Fed Totally Dissing Inflation / Dollar

A: There is a very heated debate in the macro economic blogosphere about whether Ben Bernanke & Co. are doing the right thing by aggressively lowering the fed target rate as a preventative measure to fend off any recession, or doing the wrong thing by giving wall street what they want at the expense of future inflation and the weak US dollar. Stocks like inflation. Inflation is a side effect of a hot economy, or hot global economies, and when you see record prices in energy and other commodities its hard to ignore why stocks continue to do well; especially with fed rate cuts on their side. But is all this good for us in the end? Is housing even going to be helped by the rate cuts? Is the weak dollar good for the US?

For anyone whose been reading my blog for past years, you know that I lean heavily on macro economic discussions in the hopes of understanding what may be going on to drive stocks, housing, commodities, etc.. There is never a dull moment in this arena, especially in the past few months.

The US dollar is whitering away and inflation is no where near gone as the fed decided to put two of their stated mandates on hold (keep inflation in check and price stability) and focus instead on economic sustainability. What does that mean? It means the fed made it absolutely clear that the threat of a US recession was the #1 reason for their latest move in an attempt to "...forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time."

It was preventative and the unwanted side effects of making this bold move are:

1. Moral Hazard Issue - Did the fed give wall street what they want? Did they give the lenders too much liquidity and bail them out? Were the free markets unable to correct themselves that they needed this action? In my opinion is what August's awful Jobs data that gave the fed the opportunity to pull a move like this. Without that direct evidence of a slowdown hitting the labor market, the moral hazard argument becomes way stronger and the fed probably only cuts by 1/4.

2. Wasting Away of US Dollar - Anyone who has visited Canada or Europe recently knows how weak our currency is. It's as if the greenback has cancer and we are all watching as the currency whithers away. Good for stocks, bad for consumers and purchasing power. A weakening dollar will help corporate profits (especially those with businesses abroad) but will add to inflation concerns here at home down the road (and that means possible future rate hikes!). How low can this US dollar go before action is taken, or at lease inaction (no more fed cuts) is taken?

3. Steepening Yield Curve / Future Inflation - When the fed made its move, the bond market saw yields RISE, not fall! This is because with such a stimulative move by the fed, future inflation concerns become a very real problem and the bond market prices that in. Energy prices and other commodities soar helping to bring yields higher at the longer end of the curve. Here is a chart of what 10YR & 30YR Bond yields did right before and after the fed move:

For anyone that doesn't believe in inflation or the government's measure of it, just tell me whether the cost of living, eating, heating your home, filling up your gas tank, etc has risen over the past few years? If you say NO to those questions, please tell me where you live?

4. Longer Term Lending Rates DIDN'T FALL That Much - This is why you do NOT listen to the heads of mortgage companies, brokers, or anyone with a vested interest in you making a decision that puts money in their pockets. Everyone was on the bandwagon that if the fed cuts, all will be fine and dandy and lending rates will fall big time for a very popular loan product; the 30YR Fixed! This didn't happen and here is why.

For past 3 months, lending rates didn't follow the bond market as there was a re-pricing of risk in the mortgage markets; see my post that discussed this disconnect. During the height of this liquidity & credit squeeze, bond yields fell big time and lending rates rose significantly; thus, the disconnect between bond yields and mortgage rates due to perceived added risk of lending. However, with the latest fed move in target rate and discount window, it's clear that our central bank is doing what it is needed to stimulative and add liquidity to those in most distress; the lenders/banks/holders of mortgage backed securities. With this comes an increase in confidence, at least to some level, and the beginning of a return to a more normal relationship between bond yields and lending rates.

As you see from the charts above showing you longer term bond yields AFTER the fed move, they moved higher! That means little to no relief in longer term lending rates even with the fed rate cut. Those looking into short term ARM's, holders of HELOC's, and holders of credit card debt did see some relief due to the fed rate cut as both the Prime rate and LIBOR rate eased. All of this may have been an intended side effect from our fed, as 2008 poses a very big threat to nationwide housing and secondary mortgage markets when a record number of short term adjustable mortgages will reset to significantly higher rates. Those with resetting ARM's next year won't enjoy that much relief, even with LIBOR rate easing, because as Dan Green noted a ways back, there are CAP's set to how much your rate can jump and chances are even with this fed rate cut and relief in LIBOR rates, you are still near the top end of how much your mortgage can reset at.

For now, its BYE BYE to our US dollars and HELLO to future inflation risks in the years to come. I wonder, at what point does:

* $80+ oil start to HURT the economy?
* The weak US Dollar become a priority?
* The fed take a bigger picture stance towards future inflation risks?
* Housing inventory build reverses course giving fed ammo to raise rates?
* ECB takes stance against strong Euro for fear of it slowing Eurozone economies?
* Higher commodity prices fully trickle down to consumers?

Here are some interesting reads about these topics for those wishing to learn more sides to the story:

Inflation is Dead? Part II (The Big Picture)

Eurozone Slows (Calculated Risk)

50bps Cut May Be Too Little Too Late (RGE Monitor - Professor Nouriel Roubini)

Forward Rates & Inflation Expectations (Econbrowser)

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