PIMCO & Bill Gross Call For 3% Fed Funds Rate
Kurt Brouwer December 5th, 2007
Bond manager extraordinaire Bill Gross believes the subprime lending mess has triggered widespread problems in the worldwide money system and, if we are not careful, this could lead to a recession. He believes the Federal Reserve needs to continue reducing its short-term fate — the Fed Funds rate — in order to stimulate the economy. By itself, that is not controversial. But Gross also believes that the rate has to get pretty low before it will start to help the economy get through the possible recession. Now, in point of fact, the economy is doing very well right now, at least by the numbers. See Economy Booms In Third Quarter.
But Gross sees a major traffic jam in the credit markets that is likely to produce much slower or even negative growth. In his monthly commentary, Gross expounds on his point of view in his inimitable style [emphasis added below]:
The Shadow Knows (PIMCO Investment Outlook, December 2007, Bill Gross)
‘..What we are witnessing is essentially the breakdown of our modern day banking system, a complex of levered lending so hard to understand that Fed Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August. My PIMCO colleague, Paul McCulley, has labeled it the “Shadow Banking System” because it has lain hidden for years-untouched by regulation-yet free to magically and mystically create and then package subprime mortgages into a host of three-letter conduits that only Wall Street wizards could explain.
As I’ve noted before, it is certainly true that this shadow system with its derivatives circling the globe has democratized credit. And as the benefits of cheaper financing became available to the many, as opposed to the few, placating and calming waves of higher productivity and widespread diversification led to accelerating economic growth, incomes, and corporate profits. Yet, as is humanity’s wont, we overdid a good thing…
The ultimate destination of Fed Funds is dependent on the state of the domestic economy which, in turn, will be influenced by the direction and level of U.S. housing prices. Chairman Bernanke and his divided band of governors will have to feel their way along this treacherous path with canes in hand-not totally blind, but significantly hampered by a lack of historical context which might point the way to the ideal rate via precedent as opposed to feel. Nonetheless, there are theoretical guidelines which may help to validate or invalidate current assumptions reflected in Fed Funds futures contracts which currently forecast an ultimate floor of 3¼% sometime late in 2008. Traditionalists would point to the “Taylor Rule” which formulaically computes a neutral Fed Funds yield based on divergences of real GDP and inflation from “potential” and “target” levels. Since these levels are somewhat variable and subjective, there is no one number that a computer can spit out, but nonetheless, using reasonable assumptions, neutral Fed Funds levels somewhere in the 4% “+ or -” range are produced. Assuming the Fed would have to drop below neutral to stimulate a faltering economy, the 3¼% Fed Funds futures forecast does not seem unreasonable.
Standby for a tumultuous 2008 as the market struggles to move from the shadows back into the sunlight of sounder banking and financial management, accompanied by Fed Funds levels at 3% or lower. ‘
Bill Gross has been on target on this subprime lending mess for quite a while (see Bill Gross Was Right). He suggested it would be a much bigger problem than most of us thought it would be. So, I’m inclined to put a lot of credence in his opinion. I believe the Federal Reserve will continue to cut short-term interest rates, but it is not a simple issue because the Feds are facing two competing needs, which are stimulating the economy and keeping inflation in check. In addition, there is the issue of the dollar. As interest rates have fallen, the dollar fell right with rates. Further cuts in rates will likely lead to additional dollar weakness. So, Chairman Bernanke is facing a pretty complex situation. Fortunately, it is one for which he is well suited.
Hat Tip: MarketBeatBlog
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