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.”
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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.
David,
I disagree with you on the necessity of Fed monetary ease. Monetary policy acts with a notable lag, perhaps 12-18 months. Currently, it seems to me as though economic conditions will be weaker, perhaps substantially so, than they are now, and as such, easing is a prudent policy. However, unfortunately, the Fed seems to be fighting the last war, administering policy with a lagging view towards inflation, and has not prepared markets for such a policy change, and hence runs the risk of appearing to react to panicky investors, rather than guiding policy with foresight. In any case, given the current policy-rate targeting regime, the Fed had very little discretion in providing Fed Funds this week; after all, one can’t very well target 5.25% and sit still when they’re trading 50-75 bps higher. I agree with you though, that once the repos mature, the market will have grown accustomed to that additional liquidity, and the Fed will have to ease. Similarly, your overweight call on high quality financials seems to be right on the money.
Now, if you’ll excuse me, I’m off to buy my Barron’s; and then, shortly after reading Alan Abelson’s no doubt sunny column, I’ll have the strong desire to commit ritual suicide in some overly painful way! LOL
Have a great weekend,
Steve
I think the story that most people are not focusing on is that the central banks of the world have been gradually losing control of the money supply over the past 20 years. Greenspan effectively abdicated the Fed’s role by explicitly stating that he was only targeting interest rates and not reserves/money supply. The growing and now dominant role derivatives and non-regulated financial entities have played in creating credit will significantly dilute anything the Fed tries to do.
That is why from Jan 2001 til Oct 2002 rate cuts and double digit M2 growth did little to support asset prices. Over the past two years M1 and M2 growth have been near zero in real terms, while credit has been expanding via derivatives at explosive rates. We will likely witness the other side of that coin over the next couple of years, as the Fed loosens but the credit crunch crushes the excess debt and massive misallocation of capital. This could generate a monetary and currency crisis if the Fed moves to monetize – which is VERY possible given Bernanke’s stated policy points of view. Their aggressive move to buy mortgage debt and the reaction in the gold market are just a preview of what is to come if they continue down this path in my opinion.
Mr. Dailey,
Just one note on your posting; you referred to the Fed’s “aggressive move to buy mortgage debt”. I presume you are referring to the three repurchase operations conducted on Friday. Note that the mortgage debt in question is used as collateral, in a purchase-and-sale agreement. The securities are merely held as collateral temporarily, in this case for the 3 day duration of the agreement, and are not necessarily permanent additions to the Fed’s holdings.
Otherwise, you raise an interesting point on the increasing use of derivatives, and the concomittant decrease of Fed control of the creation of credit.
Steve
Mr. Merkel,
Do you realize that the current real Fed Funds rate (rate-core inflation rate) is currently in restrictive territory and at a level that has coincided with the onset of prior recessions? Several FOMC members have explicitly stated in recent speeches that the current Fed Funds rate is “modestly restrictive”. Furthermore, as the core inflation rate recedes this real Fed Funds rate increases by definition, resulting in a De Facto policy tightening.
Now, can any sane person possibly suggest that the Fed should be running a “restrictive” monetary policy in this current market environment? Or better yet a restrcitive policy that is becoming more restrictive with every monthly release which shows moderating core inflation???
In the words of Cramer this Fed IS “asleep” and they are “nuts”. They are driving an overly tight policy by looking in the rearview mirror at lagging indicators like the unemplyment rate and current inflation numbers, instead of being being pre-emptive. That is why the finanancial markets are in a tailspin. They are voting with their wallets on a wrongheaded and overly hawkish Fed policy that is bordering on incompetence. If and when the Fed finally comes to it’s senses and cuts they will already be too far behind the curve. They alrwady have raised rates too far and have held them there too long. What is coming now is too little too late.
I suspect many like you that are preaching at the Fed to remain in this ridiculous hawkish posture are merely talking their book (ie. they are either short or underinvested and hoping for this hawkish Fed policy misstep to cause a market crash so that they can swoop in like vultures to load up on the cheap).
25 years and only 2 relatively mild recessions — a remarkable turn of events vs. US economic history. Why has this occurred and is it likely to continue? I have asked this question of many smart folks and generally the answers to why fall into a few categories (would love to hear anyone else’s ideas especially David’s):
1. improved inventory control systems reduce the time for manufacturing to adjust
2. globalization (more diversified sources of growth or a better ability to adjust to imbalances)
3. lower tax rates, less regulation — more reliance on markets.
4. financial innovations from securitized markets to derivatives that reduce the Fed’s ability to engineer a serious credit crunch.
5. Improved Fed performance from Volker to Greenspan — they made better decisions and were better able to manage the economy than their predecessors.
To me, the first 4 make sense, while the last one is ridiculous but I heard it straight from a 20 some odd year #1 II voted economist.
The economy has grown over the last 25 years IN SPITE of some poor actions by the Fed. The Fed cutting rates now just continues the cycle of moral hazzard. I think David is totally right when saying that the Fed can’t help those with poor balance sheets and losses due to poor decisions (lending to those who couldn’t repay at too low rates). the market will clear in time.
Kyle
David, very well reasoned. In principle I agree.
However, the devil’s in the details. Right now there is considerable doubt as to which financial stocks are high quality. Bear Stearns obviously not. But now even Goldman is having some difficulties of a billion here or there. (Though I am inclined to think they’ll come out doing OK.) I also saw where Citi is claiming about a 1/2 billion dollar loss on merchant lending. The regional banks are up to their eyeballs in mortgages. So, I’m open to suggestions as to which stocks are high quality, because from my vantage point they all seem suspect.
Next, concerning the liquidity helping the strongest the most, it seems commodity producers and international durable goods makers (Cat, Boeing, etc) and bonds of the (Chili, Brazil, India, Russia, etc.) will be out-performers. Yes? Anyone disagreeing, I would appreciate the counter-argument.
KSmith,
This is not a question of moral hazard it is a question of monetary policy being too tight for current economic conditions. We have core PCi at 1.9% YOY and the Fed is worried about inflation being to high?!?! This is surreal.
This neo-Austrian pre-occupation with cratering the economy in order to punish a few evil speculators is so wrongheaded that I just pray that the Fed is not foolish and incompetant enough to actually go down that path. I think Herbert Hoover was worried about Moral Hazard back in 1929 and look what resulted.
Don, no one is going to buy any argument based upon core inflation. Core inflation (AKA inflation ex-inflation) is ridiculous. If not for food, housing, and energy there’s no inflation. Well grand! If I can stop eating, driving, and sleeping then, hey, no worries.
As for a “few evil speculators”, there was a housing bubble gripping at least half the nation. By many measures housing had become totally divorced from any measure of sustainable affordability.
In your first post you referred to folks talking their book, with all due respect I have to wonder about your book.
AllanF,
I eat and drive too. The problem with basing Fed policy on headline CPI, rather than core, is that it presumes that the Fed can do something about what is affecting food and energy prices. Now, it’s true, that if they really wanted to crush the overall economy, they could drive down the demand for energy, and lower its influence on CPI. Otherwise, however, the FOMC has about as much power over the supply of oil, and the success of different crop harvests, as I do.
And I’m not talking my book, as I have no position in TIPS, but I wouldn’t argue with TIPS if one has a bearish view on headline CPI.
Hello Steven,
1st, please refer to me as James – Mr. Dailey is my father! 2nd, I am by no means an expert on Fed operations, but from what I have gathered by reading a lot of people, it appears that the aggressive buying of mortgage paper (yes all gov’t guaranteed and not “private”) is not “normal”. Essentially, they bought what banks wanted to dump and that the Fed is legally allowed to buy. The injection is surely temporary for now and done to bring the target rate back down to 5.25%. However, what happens when they take it back out? I think David hits it on the head here – we’ll see how the credit markets react this week when they try. My guess is it won’t be well received.
James,
My understanding is that of Steven’s (the man who doesn’t sleep. :-))
The Fed accepted securitized mortgage bonds as collarateral. They did not purchase them. I think a lot of sloppy reporting and heresay has been suggesting they bought them, but I don’t believe that was ever the case.
The goal was to prevent a credit run. Everyone was questioning the value of mortgage bonds and presummably was marking them to worthless, causing margin calls. The Fed stepped in and allowed banks to borrow against those bonds so as to put a floor on the margin calls and inject liquidity. Seems like a two-fer.
As for when they take it back out, I think the presumption is the market will be more orderly and there will have been enough time to establish realistic values for those bonds. Now, if the bonds have been correctly valued all along at 20 cents on the dollar… well then I reckon it does get ugly. Right now, you can see time was bought so haircuts can be administered in an orderly fashion. This is most evident by the Goldman quant fund getting a cash injection from Hank Greenberg among others. Makes me wonder if the guy that ran the NYSE is going to come out of retirement… sheesh, what was his name?
Best.
Allan,
LOL, it just looks like I don’t sleep because I’m on the West Coast. The more impressive thing is David posting intelligent, coherent, and cogent thoughts at 11:30 PM on the East Coast. I haven’t been able to do that since university LOL.
Steve
James,
I agree with both you and David, the key will be what they do when the repos mature. The use of the MBS as collateral on Friday was most likely intended as a signaling device, that the Fed was aware of market participants difficulties, and by using MBS they get extra liquidity relief for their buck. Take note though, that there is no prohibition on the Fed renewing those repos, at least in part, when they mature if they want to (if I remember correctly, the first operation on Friday using the MBS as collateral had a 3 day maturity, so that operation is already done now, collateral returned to the banks). The key thing to watch is where Funds trade in relation to the 5.25% target. David has identified the key factor that has changed here: the more that these “temporary” repos are used on an ongoing basis, reflecting the unrest in the market and Funds inability to trade at 5.25% without assistance, the more likely the Fed is to either undertake substantial permanent operations, or ultimately cut the Funds target.
My bet is they cut the target; the only question is timing and how much financial market and macroeconomic pain Bernanke wants to inflict, in order to solidify his reputation as one tough cookie who won’t bail out Wall Street. That’s a political, and personal question, and I just don’t know the man well enough to guess.
Steve
Steve,
I said you were the man that never sleeped because in reply to me saying, “If I can stop eating, driving, and sleeping…” you said, “I eat and drive too.” I noted the conspicuous absence. Wasn’t sure if you meant it as a funny or not, but I figured I’d run with it.
As for David, I suspect being able to cast his own 70’s sit-com if he so desired makes quiet time for blogging come late or never.
Anyway, from one West Coaster to another, take care.
Very intelligent responses Dr. Milos