Posts Tagged ‘recession’

The Essence of our Predicament

Tuesday, January 29th, 2008

The essence of our economic predicament is that the cost of debt has risen dramatically on instruments the Fed can’t control: longer durations and riskier issuers.

This happened to corporations and consumers simultaneously. Both rises were essentially unexpected, i.e. not priced in. Now we’re getting whipsawed as realization of the new cost of capital is priced in.

Other things equal, disinflation or deflation is the logical result of an uncontrolled, unexpected, sustained, large increase in the cost of capital.

Fed rate cuts can mitigate that, but not as much as desired, because most of the problem is concentrated at the other end of the risk and duration spectrum, e.g. 30 year mortgages or BBB corporate debt.

This essentially all resulted from a loss of faith in the judgment of the rating agencies, and in the solvency of the debt insurers. The Fed rate could go to zero, and banks would still be afraid to lend to a BBB credit, because they can’t be sure it’s really BBB any more, or that they can insure reliably against a default. So restoring faith in the ratings agencies and debt insurers is probably a prerequisite
to flattening both the yield curve and the risk premium.

As long as it stays like that, we appear to be facing an era in which asset prices are falling and cost of servicing debt is rising, so that seems deflationary. The alternative, which I prefer, is to cut Fed
rates so aggressively that things go the other way, i.e. dollar falls, durables prices rise, etc. But keep in mind that fewer people have much equity left to buy things with, no matter where rates go.

That’s how it looks from this armchair.