Fed Watch: Anything and Everything is On The Table

Tim Duy tries to sort out Fed policy in light of recent events:

Anything and Everything is On The Table, by Tim Duy: The collapse of Bear Sterns begins a new stage for the financial crisis. As is well known at this point, the Fed has effectively opened the discount window to securities dealers, cut the discount rate 25bp, and provided $30 billion in financing to support the J.P. Morgan buyout of Bear Sterns, taking shaky assets as collateral. Market participants have moved beyond the expectations for a 50bp rate cut tomorrow to 75bp or even a full 100bp cut today. At this point, it is impossible to rule anything out, although the safe bet is on the more aggressive side.

Sunday’s moves are likely a precursor to a more aggressive Fed policy to take on more failing mortgage backed securities as collateral. There is of course a risk that the Fed will take losses on such assets, and thus the taxpayer will take a loss. What I think most likely is that the Fed and Treasury will come to an understanding by which such losses would be monetized. Do not forget the advice that Fed Chairman Ben Bernanke gave to the Japanese in 2003:

My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt--so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent.

I myself see my differences between the US and Japan situations, but the necessity of a bank bailout is almost certainly similar. And someone will have to pay for it; monetization might seem like the least painful choice. And the Fed may ultimately conclude that the easiest way to reduce the household debt burden is to inflate it away. Thinking that outright monetization and high inflation may become the best policy choice reveals my grim mood tonight.

But a more immediate question comes to mind – why just a 25bp cut in the discount rate? Do any of us believe that is a meaningful policy action? To be sure, the expanded discount window borrowing is significant, as is the loan to J.P. Morgan. But it seems silly to cut the discount rate a meager 25bp on Sunday only to deliver a massive cut in the fed funds rate Monday morning.

I can think of two answers.

The first is that the Fed believed their non-discount rate actions would bring a quick halt to the global financial panic that was sure to ensue once the world realized a small but venerable US investment bank was worth just $2 a share. They were once again hoping that a seemingly bold action would put an end to the panic. Moreover, they are probably still stinging from criticism that their 75bp emergency cut in January was engineered to prop up equity markets.

Even if that strategy works, however, it works in part because market participants are expecting a full 100bp cut in the fed funds rate as a follow up. If you don’t deliver that cut, the market would collapse on Tuesday, completely undoing the Sunday policy initiatives. Moreover, as of 9:00pm Pacific Time, the Fed’s efforts to stop a global panic are failing, with Asian markets and the Dollar in free fall. So it looks like the Fed will have to deliver more policy easing Monday after all. Why not just have an emergency FOMC teleconference and get it over with Sunday?

The answer would be my second possible reason for the meager discount rate cut: Growing concern that an aggressive Fed easing at this point will trigger a Dollar collapse. The Wall Street Journal’s Greg Ip suggested this weekend that future policy must take into account the Greenback:

As the Federal Reserve meets for a crucial meeting Tuesday, more than just the credit markets are weighing on its decision: In recent weeks, the dollar also has joined its worry list. But it isn't clear whether that argues in favor of a smaller or larger cut in interest rates….

Up to a point, a lower dollar helps the Fed because it boosts exports at a time when consumers are under siege and business investment could be weakening. That is as long as there is no disorderly decline. But if the dollar feeds an impression the Fed is complacent and pushes up expected inflation, it could limit the Fed's ability to cut rates to support the economy…

As for interest-rate policy, Mr. Truman said that on the one hand, it might nudge the Fed toward a smaller rather than larger cut to show concern about the dollar. But, he said, it isn't that simple. If that meant the Fed took inadequate action against the credit crunch, the economy could ultimately end up far weaker, requiring lower interest rates and a far weaker dollar. "The Europeans are busy complaining about dollar weakness, [but] do they want the Federal Reserve to ignore the U.S. economy in the name of supporting the dollar? The answer is also no."

Ted Truman hits the central point – policy may soon be dangerously close to the having to choose between a collapse of the Dollar and a more generalized banking crisis. Another description of this tradeoff comes from Fed Chairman Ben Bernanke in a 1995 paper, The Macroeconomics of the Great Depression: A Comparative Approach:

A particularly destabilizing aspect of this process was the tendency of fears about the soundness of banks and expectations of exchange-rate devaluation to reinforce each other (Bernanke and James 1991; Temin 1993). An element that the two types of crises had in common was the so-called "hot money," short-term deposits held by foreigners in domestic banks. On one hand, expectations of devaluation induced outflows of the hot-money deposits (as well as flight by domestic depositors), which threatened to trigger general bank runs. On the other hand, a fall in confidence in a domestic banking system (arising, for example, from the failure of a major bank) often led to a flight of short-term capital from the country, draining international reserves and threatening convertibility. Other than abandoning the parity altogether, central banks could do little in the face of combined banking and exchange-rate crises, as the former seemed to demand easy money policies while the latter required monetary tightening.

To be sure, Bernanke is describing the Fed’s tradeoff during the Great Depression, when it was constrained by gold standard. Still, the basic problem remains. Tight policy would accelerate and intensify the pain in the banking system, but loose policy could destabilize the Dollar, causing capital to flee the US and also undermining the banking system. And, to make matters worse, a collapse in the banking system due to tight money could then trigger a currency collapse.

I think it is safe to describe this as a no-win situation, which means an ugly choice has to be made. And, with this in mind, perhaps the Fed only offered 25bp on the discount rate in hopes they could avoid a greater than 25bp cut in the Fed Funds rates. At this point, that does not look like an acceptable domestic policy choice, and if they ultimate cut 50bp or more, they have accepted the risk of destabilizing the Dollar.

I have to imagine that global central banks are ready to intervene at the drop of a hat, and would not be surprised by some action when New York opens Monday. If there is an intervention, it will be interesting to see if the Fed participates. Could the Fed credibly buy the Dollar one day while cutting rates 75bp or more the next? And what are the odds of a successful intervention if the monetization option looks increasingly viable in the weeks ahead?

There is nothing but tough policy questions at this juncture. We can only hope that Yves Smith’s contact is misinformed:

The Fed is badly out of its depth. Not that this is a surprise, since its actions have looked desperate for a while (was it Barry Ritholtz who said "75 is the new 25"?). This confirmation comes from a hedgie reader:

A last note on the Fed. A friend who’s got very good contacts told me today that they’re completely at sea here, not understanding what’s going on, flying by the seat of their pants, and making policy completely on an ad hoc basis. Not precisely what one would hope for in this situation.

Bottom Line: An aggressive cut in the Fed Funds rate seems likely, with 100bp certainly on the table. Still, one has to ponder why this was not part of the Sunday policy package. Could it really be as simple as not being able to contact enough FOMC members to have a teleconference? Or was it hope that a bigger than 25bp Fed Funds rate cut might not actually be necessary? Or has the Fed come to believe that their policy actions might trigger a destabilizing fall in the Dollar? At this point, I anticipate a cut larger than 50bp, with even odds on 75 and 100. The greater the cut, the more the Fed is willing to risk a Dollar collapse. [Note: RSS feed for Fed Watch posts][Tim has an update here.]

Comments

[esb]

At some moment a (very small) light will activate in the consciousness of Benjamin Bernanke, and the "gentleman" will realize that were he a sane investor in Germany or Germantown, Singapore or San Diego or any points east or west, north or south, the inflationary policies that are so truly dear to his heart would cause even him to race to the keyboard or phone and get his remaining assets out of the United States of America, "market on open."

But then, the light will go out and a comforting thought will return, the thought of "quatitative easing."

The markets are voting on this man's cherished constructs each day, and when the policies have finally opened an unfillable gap on the dollar charts, he will take his deserved position as the single most discredited (modern)central banker outside of the confines of Zimbabwe.

Mr. Bernanke, get thee to an academy, to an academy, go.

[knzn]

"...loose policy could destabilize the Dollar, causing capital to flee the US and also undermining the banking system"

This doesn't sound quite right to me. Under a freely floating exchange rate, devaluation is normally the symptom, rather than the cause, of capital flight. It's possible that it could cause problems in the banking system, depending on the specifics of the process, but it's not obvious (to me, anyhow) that it would necessarily cause such problems. If foreigners withdraw their dollars from US banks and convert them to Euros, somebody has to be a counterparty to that conversion, and presumably the counterparty would want to deposit those dollars back in a US bank. (With fixed exchange rates, as in the early 30s, you wouldn't need a private counterparty, because the government would ultimately promise to be a counterparty to any currency conversion. But in this case, the US will probably never intervene to defend the dollar, and if other countries intervene, they are in the same position as a private counterparty, needing to do something with their newly acquired dollars.)

[They Will Never Realize They Were Not Repaid]

Okay, foreign savers loaned lots of resources to US borrowers. US borrowers won't, or can't, repay. Default on the nominal debt would make foreign savers stop lending to US borrowers. Therefore, just default on the real debt by inflating it away. Foreign savers will never realize that they were not repaid, and thus keep right on lending to US borrowers. That's the plan.

[FWIW]

"...they’re completely at sea here, not understanding what’s going on..."

FWIW, stripped of esoteric sounding jargon, foreign borrowers found out that US savers don't intend to repay them. Foreign savers don't want to loan any more to US savers. No effort has been made to reassure foreign savers that future loans will be repaid in full, let alone past loans, so things keep getting worse.

[FWIW]

Make that, "Foreign savers don't want to loan any more to US borrowers."

[Lafayette]

esb: Mr. Bernanke, get thee to an academy, to an academy, go.

Not bad. But, premature, methinks.

Hamlet to Ophelia:

Get thee to a nunnery: why wouldst thou be a breeder of sinners?

I am myself indifferent honest; but yet I could accuse me of such things that it were better my mother had not borne me: I am very proud, revengeful, ambitious; with more offences at my beck than I have thoughts to put them in, imagination to give them shape, or time to act them in.

What should such fellows as I do crawling between earth and heaven? We are arrant knaves, all; believe none of us. Go thy ways to a nunnery ...

[Barkley Rosser]

An unfortunate aspect of the current situation is that the Chairman of the Japanese central bank, Fukui, has resigned, but has not yet been replaced, and there is a fight going on over who his replacement will be, with the central issue being the degree of independence of the central bank from the Ministry of Finance. Bad timing.

[Chris]

"I myself see my differences between the US and Japan situations, but the necessity of a bank bailout is almost certainly similar. And someone will have to pay for it; monetization might seem like the least painful choice. And the Fed may ultimately conclude that the easiest way to reduce the household debt burden is to inflate it away."

It seems to me that the Fed has been willing to tolerate commodity price increases but not wage increases. If they want to reduce the household debt burden they are going to have to permit wage inflation, but this is not a factor they control. Business would fight tooth and nail against it and might accelerate outsourcing. There is a risk it seems that this measure would not help the people it is presumably designed to help.

[hari]

If Fed is not careful the run on the dollar may make this current climate of uncertainty a lot more dangerous! If CBs are going to cooperate then there may be some conditionality demanded which GWB may decide (today) NOT to support. Then what?

[donna]

I think it would be best for everyone if GWB would just shut up already.

[Lafayette]

chris: It seems to me that the Fed has been willing to tolerate commodity price increases but not wage increases.

The Fed's purview is restricted to financial markets. Wages are a matter of the supply and demand for labor.

The Fed can do nothing about returns on labor, though it does influence returns on capital.

That might seem unfair and I would be the first to agree. And the only way to correct that travesty of social justices is higher taxation for those who garner exaggerated return on their capital investments.

It's redistribution on Social Expenditures would righten, a bit, that imbalance -- and still leave plenty on the table.

[Hank]

Alas.

http://dx.doi.org/10.1006/cpac.2000.0432

Securities legislation and the accounting profession in the 1930s: The rhetoric and reality of the American Dream

Barbara D. Merino and Alan G. Mayper

-----excerpts------------

.... regulation should be viewed as symbolic (i.e. not expected to result in significant changes in distribution of economic resources), a means of restoring investor confidence and preserving the status quo.
...
... symbolic legislation might be sufficient to restore investor confidence.
...
... to reestablish the viability of what has been labeled the “American dream".... as a response to a moral crisis of capitalism, generated by the “immoral behavior" of the capitalist elite.... the first priority ... had to be to establish the moral legitimacy of capitalism by restoring trust in the existing system....
...
... examining the private correspondence and the actions of the regulators during the early years of the SEC act. ... shows that the early SEC commissioners had a commitment to the private property rights paradigm, and were unwilling to confront the monied interests....
...
... even if we believed the legislation was intended to cause a “real" change, the enforcement was not ....
...
In summary, our arguments are as follows:
(i) the rhetoric used by the New Deal was intended to restore trust and fairness in American society;
(ii) the underlying basis for the political persuasion was the restoration of the American dream in a liberal environment;
(iii) ... the New Deal was doomed to failure since it would be viewed as protecting the status quo ....

[apj]

I like ESB's assessment here. The Fed may well be its own inflationary enemy right now given that it has effectively begun quantitative easing, but inflation is palpably circulating throughout the globe right now anyway. The great disinflation is well over (even as measured by the highly questionable CPI), and China, the heretofore champion of the disinflation trade, is leading the way.

The issue I expect to receive far more attention in coming weeks is just how bad the fiscal deficit is sure to become. The 400bn forecasts are a colossal 'Mine!' If if doesn't reach easily more than 5% of GDP then, to my mind, it will be an enormous surprise. The financial system is in disarray and is disintegrating. This is the lifeblood of the economy - period. The time has come Marvin K. Mooney. The time is now! Enough of the irrelevant easing, the US Govt is being called into action in a big way.

[Lorne]

The Roman Empire lasted 800 years, despite frequent episodes of currency debasement, thru clipping coins and dilution of the metal in their currency.

I wonder if the Roman Empire could have lasted even 200 years if it had a GSE with 4.7 trillion in debt and capital of a few hundred billion.

Also, the Roman Empire never had an emperor so stupid as to advertise a "zero bound" strategy in a white paper before assuming power, so that every high net Roman would know the gameplan before the inevitable event. The best part of the White Paper was praise for a previous emperor who debased the currency 50% after confiscating the gold of the masses, with nary a peep.

In case you miissed it, the Bernanke roadmap is here:
http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm