Should we worry about heavy borrowing from TAF?

How Non-Borrowed Reserves Became a Sexy Subject: Caroline Baum

Commentary by Caroline Baum

Feb. 8 (Bloomberg) -- Technically insolvent! This has never happened before! Without the Temporary Auction Facility, where would banks be?

When I got the fifth hysterical e-mail on the subject of -- sit down -- the decline in banks' non-borrowed reserves, I thought I was back in the Volcker era.

That would be Paul Volcker, chairman of the Federal Reserve from 1979 to 1987. Volcker knew interest rates had to rise significantly to slay the inflation dragon; he didn't know by how much. So he changed the Fed's operating procedure from targeting a price (the overnight interbank lending rate) to a quantity (the monetary aggregates -- specifically non-borrowed reserves).

``There is no relationship between non-borrowed reserves and anything the Fed cares about, be it inflation, employment or real GDP,'' said Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago.

He said that 20 years ago, when I was just starting out, but I still remember his exact words. They came back to me when I learned of the latest obsession with this irrelevant statistic.

A few basics are in order. I promise not to make this too geeky.

Banks are required to keep a certain amount of funds in reserve -- as vault cash or on deposit at the Fed -- to meet unexpected deposit outflows. These are called required reserves (catchy, isn't it?). Sometimes depository institutions elect to hold more than is required. These are called excess reserves.

Sources and Uses

Congratulations. You have just completed the introductory course in the uses of reserves. What about the sources?

Reserves can be borrowed (from the Fed's discount window) or non-borrowed (supplied via the Fed's daily open market operations). It matters not one whit to the Fed where the banks acquire the reserves they require. If they borrow directly from the Fed, they don't need to tap the interbank, or fed funds, market.

What's caused the hullabaloo recently is the dive in non- borrowed reserves from $44 billion in early December to minus $8.8 billion at the end of January.

It isn't a mystery what happened. The Fed announced the creation of a Term Auction Facility on Dec. 12, enabling banks to borrow for 28 days versus a wide range of collateral. The minimum bid the Fed accepts is the expected funds rate one month out, which in the current environment means cheaper funding costs than the fed funds market.

So what would you do if you were a bank?

Lower Cost

Loans made through the TAF are categorized as borrowed reserves. The Fed had $50 billion of loans in place at the end of January, which ``caused the borrowed reserves figure to balloon and the non-borrowed figure to decline by a corresponding amount,'' said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, in a Feb. 6 commentary. (He's on the same e-mail lists I am.)

All of a sudden, people who never glanced at the Fed's H.3 statistical release are now experts on ``Aggregate Reserves of Depository Institutions and the Monetary Base.'' Their e-mails have the same sense of foreboding as the missives put out by the Black Helicopter/Tin-Foil Hat crowd.

``What if the Fed's rate cuts aren't motivated by the desire to stave off recession, rather to prevent a major banking crisis?'' one e-mail read. ``The Fed's not telling anyone what it's up to because it doesn't want to cause panic, but the evidence is there in its own data.'' (Gosh, you'd think it would do a better job of hiding it. Maybe send H.3 to join M3!)

Monopolist Provider

The writer of the e-mail directs his readers to the most recent H.3 report, which shows total reserves ($41.6 billion) less TAF credit ($50 billion) less discount window borrowings ($390 million) equals non-borrowed reserves (minus $8.8 billion). The negative number is really an accounting quirk: If banks borrow more than they need, non-borrowed reserves are a negative number.

This gentleman is overlooking the fact that the Fed is ``a monopoly provider of reserves,'' said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. ``This is a non-starter. There is no such thing as a banking system short of reserves. The Fed has absolute control over the supply.''

There may be times, such as late last year, when banks are reluctant to lend to one another for a period longer than overnight. ``And any one bank can have a problem'' funding itself, Glassman said. But in a world where ``the Fed can print money, there is no shortage,'' he said. ``The banks get the reserves they want.''

Low Priority Worry

Those hyperventilating over TAF borrowing may want to consider an alternate scenario.

``Suppose the Fed cut the discount rate so that it stood below the funds rate,'' Kasriel said. (He said this yesterday, not two decades ago.) ``Would these folks be upset if banks went to the discount window for funds? What's the difference? It's a difference without a distinction.''

In a commentary this week, Goldman Sachs Group Inc. senior economist Andrew Tilton dismissed the case of the disappearing non-borrowed reserves as ``evidence of the markets' obsession with the health of the financial system.''

Some of the concern is justified, he said, given banks' massive losses and writedowns on subprime loans.

Of all the things to worry about right now, this isn't one of them.

Market bets on lower interest rates on growth concerns

Fed Forecasts Spur Traders to Ignore Warnings on Cuts (Update1)

By Scott Lanman

Nov. 21 (Bloomberg) -- The Federal Reserve's first set of quarterly economic forecasts fueled speculation that it will cut interest rates again, contrary to warnings by policy makers in the past two weeks.

The degree of ``uncertainty'' about the growth outlook is greater than that for inflation, officials said in a supplement to minutes of their October meeting released yesterday. While officials expressed confidence price increases will ease, they viewed markets as ``still fragile and were concerned that an adverse shock'' would worsen economic risks.

The wariness about a continued credit collapse pushed odds of a rate cut next month up to 92 percent, according to federal funds futures, from as low as 70 percent. Investors differ with Chairman Ben S. Bernanke and other officials, who have said this month that the dangers of a slower expansion and faster inflation were ``roughly'' balanced.

``Risks aren't balanced,'' said Michael Feroli, a former Fed board staff member who is now an economist at JPMorgan Chase & Co. in New York. ``Recent developments in financial markets increase the likelihood that they will ease.''

Treasuries climbed today, sending yields on 10-year notes below 4 percent for the first time in two years as investors flocked to the safety of government debt.

As part of its new release on the three-year economic estimates of Fed governors and district-bank presidents, the central bank discussed risks to the outlook. ``Most participants judged that the uncertainty attending'' their growth forecasts ``was above typical levels seen in the past,'' the Fed said.

Growth Forecast

Officials predicted growth will slow to as low as 1.8 percent in 2008, according to the middle range of projections. That would be the weakest since the 2001 recession. The Fed's historical estimates indicate that the actual expansion is likely to be within 1.3 percentage points above or below the estimate.

In June, policy makers anticipated 2.5 percent to 2.75 percent growth next year. Officials left their projection for inflation, excluding food and energy costs, little changed at a 1.7 percent to 1.9 percent pace for the next two years.

``The focus in the minutes is on the downside risks to growth,'' which contrasts with an ``optimistic inflation forecast,'' said Robert Eisenbeis, the former head of research at the Federal Reserve Bank of Atlanta. ``They clearly will respond if needed.''

Rate Cuts

The Federal Open Market Committee lowered its benchmark rate by a quarter point on Oct. 31, to 4.5 percent, after reducing borrowing costs a half point in September.

Since the meeting, banks have warned of billions of dollars of losses on debt tied to subprime mortgages. Stocks have also retreated, while the number of private economists predicting a recession has risen, according to the National Association for Business Economics.

While the ``most likely'' scenario is consumer spending and business investment rise at a ``moderate'' pace, Fed officials recognized a market shock ``could further dent investor confidence and significantly increase the downside risks,'' the minutes said.

Such a disruption could come from ``a sharp deterioration in credit quality or disclosure of unusually large and unanticipated losses,'' the Fed said.

In their speeches and public remarks, policy makers have said they expect growth to accelerate by the middle of 2008 and warned that surging energy and commodity prices, and a falling dollar, may push up inflation.

`Rough Patch'

Economic reports confirming a ``rough patch'' in the economy ``would not, by themselves, suggest to me that the current stance of monetary policy is inappropriate,'' Fed Governor Randall Kroszner said Nov. 16. Further rate cuts may increase the risk inflation will accelerate, he signaled.

Federal Reserve Bank of St. Louis President William Poole said in a Nov. 15 interview with Dow Jones that ``there can only be chaos'' if the Fed follows traders' expectations in setting policy.

``When you think about the effects of monetary policy, you are going to be thinking about several quarters ahead,'' said Douglas Elmendorf, a former assistant director of the Fed's research and statistics division who is now a senior fellow at the Brookings Institution in Washington. ``The FOMC is very focused on maintaining and building their credibility on keeping inflation low.''

Yesterday's forecasts are the product of a 1 1/2-year review commissioned by Bernanke to improve how the Fed communicates its policy objectives. He said in a Nov. 14 speech that the new reports will help show ``how our policy decisions respond to incoming information and will enhance our accountability.''

Less Optimistic

Fed policy makers are less optimistic about the 2008 expansion rate than private economists. The median Fed estimate of about 2.25 percent is less than the 2.4 percent consensus prediction of the Blue Chip survey of forecasters. Four of 17 Fed governors and presidents expect growth of 1.8 percent or less.

Fed officials will have more opportunities to send investors a message before the Dec. 11 meeting. Next week, at least four regional-bank presidents speak, including Philadelphia's Charles Plosser and William Poole of St. Louis. Bernanke speaks Nov. 29 at an event in Charlotte, North Carolina.

``There is a very slow movement toward understanding the severity of financial market problems and the impact on the economy,'' said Kurt Karl, chief U.S. economist at Swiss Reinsurance Co. in New York. ``The question is, what is the Fed waiting for?''

Bond markets tell a different story

Bond Market to Bernanke: Recession Threat Means More Rate Cuts

By Daniel Kruger

Nov. 19 (Bloomberg) -- The headline in the financial futures market these days says Federal Reserve Chairman Ben S. Bernanke is withholding some vital information: The economy is so bad the central bank will have to lower interest rates at least three- quarters of a percentage point to avoid a recession.

Bernanke's two rate cuts since September failed to reassure the bond market, where volatility has risen four of the past five weeks, according to Merrill Lynch & Co.'s MOVE Index. Yields on Treasury bills, the haven for bond investors in times of turmoil, are near their lows of August, when losses on securities backed by subprime mortages froze credit markets.

While the record low dollar and the fastest inflation in 14 months give policy makers reasons to keep the target rate for overnight loans between banks at 4.5 percent, traders expect 3.75 percent early in 2008. Interest-rate futures on the Chicago Board of Trade show the Fed will cut borrowing costs in December and again in the first quarter, as the worst housing slump since 1991 deepens and retailers including J.C. Penney Co. and Macy's Inc. forecast slumping sales.

Investors are sending the message to Bernanke that ``you're wrong and we're going to lead you to the next ease,'' said Thomas Tucci, head of U.S. government bond trading in New York at RBC Capital Markets. The firm is the investment-banking arm of Canada's biggest bank.

Fed fund futures show traders see a 90 percent chance the central bank will reduce its target a quarter-percentage point to 4.25 percent at its Dec. 11 meeting, 67 percent odds of another 25-basis-point cut in January, and a 43 percent likelihood the rate falls to 3.75 percent in March. Policy makers already lowered the target from 5.25 percent in August.

Worse than LTCM

The Fed hasn't cut that much since 2001, when the economy shrank and policy makers lowered rates 11 times. Even when Russia defaulted and Long-Term Capital Management LP collapsed in 1998, policy makers only had to reduce rates 75 basis points.

The yield on the benchmark two-year note, the security most sensitive to rate expectations, fell 8.5 basis points last week to 3.34 percent, according to bond broker Cantor Fitzgerald LP. The price of the 3 5/8 percent Treasury due in October 2009 rose 4/32, or $1.25 per $1,000 face amount, to 100 17/32. The benchmark 10-year note yield declined 5 basis points, or 0.05 percentage point, to 4.17 percent.

Bernanke suggested the central bank is reluctant to lower rates again when he told Congress on Nov. 8 that the economy will likely ``slow noticeably'' this quarter while also citing ``upside risks'' to inflation. Fed Governor Randall Kroszner was more pointed, saying in a New York speech on Nov. 16 that ``the current stance of monetary policy should help the economy get through the rough patch during the next year.''

Stiglitz `Pessimistic'

Financial markets aren't buying it. Wells Fargo & Co. Chief Executive Officer John Stumpf said at a Merrill Lynch conference in New York on Nov. 15 that the housing market slump is the worst since the Great Depression.

Joseph Stiglitz, the Columbia University professor and Nobel-prize winning economist, said there is a 50 percent chance of a recession in the U.S. as a worldwide increase in credit costs following the collapse of the subprime mortgage market chokes off financing. ``I'm very pessimistic,'' Stiglitz said in an interview in London Nov. 16.

Financial companies may lose as much as $400 billion because of home foreclosures, based on a ``back-of-the-envelope'' calculation, Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc. in New York, wrote in a report last week. That will force banks, brokerages and hedge funds to cut lending by $2 trillion, he estimated.

Bill Yields

Merrill's MOVE index reached 112.08 on Nov. 9, the highest since Sept. 20, and was at 99.14 on Nov. 16. The gap between yields on three-month bills and the Fed's target rate widened to 1.25 percentage points, the biggest gap since Sept. 14. Bill yields fell as low as 3.16 percent on Nov. 15, near this year's low of 3.09 percent on Aug. 20.

For the first time since 2001, yields on Treasuries maturing from three months to 10 years are below the federal funds rate. Five of the past six times that has happened, the economy entered a recession, data compiled by Bloomberg show.

Most analysts don't expect a recession. After annual growth of 3.9 percent from July to September, the economy will cool to a 1.5 percent pace this quarter and expand 2 percent in the first three months of 2008, according to the median estimate of 72 economists surveyed by Bloomberg from Nov. 1 to Nov. 8. The Fed will cut its target to 4.25 percent next quarter and leave it there through 2008, a separate survey shows.

Faster Inflation

Faster inflation is making Bernanke's job tougher. Consumer prices rose at a 3.5 percent annual rate in October, the most in 14 months, the Commerce Department said Nov. 15. Crude oil soared 56 percent this year, reaching a record $98.62 a barrel. The dollar sank to a record low of $1.4752 per euro on Nov. 9 and import prices rose 1.8 percent in October, the most in 17 months, the Labor Department said.

``It seems like there's an awful lot of price pressures,'' said Jamie Jackson, who oversees government debt trading at RiverSource Investments, a Minneapolis firm that manages $100 billion of bonds. ``It's harder to be a credible inflation fighter if you ease into accelerating inflation.''

The Fed is done cutting rates and 10-year yields may reach 4.75 percent next quarter, Jackson said.

Futures traders are betting the slump in housing and losses in credit markets will reduce consumer confidence and trump the threat of inflation, which erodes Treasuries' fixed payments.

`Saving the Economy'

``The Fed will not only need to save the financial markets, in very short order they're going to have to start saving the economy,'' said Tom di Galoma, head of Treasury trading in New York at Jefferies & Co., a brokerage for institutional investors. The 10-year yield will fall below 4 percent by the end of June and two-year yields to 3 percent, he said.

Homebuilding declined 20 percent last quarter, the seventh straight drop, subtracting a percentage point from economic growth, government data show. The National Association of Home Builders/Wells Fargo may say today that its index of builder sentiment fell to 17 this month from an all-time low of 18 in October, according to the median forecast in a Bloomberg News survey. The index averaged 42 last year.

Plano, Texas-based J.C. Penney, the third biggest U.S. department-store company, cut its fourth-quarter profit prediction by as much as a third last week. Macy's, based in Cincinnati, lowered its fourth-quarter sales guidance.

``The Fed tends to be backward looking,'' said Lacy Hunt, chief economist at Austin, Texas-based Hoisington Investment Management Co., which is buying zero-coupon and 30-year Treasuries, the most bullish bets that inflation will cool. ``They're always looking at the way the world was, not the way it will be. Market rates reflect the buying and selling decisions of millions and millions of decision-makers.''

Hunt predicts the Fed may lower its target to 2 percent in the next few years.

Bernanke's new approach

Bernanke's Embrace of Forecasting Ends Greenspan `Decoder' Era

By Craig Torres

Nov. 15 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke's decision to publish more details about the outlook for economic growth and prices represents a break with the legacy of Alan Greenspan and the cryptic phrases he used to signal policy.

``If you haven't thrown out your Greenspan decoder ring by now, you should,'' said Ethan Harris, chief U.S. economist at Lehman Brothers Holdings Inc., a former head of domestic research at the New York Federal Reserve Bank. ``Ben Bernanke is a very straight shooter. He tells it like it is. There are no hidden messages.''

Bernanke said yesterday that Fed officials will add a third year to their forecasts and double the frequency to once a quarter. The reports will give investors and companies more details on why interest rates were adjusted and offer a map for where they are likely to go.

Analysis will shift to how the committee sees the outlook, away from trying to guess where the chairman stands, as was the case during Greenspan's 18 years at the helm, Fed-watchers said.

``He wants the committee to function like a committee,'' said former Fed Vice Chairman Alan Blinder, now a professor at Princeton University in New Jersey. ``He doesn't want to dictate.'' Greenspan declined to comment.

Bernanke's forecasting overhaul brings the Fed closer to international central-bank practices and comes at a time of diverging views between policy makers and investors.

Rate Expectations

Bernanke and other Fed officials have repeatedly underscored their confidence the economy will accelerate by mid- 2008 after a lull this quarter. That hasn't stopped traders from assuming the central bank will cut rates at least once more after lowering borrowing costs in September and October.

Futures markets show a 72 percent probability the Fed will cut the benchmark rate a quarter-point to 4.25 percent Dec. 11.

Bernanke, 53, took office in February 2006 having pushed for increased transparency when he served as a Fed governor. Yesterday's announcement was the product of his 1 1/2-year review of Fed communication, and it fell short of the formal inflation target that Bernanke advocated as an academic.

At the same time Bernanke spoke on the changes, the Federal Open Market Committee released a statement detailing the new practices, illustrating that the decision was made jointly among policy makers.

`Diversity of Views'

Bernanke praised the ``diversity of views'' among the 12 district-bank presidents and seven Fed governors, who discuss rate decisions at FOMC meetings. He said the range of opinions ``serves to limit the risk that a single viewpoint or analytical framework might become unduly dominant,'' a frequent criticism of Greenspan's chairmanship.

The Fed chief also took questions from the press after his remarks yesterday, another break from Greenspan, who avoided public exchanges with reporters.

In his speech, Bernanke framed transparency as critical to the central bank's ``democratic legitimacy'' with the public, Congress and financial markets -- constituents that critics say the Fed hasn't always served in a balanced way.

``If he wants to translate the dynamics of what makes the economy change in a language that ordinary people can understand, I think that is sensational,'' said William Greider, author of the 1987 book Secrets of the Temple, which described the Fed's secretiveness as ``the crucial anomaly at the very core of representative democracy.''

Greenspan Continuity

Bernanke did note continuity with Greenspan's incremental steps. The central bank first began announcing rate changes in 1994 and later issued statements after every meeting. Greenspan also oversaw a speeding up of FOMC meeting minutes releases, to a three-week lag instead of six.

The more-frequent outlooks will bring the Fed in line with the European Central Bank and counterparts in the U.K., Sweden and New Zealand, which publish quarterly projections. The Bank of Japan puts out a twice-yearly report.

Bernanke indicated yesterday was a first, not final, step in his efforts. The Fed still trails other central banks in openness in access to the media, as the Fed chairman doesn't give on-the-record interviews or press conferences.

Bernanke put Vice Chairman Donald Kohn, a former Greenspan adviser who was at odds with the chairman's views on the merits of inflation targeting, in charge of the communications project. The decision insulated the committee from the chairman's direct influence, with San Francisco Fed President Janet Yellen and the Minneapolis Fed's Gary Stern being the other members.

Forecast Dates

Fed officials will release their quarterly forecasts in minutes of FOMC meetings in January, April, June and October. The publications will include commentary on officials' thoughts about the risks to their projections, Bernanke said.

The first new predictions come Nov. 20, offering investors a glimpse of the Fed's most recent reading on the economy three weeks before it meets.

``This is depersonalizing monetary policy,'' said Vincent Reinhart, former director of the Fed's monetary affairs division, who worked with Bernanke on the plan and is now at the American Enterprise Institute in Washington.

``When he talks about the outlook, it is going to be the him talking about the committee's'' forecasts, he said, referring to Bernanke. ``Greenspan's testimony almost never referred to those numbers. It was his outlook.''

Fed signals higher interest rates after 25bps cut

Some BOJ Members Said Low Rates Caused Subprime Rout (Update1)

By Mayumi Otsuma

Nov. 5 (Bloomberg) -- Bank of Japan board members said the U.S. subprime mortgage collapse was caused by keeping interest rates too low, signaling their intention to increase the world's lowest borrowing costs to prevent investment bubbles.

Some of the nine members said a ``long period'' of global monetary easing had led to ``excessive financial behavior'' that resulted in the U.S. home-loan crisis, according to minutes of the Sept. 18-19 board meeting published today in Tokyo.

The Bank of Japan is concerned that keeping its key interest rate at 0.5 percent risks seeding future asset bubbles. The subprime crisis was caused in part by investors who wanted higher returns amid low global interest rates buying securities linked to loans to people with poor credit histories. Defaults on the loans caused a shortage of credit and led to losses at banks including Citigroup Inc. and Merrill Lynch & Co.

The Bank of Japan is saying ```look, the risks we're talking about, that's what hit the U.S.,''' said Jan Lambregts, head of Asia research at Rabobank International in Hong Kong. ``All good central banks are forward-looking but they're caught between the short-term circumstances and long-term risks.''

The central bank last week kept its benchmark rate on hold and cut its forecasts for this year's economic growth and inflation. Governor Toshihiko Fukui said ``downside risks'' for the Japanese economy are rising as U.S. growth slows and financial markets remain volatile.

`Not a Slogan'

Still, Fukui said last week that Japan's ``very low'' rates need to rise gradually as the economy expands. Failure to do so would encourage excessive investment that may lead to swings in economic growth, he said on Oct. 31.

``This is not just a slogan. We're serious about this view,'' he said.

Most members at the September meeting said they're watching the employment situation, home prices and banks' willingness to lend to determine the strength of U.S. consumer spending.

A few members said they need to carefully check whether financial markets and the U.S. economy will affect the bank's outlook for Japan's growth and inflation, the minutes show.

Policy makers at the meeting agreed on their basic view that Japan's interest rates need to be raised gradually according to developments in the economy and prices.

One member said the bank has time to examine the influence of financial-market turmoil and global economic growth on the Japan economy.

Another board member said the bank shouldn't hesitate to raise interest rates as long as it's confident Japan's economy will keep growing in line with policy makers' predictions.

Dollar Trades Lower on expectation of lower funds rate

Dollar Trades Near Record Low Versus Euro Before Fed's Meeting
By Stanley White and David McIntyre

Oct. 30 (Bloomberg) -- The dollar traded close to a record low versus the euro before U.S. reports that economists forecast will show declines in housing prices and consumer confidence.

Signs of economic weakness may bolster speculation the Federal Reserve will cut borrowing costs this week by more than a quarter-percentage point to prevent the biggest housing slump in 16 years from triggering a recession. The dollar is trading near an all-time low against a basket of six currencies.

``The dollar's downtrend seems entrenched for now,'' said John Horner, a currency strategist at Deutsche Bank AG in Sydney. ``The U.S. economy continues to slow and the Fed is likely to cut rates.''

The dollar traded at $1.4415 per euro at 9:18 a.m. in Tokyo from $1.4425 late in New York yesterday, when it reached $1.4438, the lowest since the European currency's debut in January 1999.

It traded at $1.0484 per Canadian dollar after touching $1.0509 yesterday, the weakest since 1960, and was at 92.27 cents per Australian dollar, after yesterday sinking to 92.72 cents, the lowest since April 1984. The U.S. currency was at 114.68 yen from 114.66.

The U.S. Dollar Index traded on ICE Futures U.S. in New York was at 76.88 after falling to 76.78 yesterday, the lowest since its inception in 1973. The index tracks the dollar against six major currencies including the euro and the yen.

Home prices in 20 U.S. metropolitan areas probably fell 4.2 percent in the 12 months through August, the most on record, according to the median forecast in a Bloomberg News survey. The S&P/Case-Shiller home-price index is scheduled for release at 9 a.m. in New York.

Consumer Confidence

The Conference Board may say today that its index of consumer confidence declined to 99 this month, the lowest since November 2005, from 99.8 a month earlier, according to a separate Bloomberg News survey.

The Fed cut its target rate for overnight bank loans by a half-percentage point Sept. 18 to 4.75 percent, the first reduction since 2003, after losses from subprime mortgage investments roiled credit markets.

Interest-rate futures traded on the Chicago Board of Trade show a 98 percent chance the Fed will lower the rate by a quarter-percentage point to 4.50 percent tomorrow. On Oct. 26, traders saw a 92 percent chance of a quarter-point cut this month and an 8 percent probability of a half-point reduction.

``A housing slump, exemplified by falling housing prices, will keep dragging down the U.S. economy and the dollar,'' said Kenichiro Fujita, manager of Aozora Bank Ltd.'s derivatives marketing group in Tokyo. ``This situation may continue for two or three years.''

The U.S. currency may fall to 113.70 yen today, Fujita said.

Gross on Fed

Bill Gross, manager of the world's biggest bond fund at Pacific Investment Management Co., wrote in a report published on the firm's Web site yesterday that he expects the Fed to lower benchmark interest rates to 3.5 percent to avoid a recession.

Gross, who manages the $106.5 billion Pimco Total Return Fund in Newport Beach, California, has predicted for more than a year that the Fed will lower rates in 2007.

A government report this week may show job growth is slowing. The U.S. economy may have added 80,000 non-farm jobs this month after an addition of 110,000 in September, according to the median estimate of economists surveyed by Bloomberg. The government reports the data on Nov. 2.

The European Central Bank will keep its key rate at 4 percent at a Nov. 8 meeting, according to the median forecast in a Bloomberg News survey.

Yen Gains Limited

Gains in the yen against the dollar may be limited by speculation the Bank of Japan will lower its economic forecasts in a semiannual report tomorrow after keeping rates unchanged.

The BOJ will keep its benchmark rate at 0.5 percent, the lowest among major economies, according to all 45 economists surveyed by Bloomberg News. The yen has slid against 14 of the 16 most-active currencies in the past year as speculators borrowed it to purchase higher-yielding assets in carry trades.

Yen Carry Trades

``Investors will continue to earn money on the yen carry trade,'' said Tsutomu Soma, a bond and currency dealer at Okasan Securities Co. in Tokyo. ``The BOJ may downgrade its economic outlook. There's no reason to buy yen.''

The central bank's semiannual outlook report, to be published at 3:30 p.m. in Tokyo tomorrow, will show the nine board members' forecasts for the economy and prices for the current fiscal year and the next.

Consumer prices excluding fresh food will be unchanged in the year ending March and rise 0.3 percent next year, according to the median estimate of 15 economists surveyed by Bloomberg News. The economy will expand 1.7 percent this year and 2.1 percent in the next, the survey shows. All estimates except for next year's growth are lower than the BOJ's April prediction.

The yen traded at 165.39 against the euro from 165.38. It may weaken to 165.70 and 115 against the dollar today, Soma said.

In a carry trade, investors get funds in a country with low borrowing costs and invest in one with higher interest rates, earning the spread between the borrowing and lending rate. The risk is that currency market moves erase those profits.

Expectations of lowering fed funds rates

Pimco's Gross Expects Fed to Cut Rates to 3.5 Percent (Update1)
By Deborah Finestone

Oct. 29 (Bloomberg) -- Bill Gross, manager of the world's biggest bond fund at Pacific Investment Management Co., expects the Federal Reserve to lower benchmark interest rates to 3.5 percent to avoid a recession.

More conservative lending practices stemming from investors' reduced willingness to fund risky loans will induce a ``noticeable slowdown'' in credit growth, though not an outright contraction, Gross wrote in a report published on the firm's Web site today.

The Fed's target for overnight loans between banks will have to fall enough that interest rates will be about 1 percent above inflation, he said.

``An increasingly recessionary looking U.S. economy will likely require 1 percent real short rates and 3 1/2 percent fed funds in order to stabilize a potential growth contraction in lending not witnessed since the early 1970s,'' Gross said.

Earlier this month, he said the central bank will likely cut borrowing costs to 3.75 percent in the next six to nine months.

Gross, who manages the $106.5 billion Pimco Total Return Fund, has predicted for more than a year that the Fed will lower rates in 2007. The central bank reduced rates in September for the first time in three years.

Futures traded on the Chicago Board of Trade suggest a 98 percent chance the Fed will lower rates to 4.50 percent at its Oct. 30-31 meeting. The odds on rates declining to 4.25 percent by the Dec. 11 meeting are 69 percent.

The last 5 years in perspective

Central Banks Are Suckers
03 September, 2007
The markets are in uproar and central banks are stepping in to try to bring about calm. But should they? Or should banks get their just punishment for wreckless lending? Dick Bove, an analyst with investment bank Punk Ziegel, thinks the market should be left to seek its own solution.

(The Banker) In the past five years, the debt markets worldwide have changed dramatically. These changes can be ascribed to a number of factors.

First, there has been a shift in the control of money. After the Second World War, the only convertible currency in the world was the dollar. Now that other economies have grown and gained in strength, numerous currencies are convertible, and the dollar, which was once 100% of the world’s money supply, may now only be 24% of the total.

Second, the persistent trade deficits suffered by the older industrial economies have resulted in a skewing of the growth of world money supply to the exporting, or newer, industrialised countries. Massive cash hoards built up in these nations as a result and a place needed to be found to invest this money.

At the same time, technology was improving. Fibre optic cable was being laid all over the world. Computing power was being increased. Two important results were that unusually complex calculations could be completed in seconds, and millions of tiny transactions could be handled accurately over global distances, also in seconds.

The pools of money and the improved technology led to an explosion in product development in the financial sector. New products, from commercial mortgage-backed securities to collateralised debt obligations, were developed.

The existence of such instruments spawned a new generation of money managers. Alpha investors promised that they could show a positive return under any set of market conditions. Funds fled from beta investors who only promised to match the markets to the new alpha investors.

These money managers benefited from the low interest rates prevalent across the globe. They borrowed money in huge amounts leveraging investor funds to maximise their returns.

The new markets proved to be more facile and less costly than the older regulated bank-operated financial systems. Therefore, the protections that once existed when banks loaned the bulk of the available funds were stripped away. The new loans did not have reserves set aside; they were not backed by capital; they were not audited by third parties; and they offered no lines of credit to borrowers to provide protection in case of economic reversals.

Freed from constraints, lenders ventured aggressively into the negative amortisations arena. Payment option adjustable-rate mortgages (ARMs) were provided to households that automatically provided the borrower with the ability to borrow their debt service payments. Payment-in-kind loans were provided to corporations and private equity funds so that if necessary they also could borrow their interest payments. The system went from demanding that borrowers pay back, to ‘evergreen’ type loans, to now paying the interest for the borrower under a negative amortisation scheme.

Driven by the desire to place the funds available to them, lenders stopped underwriting loans and they no longer demanded any meaningful risk premium for providing their funds.

Inevitable fallout

For years, this new system expanded. Fed with low-quality credits, debt instruments in the US economy grew at a pace roughly three times faster than the US economy in the past five years. Then the inevitable happened: income was not growing fast enough to make the debt service payments required on the new debt instruments.

Defaults proliferated at the low end of the household markets. Lenders began to realise that they had provided monies to fund the purchase of instruments that they did not understand; had not underwritten; and had not been adequately paid to purchase. They began to lose money. They panicked. Initially, they caused disruption in the commercial paper markets by refusing to roll over their holdings. Ultimately, they shook the banking markets by forcing banks to refund the money owed on the commercial paper.

Pressure was then placed on the world monetary authorities to bail out the profligate lenders and borrowers. Seven central banks responded with what may have been an injection of $500bn to the money markets, lower interest rates in some cases for loans, and easier repayment terms based on lengthened maturities.

No steps were taken to resolve the debt crisis created by greed, inappropriate lending and borrowing, and a systemic unwillingness to adhere to even the simplest disciplines for handling funds. Old Polonius would be clapping his hands with glee saying “I told you so”. (The Shakespearian character is famous for his line in Hamlet: “Neither a borrower nor lender be.”) Lenders and borrowers failed equally in their responsibilities.

Challenging times

While monetary authorities are providing funds now to stabilise the markets, even they must realise that they are contributing to a worldwide Ponzi scheme (a scheme that offers abnormally high short-term returns to entice new investors but which requires an ever-increasing flow of new investment to keep the scheme going). They are bailing out the miscreants. It is my belief that these authorities may be beginning to realise that their actions fall in line with 19th-century American showman P T Barnum’s maxim about what is being born every minute: “a sucker”.

Ultimately, the monetary authorities will pull back. The marketplace will sort out the good loans from the bad. There will be numerous financial failures as this occurs. The economy will slow down. New regulations will be developed for lending worldwide. Times will be challenging.

The Fed's moral hazard

Bernanke Stumped by Representative Ron Paul
Scott Reamer
Sep 20, 2007 3:57 pm

In today’s testimony before the house, Fed Chairman Bernanke was questioned by Representative Ron Paul in what was a remarkable exchange. Remarkable for how straightforward, lucid, and anti-statist the question was. In his questioning, Ron Paul stated:

“I want to follow up on the discussion about moral hazard. I think we have a very narrow understanding about what moral hazard really is. Because I think moral hazard begins at the very moment that we create artificially low interest rates which we constantly do. And this is the reason people make mistakes. It isn’t because human nature causes us to make all these mistakes, but there is a normal reaction when interest rates are low that there will be overinvestment and malinvestment, excessive debt, and then there are consequences from this. My question is going to be around the subject of how can it ever be morally justifiable to deliberately depreciate the value of our currency?”

His statements continued (about how much oil, gold, wheat, corn, etc. has gone up since the rate decrease) but the heart of his question was the following moral question: ...consciously depreciating the value of the USD has winners and losers (Wall Street/banks/the rich and everyone else), Mr. Bernanke. How do you constantly choose Wall Street over the rest of America?

You will not be surprised to know that B-52 Ben didn’t answer the question. He couldn’t answer the question (at least truthfully). Was he going to say that the Federal Reserve is a quasi-private institution whose prime directive is to cartelize and protect the profits of the banking industry? Was he going to say that the only policy the Fed knows is based on the flawed Keynesian logic that wealth can be created out of thin air via printing presses? Of course not.But his non-answer is not germane. The element that Ron Paul introduced is: the morality of the Federal Reserve’s constant injection of credit into the system at the slightest hint of macroeconomic distress. And I mean slightest: we haven’t even seen a GDP print below 0. We were only down 4.2% from the ALL TIME high in the Dow (the Fed’s own research suggests that the stock market is the best leading indicator of the economy).

Back in July of 2006, I wrote a piece introducing this moral element into the discussion of the Federal Reserve’s monetary policies. I wrote then words that today, after a pre-emptive, forestalling 50 basis points decrease and more than $1 trillion in worldwide central bank injections of credit, are as germane as ever:

“A constant loss of value in the monetary unit forces all manner of dire consequences on economic actors: it favors consumption over saving, speculation over investment, capital over labor, and the young over the old; it prevents accurate economic calculation about the future and thus clouds investment horizons; it hollows out a country's middle class making for more class conflict between haves and have nots… there are grave time preference consequences as well that impact not only long term investment projects (as noted above) but also the very manner in which parents raise their children and how children care for their ageing parents, as well as the lessons of frugality and hard work that once were the bedrock of this nation.”

Bravo to Ron Paul for giving voice to the hundreds of millions or pensioners, savers, working stiffs, poor, fixed income beneficiaries, laborers, gasoline-, bread-, milk-, and egg-buyers who weren’t able to ask Mr. Bernanke why he – like every Fed chairman before him since 1913 – screwed them for the benefit of the top 5% of the population of this country.

Interest rate futures show 72% odds of lower Fed Funds rate next week - How many understand Ben?

Dollar Trades Near Record Low Against Euro as Fed May Cut Rates
By Kosuke Goto and Ron Harui

Sept. 12 (Bloomberg) -- The dollar traded near a record low against the euro as investors bet the U.S. will lose its interest-rate advantage over Europe as the housing market slumps.

The U.S. currency is heading for the longest losing streak since April after the National Association of Realtors yesterday cut its home sales forecast for the ninth time this year, raising the odds the Federal Reserve will lower its key rate next week. The yen erased gains after Kyodo News reported Japan's Prime Minister Shinzo Abe offered to resign, citing officials from the ruling Liberal Democratic Party.

``Expectations of narrowing interest-rate differentials are underpinning the euro-dollar,'' said Michiyoshi Kato, a senior vice president of currency sales in Tokyo at Mizuho Corporate Bank Ltd., a unit of Japan's second-largest lender by assets. ``It will likely hit a record high of $1.39 today.''

The dollar traded at $1.3842 per euro at 1:31 p.m. in Tokyo from $1.3839 late in New York yesterday, within 0.2 percent of the all-time low of $1.3852 reached July 24. The dollar was at 114.31 yen from 114.27.

Abe is to meet the press at 2 p.m. local time, Kyodo said.

``Abe should have been depressed after a major defeat at national elections in late July and a series of his ministers resigning,'' said Toru Umemoto, chief currency strategist at Barclays Capital in Tokyo. ``The impact of this news on the dollar-yen should be limited as the market focus is now totally on subprime problems.''

The U.S. currency has declined 8.3 percent versus the euro and 10 percent against Australia's dollar during the last 12 months as the ECB and Reserve Bank of Australia raised rates to 4 percent and 6.5 percent respectively, while the Fed kept its overnight lending rate between banks at 5.25 percent.

Declining Home Sales
Against the dollar, Australia's currency rose to a one-month high of 83.49 U.S. cents from 82.68 cents late in Asia yesterday. New Zealand's dollar advanced to the strongest in about two weeks at 70.81 U.S. cents from 69.57 cents.

U.S. existing home sales will fall 8.6 percent in 2007, exceeding the 6.8 percent drop estimated a month ago. New-home sales probably will decline 24 percent on top of an 18 percent fall in 2006, according to the National Association of Realtors, which said the housing slump will extend into 2008.

The subprime-market turmoil is ``going to last,'' said Rachana Mehta, global bonds and currency strategist at DBS Asset Management Ltd. in Singapore. ``Toward the end of the year, I still expect the dollar to weaken.''

The U.S. currency may move between $1.35 and $1.40 per euro and 112 and 116 yen by year-end, Mehta said.

Contrasting Rate Outlook
Interest-rate futures show 72 percent odds the Fed will lower borrowing costs by half a percentage point to 4.75 percent next week. A month ago, traders expected a quarter-point cut.

By contrast, European Central Bank President Jean-Claude Trichet said there is a risk inflation will accelerate, stoking bets of another interest-rate increase this year from 4 percent.

Annualized euro region labor costs, an inflation indicator, are forecast to increase to 2.3 percent in the second quarter, according to a Bloomberg News survey of economists.

The euro may weaken against the yen on speculation Japanese investors are repatriating earnings from German debt holdings on concern the credit-market crisis will spread.

Germany is due to make more than 15 billion euros ($20.7 billion) in redemption and coupon payments on government bonds on Sept. 14, according to data compiled by Bloomberg.

``There seems to be some selling of euros for yen, which is related to the redemption of euro bonds at the end of this week,'' said Nobuaki Tani, a client manager of the Market Trading Office at Resona Bank Ltd. in Tokyo. ``This may weigh on the euro,'' pushing it down to 157.50 yen and $1.38 against the dollar today, he said. The euro last bought 157.96 yen.

Higher Yen Forecast
The yen also may rally on speculation the U.S. subprime- mortgage crisis will deepen, prompting investors to sell higher- yielding assets funded with Japanese loans, known as carry trades.

Japanese investors sold more foreign bonds than they bought for a third month in August, with net sales of 690.4 billion yen ($6.05 billion), data from the Ministry of Finance showed today. The yen rose 2.4 percent versus the dollar last month.

Bank of America N.A. raised its 2007 forecast for the yen to 117 against the dollar as Japanese individuals invest fewer savings overseas.
The yen has rebounded from a 4 1/2-year low in June to become the best performer among the 16 most-active currencies in the past month as falling stocks discouraged housewives, pensioners and businessmen from taking out loans to buy higher- yielding assets.
``Japanese investors' tolerance for risk is decreasing,'' Tomoko Fujii, head of economics and strategy for Japan at Bank of America in Tokyo, said in an interview today. ``Their courage for investing overseas isn't as strong.''

In carry trades, investors get funds in a country with low borrowing costs and invest in one with higher interest rates, earning the spread between the borrowing and lending rate. The risk is that currency moves erase those profits.

Fed's liquidity strategy to weed off foolish hedge funds and investors

Fed's Strategy of Increasing Liquidity Survives for a Third Day
By Craig Torres

Aug. 22 (Bloomberg) -- The Federal Reserve's strategy of increasing liquidity rather than resorting to a cut in the benchmark interest rate survived a third day.

Yields on Treasury bills rose yesterday after the New York Fed lowered the cost of borrowing securities from its own portfolio to ease a shortage in the market. The action followed a reduction in the Fed's rate on direct loans to banks on Aug. 17, the impact of which officials said they need time to assess.

Chairman Ben S. Bernanke wants to avoid an emergency easing of monetary policy, contrasting with predecessor Alan Greenspan, who cut the federal funds rate target three times in 1998 after the collapse of Long Term Capital Management LP. Richmond Fed Bank President Jeffrey Lacker said yesterday that policy must be guided by the outlook for economic growth and prices, not entirely by markets.

``We did use the fed funds rate and that may have been a mistake,'' said former Fed Vice Chairman Alice Rivlin, who voted for the 1998 rate cuts. ``It might have been smarter to try what they are trying.''

Lacker said in a speech to a conference in Charlotte, North Carolina yesterday that while the credit crunch and gyrations in financial markets has the potential to hurt growth, signs so far indicate business and consumer spending will continue.

In response to a question, Lacker also underscored the Federal Open Market Committee's determination not to insure poor investments with a cut in the federal funds rate.

`Our Responsibility'
``The Federal Reserve isn't responsible for the size of credit spreads,'' he said. ``We leave those to be market determined. Our responsibility and what we are capable of influencing on a sustained basis is inflation and growth.''

After the rate cuts in 1998, the economy strengthened and stock prices soared, Rivlin noted, leaving the Fed open to criticism that the reductions were a mistake. Rivlin is now director of the economic studies program at the Brookings Institution in Washington.

The Fed's current strategy showed some signs of success yesterday as yields on three-month Treasury bills climbed the most since 2000 and those on commercial paper backed by assets such as mortgages slipped.

The three-month bill yield increased 0.52 percentage point to 3.61 percent late yesterday as demand for the shortest-dated government debt waned. Top-rated asset-backed commercial paper maturing in one day yielded 5.92 percent, down from 5.99 percent, posting the first drop in three trading days.

``The flight to safety may be diminishing a bit,'' said Holly Liss, a bond saleswoman in Chicago at Citigroup Global Markets Inc. ``We're seeing more calming of the market as T-bill rates come back to normal.''

Jury Still Out
Lacker said the ``jury is still out'' on whether the Fed has done enough to improve trading in the $1.1 trillion market for asset-backed commercial paper.

Investors and economists still bet that Bernanke will have to reduce the benchmark lending rate between banks, now at 5.25 percent, by at least a quarter point on or before the Sept. 18 meeting.

``Financial volatility and the seizing up of credit markets raises the probability'' of a recession, said Steven Einhorn, vice chairman of New York hedge fund Omega Partners Inc. ``The Fed needs to be proactive and not wait.''

Einhorn said slowing inflation and growth of around 2 percent to 2.5 percent give the Fed room to cut interest rates.

`All of the Tools'
Senate Banking Committee Chairman Christopher Dodd said Bernanke agreed to use ``all of the tools at his disposal'' to restore stability in markets roiled by the subprime mortgage crisis. He added that he didn't ask Bernanke to cut the federal funds rate and that the Fed chief didn't pledge to do so.

Dodd, a Connecticut Democrat who is seeking his party's presidential nomination, said banks should take advantage of lower borrowing costs at the discount window. He spoke after meeting with Bernanke and U.S. Treasury Secretary Henry Paulson.

Yesterday, the New York Fed reduced the so-called minimum fee rate that bond dealers pay to borrow its Treasuries to 0.5 percent from 1 percent.

``We are doing it to provide additional liquidity to the Treasury financing market,'' said Andrew Williams, a spokesman for the New York Fed. He said the rate was the lowest in the history of the program, which has existed in its current form since 1999.

The central bank on Aug. 17 cut the so-called discount rate half a percentage point to 5.75 percent to direct more cash to companies starved for short-term financing while avoiding an emergency reduction in its broader lending-rate target.

Banks can borrow at the discount rate with a wide variety of collateral, including everything from mortgages -- the market that sparked the credit crunch after defaults rose to the highest in five years -- to municipal bonds.

Lacker told risk managers yesterday that the Fed's district banks would even accept boat loans as collateral. It's up to the banks to establish a value for the assets as they make the loan, he said.

Market expects Fed Funds rate to be cut to 5%

U.S. Three-Month Treasury Bill Yields Climb Most Since 2000
By Deborah Finestone and Elizabeth Stanton

Aug. 21 (Bloomberg) -- Yields on U.S. three-month Treasury bills climbed the most since 2000 as demand fell for the safest government securities.

Bill yields rose for the first day in six, after tumbling yesterday by the most since 1987. The Federal Reserve Bank of New York cut the fee bond dealers pay to borrow its Treasuries, in a bid to ease a shortage in the market for loans backed by the securities. Demand at the Treasury's sale today of $32 billion in four-week bills was the weakest since at least July 2001.

``The flight to safety may be diminishing a bit,'' said Holly Liss, a bond saleswoman in Chicago at Citigroup Global Markets Inc. ``We're seeing more calming of the market as T-bill rates come back to normal.''

The three-month bill yield climbed 0.48 percentage point to 3.57 percent at 4:28 p.m., rising for the first day since Aug. 13. The increase is the biggest since Dec. 26, 2000. Yields fell 0.66 percentage point yesterday, the most since the stock market crash of October 1987 as money-market funds dumped asset-backed commercial paper for the shortest-maturity government debt.

The Treasury today sold $32 billion of four-week bills, the largest amount since at least July 2001. The bills were sold at a high discount rate of 4.75 percent. The one-month bill yield fell as low as 1.272 percent yesterday, and was about 2.6 percent before the auction. In a sign of weak demand, the government received $1.11 in bids for each $1 sold, the lowest since at least July 2001.

Fed Cuts Fee
The New York Fed cut its so-called minimum fee rate to a record low 0.5 percent from 1 percent, saying in a statement that the move is ``temporary.''

``We are doing it to provide additional liquidity to the Treasury financing market,'' said Andrew Williams, a spokesman for the New York Fed. He said the rate was the lowest in the history of the program, which has existed in its current form since 1999. The New York Fed last lowered the fee rate on June 26, 2003, the day after policy makers cut their target overnight rate to a four-decade low of 1 percent.

The yield on the benchmark two-year note fell to a 23-month low today before Senate Banking Committee Chairman Christopher Christopher Dodd said Fed Chairman Ben S. Bernanke agreed to use ``all of the tools at his disposal'' to restore stability in financial markets roiled by the subprime mortgage crisis.

The senator addressed reporters after meeting with Bernanke and Treasury Secretary Henry Paulson in Washington today.

`Right Direction'
``The comment from Dodd and the decision from the Fed are all going in the right direction to bringing some calm back to the financing market,'' said Nicolas Beckmann, co-head of U.S. interest rates trading at BNP Paribas Securities Corp. in New York, one of the 21 primary securities dealers that trade with the Fed.

Two-year note yields fell 6 basis points to 4.02 percent. The price of the 4 5/8 percent security due in July 2009 rose about 1/8, or $1.25 per $1,000 face amount, to 101 3/32. The yield earlier touched the lowest since September 2005. The 10- year note yield declined 4 basis points to 4.59 percent.

``Bonds are in favor largely around anticipation the Fed will make some accommodation,'' said Kevin Giddis, head of fixed- income trading in Memphis, Tennessee, at Morgan Keegan Inc.

On Aug. 17, the central bank cut the rate it charges for direct loans to banks by 0.5 percentage point to 5.75 percent. It was the first reduction in borrowing costs between scheduled meetings since 2001. The central bank said in a statement that risks to the economy have risen ``appreciably.''

The Fed has kept its key monetary policy tool, the target for the overnight lending rate between banks, at 5.25 percent since June 2006.
Interest-rate futures show traders are betting the Fed will lower its overnight lending rate between banks this month. Traders see a 100 percent chance of a quarter-point cut to 5 percent, and a 51 percent chance of a half-point cut, according to the August futures contract.

Retrospection - Fed's decision to keep rates at 5.25%

Fed Gives Weak Nod to Growth and Credit Risks: Caroline Baum
By Caroline Baum

Aug. 8 (Bloomberg) -- Fed to market: You made your bed, you lie in it.

That was the essence of the Federal Reserve's message yesterday when it left its benchmark lending rate unchanged at 5.25 percent and said inflation remains the ``predominant policy concern.''

Ever since the stock market started to get wobbly in late July, with losses in the Dow Jones Industrial Average exceeding 200 points some days, interest-rate futures markets got it in their head that Fed Chairman Ben Bernanke was going to bail them out.

The message yesterday was: Not so fast. Policy makers gave the weakest possible nod to the volatility in the markets and ``tighter credit conditions for some households and businesses'' without tipping their hand, or their risk assessment, away from inflation.

In the Fed's view, the ``downside risks to growth have increased somewhat'' as the housing correction continues. Inflation in goods-and-services prices is still more troubling than deflation in asset prices (specifically housing). The decline in nationwide home prices has been mild to date, but it is certain to accelerate as the bloated supply of unsold homes comes face to face with reduced demand, with credit-tightening shutting some borrowers out of the market.

The first reaction to the Fed's statement at 2:15 p.m. New York time was to sell. The prices of stocks, bonds, gold and interest-rate futures all went down initially as the Fed failed to corroborate the view that the economic environment was deteriorating rapidly.

Antidote
Until now, ``the Fed has been pretty good at describing the theme people were sensing,'' said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. in New York. Yesterday's statement ``is out of character with the reality as we know it.''

That doesn't mean the Fed is living in a parallel universe. Policy makers have to differentiate between a financial-market event and a macroeconomic one. For the moment, they have determined that the weakness in residential real estate, the widening of credit spreads and tighter lending standards aren't a threat to economic growth.

The ``cure'' for a period of excess credit is credit restraint: from the Fed; from mortgage lenders, who are faced with rising delinquencies and increased foreclosures on the part of subprime, and now prime, borrowers; and from investors, who are suffering losses on opaque collateralized mortgage and debt obligations that were supposed to diffuse the risk of the underlying loans.

Tainted Inheritance
Bernanke inherited the housing bubble from predecessor Alan Greenspan, who seemed to be rewriting history and offloading some of the blame in yesterday's Wall Street Journal. (Greenspan's greatest problem right now is that his soon-to-be-published memoir, ``The Age of Turbulence,'' may arrive just as the foundation is collapsing.)

He also inherited an institutional burden from his predecessor. Greenspan has been accused of creating a moral hazard, or encouraging risky behavior by putting a floor under the stock market (the ``Greenspan put'').

It may well be that the current Fed chief needs to expiate the sins of the father. Bernanke earned himself the moniker ``Helicopter Ben,'' early on -- unjustly, in my view -- when he compared the Fed's money-creation process to a chopper dropping dollars from the sky.
That's right out of the Milton Friedman teaching toolkit. When was the last time anyone accused the University of Chicago economist and Nobel laureate of fanning inflation?

Base Case
For what it's worth, the Fed's provision of credit, or high- powered money, has slowed to a crawl. The monetary base, which includes currency and bank reserves, grew 2.1 percent in July from the same month a year earlier, according to the St. Louis Fed's database. That's less than the inflation rate. As recently as last year, base money was still growing in excess of 5 percent annually.

There has been some suggestion -- accusation, really -- that the current Fed board is populated with academics (Bernanke along with Fed Governors Frederic Mishkin and Randall Kroszner), and that academics lack Greenspan's innate instincts about the market.
Maybe. Not all of his gut reactions were good ones, however. Greenspan lowered the federal funds rate three times in the fall of 1998 to counter the ``seizing up'' of financial markets in response to the near-collapse of hedge fund Long-Term Capital Management.

The economy didn't miss a beat. Greenspan waited until May 1999 to remove that stimulus. In the meantime, the Nasdaq Composite Index was well on its way to an 86 percent gain for the year.

Gut Check
Greenspan was slow to cut rates when capital spending was imploding in 2000, then did so with a vengeance in 2001. The overnight rate was still at 1 percent when the economy was taking off. Real gross domestic product grew at a 7.5 percent annualized rate in the third quarter of 2003, the start of a three-year trend of strong growth. Yet Greenspan took his time moving the funds rate back to a neutral level.

The Bernanke Fed, with its model-driven forecast, may turn out to be wrong in its laissez-faire attitude toward tightening credit conditions. It will come to that decision in its own way in its own time.

The inverted yield curve, with long-term rates below the Fed's policy rate, has been signaling for almost a year that the Fed is holding the funds rate too high. That disequilibrium is always resolved in favor of lower short-term rates.

I doubt this time will be different. It never is.

Fed Keeps Rate at 5.25%

Fed Keeps Rate at 5.25%; Inflation Is Main Concern (Update6)
By Scott Lanman

Aug. 7 (Bloomberg) -- The Federal Reserve, keeping interest rates unchanged, said inflation is still the biggest danger to the economy and that the six-year economic expansion won't be undone by ``tighter'' credit conditions.

``Although the downside risks to growth have increased somewhat, the committee's predominant policy concern remains the risk that inflation will fail to moderate as expected,'' the Federal Open Market Committee said today after meeting in Washington, where it left the benchmark rate at 5.25 percent.

Some investors read the remarks to mean that Chairman Ben S. Bernanke won't rush to cut rates in response to a rout in the subprime mortgage market that's prompted lenders to restrict borrowers' access to credit with higher rates and fewer downpayment concessions. The world's largest economy will survive the tumult, the central bank added.

``Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing,'' the Fed said. ``Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.''

Traders pared bets on the chance the Fed will lower rates in the next few months, according to futures prices on the Chicago Board of Trade. The Dow Jones Industrial Average fell in the minutes after the decision, before rebounding. The Dow rose 35.52 points to 13,504.30 and the dollar strengthened against the euro. Treasury notes declined, sending yields on benchmark 10-year notes to 4.78 percent, from 4.74 percent late yesterday.

`Sticking to Guns'
``They are sticking to their guns,'' said David Kelly, an economic adviser at Putnam Investments LLC in Boston, which manages $193 billion in assets. ``They think the economy is fundamentally healthy and it will get through the credit-market issue. They don't want to do anything to panic.''

Several economists predicted the Fed would say risks were balanced between prices and slacker growth, foreshadowing a possible rate reduction.

``A sustained moderation in inflation pressures has yet to be convincingly demonstrated,'' the FOMC said, repeating a sentence from the last statement on June 28.

The mention of inflation as the ``predominant'' concern has appeared in each Fed statement since March and meeting minutes starting with last December's session.

The Fed statement comes less than three weeks after Bernanke delivered semiannual testimony to Congress, an event that usually sets the tone of central bank discussions for several months. He told lawmakers on July 18 and 19 that U.S. economic growth would pick up ``a bit'' and inflation recede.

Shift in Sentiment
Investor sentiment has shifted since benchmark stock indexes reached records in mid-July. The Standard & Poor's 500 Index dropped 5.7 percent from its all-time high on July 16 through yesterday.

The culprit: subprime mortgages that customers have been unable to repay, making securities linked to the loans less attractive. At Bear Stearns Cos., where two hedge funds failed in June, the firm's chief financial officer said Aug. 3 that the fixed-income market is in the worst shape in 22 years.

At least 70 mortgage firms have halted operations, gone bankrupt or sought buyers since the start of 2006. In addition, lenders such as Wells Fargo & Co. and Wachovia Corp. are raising rates and imposing stricter standards on some of their most creditworthy borrowers.
The Fed may be reluctant to reduce its benchmark interest rate, though, unless officials see inflation as under control.

Productivity
Slower productivity growth may boost inflation because it means companies have less cushion to absorb wage increases without raising prices. A government report today showed productivity rose at an annual rate of 1.8 percent in the second quarter, less than the 2 percent gain expected, based on the median forecast in a Bloomberg News survey.

Price increases have slowed for four straight months under the Fed's preferred gauge, which excludes food and energy costs. The core personal consumption expenditures price index rose 1.9 percent in June after a revised 2 percent gain in May, the Commerce Department said July 31.

The government also said on July 27 that the U.S. economy expanded at a 3.4 percent annual pace in the second quarter, the fastest in more than a year, after a revised gain of 0.6 percent in the three months ending March.

Economists and Fed officials anticipate a slacker expansion in the second half. For the year, Fed governors and presidents expect growth, on average, of about 2.25 percent to 2.5 percent, Bernanke told Congress last month. The projections are about a quarter-point below the previous round in February, mainly because of the weakness in homebuilding.

Consumer spending, which Bernanke said last month was ``likely to continue growing at a moderate pace, aided by a strong labor market,'' is showing signs of slowing. Auto sales last month were at their lowest July level in nine years. In addition, job growth slowed and the unemployment rate inched up to 4.6 percent, tying the highest rate since last August.