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By John Mauldin | 23 September 2007
- "Of his bones are coral made:
Those are pearls that were his eyes:
Nothing of him that doth fade,
But doth suffer a sea change
Into something rich and strange"
(The Tempest— Shakespeare)
A Sea Change At The Fed
As everyone knows, the Federal Reserve cut both the fed funds rate and the discount rate by 50 basis points this week. The rate cut was clearly telegraphed and only the amount of the cut was a mystery. And for reasons I lay out later on, I think there will be more cuts. But that is not the interesting thing, at least to me. I think the Fed under Bernanke has clearly taken a new direction in determining monetary policy, one that differs with past deliberations.
At Jackson Hole on August 31, Bernanke addressing the problem of moral hazard faced by Central Banks, Bernanke noted: "It is not the responsibility of the Federal Reserve— nor would it be appropriate— to protect lenders and investors from the consequences of their financial decisions." He did acknowledge that if the system as a whole was at risk, then a central bank would have to act even in spite of the moral hazard issue.
That was then and this is now. We got rate cuts September 18. Bernanke in his testimony to Congress this week said the Fed cut rates "to try to get out ahead of the situation and try to forestall potential effects of tighter credit conditions on the broader economy." While he gave no hints as to future policy, he did note that the Fed would "keep reassessing our outlook and adjusting policy" as the situation demanded.
Read those words again. "...to try to get out ahead of the situation..." Hello. That is something new. Normally watching the Fed and predicting the next move is about as exciting as watching paint dry. The Fed has always waited until the data suggested (and/or the market demanded) a rate hike or especially a cut. The Fed has been what good friend Paul McCulley calls "opportunistically disinflationary" for the past two-plus decades. They tighten until inflation comes down and only when it is apparent that a recession is in the works, or if there is a crisis like 1987 or 1998 (more on that important distinction later) do they cut rates. They have reacted to the data rather than made forward looking assumptions.
Over time, this has been a good policy, as it dropped inflation down from the mid-teens in 1980 to below 2% a few years ago. There are those who argue (and with some justification) that Greenspan left rates too low for too long and allowed inflation to rise back to an uncomfortable 3%, although it has been tending down of late.
But the point is that inflation is merely tending down. It is not below 2%, and year over year comparisons in the fourth quarter suggest that headline inflation of closer to 3% is quite possible. That being said, the similar comparison numbers for core inflation are not as difficult, but certainly do not suggest— at this time— that we will drop below 2% this year.
Indeed, there may be some concerns that the CPI (Consumer Price Index) number could come under pressure from the housing component. Given that home prices are falling, that may be considered odd by many. But CPI does not measure home prices. It measures something called owner's equivalent rent. And even as house prices rose by 93% in real terms (per Bob Shiller) in the last decade run-up, rent in real terms did not go up all that much, so the cost of a new home was not reflected in the CPI.
Now, we may have the opposite problem. As more and more people cannot get a mortgage coupled with a very precipitous rise in foreclosures, we are seeing more people who need to rent. Rental property availability in many markets is quite tight, which means that rent prices are increasing. If you go to the Bureau of Labor Statistics and look at the housing rent data, it is not too hard to think that the housing component of CPI could easily rise by more than 4% in the fourth quarter given the current trend.
Since the housing component is about 30% of the total CPI, a 4% inflation in housing could be significant. And oil is over $80 and rising. The dollar is falling, meaning that import prices are going to rise. And should we mention that food costs a lot more than this time last year?
Given that the Fed has two mandates, stable prices and full employment, is the Fed abandoning its inflation mandate? Is Bernanke, who argued in academia for explicit inflation targeting, no longer worried about inflation? Is he willing to accept the possibility of 3% inflation? Is inflation getting ready to come back, a la the 1970s? Isn't that what the rise of gold is telling us? And aren't TIPS suggesting the same since the rate cut (a long term 2.64% inflation)?
In general I think the answer is no. I think that the Fed is concerned about other problems, and specifically heading off a recession. And to that topic, we need to turn to a recent speech at Jackson Hole by Fed Governor Fred Mishkin.
Long time readers of this letter should recognize that name. Mishkin was the co-author of a 1996 New York Federal Reserve paper on the predictive power of an inverted yield curve and recessions, which I have written about on several occasions. He was most recently a professor at the Graduate School of Business at Columbia before President Bush nominated him to the Fed Board of Governors which he joined last September, 2006. His resume is long and strong. He is a consummate and well-regarded insider. (http://www.federalreserve.gov/aboutthefed/bios/board/mishkin.htm)
At Jackson Hole in late August, he essentially argued that central bankers should ease monetary policy quickly and aggressively in response to a big fall in housing prices.
- "Presenting a paper on the final day of the Fed's Jackson Hole symposium, Mr. Mishkin said policymakers should not wait until output falls, but should 'react immediately to the house price decline when they see it.'
"He said the optimal policy response was both quicker and more aggressive than that suggested by a standard policy rule, in which policymakers respond only to deviations in output and inflation.
"He said simulations show that this approach 'can be very successful at counteracting the real effects' of even a large house price slump, because of the long lags from changes in housing wealth to changes in consumer spending." (Financial Times)
In a car, the transmission is responsible for taking the power of the engine and transmitting it to wheels. Economists also talk about transmission. How does an opportunity (or problem) in one area affect another seemingly unrelated area? How does a rise in housing prices affect overall consumer spending? What is the mechanism (the transmission) of the Wealth Effect? One obvious answer (among many) would be Mortgage Equity Withdrawals that are possible as home prices double in ten years.
And Mishkin talks about just that transmission in his paper. And he makes it clear that a precipitous drop in home prices would be a negative force. Of course, that is somewhat intuitively obvious. But the interesting thing is that he argues for a pro-active response from the Fed when it becomes clear that housing prices are getting ready to fall. Let's read carefully the following from the closing arguments of his paper. (You can read the speech at http://www.federalreserve.gov/pubs/feds/2007/200740/200740pap.pdf)
- "My discussion so far argues against a special emphasis on house prices in the conduct of monetary policy. This argument does not extend to a recommendation that central banks stand by idly when house prices climb steeply. To the contrary, central banks can take steps to reduce the negative consequences for aggregate economic activity of sharp movements in house prices. But rather than try to preemptively deal with the bubble— which I have argued is almost impossible to do— a prudent central bank would be better advised to deal with adverse macroeconomic consequences as they emerge in the wake of any substantial decline in asset prices. One way a central bank can prepare itself to react quickly is to explore various scenarios as a normal part of its business to assess how it might respond to a variety of shocks, including a drop in house prices, to achieve maximum sustainable employment and price stability.
"Indeed, the exploration of different scenarios by the central bank can be thought of as stress testing similar to that regularly conducted by commercial financial institutions and banking supervisors. They see how financial institutions will be affected by particular scenarios and then propose plans to ensure that the banks can withstand the negative effects. By conducting similar exercises, in this case for monetary policy, a central bank can mitigate the effects of a drop in house prices without having to judge that a bubble may be in progress or predict when a bubble might burst.
"One objection to an easing of monetary policy following the collapse of an asset bubble is that it might lead market participants to believe that the central bank will always act to prop up asset prices, a belief that can make a bubble more likely. The central bank can mitigate such an interpretation, however, if it publicly emphasizes that its monetary policy is not directed at stabilizing any particular asset price but is rather focused on achieving price stability and maximum sustainable employment. Making sure that a house-price collapse does not do serious harm to the aggregate economy in no way eliminates sharp declines in house prices and so does not provide insurance against such declines. The same reasoning holds true for stock prices. Indeed, we have seen substantial declines in housing and other asset prices in many countries even when monetary policy has been eased substantially."
Dr. Robert Shiller of Yale (of Irrational Exuberance fame) also presented at Jackson Hole. He said housing prices could fall as much as 50% in some areas given how home prices have diverged relative to rents.
Let's put the timing in perspective before we get back to housing. At the time of the Jackson Hole conference (my invitation once again seemed to get lost in the mail), the credit markets were in the process of freezing up. The European Central Bank was injecting hundreds of billions of euros into the economy. The Fed was also opening the monetary door. But as noted here often, the problem is not one of available liquidity, but of confidence.
The subprime problem, which everyone assured us last spring would not spread to other markets, clearly had infected the entire world. What should be a US problem was more of a problem for European banks. We were told that the housing markets were bottoming last winter and then last spring and now it is clear that we are no where close to a bottom. (I wrote about this time last year we would see a crash in the housing market in late 2007 and 2008 and this winter that the subprime problems would spread.)
By the end of August, all this had to be clear to the Fed gathering at Jackson Hole. And when Shiller stands up and starts talking about precipitous housing price drops, everyone evidently paid attention. Mishkin argues for a pro-active response, and the FOMC (the Federal Open Market Committee which sets rates) responded.
Let's run through the scenario that the US economy, and thus the world, faces. It is going to be many months before there is a functioning subprime mortgage market in the sense that mortgages can be packaged and sold to investors. We are first going to have to create transparency in the various banks to allow the commercial paper market to function. No one is going to buy commercial paper from a bank unless they are 100% sure they can get their money back. And you can't be sure unless there is transparency into the books of the lending institutions. And that includes all the SIVs or Special Investment Vehicles that allow banks to move liabilities off their books. Kind of. Sort of. Maybe. As long as there is not a problem. And then they come back.
Jumbo mortgages (over $417,000) are difficult to obtain without paying exorbitantly high rates. The only functioning mortgage markets are for conforming loans that can be sold to Fannie Mae or Freddie Mac or with FHA backing. (As an aside, I expect that $417,000 to be raised, and for government intervention in subprime markets.)
In effect, with what will be tighter standards for loans going forward, we are going to remove 10-15% of the home buyers that were in the market in 2005-6. That is a serious drop in potential demand. That in itself argues for a large drop in housing prices. Couple that with the rest of the housing market problems, and it could get ugly. Gary Shilling suggests a 25% drop. Dr. Roubini thinks 15-20%.
The total housing market value in the US is $20 trillion. Knock off $4 trillion, and you have a serious drop in the wealth of homeowners. For many, that completely wipes out equity built up over the years.
Wildness Lies in Wait
- "The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians.
"It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait."
— G. K. Chesterton
And thus the difference between risk and uncertainty. Risk has a price. You can establish the probability of a loss, and price it. Life insurance, as an example, or the likelihood of defaults in subprime mortgages (at least, before they dropped rational lending practices).
But you cannot price uncertainty. And now the markets are uncertain about subprime debt, and uncertain as to where that debt is. And so how do you price the debt? If you are no longer certain about German banks when two of them go belly up, then do you take any German bank paper? French paper? Commercial paper from Countrywide Mortgage?
You are a central banker. You can see the problem, and you can see that a housing led recession or at the very least a serious slowdown is in the near future. The mortgage credit markets are not functioning and may not for some time. Do you wait? Mishkin argues no.
Even though housing is only 5% of the economy, it is a huge part of the Wealth Effect. $4 trillion is not a small sum in the psychology of the consumer. Slower consumer spending, and consumer spending is clearly slowing, is the transmission which takes us from a housing recession to a general recession.
Slower consumer spending should result in lower inflation and lower prices. If you read Mishkin's paper, the Fed is clearly modeling the economy, and just as clearly their models suggests a problem.
And so we get a sea change. We get a Fed that is pro-active instead of reactive. That makes Fed-watching a whole new ball game.
A couple of side points. In 1998, the Fed cut rates 75 basis points in response to the Russian bond crisis and LTCM. When the crisis subsided, they took those cuts away fairly quickly. While I do not think this crisis subsides in a few months, if it does, and inflation even remotely ticks up, they will take the recent cut, and the ones they are going to make in the near future, off the table just as quickly [[BB has already said as much: normxxx]].
And I am running out of room, but the Bank of England's response to NorthRock was also a sea change. They in effect guaranteed all bank deposits in Great Britain. This will take some fleshing out on the part of authorities, but it is a big change.
I Still Think Recession
Even with a proactive Fed, I think we do not avoid a recession.
I think the Fed did the right thing by cutting rates. I think they will cut them more as the economy continues to slow. We will see a Fed funds rate with a "3 handle" before this process is over (meaning that the Fed funds rate starts with a 3 from the current 4.75%). The Fed did not start down this road with the thought 50 basis points would be enough.
The point is to try and drop rates enough to make mortgages (when that market finally rights itself) low enough that home buyers can afford to buy homes. While that will help some individuals, the more important concern from a central bankers perspective is the total economy. You do not allow the housing market to implode on your watch and do nothing.
And yes, it will help business with lower funding costs and encourage deals and risk taking. Which is what you want when an economy is on the verge of recession.
But home construction, even with lower rates, is not going to turn around fast. At the peak of the market, we were building 2,000,000 new homes a year in the US. As the following chart from the Conference Board shows (thanks to Dennis Gartman), it is not unusual for housing starts to drop below 1,000,000, and this typically precedes a recession.
Click Here, or on the image, to see a larger, undistorted image.
This of course is not helped by all the homes that are coming back onto the market via foreclosures. Mortgage delinquencies are rising, especially in the variable rate subprime market, as the chart below indicates.
Click Here, or on the image, to see a larger, undistorted image.
And all this puts pressure on consumer spending. Hugh Moore of Guerite Advisors writes:
- "Consumer spending accounts for two-thirds of the U.S. economy. Total Household Debt is particularly important in supporting the growth of consumer spending. This indicator includes mortgage debt due to the important role that Home Equity Withdrawal (HEW) has played in sustaining the growth in consumption since the beginning of the decade.
"As shown in the graph below, each time the year-over-year increase in Total Household Debt has dropped more than 40% below its recent peak, a recession (or in the case of 1967, a mini-recession) has occurred. The mid-1980's slowdown touched this level, but did not exceed it. The current 38.9% level is approaching this boundary and, based on recent credit tightening by financial institutions, is likely to drop significantly below the— 40% level."
Click Here, or on the image, to see a larger, undistorted image.
And quickly, a preview from next week's Outside the Box, courtesy of my friends at GaveKal (this actually written by Louis Gave). They track the velocity of money. As they note, central banks are pushing money into the system. But is it going anywhere?
- "Which brings us to today. Following the recent central bank actions in the US, Europe and the UK, most commentators seem to expect a sharp acceleration of either inflation, economic activity, or asset prices (or all three). As a result, gold is making new highs, the US$ is plunging to new depths, etc.... But aren't the recent buyers of gold focusing solely on likely changes in the money supply (M), while forgetting why central banks are set to dump money into the system in the first place? Isn't the reason behind the loosening of monetary policies the fact that the velocity of money (V) has been plummeting?
"As in 2001, the question investors should thus ask themselves is whether velocity is set to rebound? If it is, then investors are right to position themselves for an ample liquidity environment (long gold, long commodities, long deep cyclicals).
"But if it isn't, then the investment environment could start getting a lot trickier."
Click Here, or on the image, to see a larger, undistorted image.
We do live in interesting times. Next week I will try and look at the currency markets. The dollar is going to continue to be under pressure.
M O R E. . .
Normxxx
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