Fed Cuts Discount Rate

[c1ue]

Re: Fed Cuts Discount Rate

I was speaking with a friend yesterday who was wondering why stuff hasn't hit the proverbial item with the rotating blades

This actually is not at all hard to understand.

As Galbraith noted in his book about 1929 - one of the interesting behaviors exhibited was what he called "incantation".

Basically a bunch of seemingly otherwise intelligent and powerful men who tried their best to keep the reality of the 1929 crash from occuring.

I call it not derailing the gravy train.

All of you who have worked in any type of company or hierarchical organization have seen this: executives who refuse to act solely because it is changing the status quo (and taking on risk).

I have always believed the financial markets are the same way, as are most things in life.

[bart]

Re: Fed Cuts Discount Rate

As suggested above, there can be a delay between when the underlying loss of credibility occurs and the recognition of that loss. That is the case here, and what is being dismissed as emotional is merely the rational recognition of reality.

a.k.a. -

"The market can stay irrational longer than you can stay solvent."
-- John Maynard Keynes

and even a bit of:

“There is nothing so disastrous as a rational investment policy in an irrational world.”
-- John Maynard Keynes



I was speaking with a friend yesterday who was wondering why stuff hasn't hit the proverbial item with the rotating blades... and among other things, I just pointed out that there is a varying time lag between when something happens and when the full effects actually arrive... and of course that other things can happen during that lag and affect the eventual outcome.

Seriously problematical *stuff* was visible well before the Asian crisis or LTCM actually affected the world economies or stock markets.

It still looks from here that patience is needed... ;)

[Finster]

Re: Fed Cuts Discount Rate

Finster, JK,

Good discussion.

My question for the both of you is this:

Where in your example is the perception of the soil seller's credibility (credit worthiness)?

In my view, this is important.

Thanks, c1ue. The soil seller's credibility disappeared when he sold title to the same soil to a second creditor. Note however, that the knowledge of the lost credibility did not happen until later, when either the two creditors compared notes or when the second creditor went to claim the promised property.

Without getting into the dirty details ;), the issue I've been working to avoid is what happens if the dollar loses perceptual value due to the Fed's various machinations?

This is a non-physical belief which will have physical consequences beyond just the mechanics how many dollars represent each given unit of value in the system. This is a potential non-linear effect of credit expansin in response to our latest crisis.

As the various scandals are showing - faith in credit and credit worthiness itself created considerable wealth; in reverse the same will occur on the downside.

One of the underlying points I was trying to make is that much of the characterization of current credit crisis as being due to "fear" or other psychological or emotional factors is misplaced. The idea seems to be to dismiss the problem as irrational. As if there was no irrationality in extending as much credit as was extended in the first place. As suggested above, there can be a delay between when the underlying loss of credibility occurs and the recognition of that loss. That is the case here, and what is being dismissed as emotional is merely the rational recognition of reality.

If you believe that the dollar is more highly valued in the markets than it is "really" worth, then you would make a similar case there. In effect, that is what analysts who argue the dollar is overvalued are saying. The underlying credibility is already less than what is being reflected in the marketplace, and that the perception has yet to catch up with the reality.

[c1ue]

Re: Fed Cuts Discount Rate

Finster, JK,

Good discussion.

My question for the both of you is this:

Where in your example is the perception of the soil seller's credibility (credit worthiness)?

In my view, this is important.

Without getting into the dirty details ;), the issue I've been working to avoid is what happens if the dollar loses perceptual value due to the Fed's various machinations?

This is a non-physical belief which will have physical consequences beyond just the mechanics how many dollars represent each given unit of value in the system. This is a potential non-linear effect of credit expansin in response to our latest crisis.

As the various scandals are showing - faith in credit and credit worthiness itself created considerable wealth; in reverse the same will occur on the downside.

[Finster]

Re: Fed Cuts Discount Rate

if you assume that you have a closed system, then the seller of 2 piles of topsoil has committed fraud.

Precisely. That’s what inflation is.

i suppose you intend that this seller be equated to the central bank which has printed extra money.

I didn’t intend so much to identify the players with specific parties as to illustrate the point that credit can expand beyond its natural limits and that ultimately those natural limits reassert themselves. In other words, claims on assets can exceed the assets themselves. The metaphor is just another version of musical chairs. There are more claims on chairs than there are chairs. As long as no one tries to actually possess a chair the fraud passes unnoticed by most people. When the music stops, not everyone can have a chair. But the cessation of the music does not cause a loss of chairs; there never were enough chairs to satisfy the claims to begin with.

But you wouldn’t necessarily be wrong extend the metaphor as you suggest. Especially if you consider the central bank and the government together as a unit. The main purpose of a central bank ultimately is to expand credit. If it expands it too far, at some point somebody will try to take a chair and not be able to get one. You can think of what happened in 2000-2002 as just such an event. Credit expanded beyond its natural limits in 1995-2000, mostly in the stock market. When it deflated back, the Greenspan Fed restarted the music and added yet more claims resulting in the value of the claims falling further in relation to assets, creating the illusion that the assets themselves were again rising in value. In addition, there was an expensive war and deep fiscal deficits. But because the expansion had already hit its ceiling, something else had to give, so we saw the value of those claims decline not only in relation to assets we think of as investments, but in relation to things we consume, like oil, food, etceteras. Now the Bernanke Fed is faced with hard choices of how to allocate between falling asset prices and rising consumer prices. In order to keep consumer prices from rising further, it tried to restrain credit, but that resulted in falling asset prices. In order to bolster asset prices, it would have to expand credit yet further, but that would mean more consumer price inflation. This is broadly analogous to the choice of outcomes to the topsoil credit crisis; it make take one form or another, but the debt deflation happens no matter what.

[Jim Nickerson]

Re: Fed Cuts Discount Rate

if you assume that you have a closed system, then the seller of 2 piles of topsoil has committed fraud. i suppose you intend that this seller be equated to the central bank which has printed extra money.

Isn't anyway one figures it, a bonar is worth nothing, and any multiple of that is worth nothing?

[jk]

Re: Fed Cuts Discount Rate

Exactly what our issuer of multiple IOUs for single pile of topsoil has done.



Only if you assume that it is an open system with value coming in from somewhere else, which is what you’ve done in introducing "some other topsoil holder", "other people", etceteras. In which case the value added to your balance sheet is subtracted from his. My metaphor is for the global economy, which is a closed system.

There are no aliens out there dropping free topsoil on us.

if you assume that you have a closed system, then the seller of 2 piles of topsoil has committed fraud. i suppose you intend that this seller be equated to the central bank which has printed extra money.

[Finster]

Re: Fed Cuts Discount Rate

it is the proliferation of debt [iou's] and derivatives that causes the problem- everyone marks their account to market [or model, or make-believe] and feels rich.

the problem isn't shorting topsoil; it's creating and selling nightsoil.

Exactly what our issuer of multiple IOUs for single pile of topsoil has done.

finster, i think your metaphor obscures more than it reveals. first, in your fable, there is no problem: i am long cement and mink and topsoil, and short 2 topsoils, or net- short 1 pile of topsoil, which i can presumably acquire from some other topsoil holder. so what?

the problem lies instead in the "moneyness" of the iou's. i am long cement, mink and topsoil, short 2 topsoils and enjoying my holdings. 2 people think of their iou's as if they were worth something, i.e. topsoil. now they turn around and sell topsoil interests to other people who don't need a whole pile. say they each sell 10% piles to 10 people who want smaller amounts, with a markup so that they now hold 1 topsoil iou, short 10 one tenth pile ious, and also have been paid 120% of the cash value of a whole pile. so now there are 20 people who think they hold a tenth of a pile. these are worth something, everyone believes, so they use these iou's to trade for gasoline and groceries. thus the "money" supply has increased as long as the grocery store and gasoline station owners are willing to accept topsoil-certificates in exchange for their goods. someone notices this, and perhaps is aware that some people [me] are short topsoil, so that person prints "topsoil appreciation certificates" - i.e. topsoil options, that people can trade, and think of as having value when they look at their accounts.

Only if you assume that it is an open system with value coming in from somewhere else, which is what you’ve done in introducing "some other topsoil holder", "other people", etceteras. In which case the value added to your balance sheet is subtracted from his. My metaphor is for the global economy, which is a closed system.

There are no aliens out there dropping free topsoil on us.

[bart]

Re: Fed Cuts Discount Rate

...
But virtually any action that the Fed takes to soothe the crisis after the initial cause occurs will involve producing yet more IOUs and therefore their value will decrease and prices will rise, that is, what most people call inflation. Oil prices will be higher than the otherwise would be, gasoline, groceries, etceteras. The real question facing the Fed is how to split the topsoil.

Indeed, and as it has been since central banks have existed. Their vested interest is all about banking and credit and inflation... and "managing" expectations to hide the long term truths. :mad:

The nominal Dow for example has gone from about 70 to about 14000 since 1900 - a 20x gain. Just correcting that by the CPI+lies drops the gain back to about 4x (CPI only is about 7x).
In other words, 66-80% of the apparent gains were due to inflation *only*.

[jk]

Re: Fed Cuts Discount Rate

I think that the word "run-away" is key in EJ’s comment about preventing a "run-away debt deflation". Because "debt deflation" per se is inevitable.

Say you have a pile of top-grade top-soil in your back yard. But what you really want right now is a truckload of cement for a swimming pool. You neighbor happens to have some cement, but would prefer to have topsoil. So you trade him your topsoil for his cement. Only thing is, you need the cement right way, but he doesn’t have room for the topsoil until after he gets rid of the cement, and doesn’t need it until next spring anyway. So he delivers the cement tomorrow, and you pay him with an IOU for one pile of topsoil.

But then winter rolls around and you want to buy your wife a mink coat for Christmas. The mink dealer had seen your pile of topsoil one day driving through town, and when you showed up in his store offered to trade you a mink coat for it. He doesn’t need the topsoil till spring, so you pay him with an IOU for one pile of topsoil.

Now you have your swimming pool and a mink-clad wife, and your neighbor and your mink dealer both have title to one pile of topsoil. So everybody is happy.

That is, unless your neighbor and your mink dealer happen to run into each other on the street and compare their topsoil claims. Or if that doesn’t happen, when spring rolls around …

You have a "credit crisis".

You have a "debt deflation".

Although it is fashionable to refer to what is going on in the credit markets today as driven by psychology, emotion, fear, etceteras, it is mechanical as can be. As in our elementary little metaphor above, there was simply more IOUs for stuff issued than there was stuff. There was debt inflation. So when spring rolls around, debt deflation is the natural consequence.

The take-away here is that there is no real cure for debt deflation. The only way not to have debt deflation is to not have debt inflation in the first place. Once that has happened, somebody winds up losing. In our metaphorical economy, the neighbor might get there first, get his load of topsoil, and remain whole, while the mink dealer gets nothing. Or the mink dealer gets there first. In which case the neighbor is left holding the bag. Or the neighbor and the dealer agree to split the loss and each take half of the topsoil. We see that the value of the IOU that you issued your neighbor fell by half when you issued an identical one to your dealer. If these IOUs circulated in the marketplace like those issued by the Federal Reserve, it would now take twice as many of them to buy the same stuff, and the net effect would be a doubling of prices, what most people call inflation.

There is at least one other possible outcome that we have not considered. The mink coat goes back to the dealer. That is, he forecloses and repossesses the property bought on bad credit. In this way there is still a debt deflation but the value of the IOU is maintained. The neighbor gets all the top soil he bargained for.

So we see that there is more than one way a debt deflation can take place. It can happen by the value of the currency in which the debt is denominated falling, or the amount of the nominal debt falling. In a complex real-world economy, it can be by a combination of the two. But virtually any action that the Fed takes to soothe the crisis after the initial cause occurs will involve producing yet more IOUs and therefore their value will decrease and prices will rise, that is, what most people call inflation. Oil prices will be higher than the otherwise would be, gasoline, groceries, etceteras. The real question facing the Fed is how to split the topsoil.

finster, i think your metaphor obscures more than it reveals. first, in your fable, there is no problem: i am long cement and mink and topsoil, and short 2 topsoils, or net- short 1 pile of topsoil, which i can presumably acquire from some other topsoil holder. so what?

the problem lies instead in the "moneyness" of the iou's. i am long cement, mink and topsoil, short 2 topsoils and enjoying my holdings. 2 people think of their iou's as if they were worth something, i.e. topsoil. now they turn around and sell topsoil interests to other people who don't need a whole pile. say they each sell 10% piles to 10 people who want smaller amounts, with a markup so that they now hold 1 topsoil iou, short 10 one tenth pile ious, and also have been paid 120% of the cash value of a whole pile. so now there are 20 people who think they hold a tenth of a pile. these are worth something, everyone believes, so they use these iou's to trade for gasoline and groceries. thus the "money" supply has increased as long as the grocery store and gasoline station owners are willing to accept topsoil-certificates in exchange for their goods. someone notices this, and perhaps is aware that some people [me] are short topsoil, so that person prints "topsoil appreciation certificates" - i.e. topsoil options, that people can trade, and think of as having value when they look at their accounts.

it is the proliferation of debt [iou's] and derivatives that causes the problem- everyone marks their account to market [or model, or make-believe] and feels rich.

the problem isn't shorting topsoil; it's creating and selling nightsoil.

[Finster]

Re: Fed Cuts Discount Rate

The only things I can add is that Bernanke and the Fed are on record multiple times (as you have also noted) as being willing to use many unusual solutions, the discount rate cut being the most recent significant public one.

I think that the word "run-away" is key in EJ’s comment about preventing a "run-away debt deflation". Because "debt deflation" per se is inevitable.

Say you have a pile of top-grade top-soil in your back yard. But what you really want right now is a truckload of cement for a swimming pool. You neighbor happens to have some cement, but would prefer to have topsoil. So you trade him your topsoil for his cement. Only thing is, you need the cement right way, but he doesn’t have room for the topsoil until after he gets rid of the cement, and doesn’t need it until next spring anyway. So he delivers the cement tomorrow, and you pay him with an IOU for one pile of topsoil.

But then winter rolls around and you want to buy your wife a mink coat for Christmas. The mink dealer had seen your pile of topsoil one day driving through town, and when you showed up in his store offered to trade you a mink coat for it. He doesn’t need the topsoil till spring, so you pay him with an IOU for one pile of topsoil.

Now you have your swimming pool and a mink-clad wife, and your neighbor and your mink dealer both have title to one pile of topsoil. So everybody is happy.

That is, unless your neighbor and your mink dealer happen to run into each other on the street and compare their topsoil claims. Or if that doesn’t happen, when spring rolls around …

You have a "credit crisis".

You have a "debt deflation".

Although it is fashionable to refer to what is going on in the credit markets today as driven by psychology, emotion, fear, etceteras, it is mechanical as can be. As in our elementary little metaphor above, there was simply more IOUs for stuff issued than there was stuff. There was debt inflation. So when spring rolls around, debt deflation is the natural consequence.

The take-away here is that there is no real cure for debt deflation. The only way not to have debt deflation is to not have debt inflation in the first place. Once that has happened, somebody winds up losing. In our metaphorical economy, the neighbor might get there first, get his load of topsoil, and remain whole, while the mink dealer gets nothing. Or the mink dealer gets there first. In which case the neighbor is left holding the bag. Or the neighbor and the dealer agree to split the loss and each take half of the topsoil. We see that the value of the IOU that you issued your neighbor fell by half when you issued an identical one to your dealer. If these IOUs circulated in the marketplace like those issued by the Federal Reserve, it would now take twice as many of them to buy the same stuff, and the net effect would be a doubling of prices, what most people call inflation.

There is at least one other possible outcome that we have not considered. The mink coat goes back to the dealer. That is, he forecloses and repossesses the property bought on bad credit. In this way there is still a debt deflation but the value of the IOU is maintained. The neighbor gets all the top soil he bargained for.

So we see that there is more than one way a debt deflation can take place. It can happen by the value of the currency in which the debt is denominated falling, or the amount of the nominal debt falling. In a complex real-world economy, it can be by a combination of the two. But virtually any action that the Fed takes to soothe the crisis after the initial cause occurs will involve producing yet more IOUs and therefore their value will decrease and prices will rise, that is, what most people call inflation. Oil prices will be higher than the otherwise would be, gasoline, groceries, etceteras. The real question facing the Fed is how to split the topsoil.

[bart]

Re: Fed Cuts Discount Rate

...
The Fed can guess as well as you or I and isn't interested in finding out by experimentation.

The lesson of the Japanese experience is don't delay cutting rates. Keep inflation above zero at all costs. The Greenspan Fed applied this lesson effectively after the crash of the stock market bubble crash in 2001. However, in the context of an already depreciated dollar, lowered taxes, a massive fiscal deficit versus a surplus, and from a low Fed funds rate base of 5.25%, Fed and fiscal policy options cannot be executed today in the way they were in 2001.

The paradox is that to prevent a recession that could develop into a run-away debt deflation, the Fed needs to cut early and often, but to avoid crashing the bond market and dollar, the Fed has to wait until it sees the whites of the bond traders' eyes. Timing, wording, and execution will be critical.

As we've discussed in ShadowFed meetings, in a perfect world for the Fed, a random event occurs outside the U.S. that the Fed can use as a reason to cut.

...

Things can change very quickly, as I've said.

Very nice summary and observations oh Fearless Leader, as usual.


The only things I can add is that Bernanke and the Fed are on record multiple times (as you have also noted) as being willing to use many unusual solutions, the discount rate cut being the most recent significant public one.

And the Bank of Japan also continues to be a large wild card - their ~$300 billion add in 2001-2 to their monetary base was also a major factor in the world "recovery".






And now for something totally different... perhaps you can work out a deal with EricIsGreat.com to help out the iTulip crowd?
:eek: ;)

[Finster]

Re: Fed Cuts Discount Rate

Coming off the housing bubble, the Fed is worried about a Japan post 1992 style debt deflation. The monetary downdraft of a US recession under current household debt conditions is dangerous. A recession is a self-reinforcing process; the Fed is, and should be, afraid of where a recession will take the US economy with so much riding on housing values, and housing values riding on employment. Commentators are quick to point out that housing prices are now falling for the first time since The Great Depression, but should point out that this is the first time they have declined–ever–in the absence of a depression. What will happen to housing prices if the economy actually does go into recession...

... Things can change very quickly, as I've said.

Thanks, EJ!

BTW, one more item for the "things can change very quickly" file: one can make a case that recession is already in progress ...

[lb]

Re: Fed Cuts Discount Rate

What happens if they cut the discount rate to 4.75%, and leave the target rate at 5.25%?

I know the discount rate has been below the target rate before, but I'm still wet behind the ears and don't have any knowledge of such a time.

[EJ]

Re: Fed Cuts Discount Rate

EJ, maybe you could expand on this still further? Particularly the idea that the central banks will not be able to "control events". Some of these factors, like those relating to all the players in the credit markets, are just a big black box to me with lots of inputs and outputs but little clear internal structure.

And would we be wrong in saying that the central banks actually can get the markets moving upward again, but at such great cost that they'd be unlikely to do so before that 1987-type event occured? I believe Ben Bernanke when he says "the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services ... [and] ... always generate higher spending and hence positive inflation."

While Bernanke doesn't mention financial markets, he can sure "reduce the value of the dollar" in terms of stocks - and thereby support nominal stock prices even as real values tank. The problem is what happens if he does? So the Fed cuts rates to the bone. Hedge funds borrow and buy stocks. Since there is little demand left in the real economy for credit, the Treasury borrows and "cuts checks", say as "tax rebates" or mortgage bailouts. But this panics foreign creditors, they start dumping UST, and you get a huge spike in long interest rates, not exactly a balm for aching mortgage markets. Or they dump USD, import prices skyrocket, and all credibility on the inflation front disintegrates. Or competive devaluation resumes and global inflation skyrockets again. Or some combination of the three. Either way, real US consumption wherewithal goes down fast. So while they theoretically can "control" the markets, the choices they have are sharply limited, and the question boils down to what mix of painful outcomes they opt for. How does what you see differ, if it does? And can you make out any features on the other side of this financial singularity?

Coming off the housing bubble, the Fed is worried about a Japan post 1992 style debt deflation. The monetary downdraft of a US recession under current household debt conditions is dangerous. A recession is a self-reinforcing process; the Fed is, and should be, afraid of where a recession will take the US economy with so much riding on housing values, and housing values riding on employment. Commentators are quick to point out that housing prices are now falling for the first time since The Great Depression, but should point out that this is the first time they have declined–ever–in the absence of a depression. What will happen to housing prices if the economy actually does go into recession?

The Fed can guess as well as you or I and isn't interested in finding out by experimentation.

The lesson of the Japanese experience is don't delay cutting rates. Keep inflation above zero at all costs. The Greenspan Fed applied this lesson effectively after the crash of the stock market bubble crash in 2001. However, in the context of an already depreciated dollar, lowered taxes, a massive fiscal deficit versus a surplus, and from a low Fed funds rate base of 5.25%, Fed and fiscal policy options cannot be executed today in the way they were in 2001.

The paradox is that to prevent a recession that could develop into a run-away debt deflation, the Fed needs to cut early and often, but to avoid crashing the bond market and dollar, the Fed has to wait until it sees the whites of the bond traders' eyes. Timing, wording, and execution will be critical.

As we've discussed in ShadowFed meetings, in a perfect world for the Fed, a random event occurs outside the U.S. that the Fed can use as a reason to cut.

Assuming they pull off a magical combination of rate cuts with global central bank cooperation, which appears to still be in place, along with more tax cuts and fiscal stimulus to prevent a hard crash at this time, in the long term the Fed is still a one trick pony. It can print or not. When, not if, the US goes into recession in Q4, and unemployment begins to rise and the housing market takes its next and more severe turn down, the Fed will cut drastically.

By the way, it's time for us to start to collect iTulip Prosper.com members data. One of my reasons for setting up the group last year was to establish a baseline so we'd have more proprietary data for the ShadowFed. I checked with a few other members informally and they are seeing a huge spike in defaults in August after almost no defaults before July 2007. One reported only one default among 100 loans and that was in July, then six so far in August.

Things can change very quickly, as I've said.