Thursday, February 21, 2008

it's not much like 1931

I know this sounds heretical and somewhat insane, but someone must say it:

the fed has to raise rates now instead of cutting them.

I know this will never happen and we're bound to repeat the mistakes of latin america in the 1980s, printing money with abandon and creating years of gnawing stagnation. but imagine this other alternative:

the fed raises rates and the dollar rallies. immediately, all of these hot AG trades and anti-dollar trades such as gold and oil are crushed. they're such crowded positions that the selling could take years. this would drive down the non-core elements of CPI and would also slow the global economy.

this policy would render inflation much less of a threat. right now I think few fully understand how much of an inflation problem we're facing right now. cheered on by wall street, ben is about to lead the US down a trail already blazed by latin america and weimar germany, printing money with abandon and getting nowhere in the process.

another, seldom considered reason to raise rates: it would flatten the yield curve. when 2yr notes were yielding more than the 10yr, it was simply too hard to make money in the bond market. everyone searched for yield and eventually wound up selling their souls for the extra 30bp they'd get from AAA subprime paper. the insurance companies and pension fundes were the clowns who forced all of this money into the mortgage market... bored with corporate debt, which grew increasingly expensive in 2003-5, they sought their supper in cmbs, then cdos and subprime -- oh how they especially loved those pre-payment penalties!! aided with chinese and japanese liquidity, (oh, the global savings glut!), they channeled vast sums of money into houses and counsider debt.... CDOs and CDOs squared!

all fruits of a flat yield curve. so, I think: if it could get us into this mess, it can help get us out of it.

instead, the fed is steepening the curve, depriving the risk markets of their billions when they're most needed. I know it sounds insane that raising rates will free up lending in the mortgage market, but it's actually true -- honest!

so, why is ben bernanke luring them away a huge yield curve?

the explanations for easing are orthodox enough:

-the slowing economy will push prices lower... or will they? ask yourself: how will a recession in the USA make the chinese eat less wheat and pork? these people have entered the middle class. this is a new permanent appetite.

-it will encourage people to lend. will it? mortgage rates are higher and loan volumes have plummetted.

-it will help the banks .... ah, yes -- this is, in fact, the right answer. it is they will will profit from the steep yield curve ... they might even dare to borrow at overnight rates and buy 10yr notes!! risk-free carry! what's a better way to recover after getting burned in last vegas, florida and detroit?

meanwhile, prices will rise across the board, americans' purchasing power on the global stage will decline and growth will languish as we repay trillions of debt. deleveraging isn't fun.

in the end, the banks win and the economy looses. after all, who owns the Fed after all? the banks.

it's time to explain the title for this post: it's not much like 1931. bernanke grew up learning about how the fed worsened the depression by boosting interest rates. but consider the difference: then, oil cost pennies per barrel and grain was burned en masse. back then, deflation was something really to worry about. all the central bankers know this story now. but the current commidity-price environment is completely different than back then. we have to stop fearing deflation. if anything is certain going forward, it's this: deflation is not our problem.

I should also note raising rates will cause plenty of short-term pain. many LBO companies etc would go bust with higher libor, and stocks would suffer. but in the macro, long-term picture, this is what needs to be done (and will happen eventually anyway. )

over any period of time, the benefit of monetary stability is far more important ... oh that vexing dual mandate that plauges not the fortunate europeans!

I fear gentle ben will prove another arthur burns... swayed by what others want. then we'll need another volker strangling the economy with high rates so everything gets blown out and starts again.

but wouldn't it be nice to avoid the whole mess in the first place?

it's not 1931. it's time to get real about inflation and raise rates soon.

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