What to Expect from the Fed

Tomorrow's Fed announcement should not be much of a surprise in terms of the fed funds rate.  What is at issue?

There is a cacophony of complaints about debt.  A Google search on "Fed printing money" gets 34 million hits.  Wow!

In any public policy issue there is an easy side — simple to explain, playing to predispositions — and a tough side.  The tough side generally requires open minds, education, and some analytical skill.

When we made the transition from the academic world to financial markets, a key attraction was exploiting bogus investor fixations.  We have learned that it works extremely well in the long run….

The "Easy Side" of Fed Policy

The easy to understand part of Fed policy is that they are doing a lot of lending, accepting more varied collateral, and greatly expanding the monetary base.

There are some who believe that these policies have already put the US on the path to disaster.  Since other central banks have pursued similar policies, it is seen as a world-wide blunder.  It is pretty easy to criticize from the layman's perspective.

Here is an interesting challenge for the pundits taking this viewpoint.  Let them step up to a blackboard, give them a piece of chalk, and present a tiny Econ 101 problem.  It is too bad that this test is not required before blogging.  The result would be a revelation to most of their readers.

We see this viewpoint represented mostly by self-styled economic experts who take a very one-sided view of the problem.

The Tough Side to Explain

The first aspect of understanding Fed policy is realizing that much of the policy action from the past year is substituting for private lending that seized up after the fall of Lehman.  The Fed stepped in to restore what we call "normal and sensible lending."  After Lehman, many businesses could not get routine commercial loans against inventory or receivables.  Banks did not trust each other.  Hedge funds pulled accounts.

We got a quick look at what would happen if we went from excessive leverage to zero leverage in a heartbeat.

Lending ceased.  CEO's cut costs, laying off workers.  Everything got worse, much worse, and it happened very quickly.  Instead of a depression, we had some world-wide leadership that took us back from the brink.

So where are we now?  Here is what you probably do not know.

The extraordinary additions to the monetary  base have not increased the monetary supply.  Here is a nice article from Business Week, Shrinking Money Supply Dampens Inflation Fears.

This is a key quote from author Peter Coy (but read the full article, nicely done):

The Federal Reserve
stands accused of risking high inflation by recklessly printing too
much money. But as Fed rate setters meet in Washington on Sept. 22-23,
they won't see an excess of money sloshing around. Just the opposite.
Paradoxically, the latest statistics show a shrinkage in the broadest
measures of money.

Investors need to understand that the increase in the monetary base, which is still lower than when Obama took office, has not increased the money supply.  The problem is the velocity.  The additional liquidity has not really stimulated a lot of lending.

For those who would rather watch a video, here is the excellent observation from Bob McTeer.  This is insight from an experienced expert and one dedicated to free markets.  In spite of interruptions from the others in the interview, he calmly explains that the Fed should signal the need for an exit strategy, but not act as though it is imminent.

This is the most important thing we should be watching for in tomorrow's Fed statement.