Correction: Pushing on a String? Credit Marches to its Own Drummer.
With apologies to Mr. Krugman, I must correct some of what I wrote in my piece, “Pushing on a String? Credit Marches to its Own Drummer.“ When one does statistical analyses, one needs to understand the limitations/features of the tools that one uses. Bloomberg’s regression function had a funny default that led me to make an error. Had I done it right, the R-squared over the full sample period would have been 64.8% (correlation 80.5%), with a beta of 0.614. Lagging the Fed funds target by one year, roughly the time it takes Fed policy to work boosted the R-squared to 77.2% (correlation 87.9%), with a beta of 67.1%.
But, here ’s what is unusual. If one is looking at the last five years, the relationship has broken down. During that period, with no lag, the R-squared was 11.2% (correlation 33.5%), with a beta of negative 13.0%. Even with the lag, the R-squared was 3.8% (correlation 19.4%), with a beta of negative 3.7%.
My conclusion: given the unusual credit conditions in the 2000s, where we have had extremes of default and monetary policy, I would not rush to say that the Fed is pushing on a string, yet. That said, the debts of financial companies are a larger part of the index than they were five of ten years ago, and they are the ones in trouble at present, unlike the prior difficulties in industrials and utilities in 2001-2003. Because of that, the Baa index of Moody’s may lag longer than ordinary versus Fed funds… but Fed policy has been called impotent before, and usually just before it shows its bite, as in the tech bubble of 2000, or the liquidity rally of spring 2003.
To my readers: if you see something that might be amiss in my writings, post a comment. I owe it to all of you that I post corrections when I make mistakes. Thanks for bearing with me on this one. In the original piece, I sounded more certain than I should have, to my detriment…
February 19th, 20085:29 am at
Thanx for this (& every) update — I read both your & Krugman’s blog — and find each of you, highly principled, consistent & informative.
February 19th, 20089:22 am at
I would argue that the reason the relationship has broken down in the past 5 years is relatively easy to recognize. The Fed and ECB have lost control of the credit systems and the “shadow banking system” has taken over “control”. The manufacturing of all things leverage/derivatives in the past 5 years dwarfed anything the fed has done. The enormous size of the outstanding interest rate and credit derivatives dwarf the tiny amount of reserve money the Fed controls. The Fed is spitting in the wind as that system is now in free fall/implosion.
Given the massive excesses in these markets, which absolutely dwarf those surrounding the S&L crisis, it is absolutely laughable in my mind that the end result could be as relatively benign as what we’ve seen in the past 6 months. Sure, things have been bad in the credit markets but not to a generational extreme, which is what usually follows generational extremes in greed.
While a temporary reprieve is certainly possible, I would be shocked if there is not MUCH WORSE to come from the credit markets and the banking sector.
All of the fixed income guys I know remain amazingly complacent about the ability of the Fed to address the problems. I’ll repeat here what I keep telling them – watch the dollar. It may prevent the Fed from being as reckless as they probably want to be. Even if they are reckless, then I don’t think it is any assurance that it will be enough to “fix” the shadow banking system, just as it didn’t fix the Telecom/Tech bubble.
February 19th, 20083:33 pm at
With respect to James Dailey’s comments above, I would argue that in the case of the Fed, control of the money supply was willingly ceded to Wall Street in the mid-1990’s. For those greedy crybabies constantly carping and whining for “free, unfettered markets”, you have just witnessed one at work. Now it’s time to pay up.
Now that this country has had the stupidity to throw away its manufacturing pre-eminence, it is no longer in any kind of position to just start counterfeiting paper money hand over fist and get away with it.
February 19th, 20083:46 pm at
For you, David, I would say your mental brilliance is exceeded only by your sense of honesty and humility.
February 22nd, 20085:08 pm at
Krugman: “PUSHING ON A STRING?” this has only applied to the period during the Great Depression where at times excess reserves were greater than required reserves.
If today, there are not enough credit worthy borrowers in the private sector (as in the Great Depression), the Fed can now (unlike during the GD where there was an insufficient volume of government debt), buy an unlimited volume of earning assets. (With the federal debt at over 9.+ trillion, and expanding, and billions of dollars of “eligible paper” available, the term “unlimited” is not an exaggeration in terms of any potential needs of the Fed.)
In the process of buying Treasury Bills etc., new Inter-Bank Demand Deposits (IBDDs) are created. These deposits can be cashed by the banks into Federal Reserve Notes, without limit, on a dollar-to-dollar basis.
On the basis of these newly acquired free reserves, the commercial banks can, and do, create a multiple volume of credit and money. And, through this money, they acquire a concomitant volume of additional earnings assets.