'FED TO HOLD FIRE', WHAT FIRE?

According to this piece in Reuters "The Federal Reserve will hold its fire over the next few months and hope the U.S. economy gets back on its feet". But well may we ask, what fire? With interest rates now at 1.25% the Fed is about done with monetary policy. According to Reuters "Economists interpreted the aggressive move by the Fed as an attempt to bolster business and consumer morale, and that the Fed is signaling its work is done by stating the risks to the U.S. economy are now evenly balanced between weakness and inflation." For Morgan Stanley's Japan economy watcher Takehiro Sato the recent Fed move is surprisingly reminiscent of Japan in 1995. The reason, the impact on expectations. Are we living in this very moment the turning point where investors and consumers begin to orient their behaviour according to deflationary rather than inflationary expectations. This 'expectations shift' even more than any detailed technicalities associated with the subsequent liquidity trap is what really does the damage, and what 1930's experience shows may be the hardest corner to turn. (NB it is after all the expectation of falling prices and near zero interest rates- the so called ZIRP - that places a lower cost on holding money, and at the same time leads to the postponment of consumption and investment decisions). Bottom line: is this now a heads I lose, tails you win scenario for the Fed? And lets not even think about all thos geopolitical headwinds out there just waiting to blow. As Reuters says, all we have left is the hope the US economy gets back on its feet. Get your fingers crossed!

The FRB rejected market consensus and went ahead with a 50bps rate cut, dropping the FF rate to 1.25%. To veteran BoJ watchers, this move is reminiscent of Japan’s monetary easing in March-April 1995. The Bank at that time had (in late 1994) been encouraging the unsecured call rate to move higher amid rising cyclical recovery momentum. Yet it was forced to switch course to monetary easing by a series of negative shocks -- the massive Hanshin earthquake in January 1995, the subway sarin attack in March, and rapid yen appreciation during March and April. With the yen sinking to the ¥80/US$ range in March and April, BoJ officials sought to head off easing pressure by encouraging the unsecured call rate to drop 75bps, a larger margin than expected by the market. Yet this strategy failed and only accelerated the timing of the transition to ZIRP. It again tried to foster an end to easing sentiment with 50bps cuts each in the call rate target coinciding with forex market intervention in July and government economic measures in September of the same year. In retrospect, efforts in 1995 to reenergize markets by taking stronger-than-expected additional monetary easing were a significant milestone on the road to ZIRP. In fact, the economy itself, and not only financial markets, shifted from inflation to deflation expectations from 1995. Data for various key macro parameters, such as relationships between short-term rates and the long-term/short-term rate spread and the current account surplus and long-term rates, show a major dislocation occurring in 1995.

Nearly two and a half years have passed since the IT bubble collapsed (around 10 quarters), and the US is approaching the point at which the deflation impact from Japan’s stock price collapse started to manifest itself in the real economy.
Source: Morgan Stanley Global Economic Forum
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