Saturday, December 29, 2007

The unintended consequence of Fed's rate cuts

Mr. Ranson argues that market expectations of further Fed's rate cuts may be the reason that has been stalling the real economy, as evidenced by corporate bond spreads between Baa vs. Aaa bond yields. I certainly see the merits of such argument in home purchases: potential home buyers will wait longer, and wisely so, in anticipation of more price falls in the future, thus further beating down the housing market.

However, I am not convinced on the causal relationship, i.e. it's Fed's rate cuts that made matter worse...maybe the real reason is the delay of the subprime's spillover effect.

Last word, if we look at the corporate bond spread over a longer period, you may find it less scared. In fact in 2003, when we were completely out of recession of 2001, the spread was much higher than today.

The Fed's Predicament

Day by day forecasters, already pessimistic, lose further confidence in the economy. I too must plead guilty to being drawn in, although I had argued for months that the economy would come through the subprime mess more or less unscathed.

However, the indicator on which we at my firm rely most -- the tightness of spreads in the quality end of the corporate bond market -- has abruptly changed. As recently as a couple of weeks ago, these spreads were tighter than they had been all year. Now it seems that the corporate bond market has begun to corroborate the general panic.

If enough people in a crowded theater stand up and cry fire (when there isn't one), they can set off an unnecessary catastrophe. I believe that what is happening now is a classic example of this mechanism, and that the Federal Reserve is the central player in the drama.

Market-based forecasting of the economy is not a new idea; theoretically, the stock market should be a harbinger of the future economy. But the credibility of market-based forecasting has long been compromised by the stock market's abysmal record as a forecaster.

During turbulent periods, as we have been experiencing since late July, the market is hurled to and fro daily by alternating fear and relief. But spreads in the corporate bond market have an excellent record of forecasting the economy and don't seem to suffer from this vulnerability. And, until recently, they have remained aloof.

Far better than the stock market, the spread between corporate Baa and Aaa bond yields tracks the immediate future of the overall economy closely and consistently. The logic of his very sensitive indicator is simple. Spreads between yields of slightly different grade reflect the market's perception of risk. A slower economy simply means more risk.

The necessary data are published on a daily basis, though not necessarily watched closely, by the Fed. Our research suggests that the timeliness of the spread signal, and its lack of volatility, make it a better indicator than even the GDP estimates themselves on a short-term basis. Better still, it is a leading indicator, providing a forward picture of what GDP data can only show us in the rearview mirror.

Throughout the mortgage-market panic, spreads remained tight, allowing us to predict (correctly) that there would be no significant slowdown in the economy until now. This remains true as far as the rest of 2007 is concerned.

But just in the last couple of weeks, the Baa/Aaa spread has broken through 100 basis points for the first time in several years. Having traded in a range between 85 and 95 basis points all year, it had widened to nearly 120 basis points by mid-December, suggesting a hit to GDP and consumer spending by the first quarter of 2008. According to the most recent data, it has fallen back a bit and the estimated slowdown still looks moderate in severity. But if spreads were to widen further, it could be more acute.

It looks to me unlikely that the unraveling of the subprime mortgage boom is directly responsible for this change. Bond yield spreads should have widened months ago, if that had been the economic threat so many forecasters thought it was. Bond-market data indicate that the economy was weathering the credit crunch perfectly well until this most recent jump in the Baa/Aaa yield indicator.

But there could be a connection between the threat to the economy and Washington's misplaced efforts to address the turmoil. The Fed's policy is quite naturally based on the universally accepted notion that prices affect economic activity. It assumes that an interest-rate cut will promote borrowing and that, in turn, will boost the economy. But there is one aspect of this theory that it has missed: the role of expectations.

In this space, 16 years ago, I argued that "economic activity is often free to migrate from unfavorable to favorable climates," and that one of the less-recognized examples is "the migration of GNP from one time period to another," motivated by "an urge to exploit expectations about the future."

Consider the following thought experiment. The Fed is in the position of an industrial company that fears a shortfall in the demand for its product. The simple solution is to cut the price. The firm does so, but what if its customers are unimpressed and lobby for a deeper one?

The company is uncertain and opts to "wait and see" whether an additional price cut is necessary. The board of directors, which meets every six weeks, promises to announce its decision at the next meeting. In the meantime, pressure for more cuts intensifies and customers postpone their purchases in the expectation of getting a lower price.

Imagine the predicament in which that company now finds itself. Whether or not the first price cut was sufficient, further cuts are widely expected, and sales continue to slump. That induces the disappointed directors at their next meeting to cut again. Now every additional price cut creates expectations that cause sales to slump further. This chain of events repeats itself -- until something breaks. This occurs when the firm wakes up to what is happening, and manages to convince its customers that there will be no more price cuts. At that point, finally, sales bounce back and stability returns.

So, ironically, when the Fed cuts interest rates to support the economy, it can actually create a slump -- by cutting rates slowly and reluctantly enough to encourage more and more aggressive hopes of further cuts. Fortunately, the downward spiral cannot last forever and, when it stops, the economy will snap back. But in the meantime, the Fed has been tripped up by another instance of the law of unintended consequences. It looks to be in the process of precipitating the very recession it is trying to head off.

Mr. Ranson is head of research at H.C. Wainwright Economics Inc.

Paul D. Deng
Department of Economics
Brandeis University
IBS, MS 032
Waltham, MA 02454