Letter from the Fed

Our economist, Steven Andrew and I visited the Washington Fed and New York Fed last week. Here are Steven’s quick and dirty comments on what we learned from them – written on his Blackberry at Newark airport, so he asks you to be gentle on the terse style.

Some quick thoughts from our meetings with the Fed this week:

The Fed in Washington
Largely upbeat (they’re never anything else). Not genuinely fearing inflation – current communication on this is designed to anchor inflation expectations (seen by Bernanke as top priority – he is far more keen on communicating than Greenspan was, to the extent that he’s introducing a quarterly ‘inflation report’ type thing (it won’t be called that). I haven’t heard this reported in the media yet but Bernanke has definitely charged the Fed staff with setting it up. Bernanke’s arrival apparently has led to lots more work compared to Greenspan’s days. Now seen as a committee of textbook wielding economists (oh dear).

Other changes under Bernanke
More focus on core CPI, more willing to talk about regulating consumer credit (maybe just a sign of the times).

from his testimony this week, Bernanke is clearly no longer happy to declare sub-prime as ‘contained’. The Fed staff we spoke to were naturally reluctant to add much – but said they’d worry more if the risk was still on the banks’ books (rather than in hedge funds and CDOs). Curiously, in my view, there is some optimism that rising equity markets can offset the declining housing market in the ‘wealth effect’ stakes – this from the guy who wrote (with Greenspan) the seminal piece on housing wealth effects concluding that it was many times more powerful than that from equities. Still, I guess the useful thing about these Fed meetings is spotting the bits that don’t add up as the areas most likely to be of concern to the Fed, so this is almost certainly one of them.

Mixed views on this. Why is employment so strong given the collapse in housebuilding? Laying off illegals is seen as having prevented a sharper fall in residential construction jobs, as is some shift to non-residential construction. (Brokers views on this were either ’employment weakness is coming with a lag’ or ‘the statistics are lousy, it’s already happening’).

The Fed is largely untroubled by the employment picture: happy to see the service sector payroll expanding although in truth it’s mostly government, healthcare and hotels (hotel employment and indeed pricing are both very robust, perhaps due to more foreign visitors taking advantage of the weak dollar, and more Americans staying in the country as the same weak dollar makes it too dear to travel abroad). I suspect they’re more troubled than they’re letting on.

The Fed in New York was most bullish. Gloom and doomsters are ‘hobgoblins’ trying to unearth obscure nuggets of bad news. They were dismissive of housing wealth effect. Consumer seen as solid despite recent weakening (because jobs are holding up). Middle America seen as frugal already, not ‘credit obsessed’. High earners are responsible for declining savings rate, so no big deal/correction to undergo.

The Fed isn’t going anywhere until the unemployment rate starts to rise (then I think it would cut rates quite quickly). Labour market data are getting noisier without really showing any proper slippage yet. But it can’t be too far away, in my view. The over-riding focus on inflation is a red-herring/communications device, not a meaningful barrier to lower interest rates if need be.


The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Discuss Article

  1. Jim Leaviss says:

    The paper by Alan Greenspan and James Kennedy (“Estimates of Home Mortgage Originations, Repayments, and Debt on One-to-Four Family Residences” (2005)) can be found via footnote 2 on this page of the Fed's website (https://www.federalreserve.gov/boardDocs/Speeches/2005/200509262/default.htm). There are some other Fed papers there on mortgage refinancing that you might find interesting too.

    Posted on: 26/07/07 | 12:00 am
  2. Ben Yeoh says:

    I'd be interested in the paper you refer to: “(with Greenspan) the seminal piece on housing wealth effects” — can I find it on the Fed site somewhere? I agree it probably is a bit of a red herring but that a report such as the quarterly inflation report if it increases “transparency” would be a good thing. Have you looked at the latest views from the PIMCO guys? Keep up the interesting views on the blog. (I'm more on the equities side but still find this interesting).

    Posted on: 26/07/07 | 12:00 am
  3. Ben Yeoh says:

    Thank you! This is part of PIMCO's comments (which you've probably seen): “Well the caloric content of the gruel in recent years has been barely life supporting and unhealthy to boot – sprinkled with calls and PIKS and options that allowed borrowers to lever and transfer assets at will. As for the calories, high yield spreads dropped to the point of Treasuries + 250 basis points or LIBOR + 200. Readers can sense the severity of the diet relative to risk by simply researching historical annual high yield default rates (5%), multiplying that by loss of principal in bankruptcy (60%), and coming up with an expected loss of 3% over the life of future loans. At LIBOR + 250 in other words, high yield lenders were giving away money! Over the past few weeks much of that has changed. The mistrust of rating service ratings, the constipation of the new issue market and the liquidity to hedge the obvious in CDX markets has led to current high yield CDX spreads of 400 basis points or more and bank loan spreads of nearly 300. The market in the U.S. seems to be looking towards this week’s large and significant placing/pricing of the Chrysler Finance and Chrysler auto deals to determine what the new level for debt should be. In the U.K., a similarly large deal for BOOTS promises to be the bell cow for European buyers. But the tide appears to be going out for levered equity financiers and in for the passive owl money managers of the debt market. And because it has been a Nova Scotia tide, rising in increments of ten in a matter of hours, it promises to have severe ramifications for those caught in its wake. No longer will double-digit LBO returns be supported by cheap financing and shameless covenants. No longer therefore will stocks be supported so effortlessly by the double-barrelled impact of LBOs and company buybacks. The U.S. economy in turn will not benefit from this tidal shift and increasing cost of financing. The Fed tightens credit by raising short-term rates but rarely, if ever, have they raised yields by 150 basis points in a month and a half’s time as has occurred in the high yield market.

    Posted on: 27/07/07 | 12:00 am

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