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 Time to Do the Wrong Thing

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Number of posts : 440
Registration date : 2007-07-01

PostSubject: Time to Do the Wrong Thing   Thu Aug 30, 2007 10:19 pm

Time to Do the Wrong Thing

is wrong here. Even though the Fed and its chairman (not to mention
anyone who has studied the evidence rigorously) believe that there was
never a Greenspan put, the Fed seems to feel that it has to be very
careful not to create the impression that the Greenspan put exists. In
other words, to some (hopefully not very large, but I'm not sure)
extent, the appearance of bailing out Wall Street is now an argument to
the Fed's objective function. Which means that, under some
circumstances, the Fed will deliberately follow bad policy -- bad
meaning suboptimal with respect to the balance of growth and inflation
risks -- because the better policy would have the appearance of being too Wall Street friendly.

In fact, since the history of the Greenspan era suggests that following an ex ante optimal policy for growth and inflation does create the impression that there is a Greenspan put, the Fed can expect that it will occasionally have to make a deliberate mistake. Something is wrong.

the Fed doesn't cut the federal funds rate target in September --
barring a truly dramatic improvement in credit conditions or a series
of economic reports that are either stronger or more inflationary than
expected -- I will, as I said a few days ago,
be puzzled, but perhaps not all that puzzled after all. By such
inaction in the face of widening spreads and credit rationing, I argued
then, the Fed would be "either making a mistake or acknowledging that
they made a mistake earlier by not having raised the rate higher in the
first place." But I hadn't considered the possibility of a deliberate
mistake. Does one need to sacrifice a virgin on the altar of Moral
Hazard Avoidance, not because it will in fact result in a better
harvest, but because the people think so, and they won't bother
planting unless you do?
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PostSubject: Re: Time to Do the Wrong Thing   Thu Aug 30, 2007 10:20 pm

Monday, August 20, 2007

A September Cut would Make Sense

not saying the Fed necessarily will ease in September, or even that it
necessarily should*, but if it doesn’t (barring a dramatic improvement
in credit conditions between now and then) I will be somewhat puzzled.

Fed’s mandate is to pursue price stability and maximum employment. It
pursues these objectives by influencing macroeconomic conditions in the
real economy, but it influences those conditions using only financial
instruments. In particular, it tries to hold the federal funds rate at
a level that will produce the best macroeconomic results.

the federal funds rate has no direct influence on the real economy. It
has indirect influence through a number of channels, and it also acts
as an indicator of other indirect influences that Fed policy has on the
real economy. I won’t attempt an exhaustive list of these channels and
influences, but among them are: corporate bond yields, which help
determine capital spending choices by corporations; commercial loan
rates, which also help determine capital spending by businesses;
commercial paper rates, which help determine the cost of holding
inventories; consumer interest rates, which help determine spending by
consumers; mortgage interest rates, which help determine housing demand
and consumers’ ability to draw on home equity; housing values, which
help determine consumer spending through a so-called
wealth effect; and the availability of credit, which influences all
these things by determining consumers’ and businesses’ ability to take
advantage of whatever rates are offered.

One thing all the
mechanisms I listed, and undoubtedly some others that I didn’t list,
have in common is that they have all deteriorated recently even as the
federal funds rate target has remained constant. As far as financial
influences on the real economy are concerned, the Fed is effectively
(if unintentionally) following a tighter policy today than it was a few
months ago. So if the Fed believed a month ago that a 5.25% federal
funds rate would produce the optimal set of consequences for the real
economy, it would not make much sense to believe today that 5.25% will
still produce optimal consequences, unless, of course, the Fed thought
that the condition of the real economy had strengthened.

from the recent inter-meeting policy statement, it is readily apparent
that the Fed does not believe the condition of the real economy has
strengthened. If anything, it has gotten worse. Therefore, it seems to
me, if the Fed governors choose to leave the federal funds rate target
at 5.25% in the September meeting (again, barring dramatic improvements
between now and then), they are either making a mistake or
acknowledging that they made a mistake earlier by not having raised the
rate higher in the first place.

* Just for the record, I do think that the Fed should ease, but that’s not the topic of this post.
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PostSubject: A Fed Chairman's lot is not a happy one (happy one)   Thu Aug 30, 2007 10:33 pm

A Fed Chairman's lot is not a happy one (happy one)

by Christopher Dodd, Chairman of the US Senate’s Banking Committee (and
also a candidate for the Democratic nomination for the US Presidency)
and by Hank Paulson, US Treasury Secretary, Ben Bernanke looked more
like a Taliban hostage than an independent central banker at his August
21 meeting in Dodd’s office. The letter from
Bernanke to Senator Charles Schumer, circulated around Washington DC on
Wednesday August 29, 2007, in which the Governor of the Federal Reserve
offered reassurances that the Federal Reserve was “closely monitoring
developments” in financial markets, and was “prepared to act” if
required, reinforces the sense of a Fed leant upon and even pushed
around by the forces of populism and special interest representation.

This is not a new phenomenon. With the explosion of operationally independent central banks since the New Zealand experiment of 1989, the US has become one of the least operationally independent of the central banks in the industrial world. Only the Bank of Japan is, I believe, even more readily influenced by political pressures from the Executive or from Parliament. Also, what operational independence the Fed has, is of relative recent origin. From
1942 until the Treasury-Federal Reserve Accord of 1951 released the
Federal Reserve from the obligation to support the market for U.S.
government debt at pegged prices and made possible the independent
conduct of monetary policy, US monetary policy was made in the Treasury. For those 9 years, the Taylor rule was: i = 2%.

after the Accord, the fact that the Fed is a creature of Congress, and
can be abolished or effectively amended out of existence with simple
majorities in both Houses, has acted as a significant constraint on
what the Fed can do and say. The strong
populist, anti-banking currents in American politics in general, and in
the Congress in particular, mean that the threat that what limited
operational independence there is could be taken away is not perceived
as an idle one by any Fed governor.

illustrate the difference between the degree of operational
independence of the Fed and the ECB, consider the inflation target. The ECB has price stability as its primary target. Without prejudice to price stability, it can pursue all things bright and beautiful, and is indeed mandated to do so. All this is in the Treaty. There is, however, no quantitative, numerical inflation target in the Treaty. Nor does the Treaty spell out which institution should set such at target, if there were to be one. So
the ECB just went ahead and declared that an annual inflation rate of
just below but close to 2 percent per annum on the CPI index, would be
compatible with price stability. Neither the European Parliament, nor the Council of Ministers were consulted.

The Federal Reserve Act has stable prices as one of the three goals of monetary policy. The other two are maximum employment and moderate long-term interest rates. There is no quantitative or numerical definition of any of the three targets in the Act. Could the Fed do what the ECB did, and specify a numerical inflation target? Most certainly not. Congress would not stand for it.

Politically, the job of Chairman of the Fed is therefore much more difficult than that of the ECB or even the Bank of England. Strong
Chairmen, like Paul Volcker and Ben Bernanke, manage to create a larger
choice set for the Fed than a weak Chairman like Alan Greenspan, but
even the most independent-minded and strong-willed Fed Chairman is much
more subject to political influences and constraints than the President
of the ECB or the Governor of the Bank of England.

Both populism and special interest representation are key driving forces in the US Congress. Preventing
large numbers of foreclosures on madcap home mortgages taken out
especially since 2003, unites the forces of populism and special
interest representation, although they tend to part company when it
comes to who will pay the bill for the bail-out.

the Congress and the Executive branch of government lobby mightily for
Fed actions aimed at preventing or at least limiting the losses on
highly leveraged bets taken by hedge funds, private equity funds and a
large number and variety of other financial institutions and special
purpose vehicles - ‘conduits’, ‘structured investment vehicles’; the
names vary but the economic essence of highly leveraged open positions
is the same. Appeals to safeguard systemic financial stability often obscure the obvious truth. The
special interests that would benefit most directly from such actions as
a cut in the Federal Funds rate - highly leveraged Wall Street firms
and tycoons caught on the wrong end of the increase in credit risk
spreads and the disappearance of liquid markets for structured products
and other contingent claims –claims that had often been touted as the
‘techfin’ solution to the illiquidity of traditional forms of credit
such as secured (mortgages) and unsecured (credit card debt) – rarely
play a systemically indispensable role in the intermediation of saving
into investment or in the efficient management of financial wealth. Were
they to go bust and disappear, they would be missed only by their
shareholders and other stakeholders, and those who had lent money to
them. If these shareholders and creditors are systemically significant,
one assumes that the prudential regulatory regimes they are subject to
would have ensured sufficient portfolio diversification for them to be
able to absorb the losses caused by the insolvency of a number of
highly leveraged funds/institutions.

response to financial turmoil, disorderly credit markets and the sudden
illiquidity of assets previously deemed liquid, should not be a cut in
the monetary policy rate – the short-term risk-free nominal rate of
interest. It should not even be to provide
liquidity in large amounts at the policy rate (in the US, to keep the
Federal Funds rate close to the Federal Funds target, currently 5.25%;
in Euroland, to keep the overnight interbank market rate near the ECB’s
Main refinancing operations Minimum bid rate (currently at 4.00%); in the UK to keep the overnight interbank sterling rate near Bank Rate (the repo rate currently at 5.75%). Market participants should pay a penalty for being caught with their liquidity pants down.

a credit crunch/liquidity crisis, the central bank should make funds
available freely, but at a penalty rate and against collateral that
would be good under normal circumstances, but may have become severely
depreciated as a result of the liquidity crisis.

Bagehot in the 21st Century
Both the Fed and the ECB failed to deliver the second part of Bagehot’s package: to lend at a penalty rate. One
obvious way to provide liquidity at a penalty rate is to require banks
and other eligible counterparties to access collateralised loans not at
the policy rate, but at the discount rate. For the Fed, the primary discount rate used to be (until August 17, 2007), 1.00% above the Federal Funds target rate. Then, in response to the credit and liquidity crunch, the Fed, on 17 August 2007 lost its nerve and cut the primary discount rate from 6.25 percent to 5.75 percent. This reduction in the penalty for providing liquidity was the exact opposite of what Bagehot would have recommended. What is more, it is a recipe for increasing moral hazard without any appreciable gain as regards the provision of liquidity. The ECB kept its discount rate (the rate charged on its Marginal Lending Facility) at 100bps above its policy rate. It
provided so much liquidity at the policy rate, however, that hardly any
spontaneous takers turned up to rediscount eligible collateral at the
Marginal Lending Facility. Only the Bank of England followed Bagehot’s nostrum,. Not
only did it keep its discount rate (the rate on its Credit Facility) at
an unchanged 100bps above its policy rate, it was quite willing to see
the overnight interbank market rate rise towards the policy rate. It
is not surprising that the least operationally independent of these
three central banks, the Fed, bent furthest in response to financial
market pressures for rate relief. It is
surprising that the most operationally independent of the three, the
ECB, was, in different ways, almost as accommodating as the Fed. The
reason for this is probably lack of self-confidence by the ECB; they
are the youngest and most untested of the three institutions. It
looks as if they panicked and kicked the ball into touch by providing a
massive (and excessive) injection of liquidity against high-grade

The central bank as Market Maker of Last Resort
charging eligible counterparties during a credit crunch/liquidity
crisis a penalty rate of 100bps over the policy rate is unlikely to be
a sufficient deterrent to reckless and irresponsible risk-taking by
these counterparties. There is a way in which
the monetary authority can simultaneously address the core of the
liquidity problem and provide the right incentives to encourage private
financial institutions to manage their portfolios with greater regard
to liquidity risk. That is for the monetary
authority to act as Market Maker of Last Resort (MMLR) by expanding the
range of assets eligible for rediscounting (or more generally
acceptable as collateral in liquidity-providing open market purchases)
to include illiquid assets, both investment grade and non-investment
grade, but at a punitive price. This
means that the net price received by the seller of the asset to the
monetary authority represents a significant ‘haircut’ over what its
fair or fundamental value would be under orderly market conditions. Operationally, this could, just to provide one example of a practical mechanism, be done through a Dutch Auction.

monetary authority would first have to make it clear what kinds of
assets (including possibly rather complex structured investment
products) it is in principle willing to purchase in its auction. It would also have to specify the population of eligible counterparties. I
would propose this be restricted to institutions accepting the
appropriate degree of prudential regulation from the point of view of
the Monetary Authority.

Finally, given the eligible instruments and counterparties, the Dutch Auction could start. The
central bank would announce that it would be willing to buy up to, say,
$10bn (at notional or face value) worth of CDOs backed by impaired
subprime mortgages. It would start the auction offering a buying price
of, say, one cent on the dollar. CDOs offered at that price would be
accepted, up to the total amount of the auction ($10bn face value). If
the total amount offered at 1 cent on the dollar were to exceed $10bn
face value, there would be pro-rata sharing among those making offers
to sell. If less that $10bn face value were offered at one cent on the
dollar, $ 2bn, say, the central bank would offer to buy up to $8bn at,
say, 2 cents on the dollar, all the way up to 100 cents on the dollar.
A further haircut could then be applied to the sequence of auction
prices established through this mechanism.

a Dutch Auction is a price discovery mechanism. The central bank does
not need to know the true value, it simply needs to have a mechanism
for discovering the reservation prices of the private holders of the
illiquid securities. The central bank has all
it needs to conduct such an auction: deep pockets and the absence of a profit motive. It does not need superior information about the fair or fundamental value of what it buys.

Policy rate cuts
Policy rate cuts are justified if and only if the legally mandated objectives of the monetary authority require it. For
the Fed these objectives are the triple mandate of maximum employment,
stable prices and moderate long-term interest rates set out in Federal
Reserve Act as amended in 1977. Credit crunches
and liquidity crises therefore matter only to the extent that they
affect these three goals, now or in the future. Fortunately,
instruments exist with which credit squeezes and liquidity crises can
be addressed effectively, and without creating moral hazard (such as
the MMLR at punitive prices described above) that do not involve
changing the monetary policy rate.

hope and expect that if and when the Fed perceives that real economic
activity is likely to weaken materially going forward and/or that
inflation is likely to undershoot its comfort zone (wherever that may
be), rates will be cut decisively and without delay.

also fear and expect that, because of the relentless pressure being
brought to bear on the Fed by all branches of the Federal Government
(with the exception, as far as I know, of the Supreme Court), the Fed
will be convinced to cut the Federal Funds target rate, probably as
soon as the September meeting. I fear this could
be not because this is the best way to guarantee the optimal trade-off
between its three macroeconomic goals, but because this is the only way
to salvage some measure of future independence for the Fed, in the face
of irresistible pressure for a cut now from a lobby for a lower Federal
Funds rate that includes special interests ranging from low income
households unable to service their wildly inappropriate mortgages to
extremely high net worth hedge fund managers facing massive losses and
early retirement.

I hope I’m wrong on the last point.
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