In emergency take stairs

Stocks tanked today as investors reacted to the Fed's decision to slash a modest 25 basis points off of short-term interest rates (see Inman News story).

One reason stocks fell is that investors had already priced in today's action. Only a more drastic 50-basis point reduction -- like the one the Fed instituted on Sept. 18, after credit markets virtually shut down in August -- would have made some investors happy.

One astute observer of mortgage and bond markets, PIMCO chief Bill Gross, says the federal funds rate is likely headed below 3 percent, but that there reasons the Fed might try to get there through more gradual, 25 basis point reductions. 

It used to be a given that when it wanted to put the brakes on economic growth, the Fed would put short-term rates on a gently rising escalator, instituting increases 25-basis-points at a time (which is what it did in 17 consecutive meetings from 2004 to 2006). When the Fed wanted to stimulate growth, it would put short-term rates on a rapidly descending elevator, cutting rates by 50 basis points at a time.

Today, Fed chair Ben Bernanke "may face a problem with this elevator-based ease in monetary policy," Gross wrote back in September. The problem, Gross says, is that the federal funds rate can no longer be neutral for households and corporations alike. A rate that is not restrictive for corporations with good credit and global opportunities may be far too high for "homeowner Jane Doe and two million of her neighbors facing higher and higher monthly payments on adjustable rate mortgages," Gross wrote at the time.

"Whereas in prior decades a 'one size fits all' policy rate move has coincidentally and democratically affected households and corporations alike, the 21st century has ushered in an innovation revolution favoring corporations with global investment opportunities as opposed to individuals with daily bills to pay," Gross wrote at the time.

If Bernanke puts the federal funds rate on a rapidly descending elevator ride -- and then decides to freeze it in mid-descent (because of worries about inflation), "he risks exacerbating a housing crisis in the making," Gross says. But if the Fed favors homeowners over corporations through a series of steep cuts, it "risks reigniting speculative equity market behavior, and – in addition – a run on the dollar."

So far, the Fed's taken the elevator down a couple of floors, and then switched to the stairs.

After the secondary market for subprime and alt-A mortgage loans dried up -- with investors also spurning short-term corporate debt that mortgage lenders like Countrywide Financial Corp. depended on -- the Fed cut both the federal funds rate and the discount rate by 50 basis points.

Since then, worries about inflation and a devalued dollar have led the Fed to make less drastic, 25-basis point cuts in both rates on Oct. 31 and again today.

Weighing in last week on expectations of the Fed's move, mortgage broker and syndicated columnist Lou Barnes correctly predicted the Fed would cut rates today, but warned that a 50-basis point cut might actually send mortgage interest rates up, because it would signal the end of an easing cycle (to use Gross's anaolgy, it would indicate that the Fed was coming down fast on an elevator, not the stairs, and preparing to hit the emergency stop button).

"If they chop a quarter of a percent, it will do nothing to help mortgages (already built in)," Barnes wrote. "If they chop a half a percent, it's more likely to hurt than to help. All bond traders know to sell before the Fed ends an easing cycle; for the Fed to go below 4 percent (it's at 4.5 percent at this minute) the credit crunch will have to deepen. I think it will, but the bond market wants to see the fact."

Gross doesn't think the Fed has a healthy appreciation for the depth of the problems created by the "shadow banking system" that dreamed up the complicated structured investments that funded mortgage lending and corporate borrowing during the housing boom. In his Dec. 7 Investment Outlook, he says there will be no quick turnaround.

"Those that claim that the current cycle of Fed ease will inevitably—and shortly—lead to vigorous economic growth do not really have their ears to the ground or their eyes on their Bloomberg screens. The Fed needs to bring Fed Funds levels down steadily and significantly more in order to counteract the contraction of the shadow banking system which has imposed, and will continue to require, higher risk premiums for non-Treasury securities in an increasingly risky financial environment."

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