Limits to the Power of Monetary Policy

I posted this on RealMoney on 5/6/2005, when everyone was screaming for the FOMC to stop raising rates because the “auto companies were dying.”


On Oct. 2, 2002, one week before the market was going to turn, the gloom was so thick you could cut it with a knife. What would blow up next?

A lot of heavily indebted companies are feeling weak, and the prices for their debt reflected it. I thought we were getting near a turning point; at least, I hoped so. But I knew what I was doing for lunch; I was going to the Baltimore Security Analysts’ Society meeting to listen to the head of the Richmond Fed, Al Broaddus, speak.

It was a very optimistic presentation, one that gave the picture that the Fed was in control, and don’t worry, we’ll pull the economy out of the ditch. When the Q&A time came up, I got to ask the second-to-last question. (For those with a Bloomberg terminal, you can hear Broaddus’s full response, but not my question, because I was in the back of the room.) My question (going from memory) went something like this:

I recognize that current Fed policy is stimulating the economy, but it seems to have impact in only the healthy areas of the economy, where credit spreads are tight, and stimulus really isn’t needed. It seems the Fed policy has almost no impact in areas where credit spreads are wide, and these are the places that need the stimulus. Is it possible for the Fed to provide stimulus to the areas of the economy that need it, and not to those that don’t?

It was a dumb question, one that I knew the answer to, but I was trying to make a point. All the liquidity in the world doesn’t matter if the areas that you want to stimulate have impaired balance sheets. He gave a good response, the only surviving portion of it I pulled off of Bloomberg: “There are very definite limits to what the Federal Reserve can do to affect the detailed spectrum of interest rates,” Broaddus said. People shouldn’t “expect too much from monetary policy” to steer the economy, he said.

When I got back to the office, I had a surprise. Treasury bonds had rallied fairly strongly, though corporates were weak as ever and stocks had fallen further. Then I checked the bond news to see what was up. Bloomberg had flashed a one-line alert that read something like, “Broaddus says don’t expect too much from monetary policy.” Taken out of context, Broaddus’s answer to my question had led to a small flight-to-safety move. Wonderful, not. Around the office, the team joked, “Next time you talk to a Fed Governor, let us know, so we can make some money off it?”

PS —  Before Broaddus answered, he said something to the effect of: “I’m glad the media is not here, because they always misunderstand the ability of the Fed to change things.”  A surprise to the Bloomberg, Baltimore Sun, and at least one other journalist who were there.

And now to the present application:

My main point in posting this story is to point out the impotence of Fed policy in helping areas of the economy with compromised balance sheets.  When credit spreads are wide, cuts in the fed funds rate do not appreciably affect the funding costs of firms deep in junk grade.

Beyond that, temporary injections of liquidity are meaningless, and that is all the major central banks of the world have done, together with words saying they will support the markets.  Well, what happens after the market digests that, and the temporary injections of liquidity are gone.  They will expect the Fed to stand and deliver something more permanent.  Much as I have resisted this thought, and hate it in terms of public policy, the FOMC will cut rates at that point in time, and begin a loosening cycle.  It’s the wrong thing to do, and won’t achieve the goals intended, but my view of Fed policy is that I must focus on will they will do, not what they should do.

So you have my change of view here and now.  The central banks of our world have caved in to an unrealistic fear of what is going on in the fixed income markets.  The next move of the Fed is to loosen.  It will happen in 2007.  Look for the areas of the economy that are healthy, and will benefit from cheap financing, because they will get it.  The trade: buy high quality financial stocks.  Time to overweight.