My preferred monetary policy in normal times is for the yield curve to have about 50 basis of positive slope from twos to tens. That’s enough slope for the economy to grow, and the banks to make a little money, but not lend aggressively. It’s flat enough to restrain inflation as well. Sounds good, but it would require discipline on the part of the central bankers to stick to it, because of political pressures to goose growth, or banks complaining that they can’t earn enough.

These aren’t normal times, though. Let me explain two ways that it is abnormal. First, the Two-year Treasury, which is a good measure of what the market expects Fed funds to be in 6-12 months, is about 1% lower than the current Fed funds rate. Second, the short-term private lending markets have not followed the 3-month T-bill yield lower. The one that I have looked at most closely recently is the Treasury-Eurodollar Spread [TED Spread], which is the difference between the 3-month LIBOR yield, and the yield on a 3-month T-bill. It closed out yesterday at a spread of 2.04%. Anything over 0.60% indicates stress in the short-term lending markets.

Not so good, huh? Will the Fed try to boost the size of the TAF again to fight this? (Hey, is that a head-and-shoulders pattern? 😉 ) Now we can look at the Treasury yield curve:

Well, at least the curve is positively sloped over all of its major segments now. That is a positive, right? 😉 Well, in a situation where the economy is growing, it would be normal, and good for lenders. When it is because of a money market flight to safety, that’s another matter, and not a positive, at least not yet.

That brings me to my second point. The lowest prime grade of Commercial Paper, A2/P2 CP, has an inordinately high yield compared to safer short term loans when the financial system is under stress. My thought was to create a combination measure that took into account both measures of short term financial stress. Both series come from the Fed’s H.15 report. My measure is subtracting the yield on nonfinancial A2/P2 CP from the two-year Treasury yield.

A2/P2 financial paper outyields the Two-year Treasury by 1.60% at present. That’s not as bad as things were in August or December of 2007, but that level eclipses levels reached in the LTCM crisis, but not the monetary tightness overshoot back in December of 2000.

Note that the average level over the eleven-plus years that I was able to get data is very close to zero. The positive periods tend to be long and shallow, like most bull markets. Seemingly also, the measure seem slightly correlated with stock market returns, but I could be wrong there. The negative periods tend to be short and sharp, like most crises. This present period is an exception — we’ve been in the negative zone for two years.

Am I saying the FOMC should loosen aggressively from here? Not necessarily, but I am saying that the financial system is still under significant financial stress, and existing measures like the TAF have not cleared that yet.

The Fed is facing some very hard choices here. I wouldn’t want to pursue a zero interest rate policy here in the US like they have in Japan, with not that much success. But maybe that’s because the Fed is behaving like the Bank of Japan. The Fed has been sterilizing its rate cuts and its unorthodox measures, and not allowing the monetary base to grow, which makes no sense to me in a loosening cycle. (Well, I take that back, it makes perverse sense. They are trying to draw to an inside straight — they are trying to restrain price inflation at the same time they solve problems in the financial system by downgrading their own balance sheet by lending and selling Treasuries. I don’t think it will work.)

Maybe the Fed should buy A2/P2 CP (please no 🙁 )? My view is that they should let the monetary base grow, and do some permanent injections of liquidity. We haven’t had one in 10.5 months, which is really unusual, particularly for a loosening cycle.

Will they do that? My guess is no, not until they have run out of Treasuries to sell or lend.

Update

Go to Alea and look at the repo fails on Treasuries.? Just another sign of system stress.

There were a number of commentators who noted the double dissent today of Fisher and Plosser. I looked at that and wondered how common dissents were on the FOMC.

One of the things that Fed-watchers have to realize is that vote disclosure is a relatively new thing at the FOMC. It started in 1982, and became regular in 1984. In the earlier days, the internals of the FOMC were even more of a ?black box? than they are today. In order to gauge any policy change, one would have to look at the effect of open market actions on Fed funds; there was no announcement.

Late in the Volcker Era, the FOMC began announcing the votes on policy. Early in the Greenspan era, the FOMC would publish a statement, and indicate who dissented. Finally, they began recording the reasons for the dissent in the middle of Greenspan?s tenure.

Over the past 25+ years, how common has dissent been?

Single dissents happen about 27% of the time, and double dissents 10% of the time. Dissents of three and four occur 5% and 1% of the time.

The two quadruple dissents occurred during the 1989-1992 easing cycle, when commercial real estate was in the tank. Both occurred at meetings where no action happened, and the alternative was loosening.

In general, high levels of dissent occur near cycle turning points. That said, in the latter part of the Greenspan era, discipline was tight enough that dissent was rare. Wait, how does dissent vary among Fed Chairmen?

For Volcker we only get the latter part of his tenure, but dissent was relatively common. For Greenspan, you can divide his tenure into two parts. Prior to 1993, dissent was common, but after that, he effectively brought the remainder of the FOMC into lockstep. He was very effective at controlling meetings, as was noted by Laurence Meyers.

http://www.federalreserve.gov/boarddocs/speeches/1998/199804022.htm

Look at this graph for an example of how Greenspan got stronger over the years:

Bernanke is still in his break-in phase, and he is faced with the difficulties of an easing cycle. Dissent is more common easing cycles:

Personally, I would not make that much out of a double dissent at this phase in the FOMC cycle. This is the time that we should be seeing dissent ? early in Bernanke?s tenure, and loosening. Also, Bernanke is taking a looser hand to the remaining Governors ? he wants them to speak their minds. It is much the same way it was when he was an economics department chairman, except now the stakes are higher. Much higher, Ben, if you are reading this. (I harbor no illusions here, I know a few people read me inside the Fed, but my thoughts aren?t worthy of the attention of any of the Fed Governors. They are busy people.)

Now, that said I would like to point to some comments on the current FOMC actions by Paul Volcker. I?m glad he is still around. He is one of the few people who have instant credibility when talking about the current Fed actions.

http://blogs.wsj.com/economics/2008/03/18/volcker-feds-extreme-intervention-raises-some-real-questions/

In one sense his main point is that the Fed is charged with protecting banks that they regulate. They are supposed to act in the interest of all Americans, and when it intervenes on behalf of investment banks that they don?t regulate, or one in particular, Bear Stearns, there is a question as to whether it is right for them to do so.

When Volcker was Fed Chairman, derivatives were not an issue. They are now, and the interlinkages almost require a rescue. Now, better that the Fed should regulate investment bank leverage, particularly if they are lending to investment banks now. I am not a fan of regulation or central banks, but if we are going to have a complex financial system with derivatives and central banks, they need to be regulated by the central bank. (Let?s just go back to a gold standard, okay? 🙁 Yeah, I didn?t think so.)

There are real problems with what the current FOMC is doing, but to me it seems the best solution at present. Greenspan should not have lowered rates so much in 2001-2002, nor should he have raised them so much in 2004-2006. There were ways to avoid this crisis in the past, at a cost of some minor short term pain, but we weren?t willing to do that in the latter era of Greenspan.

Now Bernanke is stuck with a badly-dealt hand. He?s coping as best he can. In general, I don?t like the way monetary policy is going, but I will say that we are taking a policy path that is close to optimal in the short run (though I would be expanding the monetary more aggressively). The real question is whether we will have any additional blowups that the Fed?s balance sheet is too small to handle.

From RealMoney:

		David Merkel
		FOMC: Fanning Our Monetary Conflagration
		3/18/2008 2:16 PM EDT

The Federal Reserve Open Market Committee lowered the Fed funds target and discount rate by 75 basis points. The vote was 8-2, with Fisher and Plosser dissenting. The growth risk assessment is weakness.

The prices risk assessment is balanced.

Overall, FOMC makes noises about some inflation, lending markets, and economic weakness.

The 10-year Treasury yield was down 2 basis points in yield after two minutes. The S&P 500 was down 80 basis points.

We now return you to our regularly scheduled programming. The fixation is ended! Trade!

Position: none

Okay, so 75 basis points isn’t 100. 75 is still pretty aggressive, and combined with all of the other actions that the FOMC has taken, it provides some stimulus. It would provide a lot more stimulus if they stopped immunizing all of their unorthodox policy measures, but hey, they are trying for a hat trick:

• Solve the problems in the lending markets.
• Don’t permanently add to the monetary base, and so restrain price inflation.
• Stimulate a weakening economy.

Personally, I think they will eventually have to stop giving with the right hand and taking with the left, but for now, they can continue this policy. It might even work if nothing else material blows up. Credit spreads are considerably tighter today, but one day does not a recovery make.

I?ve put together a PDF file that summarizes the current Federal Open Market Committee.? My objective in this exercise is provide a handy way of getting data on the various Members of the Federal Open Market Committee.? It was also a way for me to better understand who is making out monetary policy, and from a social angle, try to understand their biases.

Most of the data in the PDF file (Excel file available here), comes from the Fed?s own websites.? I reorganized it, and deleted some bits of data that I thought were less important.? I added links to their bio, books, speeches, academic papers, etc.? (Full disclosure: if you buy a book from Amazon using one of the links, I get a small commission.)

When I look at this data, what jumps out at me is the number of Ph. D. economists ? they are 10 out of the 15 here, then three MAs in Economics and related fields, one MBA (Fisher) and one JD (Warsh).? (Personally, I would want to limit the number of Neoclassical economists on the committee to five, and put in a few Austrian School economists.? Monetary policy is too important to be left to a bunch of Neoclassical economists.)? Beyond that, among the economists, there are many of them that have done direct work on the inter-linkages between monetary policy and financial markets? (Bernanke, Kohn, Kroszner, Mishkin, Plosser, Evans, and Lacker).? A number of them have written about central banking and financial markets under conditions of stress.

Historically, it would be hard to find a group of Fed Governors more prone to using unorthodox methods to try to fight a crisis in the financial markets.? They have the training for it, and they do not want to go down as not having learned from the received wisdom on monetary policy regarding the Great Depression.? They will be fast, not slow.? Unorthodox, not orthodox, and bending/breaking the rules where possible.? They will tolerate a possibly large permanent increase in inflation, and avoid the Japanese experience 1990-Present.? They will pursue a unilateral course of action, and ignore foreign grumbling.

This is the FOMC that we have today, and the composition of the committee matters when considering how they will execute monetary policy.?? Expect aggressive responses, with considerable volatility.

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

Two postscripts: To me, the Committee seems young, with an average age of 51.? Second the compostion of the committee will likely change after the elections, because Congress is holding up the nominations that President Bush has put forth.? The nominees are Fed Governor Randall Kroszner, whose term officially ended Jan. 31, Capital One Financial Corp. executive Larry Klane and Virginia community-banker Elizabeth Duke.? Kroszner can continue to serve at the Fed until a successor is appointed. ??

The two businessmen would have been an interesting addition, but will not likely be approved because of the politics.? The one that wins the presidential election will have a large impact on the Fed, because he will get to appoint three board members.? The current economic volatility will have a large impact on the skill set of those that get nominated.

FOMC cycles usually have some sort of underlying consistency to them. In this cycle, the underlying consistency has been:

• Unorthodox measures, attempting to use the asset side of the Fed’s balance sheet to solve lending problems among banks and broker-dealers.
• They have effectively “sterilized” their unorthodox measures by withdrawing other liquidity from the system, leading to…
• Lack of growth of the monetary base, which has only risen 2% in the last year, and the last permanent injection of liquidity was 5/7/07. (After reviewing the Annual Reports of the Open Markets desk of the NY Fed 1996-2007, I think that’s a record… it is certainly a record for a loosening cycle. How can you have a loosening cycle without growing the monetary base significantly? Unless they are planning on reversing their policy easing rapidly once the financial crisis is past.)
• They have never cut rates less than expected.

So, that leaves me at a 1% cut in Fed funds tomorrow, with a parallel cut in the now-meaningful discount rate. Now that primary dealers can borrow there, that will be an active window. That said, the Fed will probably try to sterilize any borrowings there, withdrawing liquidity elsewhere.

Come to think of it, that was one of the problems with the Bank of Japan as they slid into their crisis in the 1990s. They always sterilized their monetary policy so that it had little effect, thus restraining inflation, but not doing much for their overleverage situation.

In this case, that’s a mistake. We can live with price inflation. Dealing with the collapse of leverage is a lot tougher. The Fed can use unorthodox measures until their supply of lendable/saleable Treasuries runs out. Then they will have no choice but to begin monetizing the debts of the US Government or its agencies, if they want to attempt further stimulus. Then we will get price inflation. As for me, I would own TIPS here. CPI inflation will likely rise if the bailouts needed exceed the size of the Fed’s balance sheet. I also like agency residential mortgage bonds here. Implied volatilities can’t get that much higher, so we should get some sort of rally.

Let see what happens tomorrow.

Update

So what happens after I hit the publish button, but I receive a great article from Calculated Risk talking about the same issues.