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Monday, March 17, 2008

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.]

    Posted by on Monday, March 17, 2008 at 12:15 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (14)

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