Which brings us to Tuesday’s interest rate cut:

click to enlarge

Unfortunately, since last month the gap has gotten worse! The Federal Funds rate gap is now 133 basis points away from what the short term bond market is saying it should be at.

So while another 75 point basis cut is dazzling, until the Fed actually gets in front of the short term bond market for at least a day or week, I can’t see this mess getting mopped up.

And believe you me, there is a fine mess out there. The Bear Stearns(BSC)/JP Morgan Chase (JPM) story has grabbed everyone’s attention but there is a lot more happening out there:

  • MF Global (a subsidiary of MAN Capital) was taken behind the toolshed
  • Carlyle Capital Corporation is about to go tits up
  • Hedge funds and private equity funds are being closed right, left and center

So on the one hand, things are darkest before dawn, but on the other, the way Bernanke is dragging his feet worries me.

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This article has 1 comment:

  •  
    Mar 21 11:01 AM
    All actions of the FED are secondary to the purpose of preventing riots in the street by instilling confidence in the market. The appearance of an orderly market is paramount.
    Reply | Link to Comment
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