Commentary by Caroline Baum
-- The Federal Reserve defied market expectations amid a Category 4 hurricane on Wall Street and widespread flooding on Main Street, holding its benchmark overnight rate at 2 percent.
Whether it turns out to be the right decision in the long run, it was the Fed's, not the market's, to make.
Before the Fed comes under attack -- it's already starting - - for being out of touch and causing Great Depression II, a review of recent history is in order.
It was only three months ago that the collective wisdom of the market anticipated a 75-basis-point increase in the Federal Reserve's benchmark rate by year-end. Inflation was heading higher, policy makers were talking tough, and unless the central bank atoned for the error of its ways and corrected the negative real interest rates, the U.S. was destined to repeat the 1970s.
By early September, expectations for rate increases had evaporated. Stasis, always an uncomfortable place for bond traders, was short-lived. The fed funds futures sashayed in the opposite direction.
As this week got under way, Lehman Brothers Holdings Inc. filed for bankruptcy, Merrill Lynch & Co. leapt into the arms of Bank of America Corp., and American International Group Inc. was scrounging for an emergency loan. The changing financial landscape changed expectations again.
Financial futures contracts were quick to price for a 25- basis-point rate cut at yesterday's meeting. Some economists called for a 50-basis-point reduction in the federal funds rate, which has been at 2 percent since the end of April. A few said the Fed couldn't wait for the meeting and had to cut immediately. The future was looking like 1929, not 1970.
Quantity, Not Price
Yesterday, with stock markets around the world tanking, AIG gasping for air, central banks pouring in liquidity to prevent interbank lending rates from rising further, the Fed demonstrated that it was not in the market-appeasement business.
Why lower the fed funds rate? Banks and a select group of non-banks can borrow at the Fed's come-one-come-all discount window at a cut-rate price of 2.25 percent. The quantity is unlimited. The quality of the securities that the Fed accepts as collateral has gone down. And price isn't the issue.
This is about the availability of credit, or, in this case, the lack thereof. The Fed is trying to address the private sector's tightening of credit with several ``enhancements'' to its alphabet soup of liquidity facilities.
Last weekend, the Fed announced it was expanding the range of collateral it will accept on overnight loans at the Primary Dealer Credit Facility (PDCF) to include equities and non- investment-grade debt, or junk by any other name. Previously, the collateral had to have an investment-grade rating.
More Better
The eligible collateral for the Term Securities Lending Facility (TSLF) was expanded from AAA-rated to investment-grade debt.
The Fed upped both the size and frequency of its TSLF auctions. It pumped a combined $120 billion into the money markets on Monday and Tuesday to address the spike in the interbank lending rates.
A reduction in the federal funds rate isn't going to convince stock market investors that financial companies have properly accounted for their losses. (It wouldn't have the impact, say, of the prospect of a Fed loan package for AIG.) It isn't going to help reduce inflation, which is running well above the Fed's comfort zone and still a concern to policy makers, according to the statement released at the conclusion of yesterday's meeting.
And it isn't going to boost the U.S. dollar, which has been rallying for two months.
Yield Curve Relief
The one thing it will do is ``steepen the yield curve,'' says Paul Kasriel, chief economist at the Northern Trust Co. in Chicago.
Before the Fed announcement, the two-year Treasury note was trading at 1.7 percent. With the funds rate at 2 percent, ``it's hard to make a profit no matter how much volume you do,'' Kasriel says.
And who knows? The drop in two-year note yields might have matched any cut in the funds rate, keeping that spread constant.
The good news is that intermediate and long-term Treasuries offer a positive spread over the funds rate. By borrowing from the Fed and buying risk-free Treasuries, banks ``can earn the spread, improve their profits and build capital,'' Kasriel says. Treasuries aren't subject to the same risk-based capital requirements as private securities.
The positively sloped yield curve provided a way out of the 1990s savings and loan crisis. And it will do the same this time around, too -- slow, arduous process that it is.
Sept. 24 (Bloomberg) -- Shoichi Nakagawa, Japan's third finance minister in two months, will likely back an increase in spending and cut taxes to ``jump start'' the economy, signaling the first policy shift in two years.
Nakagawa, 55, a former policy chief of the ruling Liberal Democratic Party, will replace Bunmei Ibuki, 70, after parliament approves Taro Aso as prime minister later today, said a ruling-party lawmaker briefed on the appointment.
Japan will be the ``laughing stock of the world'' if it prioritizes debt reduction when the economy is on the verge of a recession, Nakagawa wrote in the Yukan Fuji newspaper on Sept. 5. His appointment signals Japan's first shift in economic policy since 2006, when then Prime Minister Junichiro Koizumi set a goal of balancing the budget by 2011.
``Japan is now shifting to focus on boosting the waning economy,'' said Masamichi Adachi, a senior economist at JPMorgan Chase & Co. in Tokyo. ``Japan's structural reform, including balancing the budget, is set aside.''
The yield on the benchmark 10-year bond rose 1.5 basis point to 1.495 percent at 12:43 p.m. in Tokyo. The yield on the five-year note rose to 1.085 percent.
``We expect a shift to expansionary fiscal policy centered on tax cuts, with structural reform on the back burner until the economy returns to cruising speed,'' said Tetsufumi Yamakawa, chief Japan economist at Goldman Sachs Group Inc., wrote in a report. ``The market's judgment on Aso-nomics will depend largely on the details of fiscal expansion and its funding.''
Former Banker
A graduate of Tokyo University and a former banker at the Industrial Bank of Japan Ltd., a predecessor of Mizuho Financial Group Inc., Nakagawa represents a constituency in Hokkaido, Japan's northernmost island. He served as trade minister and agriculture minister under Koizumi.
``We're not in a situation where we can stick to the goal of restoring a primary surplus by fiscal 2011,'' Nakagawa wrote in the Yukan Fuji newspaper this month. ``If the surplus is attained at the expense of the Japanese economy sinking, we'll be the laughing stock of the world.''
``We need fiscal stimulus, including the reintroduction of income-tax breaks, lower corporate taxes and other economic measures that will jump start the Japanese economy,'' he wrote.
Nakagawa recommends cutting company tax to about 30 percent from 40.7 percent, the highest among Organization for Economic Cooperation and Development nations.
``Even if tax revenue falls in the near term, a tax cut may help revitalize business activity and eventually lead to a rebound in tax receipts,'' Nakagawa said in an interview in August.
``The issue of lowering corporate taxes to increase companies' competitiveness as the population shrinks is unavoidable,'' said Kyohei Morita, chief Japan economist at Barclays Capital in Tokyo. ``This appointment may make that implementation easier.''
Party Survives
Nakagawa may have to wait to see if his party survives a general election that may be held as soon as next month before implementing any policy. Ichiro Ozawa leader of the Democratic Party of Japan, is hoping to kick Aso out of power by capitalizing on the party's dwindling ratings among voters.
Nakagawa is married with two children. His hobbies include reading, tennis and gardening, according to a profile on his Web site.
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