Fed essentially 'pushing on a string'

By DAVID MOON, Moon Capital Management, LLC
April 4, 2010

When the Commerce Department announced that February consumer spending increased 0.3 percent, casual observers found a glimmer of positive news. After all, consumer spending accounts for 70 percent of the US economy.

As usual, however, the devil is in the details.

February was the 5th consecutive month in which the increase in consumer spending outpaced the increase in consumer income.

Consumer spending is influenced by the wealth effect – that is, spending patterns are correlated with the values of personal assets, such as 401(k) plans and homes. With short-term interest rates hovering around zero, values of single family homes have stabilized and stock prices soared last year.

Is that impetus – zero percent interest rates – a sustainable stimulus?

One of the most powerfully positive influences in the economy and financial markets over the past 28 years has been declining interest rates. Falling rates is the magic elixir that makes everything taste just a little bit better. Real estate prices increase, the Dow grows like ivy climbing a pole and men think they are a bit more handsome.

It’s like having a secret two-point play in football that always works. Until everyone figures it out.

The MIT Real Estate Center estimates that 55 percent of the $1.4 trillion in commercial real estate loans coming due in the next five years are underwater – that is the loan balances exceed the property values. Someone is going to have to eat those losses. The owners won’t be able to refinance the amounts they owe – because the properties won’t appraise high enough. The borrowers will either have to come up with the cash to make up the difference (highly unlikely) or a bunch of banks are going to end up unintentionally owning a lot commercial real estate.

The Fed can continue to manipulate short-term interest rates to near zero levels, but investors don’t buy it. Thirty-year Treasury rates are 12 times the one-year rates. Investors were less than enthusiastic about the most recent auction of Treasury securities. Yields on ten-year bonds jumped from 3.70 percent to 3.88 percent. And those ten-year yields increased above the ten-year swap rates for the first time since… well, for the first time ever.

The Fed is, in essence, “pushing on a string,” meaning that the tool that worked so well for so long – lowering rates – has lost its effectiveness.

Banks are currently sitting on more than a trillion dollars in excess liquidity, the most potentially inflationary impetus since the 1970s perfect-storm combination of the Vietnam War driven budget deficits, abandoning the Bretton Woods gold standard agreement and the Arab oil embargo.

When I was a kid, we would occasionally discover that gasoline was being stored in a different automobile fuel tank than it ought to be. To correct the situation we would insert a piece of a garden hose into the improperly filled tank and suck on the open end of the hose until a vacuum was created and gas began to freely flow.

What happens when there is no gas left in the tank to siphon?

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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