bizzXceleration: Performance, Value and Profit

1. The traditional tradeoff for Central Bank/Fed policy is to weigh the evidence and find an appropriate balance between economic risks and inflation/currency risks. They've done a pretty good job but:

• the business cycle is the business cycle - they can't get too far above or below but simply try to manage as best they can around it. The economy is slowing on a worldwide basis (recent admission on many parts though visible to us domestically since early this year)
• inflation threatens to grow, get embedded and accelerate unless carefully managed because, for the first time post-WW2 we're facing a worldwide supply/demand imbalance in foundational goods due to the emergence and rapid growth of the BRICs. 

 2. The traditional tradeoff is NOT the major policy problem right now. The other major responsiblity of a Central Bank is to maintain orderly markets - or in peoplespeak to keep markets from screwing up and taking our livlihoods and lifes with them when they blow up. Right now THE major problem is the consequences of perverse incentives of structured debt finance and too much leverage which are periodically freezing the debt markets [again please see the earlier posts on the nature of the credit problems here and here].

• Traditional policy and tools aren't appropriate to address these problems. What's required is some technical mechanics to inject money into the banking system and free up the frozen gears of the credit markets. The last 24 hours have seen a wealth of announcements to do just that and it shor warn't on the spur of the moment nor war it without some real tool bldn, gosh darn it. In other words they've bloody well been thinking about this for some time and drawing on institutional memory and toolkits streching back decades.
• If you think you've got a better idea speak up because that whooshing sound you hear are the wings of the Angel of Death and all his minions (figuratively speaking of course).

3. While we've all been adgitating about this and that Dr. Ben and the crew have been wrestling with real problem in the real world with the available real data - which isn't so good. It's easier to be clever and profound ex-post than ex-ante and this is in "The Heat" as my milspec buds like to put it. These guys are playing Big Casino with enormous table stakes under near real-time pressures and dancing with about as much style and grace as anyone.

The last two times the US was edging into this sort of thing the years were 1907 and 1929 and it was "make-it-up-as-you-go" by amateurs following badly flawed mental models. In fact just as a historical sidebar you'll get a certain perspective reading Keynes' "Essays in Persuasion", one of which retales his very unsuccessful efforts to persuade Churchill (Chancelor of the Exchequer then) to NOT return to the gold standard just because common wisdome about sound money said to. The result was a depression for Great Britain prior the Great on. Be very thankful for what we've got, considering history, very thankful indeed.

• These guys either don't know what's going on or they've really got some big brass cojones. Let's all hope it's the latter 'cause this is going to go on a while and they seem to be in a minority who get it.
  

So on balance they're doing it about as well as it can be done weighing all their obligations and responsiblities in the short- and long-runs; not just pandering to the street. (So much for the Fed is the Street's bitch talk eh ? :). Below we look at the Fed's view of the macro-environment & what it says about their policy and instrument choices, the credit market dilemma's and a bit about the tools they're pulling out of their kits to try and wrestle all this down.

First to understand the strategic context that the Fed sees we need to understand how they view the outlook for growth, unemployment and inflation. Well, they've been increasingly transparent about all that but with the last meeting minutes containing their outlook thru 2010 transparent isn't the word. In fact their outlook is consistent with my own much short-term analysis and beyond my capabilities. Other issues aside we ought to be looking at this as one of, if not THE, best longer-term outlooks and using it to plan our assessments of growth, profits and earnings. Sigh...fat chance, right ? Anyway the Fed sees a relatively benign environment of slow growth (below potential), a pickup in inflation that's then dampened by that slow growth and slowly eases back to the target area. Along with an unemployment rate that worsens a bit but not severely. If the recession accelerates into existence because of a sudden slowing of consumer spending (a major risk and with a moderate/high outlook) or spillover from the credit crisis (an even more serious risk but with a low/moderate outlook if they can manage it) then all bets are off. Meanwhile THIS IS the picture of the world they're using and taking a fairly courageous stand to try and cut off inflation, protect against a downturn as best they can and still address credit problems. It's the picture you need to keep in mind - agree or not - when juding their actions.

Next are the credit problems, best captured in the spreads between risk-free short-term instruments and inter-bank lending rates. Now here's the thing that gripes me - for years and years all we had to do was pay attention to Tresuries, the yield curve and the spreads 'cause otherwise this was all divinely defined machinery that never changed. Well, nevermore quoth the Raven. All that machinery has gone bust big time. When I say the Fed's between a rock (growth) and a hard place (inflation) that's point one - and bear in mind the regime change that makes it more difficult than it's been in 25+ years. When I say there's a tsuanmi sweeping down the gulch we're trapped in this is the problem. So how do we keep our heads above water or do we bend over and making smaking noises under-water ? The chart at the left catches the spread problem (the earlier post More on the Credit Crisis: the Rocks in the Pond "Model" has an even better one that's worth reviewing because of the timeline).

So third is what straw to breath thru are we being offerred ? What the Fed's doing, to the best of my understanding is adapting some pre-existing tools in concert with the rest of the Central Banks, to inject funds and aim them directly the center of the fire. In other words instead of lowering the Fed or Fed funds rate it's created a much more selectively mechanisms that will put funds more closely on target instead of spraying the whole area. If you'd like a comparison it's the difference between WW2 carpet bombing and fire-storm setting and today's highly targeted smart bomb technology. The first may damage the enemy but the collateral damage is pretty extensive. The latter can get down to a 200' radius of destruction. Which is all to the good because, remember the tradeoff problem, the space between the rock and the hard place is darn narrow.

That, in a (my) nutshell is the three-corned policy dilemma and what the Fed is doing to resolve it. We don't know if it's going to work and it IS going to take a long while to work out. We're going to be sweating this for a long time. If you believe that and the prior analysis of the scope and magnitude of the credit problems a couple of final observations to think about:

1. You'd better hope they get it right.

2. Now doesn't strike me as time to be buying back into Financials.