Lower the fed funds rate now, please

So there’s this Dillon Reed and Davis Polk fellow, Jerome Powell, who now runs the Fed. Perhaps Janet Yellen should not have been replaced.

The world keeps changing. We did an IPO of a company with that IB and Jamie Dimon’s firm, Smith Barney. FYI, Smith Barney and Dillon Reed are no longer around.

In our view Powell is screwing up by raising the fed funds rate when there is zero reason to do so, given both high GDP growth and full employment with essentially no inflation. In case you think it inappropriate to second guess him, we’ll take a trip down memory lane from a decade ago. Here’s the insanely disastrous thing that Hank Paulson, former CEO of Goldman Sachs (CEO OF GOLDMAN SACHS!) did when he was Treasury secretary, regarding the troubled investment bank Lehman Brothers, as we relive a post from 2008:

Short version: Paulson made a catastrophic mistake that almost reduced the world’s financial systems to rubble. Powell has the same degree of excellent judgment in our view. We continue in quoting our 2008 thoughts:

At this moment, in 2008, the bankers seem to have made the same mistake that brought about the Great Depression in 1929, and it has nearly brought the system down again. The Fed Chairman who is a student of the Depression and the Treasury chief who was CEO of Wall Street’s perhaps most storied name, appear to have repeated one of the critical mistakes in judgment that brought about the Great Depression – and they have been scrambling to recover from this mistake for a month. In 1930 the Fed let the Bank of United States fail, the dominoes fell, and the Great Depression was born. On September 15, 2008 the Fed let Lehman Brothers fail, and once again the US is courting financial catastrophe.

One month ago, the Fed and the Treasury let Lehman Brothers go bankrupt, and all hell broke loose, not just because of mortgages, but because of Lehman’s systemically toxic CDS’s — unregulated insurance policies without reserves with other banks — that could bring down the entire industry. This is also the view of the French finance minister. Telegraph:

Mrs Lagarde — attributed with playing a key role in brokering a bailout deal among G7 finance ministers in Washington last weekend — dubbed Mr Paulson’s decision to let the bank go under “horrendous” as it triggered panic in markets and banks to the brink of a 1929-style financial meltdown.

The entire banking system seized up; the banks were set up like dominoes to sequentially fail. Short sellers had a no risk strategy to bet on bank failures and the Treasury had created a Doomsday Machine that would take them down, one after another. Credit and stock markets crashed, and good news had become irrelevant.

In effect, the US government had created one of the conditions that turned the recession of 1929 into the Great Depression. In that earlier time, the New York Clearing House banks allowed the small bank with the big name, Bank of the United States, to fail. After that failure, which would have been so easy to avoid, another 8000 banks failed. Of course, the government at that time had to wait until 1933 for the creation of the FDIC and other tools to stem the runs on the banks.

For a month the government has been improvising various solutions to the Lehman mistake, and often it has looked like making sausages. It hasn’t been pretty, and no one knows whether it will be ultimately effective. But the actions of the Euro-zone countries, after their initial stumble, are encouraging. Likewise, the reaction to the revised Paulson plan, which has morphed from buying $700 billion in mortgages to providing a much needed $250 billion in new bank capital, also appears positive. It is possible that we have seen a version of 1929-1933 play out in a very short time (as events are often accelerated these days). But there was still a long way to go for the US economy to recover after 1933.

UPDATE 1 — Andy Kessler has a good summary in the WSJ of what US and European authorities are trying to do with their remedial measures.

UPDATE 2 — we should disclose that our firm was previously retained by the FDIC to review a number of its procedures and methods regarding bank creditworthiness, and no confidential information forms part of this analysis.

UPDATE 3 — it is perhaps ironic, given the world of today, that the one person who saw the Paulson disaster for the disaster that it was, is the French woman who currently runs the IMF, Christine Lagarde.

One Response to “Lower the fed funds rate now, please”

  1. Bob Risko Says:

    From the Peter G. Peterson Foundation website: “Today (26 September 2018), the Federal Reserve announced an increase in the federal funds rate to between 2.0 and 2.25 percent; that increase was the third so far this year. After a lengthy period of holding the federal funds rate close to zero in an effort to help the economy recover from the financial crisis, the Federal Reserve began increasing its target rate in December 2015. There have been six subsequent increases since then; the most recent increase before today was in June 2018 and set a target rate between 1.75 and 2.0 percent.

    The Federal Reserve sets policies to foster conditions that they believe to be consistent with achieving maximum employment, stable prices, and moderate long-term interest rates. Setting the target for the federal funds rate — the interest rate at which commercial banks lend to each other overnight — is therefore an important tool for the bank. That rate is the benchmark for Treasury bills and other short-term interest rates. Expectations about those short-term rates, combined with other factors, affect the longer-term rates that are applied to consumer borrowing such as for mortgages, car loans, and student debt.

    The continued tightening of monetary policy should be viewed as a positive sign of economic strength — it demonstrates the bank’s confidence in the progress the economy has made toward its economic objectives. However, higher short- and long-term Treasury rates mean that the federal government’s borrowing costs will also rise, thereby generating significant consequences for the budget and the national debt.”

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