Is the Fed Ahead of the Curve?

The overwhelming sentiment of popular market pundits is that the Fed is out of touch and "behind the curve."  (One of our hopes for 2008 is that writers will find some other phrases to describe this tired sentiment).

Other Expert Views

Fed policy has an effect with a lag.  One way of examining this is to compare Fed action now with policy in past possible recession situations.  This method is not used by those pundits whose overconfident view of the future leads them to data supporting what they already see as inevitable.

An interesting contrast is to look at observers who do make this comparison.  Two of the very best in recent years have been Dick Green, the CEO of, and David Malpass, Chief Global Economist for Bear Stearns.  At "A Dash" we have frequently cited their comments.

Dick Green of has a consistent and sensible approach, that has demonstrated accuracy over several years.  He writes as follows:

Enough data is now in to state conclusively: fourth quarter GDP will post a
solid gain.  That means the Bernanke Fed began cutting interest rates well ahead
of significant economic weakness.  Their early action will help prevent

Green goes on to explain the basic rationale (but follow the link to read the entire article):

The Bernanke Fed has therefore cut the fed funds rate target from 5.25% to
4.25% even as real GDP growth was up at a 5% annual rate in the third quarter
and a 2% annual rate in the fourth quarter.

Furthermore, the Bernanke Fed has taken strong efforts to provide liquidity
to the banking system to address the problems in the credit markets.  This is
now starting to pay off.  Credit growth has continued, as evidenced in the weekly H.8 data,
and now the prices of mortgage-backed securities appear to be stabilizing, as
reflected in the ABX
derivatives contracts

David Malpass has a similar view, with similar reasoning.  Malpass still sees slowing growth, but rejects the notion of a housing-led recession.  His recession odds have been lowered to 20% (which is actually the long-term average for a given year).  Malpass wrote on December 21st (you need to be a customer to get this) as follows:

We think the Fed has been unusually proactive – it is now probably at or close to the end of its rate cuts, and will try to use other confidence-building techniques going forward. We think an expression of interest in a stronger dollar would be the most useful, but is unlikely.

This shows his view of the economy, but those wanting more rate cuts will find it discouraging.  Malpass explains his reasoning:

We think the Fed has been distinctly more proactive than in past slowdowns. The Fed maintained high interest rates until the brink of recession in 2001 (Fed funds at 6.5% in early January 2001 with recession starting in March 2001) and into the recession in 1990 (Fed funds steady at 8% through October 1990, even though the recession started in August.)

The Fed acted earlier this time, and is also using innovative methods like the TAF auctions.

Many bears highlighted Malpass when he became more pessimistic earlier this year.  Doug Kass, for example, called Malpass a "must-read."  We are waiting to see what Doug and others say about Malpass’s latest perspective.

Our Take

The assessment of recession prospects and the Fed reaction has been one-sided.  Whether one reads the mainstream media, blogs, or watches financial television, the popular comment is that the Fed has not acted quickly enough. (If only we could collect royalties on "behind the curve.")

At "A Dash" we have tried to emphasize that the Fed is attempting some creative tools in addition to cutting interest rates.  Meanwhile, those who have long-standing recession predictions appear to be wrong once again this quarter.

There should be a statute of limitations on these forecasts.  The key question for the investor and trader alike remains how much of the "baked in" earnings discount from a recession will actually occur.


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  • Karl Smith December 26, 2007  

    I think the Fed is in rough position and that where there have been mistakes it has mainly been on the public relations front.
    This Fed has taken a more academic approach in its interaction with the financial community, unlike the Greenspan Fed which was somewhat more paternalistic.
    While I think thats good in theory, pun intended, I don’t think the community has digested it well. Sentiment matters. Or if you want to be more econ nerdy, expectations matter. If I believe that the Fed will make the problem go away that lowers real risk spreads and in and of itself can reduce the problem.
    That allows the Fed to hold back its firepower for when things really start to look ugly, while at the same time hedging the inflation risk.
    So, that in a nutshell is my concern over fed communications. Other than holding in Oct and then cutting 50 bps in Dec (which is arguably more behind the curve) I agree with the policy.

  • shrek December 26, 2007  

    The fed has realized that the amount of credit expansion the last couple years is not sustainable at any interest rate. The best course is try to manage the downturn as best as they can and provide liquidity as best they can. If you are bullish you have to believe that the credit system is going to go into orbit again sometime in the next couple of months. I dont see it happening.

  • Jeff Miller December 26, 2007  

    Karl – Thanks for your sharing your thoughts. It is especially important for our readers to hear thoughtful perspectives. As a faculty member in an inter-disciplinary program you get daily exposure to a range or well-informed opinions. I miss those days!
    I believe that the Fed thought they were making timely statements, but I guess that shows a lack of feeling for the markets.
    Thanks for your comment.

  • Jeff Miller December 26, 2007  

    Shrek – When you talk about credit expansion over the last couple of years, what measure are you using?
    I think that there are many misperceptions about the money supply and various measures. I am planning a few pieces on that theme, and I hope you will continue to comment.

  • Tulip Kweli December 26, 2007  

    Nope. They use the Taylor rule. (The linear equation that a 9th grader knows how to use.)

  • Bill aka NO DooDahs! December 27, 2007  

    9th grader in which country? LOL!

  • Rob December 27, 2007  

    “If I believe that the Fed will make the problem go away that lowers real risk spreads and in and of itself can reduce the problem.”
    Karl, what are you trying to say here? I think you’re saying “If the Fed is successful, as I believe, that lowers real risk spreads, and in…” If this is what you meant, why do you believe that–how would the Fed affect that? Do you think they’ve already pulled all the levers they need, or are you anticipating further action (either traditional or something like the recent auction)?
    Great site Jeff, it’s my homepage now (switched from doom and gloom [and liberal] Barry Ritholtz, then switched again from Don Luskin). None of us are perfect thinkers, and I appreciate your skepticism.