A year ago there was general worry amongst the investment community that the Fed was keeping rates too low. Inflation expectations were high, commodities were soaring and the stock market was performing well - capital was easily accessible. The Fed and other central banks insisted that their main goal was price stability, they were concerned about inflation, but maintained that risks existed to both sides.
Then 2008 came around and within a few months the Fed was criticized for not cutting fast enough as housing prices started to collapse. At that point, the Fed was criticized from both sides for all the wrong reasons. Raise rates to fight inflation! Cut rates to save the housing market! While the second may seem more accurate in hindsight, those calls were largely made by those who benefit from lower rates, not people who saw credit violently contracting. The Fed ultimately started to cut, under extreme criticism from the dollar bears. They also experienced criticism from the market bears who wanted to see more action.
Looking back the Fed made some really good decisions. Interest rate volatility was kept to a minimum and the message was as consistent as anyone could have expected given the severity and the time-frame in which this crisis occurred. Compare that to Australia who saw a reverse V shape in their interest rates as they battled inflation earlier this year. On top of all of the structural reasons for dollar strength, I believe that this minimal volatility instilled some confidence in the Fed and hence the dollar.
Today’s (Thursday) Interest Rate Action
Today we saw:
- BOE cut a massive 150bps from 4.5% to 3%. A 50bps cut was expected but many large players expected 100bps.
- SNB had an unexpected rate cut of 50bps
- ECB cut 50bps as expected
Inflation vs. Deflation
Ah, the question I have been tackling for months.
There is a large concern that all of these rate cuts are very inflationary but we are hearing lots of reassurance from officials stating that their respective central banks are focusing on price stability. They argue that they are not reacting to market movements but rather the change in the level of prices and future price expectations. That’s a scary thought if it is indeed the case that they are not supporting the market and are THAT worried about global deflation. Nouriel Roubini believes that these actions will be anything but inflationary. But is the market buying into it?
The answer is a resounding YES! Take a look at commodities with crude leading the way. Take a look at Gold and Silver. Take a look at TIPS. Take a look at equity markets that continue to deflate.
We return to the question of this credit finding its way to the private market, something that isn’t happening. While interbank lending spreads have come down recently, banks are still either unable or unwilling to pass on the lower rates to consumers. Government officials are starting to get angry. From the UK, to Europe, to the U.S and Canada, government officials are doing whatever they can to encourage banks to lower rates - everything short of forcing them to do so. During times of crisis the pendulum usually swings to over regulation, could the government go so far as to take control of mortgage and credit card rates? That’s very unlikely because it would cause bank failures to rise significantly, but its not like regulators have never made similar mistakes in the past.
As Roubini points out, it is unexpected inflation that really hurts the market. If inflation were to emerge over the next 6-12 months it would be disastrous. The risk does exist, but the odds are on deflation. Over the next 12 months we are likely to see companies continue to sell assets to fix their balance sheets. They will also be conservative on CAPEX and M&A will continue with an emphasis on cost cutting synergies. Consolidations will continue. Those such as CAW chief Ken Lewenza are fighting losing battles. He’s against the GM-Chrysler merger because he is worried about how many jobs will be lost in the short run, while the real issue at hand is if ANY jobs can be saved in the long run. Anyone who knows me knows my position on the destructive characteristics of unions - but I digress…
There is capital out there, but it’s scared. There is a lot of real capital that will enter the market long before borrowed money will reign again. For this reason and the others mentioned, these rate cuts do indeed appear to be price stabilizing and not expansionary, hence not inflationary. I expect velocity of money to fall below 2003 levels.
While the risk of inflation is low in terms of probability, the risk is high in terms of the asymmetry of the payoff. Unexpected inflation can be dangerous and can occur quickly. That being said, rates cannot go below 0 and if deflation continues with 0% nominal rates, that is the greater risk to the economy. The central banks are acting appropriately given the current circumstances.