RateWatch #413 – The Last Mile. The Fed.
June 13, 2004 by Dick Lepre
dicklepre@rpm-mortgage.com
What's Happening
Existing Home Sales were strong. But, revised 1st Q GDP was +3.9%. This is down from the initial +4.2%. The below-4% GDP growth eliminates any possibility of a greater than 25 basis point hike at next week's FOMC meeting. The GDP Price Deflator (the broadest possible measure of inflation was revised to +2.9% with core at 2%.) The dynamics of the economy are most interesting: we have lower than desired GDP growth but higher than the Fed wants inflation.
The move to a higher Fed Funds rate will indeed occur at a measured pace and will not be easy. If it raises rates next week the Fed is going to declare preemptive war on inflation at the risk of "taking something off the top" of GDP.
The goal of the Fed is to get the Fed Funds rate above core CPI in a manner that hurts GDP growth as little as possible. This is not a simple task. We are dealing now, more than ever with a world economy which serves both to contain inflation and to take bites out of GDP. Higher rates may lead to a stronger dollar which will hurt exports and GDP. The unstable situation in the middle-East puts energy prices at risk. This particular move to higher rates is particularly risky. The biggest risks are deflation and stagflation. Deflation is particularly dangerous but unlikely. "Stagflation" is inflation with flat or declining GDP. The next biggest risk is inflation with growing GDP. A more likely scenario is contained inflation with GDP growth perceived to be too low.
The most interesting economic news of the week may have been SBC's announcement that it would invest $4-$6 billion over the next 5 years to provide "last mile" delivery of fiber optic service to residential users. Business has been frustrated for years by the large amount of fiber
optic cable in place without the physical cable to take the data from the central offices to homes. It has been like building a freeway with no off ramps. This overabundance was largely responsible for the telecom bust of the late '90's.
What SBC is proposing is called "fiber to the curb" or "fiber to the node." That is, delivery of fiber
optic service to those little boxes on the corner near your house. In a sense this is making the
"last mile" problem into "the last hundred yards" problem.
In addition to offering high speed internet access the most obvious service is video on demand. This competition if fierce: cable TV and video rental stores are served notice.
The point is that if fiber optic access is made available to our homes there may be something akin to another Internet surge of the '90's. In addition to the ability to see any movie when you darn well want, some other possibilities are: high quality video conferencing, decentralized education, and as with everything technical since the '70's, a high-tech method of delivering porn.
The hope would be that this were a more healthy iteration of the dot-com thing. There would not be as many players and over-investment leading to the boom-bust cycle that was created by the large amount of speculative investment in bad ideas. If there is a second-wind Internet boom it will involve a much smaller number of players but will probably lead to jobs that are more permanent. Of additional significance is the fact that this will occur in a "post-outsourcing" environment. Apart from laying the cable, there is no guarantee as to where the jobs will be.
It would serve to point out that there are significant regulatory issues which must be worked out. Congress (and the government in general) has been slow to act or react on issues involving telecom and cable. There is going to be some ferocious competition between the phone and cable companies. Cable companies want to offer phone service (voice over Internet protocol). Phone companies want to offer video services. Hopefully, the competition will benefit the consumer.
The Fed
The Fed's power comes largely from perception. As long as Mr. Greenspan can maintain the perception that the Fed is in control they folks will follow and it will de facto be in control.
Let's review, from some of our previous discussions, what the Fed is and how it derives its power.
The folks who framed the Constitution drew on the experiences of European governments and formulated a 3 part federal government: the president, Congress and the courts. A system of "checks and balances" among the 3 branches is supposed to prevent any one of them from becoming too powerful.
There are times when it is obvious that this system functions. Recent examples of this include the Clinton impeachment. It was obvious that neither the President nor Congress had a lot of power. The Bush-Gore photo-finish election was another example. It was not the executive branch or Congress that controlled the situation and when the U.S. Supreme Court opined it revealed, with startling clarity, that it was as divided as the rest of the country.
In many countries the military has the real power. This seems to work in smaller countries but in the US the military wields no substantial political power.
Like it or not, there is one pervasive power in the US - money.
Money is brought to you by the Federal Reserve. The Fed functions in a manner to make it something akin to the 4th branch of the government. The Chairman of the Federal Reserve, Alan Greenspan, has on his desk a sign saying "The Buck Starts Here."
The Federal Reserve was created in 1913 see: http://landru.i-link-2.net/monques/FR1.html
to provide, duh, a Federal Reserve - a way for banks to share each others' reserves if there was a "run" on one. After the Depression, Congress, in 1935, created the system whereby the Fed was able to create money by purchasing government securities. When it did that, it probably did not understand how important that decision was.
The Fed controls business and the economy by controlling the money supply and by its ability to control interest rates by buying and selling government securities on the open market. More impressively, the Fed can send shock waves through the economy by merely talking about raising rates. The rate that the FOMC sets is the "target" for the Open Market yield of the 30-year Treasury bond. It is maintained not by edict but by persuasion and a active participation by the Fed itself in the market. It is, in effect, engaging in price fixing - perhaps "price control" would be a gentler term.
The "deterrent" force of Greenspan's mouth is akin to the nuclear deterrence of the '50's and '60's. The threat of raising rates has as much effect as actually raising rates.
In recent years that power had been mitigated by the run-up in equities. Real disposable wealth (i.e. money) was created. The Fed was unable to regulate the supply of this "money." To a significant extent, comments by Greenspan during 2000 served to "talk down" equities. Equities have been more "under control" since those comments. This is by design as much as anything else.
What Powers Does the Fed Have?
The Fed has 2 main sources of power:
1) the power to "diddle with rates" both by resetting the actual Fed Funds target or by merely
talking about it and
2) the "magic checkbook" whereby the Fed can create money out of nowhere and buy bonds on the open market. The power to create money out of nowhere (so called, "fiat money") is impressive. I'd like to be able to do that.
Let's for the moment grant that the very ability to create money makes the Federal Reserve a separate branch of the government. (Of course it is not, it is still part of the Treasury Department.)
It is imperative that the Fed buy debt on the open market and not directly from the Treasury Department. This idea of "open market" is extremely important. The Fed can open up its checkbook (the magic one with the near infinite overdraft protection) and inject money into the economy by buying government notes and bonds. But, it must do so on the open market. Congress' sovereignty over expenditure is maintained by forcing the Fed to buy from private
holders of government debt. If the Treasury Department ran the show, Congress would have succumbed its budget powers to the executive branch.
So What?
The Federal Reserve has very significant control over the economy. But it does not "make or break" the economy. It smoothes out the sizes of the economic cycles by avoiding potholes.
The Fed has looked so good lately because inflation has remained contained. With inflation contained, the Fed has the ability to "fine tune" rates and look great. Contained inflation is
like driving down the highway on a clear, sunny day with dry pavement and little traffic. Everyone drives well. If inflation is out of control, the correcting forces of the Fed are like someone trying to avoid other cars on a wet road, at night with a 45 mile an hour crosswind. There will be some wrecks.
The success of the economy of the '90's was not due to politicians or even the Fed. It is due to the combined sanity of workers, businessmen, investors and the Fed. It is very easy for bankers to make a lot of money and the Fed to look great in this environment.
The Fed has power in its ability to create money. But it has not created wealth and prosperity. Wealth is the product of hard work, a healthy measure of greed and a good bit of luck.
The Real Power of the Fed
I think that, in final analysis, the Fed is one big bank. It can create money, but unlike other banks it operates with almost no control from other parts of the government. It is not subject to the audits that other banks are. (The Fed is audited by the GAO and the district branches are subject to outside audits but the audits do not look into the policy making, open market operations or discount window operations.) It is relatively free to buy and sell gold and US and foreign bonds and currencies. It is the lack of intervention from politicians that enables the Fed to work and gives it power. The Fed has served itself well by not causing any scandals. No Michael Milkens, no Espys, no Monicas, no Chappaquiddick, no pardons, no Oliver Norths.
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