The Fed’s Big, Big, Step! (posted 3/20/09)

I could simply republish my December 2008 Musings instead of writing this. I said then that the Fed had taken a depression off the table by officially adapting quantitative easing to whatever extent necessary to prevent an economic catastrophe. (Please read my December Musings for more on this)

I thought then that investors’ depression/deflation fears were probably being reflected in stock prices, and that such Fed pronouncements would moderate the intensity of fright. That proved to be a premature conclusion as a tidal wave of bad news from the labor market and the banking system overwhelmed the prospect that quantitative monetary easing would, by later this year, give the economy some traction.

The stock market tanked. The 25% decline erased the rally from the November lows and then some. The bond market also backed up, and investor psychology, mine included, hit the skids. It didn’t seem that that the stimulus package was enough of the right medicine on a timely basis. Also, monetary easing seemed to come to a standstill, and the Treasury Department couldn’t seem to get their act together. Pessimism was extremely high.

The markets were ready for a rally and we are now in one. Investors with the guts to do so could have tripled their money in Citi and doubled it in GE. I wasn’t among them. I still felt that the market was a falling knife that I did not want to try to catch. No guts.

Had we hit bottom? Frankly, I have no idea, but until yesterday I would have said we were only in a typical bear market rally. But……..Thursday’s announcement by the Fed was truly BIG and makes me less certain of that opinion. Here is the important part of the Fed’s announcement:

“………the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets.”

This is mighty reinforcement to the Fed’s policy of quantitative easing. Fed action on this should drive long and intermediate term interest rates down, drive money supply up, and make it relatively more attractive to move money from the safest most liquid assets to less liquid and/or more risky assets. It also raises my confidence that the bottom of the economic decline will have been reached by the third quarter.

That said, it is still a very open question as to how and when a recovery will begin. There remain huge problems. The one that bothers me the most is that the quality of bank assets will continue to decline as the economy takes its toll on business loans, credit cards, leveraged buyout loans, and state and municipal credits. I still believe that we cannot build a trustworthy and lasting recovery of either sentiment and confidence until there is some better assurance that the banking system’s problems are solidly on the road to solution.

Additionally, we are not immune to the problems of Europe, where several Eastern European countries are in dire condition, affecting the European banks and Western Europe’s real economies that have benefitted from strong export demand from the eastern countries. World trade has been contracting rapidly, and its prospects for the several quarters ahead do not look good.

It seems fairly certain that the dominant downward pressures on the economy will be changing. Housing will remain depressed but not get worse. The same is true for autos. Both these areas are experiencing current demand well below their long-term demand determinants. Increasingly it is commercial construction and capital expenditures that are the negative forces.

The next worries will be about the strength of the recovery. There are really two worries. First, is about the initial bounce off the bottom, and second, will be about the following several years. I will try to address these in my next posting.


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