One of the characteristics of a bubble economy is the delinking of the equity markets from the actual performance fo the economy. At their peak in March 2000, stocks were valued at 181% of GDP (Dada from Bianco Research) while at the beginning of the decade they were 60% of GDP. This is what I mean by "delinking." That is clear eveidence that the wealth effect does not reflect the performance of the economy. One of the few valid points made by Greenspan was that the wealth effect created imbalances that was more than the conventional time lag. The Fed, in its attempt to manage the economy, operates under strict principles of monetary policy. The fundamental behinds these principles is the monetary base, the expansion or contraction of which is measured by the injection or drain of money supply. The Fed has generally preferred to control money supply through the manipulation of the interbank Fed Funds rate and to a more reluctant degree the discount rate when banks borrow directly from the Fed through the discount window. Volcker experimented briefly in 1980s with targeting the monetary base by introducing his "new opreating mechanism" with the disastrous and damaging result of violent fluctuation of interest rates. It is generally recognized that the most effect way for the Fed to act is through a consistent, gradual "steady as she goes" manner without minimum surpise or sufdden reversals. The credit market has grown accustomed to gradual interest rated policies. That is the rationale for a soft landing. Anytime that the Fed acts suddenly and with large steps generates an atmosphere of crisis which tends to exacerbate undesirable trends that in any event cannot be impacted by Fed actions for at least six to nine months down the road. Thus the Fed action at mid business day on January 3rd, with a unusaul 50 baisis point cut in the ffr, backed by a 25 basis point cut in the discount rate with a promise of a further 25 basis point if needed, acted as a clear signal that a hard landing within the next 6 months is certain. The monster surge of the share prices yesterday actually instantly enlarged the delink of the equity mearkets from the economy, and thus enlarging the bubble and worsen the impact of the inevitable burst. Greenspan seems to have boxed himself into a corner. One of the reasons he had unleashed 6 consecutive rate increases in 2000 was because of the imbalance in the economy created by the wealth effect due to irrational exuberance in the equity markets. Yesterday's surprise of sudden and large rate cut produced an immediate resumption of irrational exuberance through a reactive rebound in the market. If it turns out to be a dead cat bounce, then Greenspan has proved his impotense (As it turned out by Friday, the rebound was a one day wonder). If the rebound holds, it forecloses the Fed ability to cut interest rates further, thus removing the hope of a soft landing. There are many projections that say that any ffr reduction less than 250 basis points from the peak of 6.5% would not have much meaning in helping the moribund economy. A further 150 basis points drop may take three or more moves spread out over three or more months in order to prevent a panic appearance. That means the full impacts of interest rate cuts may not manifests themselves until the end of 2001, by which time the economy will have felt the full impact of accumulated damage from the downward momentum that started in November 2000, before any possitive signs. The market's knee jerk reaction to rate cuts is going to be the phenomenon that neutralizes Greenspan's silver bullets. But even effective silver bullets cannot avoid collateral damages. The 10 year Treasury note, on which real estate mortgage rates are based, jumped yesterday, narrowing the inverted yield curve. This will move up the real estate collapse which otherwise would not have been felt in the early phase of the slowdown. The WSJ reported the day after the Greenspan action day that calls from customers to one mortgage broker for refinancing has increased 300%. Because of Collateralized Mortgage Backed Obligations (CMO), mortgage rates respond instantly and often months in advance of actual or anticpated Fed moves. Refinancing is very bad for mortgage securitization, because it is the most significant risk that securitization expose investors to. If the CMO market freezes up, the real estate sector will tank, nevermid waiting for individual defaults. February oil futures rose 75 cents to $28 a barrel on expectation of a prolonged bubble. This will both drain money from the economy as well as accelerate inflation. The exchange rate of the dollar is the most problematic. There is no avoiding the impact of a falling dollar from US rate falls. The dollar's fall against the euro was temporaily cushioned by the Fed cut, because traders felt the Fed had gotten ahead of the curve in retarding the slowdown in the US economy. The dollar's falls against the yen yesterday was attributed to the unwounding of longterm euro positions against the yen, rather than to fundamentals. The Nikkei fell yesterday, the only index adverse affected the the Fed cut. Another 150 basis points drop in ffr will only hurt the dollar against either the yen or the euro. Greenspan is being reminded by the market that there is no free lunch. Henry C.K. Liu _______________________________________________ Crashlist website: http://website.lineone.net/~resource_base
