Teton Reflections

This week in Outside the Box, good friend Paul McCulley of PIMCO fame addresses the important topic of fed fund easing. Paul addresses the predicament the current Fed finds itself in on account of not wanting to bail out those who took excessive risk in what he dubs the "shadow banking system," - comprising an alphabet soup of levered non-bank investment conduits, vehicles, and structures. The crux of the matter as Paul highlights is that the 50bp discount rate reduction still remains a penalty to the Fed Funds rate, hence simply not an attractive source of funding for real banks, who have access to the Fed funds rate. Bernanke and company are trying to kill the notion of a Fed Put, whereby the Fed "bails out" Wall Street whenever losses increase significantly which further worsens excessive risk taking, or moral hazard. The conclusion is while many would like to think this simply is a Wall Street quant fund predicament, the reality is that Main Street shares the pain in the form of tightening terms, conditions and rates for all but conforming mortgages. Thus, the Fed needs to reduce the Fed funds rate not to bail out Wall Street but rather to save Main Street from recession on account of weaker growth, which to boot would carry serious debt-deflation consequences. I have provided Chart I below in larger print for illustrative purposes.