19 February 2010

FED quantitative easing exit: has it started?

The FED 0.25% discount rate hike yesterday evening came as a surprise. Banks are now borrowing at 0.75% instead of 0.5%, not a big deal: there is still plenty of space for banks to play the yield curve.

Two days ago I wrote that I did not see a hike in interest rates any time soon, so this move is a surprise regarding the timing. First, its significance is rather minor since it is applied to emergency funds provided by the FED to financial institutions. The fed funds (0.25%) are the ones that really matter since they impact borrowing costs for companies and consumers (mortgage in particular) and the FED indicated that an increase in the discount rate did not imply an increase in FED fund in the future. Second, I view this increase as is a signal sent to the market psyche about the FED seriousness in preparing the QE exit, controlling future inflation and therefore tame investors' future inflation expectation to keep rate in check (don't forget that the US a has a huge debt to finance).
True, the Fed had been warning for some time that this was going to be part of the process of taking the emergency stimulus out of the financial system and Wednesday’s FOMC meeting contained recommendations to start raising the discount rate as soon as possible. However, the difference between fed funds and the discount rate is only increasing to 0.5% from an average of 1% before the crisis. This move is really a "marketing" exercise than a real shift in policy. It is also a way to make banks a bit less comfortable (this plays in Obama's hands).

If TIPS are a good indicator of forthcoming inflation (which is really debatable), there is nothing to worry short/medium term. In any case the economic recovery is pointing towards a slow and bumpy one and wages are still in a deflationary environment with food and energy prices contained: without wage inflation and /or energy/commodities inflation, there will be no inflation near term (longer term we will get it due to all the money created worldwide). CPI number for January came at 0.2% today and -0.1% for core CPI (i.e. less food, energy and commodities), and 2.4 over the past 12 months (unadjusted) mainly due to energy prices hike.

I agree with David Rosenberg when he comments today:
So, it would stand to reason that the real test for the markets is going to come not from the discount rate, but by what happens when the Fed begins to shrink its balance sheet — particularly the ramifications for mortgage rates.
Last word: policy makers are prone to mistakes; I hope that my analysis of the stance taken by the FED is right, otherwise run for cover!


Bureau of Labor Statistics: Consumer Price Index Summary

Gluskin Sheff: Breakfast Lite with Dave