Days of Wine and Roses

Earlier this morning, the Fed unexpectedly pumped in over $17 billion dollars to the financial system in three separate actions. This is much more than they’ve done in recent days where new cash additions had been hovering around $3 billion dollars. Undoubtedly, these money-adding operations were aimed at soothing the commercial paper market (the money market area where short-term corporate loans are financed) that has been reduced to total dysfunction.

Did I say dysfunction? Add to that deflation.

In the most recent week, outstanding U.S. commercial paper fell by more than 4 percent. That’s the biggest weekly drop in almost seven years going all the way back to November of 2000. In fact, over the past two weeks, outstanding commercial paper has dropped by more than $180 billion dollars—an eight percent haircut.

The worst part of this story is in asset-backed commercial paper. These are the loans that are collateralized by debt from mortgages, credit cards and auto loans. This asset backed paper -- which amounts to about half of all commercial paper -- has dropped $125 billion dollars in the last two weeks, representing an almost an 11 percent decline.

That’s called evaporation.

(And by the way, in the next three months commercial paper borrowers will have to roll over $550 billion dollars. Where exactly is that money going to come from?)

Right now, short-term investors are flocking to gilt-edged, risk-free Treasury bills. They have no stomach for corporate risk. Accordingly, Treasury bill rates have plunged to around 3.5 percent due to this huge appetite for risk-free cash,

The Fed’s recent discount window loan advances have so far had virtually no impact on thawing the commercial paper freeze. It’s going to require much more radical action by the central bank, namely, permanent cash additions to the money market to fix this mess.

This can only be accomplished by lowering the fed funds target rate to around 4.5 percent as suggested in this mornings WSJ op-ed by former Federal Reserve governor Wayne Angell. My supply side mentor Art Laffer also holds this view. The Fed should be watching and listening to the meaning of the plunging Treasury bill rate in the context of the extreme financial breakdown of the commercial paper market.

Countrywide Financial Corp CEO Angelo Mozilo (who just sold 20 percent of his company, the largest mortgage originator in the country to Bank of America) believes that the Fed’s discount window operation is inadequate to the task of dealing with the money market’s liquidity shortage. He’s right. Incidentally, Mozilo also sees a recession ahead.

I’m not ready to go there. Rising jobs, incomes, and business profits should continue to hold the economy up in a 2 percent growth range. But Art Laffer’s point is right on target: The subprime mortgage virus has created an enormous increase in money demand that will only be resolved by an increase in money supply.

The fed discount window strategy is simply not going to cut it. It’s too coy. What the central bank needs to do is get out there, pull up its collective sleeve, and bring out the full Monty with a permanent injection of new cash by lowering the fed fund target. The sooner the better.

Think of this: If skittish investors insist on socking away their money in Treasury paper, then where’s the dough going to come from to finance U.S. business expansion and the economy? I’d much rather have American businesses get the money then the government.

On a more positive note, today’s CBO report estimates that the federal budget deficit is falling all the way down to $150 billion for FY 2007. Let’s just hope that American businesses don’t experience a rising deficit in the weeks and months ahead.