The Fed is telling us that it will maintain a zero interest rate policy—the same emergency policy that has been with us since December 2008 — for nearly two more years. 

Fed Fund futures had only priced in a 25 basis point increase in its June 2013 contract prior to the announcement so this shouldn’t have been than much of a shock. But I have to admit it shocked me.

Perhaps if they announced a third round of quantitative easing (QE3) it would have seemed too much of a reaction to the recent Standard & Poor’s downgrade of U.S. credit. And the market doesn’t seem afraid of U.S. credit as 10-year Treasury note futures rallied to all time highs (record low yields) so there is no immediate need for the Fed to starting buying up more Treasuries (see chart below). But it needed to acknowledge the recent weakness in the economy and at least appear to be taking some action.

It did, however, leave the door open for QE3: “The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability.  It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.”

We have been critical of the Fed who have appeared to be talking out of both sides of its mouth during this crisis. At one point claiming the economy is improving and at the same time keeping rates at zero.

There was no confusion here as the outlook was grim.

More confusing is the market’s reaction. Equities where on their way to a pretty strong rebound when the announcement caused equities to tank to new lows. Then just as quickly they rebounded to close on their highs.

While this type of whipsaw reaction is seen during Fed auctions, the results of which are sometimes hard to read, their statement was pretty straight forward. It was either good news or bad news. I began wondering if conspiracy theorists would start to bring up the mysterious, “Plunge Protection Team”.

The market reaction was so weird it caused Andrew Wilkinson to write today: “The equity market’s strongest rally in several years is about as misplaced as had parents thrown a celebratory party for an eighth-grader after hearing their child would spend the next two years at the same grade level.”

I think Andrew is looking at the whole more than the parts. Remember the initial reaction was extremely negative. What happened next is a mystery to me as well, though I think it is related to the perma-bull mentality that is still rampant in the equity brokerage world. The internet was full of analysis from this space claiming we are at an historic buying opportunity. And yesterday’s S&P low represented a 20% drop in the index over one month. Surely the market was oversold and there is a portion of the investing world looking to buy a major bottom, and every serious downturn produces claims that this is a major bottom. Also, whether or not you subscribe to the PPT conspiracy theory, there is ample proof that the Fed will take action to attempt to prop up equity markets.

There have been numerous comparisons about what is going on in the U.S. economy with the Japanese lost decade (now decades). With the projection of a five-year period of zero interest rates, no time has that comparison been more apt.

Not exactly a bold statement but a necessary one as it became imperative to say something supportive of the dollar after last week’s weakness. It has not lasted as the dollar made a new low for the move today.

What is so bothersome about Bernanke’ comment is it ignores what he has been saying all year. We noted here recently the Chairman’s rhetoric doesn’t match his actions. First he has been talking about improving conditions for months then he says “when the economic outlook has improved sufficiently.” What is sufficiently and why hasn’t the tightening begun?

All this most recent comment means is that at least someone at the Fed has an eye on the dollar and suggested to Ben maybe he ought to say something.

The Aussies raised rates last week from its recession bottom of 3%. Yes the Australian economy and banking sector wasn’t as sick as ours and is also quicker to recover but note that the bottom was 3%, a level that is now too accommodative. 

The Fed has maintained after recent meetings that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

Understood. But we are at zero. Bernanke has said we are probably out of the recession and things are improving. A zero rate policy is extraordinary; anything below 3% is accommodative.

If you wait until things are growing, and growing briskly as opposed — I guess — to the type of improvements the Chairman has been seeing lately, how do you put the brakes on? How do you go from zero to not accommodative—most recently judged to be somewhere between 4.75%-5.5% based on the last tightening cycle and historically much higher. A zero percent Fed Funds rate is not accommodative, it reflects  emergency conditions.  

Basically what the Fed has been saying all year  is that while the economy is still weak, the emergency is over. So why not act like it is.

Those words probably don’t mean a lot to those who have lost their jobs or those who will soon lose their jobs as the economy continues to shed jobs, albeit at a slower pace than in the heart of this recession.

What Bernanke probably meant is that when the third quarter gross domestic product report is released, it will show positive growth. This is small comfort to the afflicted and not terribly meaningful given the way the reporting has been manipulated to produce more positive numbers. Some believe this to be the case and others are more doubtful. The disturbing part from our point of view is that the more optimistic voices come from those who never recognized the problem and felt the crisis was over before it really hit in earnest, whereas the more pessimistic voices where the one warning us several years ago.

The Fed will conclude its September meeting in about one hour and will put out a statement. Most experts believe that the Fed will keep interest rate steady. Why? If we are most likely out of the recession, why not begin to raise rates? The current Fed Funds target is 0- 0.25%. If the Fed rose rates to 1%– a substantial action—it would leave rates at an extremely accommodative level.

 An annoying theme of the Bernanke tenure is how his assessment of economic conditions does not match his actions. He provided reassuring words while taking dramatic action. There is a disconnect when  he downplayed the current crisis prior to the Lehman failure while dramatically cutting rates, creating numerous lending facilities and opening the discount window to investment banks and brokerages — something not done since the depression.

 Part of this is understandable. He must avoid creating panic and there are those people who insist perception is reality. As noted here before, if that was the case why didn’t all the happy talk by the previous administration prevent the current crisis.

But his words matter and if he thinks we are technically out of the recession, he should start acting like we are. As we noted a 1% Fed Funds rate is remarkably accommodative especially as there is some quantitative easing left to do according to the Fed. During the last two recessions the Fed did not drop the Fed Funds rate below 1%. The rate was 1.75% as we emerged from the 2001 recession even though the Fed, a full year after, would cut rates to 1% (an action many feel contributed to our current crisis). In the 1990-91 recession the Fed cut rates to a low of 3%. Yes the Fed cut rates from 4% to 3% after we were technically out of the recession but we didn’t know it at the time and  we had several quarter of minimal (0.1%) growth.

During the last tightening schedule there was talk as to where the Fed would end. What is the proper interest rate level, all things being equal? All things being equal meaning there is a balance between fear of recession and inflation. That number was believed to be somewhere between 4.5% and 5.5%.

 Many analysts believe we have the making for massive inflation ahead of us. And when it hits it will be hard to slow down. Bernanke acknowledged that the economy was still in serious condition but a zero Fed Funds rate denotes a crisis. The Fed stated after the August meeting that, “The Committee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” A Fed Funds rate of 1, 2 or even 3% is historically accommodative and a 1% rate qualifies as exceptionally low.

 Bernanke spent much of the speech patting himself and other central bankers on the back for their quick action in averting a financial meltdown. But many people believe the meltdown was just delayed. The outstanding question is, how quick will Bernanke be in addressing a potential Act 2 to this crisis?

The peak marks the end of expansion and the beginning of a recession. The NBER does not accept the common definition of recession: two consecutive quarters of negative GDP growth.
NBER defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators.”

The report goes on to say, “All evidence other than the ambiguous movements of the quarterly product-side measure of domestic production confirmed that conclusion.”

The word “all” is pretty revealing. So every possible measure of economic activity indicated we have been in a recession since December 2007 except the one official measure. That is an interesting point of view though not a unique one. John Williams of Shadow Government Statistics has been making that point for quite a while.

There were a few other clues as well. The Federal Reserve usually does not cut its Fed Funds rate 350 basis point in less than a year (which they have done since Dec. 11, 2007) when the economy is doing alright, let alone open up their lending facilities to investment banks and brokerages for the first times since the 1930s, which the Fed has also done. Rarely does our government bailout numerous large institutions—Bear Stearns, Fannie Mae, Freddie Mac, AIG—when the economy is in the pink.

There are the myriad of other indicators as well such as rising unemployment, declining retail sales, plummeting housing values and consumer confidence. Yet so many market analysts and government officials dismissed the notion that we were in a recession. Many in fact, peddled the notion that any economic weakness was caused by the constant negative drumbeat of all the “Chicken Littles” out there. If it weren’t for that, everything would be fine. This was after all an election year. Too many of our leaders have been attempting to manage expectations, I am not sure if some of them know the difference between reality and spin anymore. But the endless campaign has come with a cost.

If you cannot define the problem, you cannot address it.

Unfortunately none were forthcoming on the eve of the Fed’s announcement on interest rates. Tuesday the S&P Case-Shiller Home Price Index for February showed continued weakness in the housing sector.

“There is no sign of a bottom in the numbers,” said David M. Blitzer, Chairman of the Index Committee in a release. “Prices of single family homes continue to drop across the nation,” Blitzer added.

The index showed all 20 metropolitan areas in the index dropped. The 20-city composite dropped by 12.7% year over year and the 10-city composite dropped 13.6%.

In addition to the Case-Shiller numbers, the Conference Board reported that consumer confidence continues to retreat. The April consumer confidence index dropped to 62.3, down from 65.9 in March.

Lynn Franco, Director of The Conference Board Consumer Research Center said in a release, “This month’s decline in Consumer Confidence was the result of yet another sharp decline in the Present Situation Index. This continued weakening suggests that not only has the feeble level of growth in the first quarter spilled over into the second quarter, but that economic conditions may have slowed even further.”

With the economy seemingly drifting into recession, a consensus is building that today’s expected 25 basis point cut by the Fed will be the last. In fact Fed Fund futures traded at the Chicago Board of Trade indicates that the benchmark short-term interest rate will begin to move higher by yearend.

Today’s Gross Domestic Product report (up 0.6%) has been dismissed in many sectors as not reflecting reality. First inventory building accounted for 0.8% of the growth, which indicates that we are in recession and increases in government spending account for another 0.4% of the quarterly figure. Add that the government insists on using core inflation in its adjustments and you can picture where we really are.

Unless the Fed surprises us later today, don’t expect much action until the minutes of their deliberations are released. Even if they do plan on pausing after today, that plan will be tested if the numbers continue to go south.

Perhaps the best gauge is the market and based on the April 2008 Federal Funds futures contract traded at the Chicago Board of Trade, the market is expecting a full point.

One trader on the floor expects equity index markets to react positively to even a 75 basis point cut but if the Fed comes in with anything lower, our trader says, “It will get ugly to the downside.”

With such aggressive market expectations continuously being met by Mr. Bernanke and the Fed, you have to wonder what will happen if the economy does not turn around quickly. A full point rate cut leaves the Fed with very little ammunition. All the experts we talk to expect further subprime fallout and say the we are still not close to seeing the complete magnitude of the current credit crisis.

At the current pace, the Fed will run out of bullets before we run out of stories of further write downs, declining housing markets and investment banks at risk.

“The ball started rolling with the recession-like rise in unemployment in December,” says Jim O’Sullivan, UBS chief U.S. economist, adding that last month’s decline in the CEO confidence index, combined with a slipping stock market and weak jobs report have tipped the balance. “It’s just the sense that businesses and consumers are getting more cautious. And the down turn in housing is starting to feed on itself,” he says, adding that he anticipates recovery in the second half of 2008.

O’Sullivan also notes that today is the first time since 9/11 that the Fed has done an inter-meeting rate adjustment. “Certainly the market has calmed down today. The market is only down a little over 1% [down] now, when we were looking at minus 5%,” this morning, he says. He also is expecting another rate 50 basis point cut at the Federal Open Market Committee meeting on Jan. 29.

“At this point, if we are moving into recession, it’s just limiting how bad it will be, rather than affecting whether we are going to have a recession. They are worried obviously and they are trying to get in front of this. There has been some criticism that they are moving too slowly, but I think they are showing some aggressiveness here.”

Since Bernanke’s testimony on Jan. 17, suddenly there is a consensus between the President and the Congress that we need a financial stimulus package. “The mood has changed dramatically in the last couple weeks,” he says. “In the end, it should at least limit the weakness,” he says, but whether it is enough to avert a recession remains to be seen.