September, the Fed believes bias is towards weakness, and does nothing

November, the Fed beleives the bias is balanced, and cuts 50bp.

Why do you cut 50bp if you're not worried? And, as Brad says, why not act earlier?

I guess what I like most about economists is that the economy is a complex system and there are no tests for anything, so any claim gets lost in counterfactual land. Six months earlier? Should have cut the rates even more? Um yeah right. Remember the Keynesian deficit spending of our youth? The idea was, the government should spend during the recession, save during the good times, and smooth out the business cycle. Of course what happened, the government spent during the recession and - still spent during the good times, because there was always some worthy cause that needed money. We will soon see the counterparty now with monetary policy. The Fed will cut rates during the bad times and - never be able to raise them, because the minute it tries to, it will find such a debt overhang that left-right-and-center are all ready to go bust. All these interest cuts are leading us down the Japanese road, and not away from it. Low rates, no growth, deflation. Get used to it.

Three weeks ago bond prices were falling rapidly and the Fed governors were suggesting there would be no rate cuts this year. The economy has been weakening again for 2 months. Why then did the Fed reverse course so "suddenly?"

The Fed is indicating there will be no further interest rates cuts. This would seem to make long term bonds or even intermediates quite risky to hold from here on. Suppose intermediate and long term bond do not rise in price, or even fall from here? What of the stimulus effect.

Stephen Roach is continually worrying about deflation. The case is all to convincing. For example, think of a fierce Cisco competitor in China. Will China present a growing deflation problem even in high tech?

"We also saw the quality story first hand at Huawei, the giant Chinese counterpart of Cisco. With its vast array of telecom network solutions conforming to the international quality standards and protocols, Huawei’s cost efficiency loomed all the more formidable. As one of the investors said, "It’s easy to lose money in technology these days, but Huawei may have the best cost structure in the world to produce increasingly commoditized technology products. The high-cost industrial world isn’t even close." Nor is Huawei just about cheap, high-quality production. It is nearing completion on a new R&D complex in its Shezhen campus, a high-rise facility that can house up to 10,000 of Huawei’s engineers and scientists. China has long been criticized for its lack of IT innovation. Huawei’s massive R&D efforts promise to challenge that perception."

Stephen Roach

The ECB isn't going to cut rates? What a shock.

This interest rate cut will have effects on economic activity roughly around Christmas of 2003, boosting real GDP then by perhaps $150 billion at an annual rate.

Greenspan recently said the assumed lag for monetary policy changes to affect the real economy has compressed from the old 12-18 month standard down to six-nine months. That would bring the impact in to mid-2003.

Frankly, I think this cut will do very little. The interest rate-sensitive sectors, cars and houses, are already booming/saturated. And the curve-steepening/failure of long rates to decline [and recent 20% stock market bounce] means capital markets have sniffed out the turns in activity and the rate cycle.

Given that it doesn't look to be matched by similar rate cuts in Europe and Japan, it looks too small to me.

The Japanese and the ECB don't set US rate policy, and have made a perfect hash of their own.

Moreover for most purpose long term rates are what matter, not short term. I personally would not get locked into current long term rates because I think inflation remains a larger issue (from the point of view of the return on my bonds) than deflation. Let's see why.
China CAN export deflation to the US in terms of the cost of material goods. But that's all. The costs of services will not fall (at least not fast---it will take time to move all those service jobs to India), and once the housing boom is over, the old adage remains that they aren't making any more land so there is a floor under the cost of housing.

Meanwhile in the other corner we have an administration that will undoubtedly cut taxes even more (not that current taxes won't already pile up a whole lot), versus the costs of govt services. How will this play out? The last time this happened in the 80's, the Republicans proclaimed master plan, to starve the budget and thereby role back services simply didn't happen. The tax cuts went through, but not the service cuts. Will it be different this time round? Perhaps. The Republicans appear to be even more greedy and more vicious this time around, and money plays a larger role in staying elected than votes. But perhaps not.
The point is, assuming tax cuts but no service cuts, we have massive borrowing pressure by the feds. This results in two things. One is a ramp up in the cost of money. The other however is that it becomes in the feds interests to stoke inflation to reduce the cost of previous debt.
So you say, the administration would never be so short-sighted as to do something like that, nor would they hire people who would go along with such a plan. And of course the obvious answer to both of those is the whole game we have see with Harvey Pitt, and the SEC, The administration has been quite willing to hire sycophants who will do what they are told, and it has been quite willing to burn its seed corn (in terms of public faith in the capital markets) for the sake of the gain of a few thousand wealthy individuals.

GNMAs at 5%, with a possible maturity of 18 yrs or so! (Yea the avg is the past was 12 yrs, but with so many people refinancing at such low rates, the future maturity will be a lot longer). You've got to be on crack to buy something like that. In 5 yrs I could well believe we have a CPI of 5%, willingly engineered by the administration (who BTW told its friends beforehand of its plans, but that's a different issue.)

Holding long term investment grade bonds makes little sense with yields this low, but what of a GNMA fund or a high yield fund? Weighted maturities or durations are quite low for a fine GNMA fund with about a 5% yield, and a high yield bonds have not yet benefited from 2 years of falling interest rates. The only other option that makes sense now is all stocks in an index fund.

"In 5 yrs I could well believe we have a CPI of 5%, willingly engineered by the administration (who BTW told its friends beforehand of its plans, but that's a different issue.)"

Jeez, Louise!! First they shoot down Wellstone's plane using a CIA Predator drone, then "fire" Pitt; now we find the the White House is engineering pushing inflation up to 5%. Who can stop this?

Vanguard has a GNMA fund with a weighted maturity of about 2.5 years and a yield of about 5 percent. Seems quite safe if you like bonds at all. A further drop in price indexes seems a far greater likelihood than an increase in inflation.

Since it is not clear that the Fed rate reduction will lower 10 years treasury rates much, there may not be as much mortgage refinancing in coming months.

The duration of the Vanguard GNMA fund is 2 years. I can not see any significant risk given such a conservative stance.

Stephen Roach, in "A Dissenting View," whilst applauding the Fed's move, suggests that the "the risk is it may be too late."

What day is complete without a decent helping of Delong and Roach?

http://www.morganstanley.com/GEFdata/digests/20021107-thu.html#anchor0

Stephen Roach, in "A Dissenting View," whilst applauding the Fed's move, suggests that the "the risk is it may be too late."

What day is complete without a decent helping of Delong and Roach?

http://www.morganstanley.com/GEFdata/digests/20021107-thu.html#anchor0

Nothing is as it seems. The curve flattened about 20 bp today. If, as George Zachar suggests, steepening mean growth expectations prior to the ease, does the flattening mean the ease has dashed those expectations? Steepening is a natural response to expectations of an ease. Flattening is a natural reaction after the fact. It is how money is made on a short term basis in the Treasury market. It doesn't tell you much. Over a slightly longer term, yup, the curve has been steepening, but that may have been war-worry-driven, piling into safe-haven short-maturity paper. Yes, confidence in growth 6-months out may be reflected in the October run-up in stocks - isn't that the traditional view of how far forward stock investors look (without seeing) into the future? Problem is that Christmas falls into the intervening period, and can change everything.

Boucher and Handley worry about inflation, but I have to wonder whether that isn't looking back a bit. To some extent, our 1970s-80s advanture with inflation looks like a learning problem. Policy-makers accustomed to using monetary policy to keep fx rates steady suddenly have the opportunity to use it for some other purpose, latch on to a Phillips-curve notion that proves to be a formula for inflation, and have to screw up the courage to go through a painful period of reversal. Give that wringing inflation out costs so much more in terms of output that allowing it to arise provides - after such knowledge, what forfiveness? As to the China effect, it raises the interesting and unhappy prospect that Western economies will have to go through a period, not of inflation, but of painful relative price adjustments. This will keep trade protection alive and well, cause job market and stock market churning and make life more a winners-and-losers prospect that what we enjoyed during the past decade. Lots of other indicators in that direction, as well. Worker cCompensation rose at a 4.8% annualized pace in Q3, the fastest in a long time, but it seems unlikely that workers saw much of it as take home pay. Firms footed the bill (0.8% unit labor cost rise, despite a 4.0% productivity gain) as benefits providers took a big bight.

New York Times -

"Bucking both the Federal Reserve and the increasingly plaintive calls of European politicians, Europe's central bank said today that it would leave interest rates unchanged.

"A day after an unexpectedly large cut in rates in the United States, the European Central Bank said it would wait for more evidence that Europe's economy was faltering before it lowered its key rate.

"The Bank of England also left its benchmark rate unchanged today, though with Britain's economy in generally better shape than those of Germany, France and Italy, the decision was less contentious."

Oh dear....

Why is it that 10 percent unemployment in Germany is not seen as reason enough for the European Bank to cut rates? The problem is serious, but perhaps lees chronic than the Bank wishes to believe if only it were to stimulate the European economy with lower rates. Is an inflation prospect really a problem? Good grief.

Central bankers can be too insulated from public pressures....

Remember - There is simply not enough job growth to look for a rise in inflation in America.

GNMAs yielding 5%? which GNMAs? GNMA's backed by pools of 30 yr FRM will have very different weighted maturities (and durations) than Ginnies backed by 15yr FRMs or by ARMS (adjustable-rate mortgages) They should NOT all have a current yield of around 5%. If the Fed is finished cutting rates and GNMA30s are yielding 5%, then this is a one-way suckers' bet.

WOW. Those Vanguard durations/maturities are phenomenally conservative (IMHO) for a GNMA fund, which I guess means there's at least one person out there managing serious money who has the same concerns that I do.

The other question, of course, is who is the sucker holding all the long-dated GNMAs?

Hmm. Now that I think about it more, exactly how does a fund like Vanguard measure the maturity of a portfolio of GNMAs? In particular how is the pre-payment risk handled? Is the calculation something based on the very recent past (meaning that all their long-term bonds appear to be short-term because of so many recent refinancings)? Even if the risk is based on statistics ranging over a reasonably long period of the past, do they have scope for adjustments based on the facts that with so many people having refinanced, and having locked in low rates, refinancings in future are likely to be a lot less common?

>>Central bankers can be too insulated from public pressures....<<

I doubt it. The opposite really would be a problem. Look at the difference between fiscal and monetary in the EU. The fiscal decisions are far more tied to public pressures and votes - ie short term decisions. What happens. You get to be on the 3% ceiling before the problems start, then when things get tough you cry foul, there is no flexibility.

Duisenberg faces three tough problems. One is credibility. Two is really being able to measure consequences. Three is the fact that the EU economies are far from homogenous.

If we start from the idea that what matters are real, not nominal rates. Germany has 1% inflation (and dropping), so the ECB rate of 3.25%represents a real rate of 2% - far two high. Spain has an inflation rate of 3.5%, thus the real rate in Spain is -0.25%, ludicrously low for a country with a chronic inflation problem.

The present rate is bad for both countries. So what do you do, raise or lower? Why, oh why, did anybody dream up the idea of the Euro in the first place?

K Harris says: Steepening is a natural response to expectations of an ease. Flattening is a natural reaction after the fact. It is how money is made on a short term basis in the Treasury market.

To which I say, it is also how money is LOST on a short term basis in the Treasury market! :)

The sprint out the curve likely reflected mortgage security convexity neutralization buying, as well as folks unwinding briefly profitable steepening trades.

In the interest of full disclosure, I am a client of K Harris' firm, MCM.

Suggest looking at the structure of the Vanguard GNMA fund. Frankly, I think it is a splendid fund in line with all John Bogle's thinking. A fund that is truly shareholder responsive. The average weighted maturity and duration are calculated monthly, and are now conservatively low. The yield is about 5.1 percent because the cost of fund is fair to shareholders and so low.

Prepayment could be a risk if interest rates are to fall further. If rates rise, the low duration is a fine protection.

Vanguard's GNMA duration is calculated according to a widely used and reliable Solomon Smith Barney formula. I simply love this fund, though just now bond prices are relatively high and yields low. Vanguard and TIAA-CREF strike me as having by far the most investor friendly bond funds. Conservative management and fine returns helped along by keeping costs fair.

If there are better families of bond funds, I sure haven't found them.

Stephen Roach notes -

More than half the world's economies are deflating. We have needed interest rate reductions in Europe, we have not had the needed cuts.