Wednesday, December 12, 2007

Kudlow 101: The Fed Has More Work to Do

Here’s why I wanted 50 basis points from the Fed, and why I believe the U.S. central bank still has more work to do.

The following charts illustrate why there’s still not enough liquidity, and why the credit clogging and short-term funding markets need some help.

Let me begin with the yield curve spread. (This is the 10-year less the fed funds rate.)

Notice what has been happening. Since mid-2005, this spread has gradually turned negative. Look at that move. First it flattened, then it continued on, eventually turning negative. It is still inverted. It has been 18 consecutive months. It is still inverted by about 18 basis points. It’s been a year and a half since the fed funds rate was above the 10-year rate. That is unsustainable. It is a recession warning.

Okay, next chart—adjusted monetary base.

This is the basic money supply measure controlled by the Fed. When they buy bonds, they inject cash into the economy. That adds to the money supply. When the Fed sells bonds, they withdraw cash from the economy. That subtracts from the money supply.

As the yield curve got tighter and tighter, the Fed’s monetary base got slower and slower. This goes back to 2003. It started this journey at 8 percent and is now at only 2.1 percent. Guess what? If you can’t borrow short to lend long, then the whole money supply creation and credit creation process is turned upside down. That’s what we’ve experienced. The Fed has got to make a correction. The fed funds rate has got to get down below the 10-year rate.

The next chart illustrates the credit clogging. It shows 30-day asset backed commercial paper compared to the fed funds rate.

Short-term funding markets are clogged up. They’re not working. Businesses are having trouble getting overnight loans. If this isn’t corrected then the economy will falter.

You’ll notice that it’s actually worse than it was this past summer. Last summer it got as high as 108, and then fell quite a bit to 13. But look at what’s happened in the last month or two. It’s gone all the way back up to almost 200 basis points. This is what the Fed’s Donald Kohn was talking about recently. This is why people thought the Fed was going to be more aggressive yesterday.

And finally, let’s take a look at the London interbank market.

The dollar spread is almost to where it was last summer. Look at what’s happened in the last couple months. It’s back up over 100 basis points.

These are all reasons why the Fed has got to unclog these credit markets. They’ve got to right the yield curve and provide more money supply growth in the form of the monetary base.