BEST OF DOUG NOLAND

May 11, 2005

There is a prevailing view that economic vulnerability precludes the Fed from significant further tightening. The unfolding issues with auto and auto-related debt and derivatives only add to the litany of financial sector fragilities. Even the discerning Stephen Roach made an abrupt u-turn after two weeks back arguing that a 5.5% Fed funds rate might be required. This week he suggested the Fed may be done. Sticking to their guns, the gentlemen at Pimco argue the Fed must soon end its tightening campaign or risk recession for the overleveraged, finance-based U.S. economy. I will dig in my heels and disagree. The Fed still has much work to do, acute financial fragility notwithstanding.

First of all, there is at this point absolutely no way around financial crisis and recession. And while there is the understandable preference to delay one’s comeuppance, when it comes to monetary and economic management it is of utmost importance to accept responsibility and take the pain early. The Financial Sphere has inflated dangerously and sustaining this Bubble is a precarious losing proposition. The wildly maladjusted and unbalanced U.S. economy must suffer through a wrenching adjustment period. Historic excess throughout mortgage finance must be reined in. The U.S. Current Account Deficit must be brought under control. The vulnerable dollar must be supported with significant yield differentials. The global economy must be weaned from the massive destabilizing pool of largely dollar-denominated liquidity.

The bottom line is that the Fed faces an enormously arduous task dealing with these now intransigent imbalances. The wildly inflated and dysfunctional Financial Sphere is not about to magically transform itself into a mechanism soundly financing a stable and well-balanced Economic Sphere. Powerful Monetary Processes must be contained (and eventually eradicated) and the adjustment process commenced. Three percent Fed funds is not up to the task, and fear of the unavoidable adjustment process is not pardonable analysis…..

Not unjustifiably, the marketplace perceives that the leveraged speculating community is much "too big to fail." This perception is an important aspect of the powerful inflationary bias (proclivity for higher prices/lower rates) that perseveres throughout the bond market (and stokes the destabilizing Mortgage Finance Bubble). At the first sign of system stress – GM debt problems, for example – Treasury, agency and MBS yields head lower. This ushers in "The Conundrum" – or the necessity for the huge amount of hedges against higher interest rates to be unwound, while hedges for protection from lower rates are implemented. And let's not forget the speculators intent on buying ahead of the derivative traders. The entire process has worked swimmingly to sustain excesses and avoid commencing the necessary adjustment process (although it does seem to have taken on a wrecking ball effect of late).