Wednesday, April 23, 2008

Mr. Bernanke, Raise The Fed Fund Rate!

Difficult Times Require Drastic Measures
European Central Bank (ECB) is doing the right thing by addressing the inflationary pressure on basic good by contemplating raising interest rates rather than lowering as BoE, U.S., and Canada have done. With consumer prices rising at an annual rate of 3.6%, the ECB is tackling the problem that vexes most people affected: the consumers.

The European banks are also afflicted with the same credit crisis that afflicts the U.S. and the English banks. In fact, the banks with the largest write-downs have occurred to UBS with about $40 billion since 2007. However, the banks’ write-downs and adding to their capital are not deterring the ECB from addressing the inflation worries.

This is a drastic measure that is being positively viewed by the market as the Euro zoomed to a new high against the dollar today. While the accounting rules are different in Europe than in the U.S., it is not that different. In fact, the U.S. accounting standards is scheduled to converge with the International Financial Reporting Standards (IFRS) used in Europe in 2008.

So why is the ECB looking hawkish on inflation while the Fed is not? The credit crisis has hit both sides of the Atlantic and some Asian Banks. I think the difference lies in the different thought processes. The ECB is looking at the overall impact of the inflation to the common folks while letting the banks fend for themselves. The opposite appears to be true in the U.S.

With the Fed fixated on restarting the economic engine by pumping more liquidity into the market, there is no hope that the Fed will finally realize that for all their efforts to date, the economic engine that the banks once were is kaput and should be left alone to resolve itself.

Drastic Measures
If the Fed can come to grips with the fact that the inflation is affecting 300 million Americans, which comprises nearly 70% of GDP, while the bank credit crisis is affecting less than 10% of GDP, then they will reverse their trend and raise the Fed Fund rate.

The effect of raising the Fed Fund rate will be immediate. For one, the U.S. dollar will begin to firm up against foreign currencies. This will force the commodity speculators, especially the ones speculating in oil to sell out of their positions, thereby quickly reducing the cost of oil and other commodities that have seen substantial appreciation.

The naysayers will say that the increase in Fed Fund rate will make borrowing difficult. Hello, it is already difficult. The credit lending standards have reverted back to a conservative stance, forcing marginal borrowers out, which is a good thing. The nasty secondary effect of the tightening of the lending standards was the widening of the CDS spread. However, cooler heads are asking if the CDS spreads were overdone.

For the average consumer, the rising prices of basic goods are more hurtful and immediate to their finances than the credit crisis. Even to the consumers who are underwater in their mortgage. The banking industry will survive, even with all of the level 3 assets. While some banks will disappear a la Bear Stearns, the shake out will result in a chasten industry that will emerge from this mess well capitalized.

The risks from low Fed Fund rate are hurting the U.S. far more than the credit crisis. There are some Fed Governors that realize this. The more the Fed persists in helping the few at the expense of the many, the higher the likelihood of the U.S. going into a stagflation period. Hopefully these few Fed governors will convince Bernanke to reverse course and increase the rate. To mitigate the shock to the banking system, the Fed can leave the discount window rates at its current level and, simultaneously, expand their TAF and TSLF programs, which will provide liquidity to the banks while the Fed fights inflation. These are difficult times and drastic actions are now required.

Ed Kim

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