Fed Watch: Passing the Baton

Tim Duy:

Passing the Baton, by Tim Duy: The Federal Reserve will offer up the results of its two day meeting this afternoon. It is hard to find much to argue with Rebecca Wilder’s conclusion that not much has changed in the past six weeks, and hence we should expect little from today’s statement. CR opines on the possibility that Bernanke & Co. might update us on their evaluation of the potential benefit of purchasing longer dated Treasuries. Economists at Merrill Lynch suggested earlier this week the Fed may be forced to pursue that option sooner rather than later if yields keep rising (although some think that bonds are about to make a technical turn in direction anyway).

It seems, however, that outright purchases of Treasuries to hold rates lower would shift the Fed’s attention from the asset side of the balance sheet to the liabilities side, which would put them in the realm of their definition of quantitative easing. It doesn’t seem like they are quite ready to go there; just six weeks ago they made an effort to differentiate between their policy and Japanese style quantitative easing. Seems too quick for a reversal given the relative calm of credit markets since the December meeting. Given the lack of Fed preconditioning to expect a significant policy shift, today’s statement is not expected to move markets, and will be carefully dissected to see how, if any, the Fed’s view of the economy or credit markets have changed.

So what now is the ultimate intention of policymakers? What do they hope to accomplish?

Caroline Baum at Bloomberg thinks she has that answer – a recreation of all that caused the massive economic dislocations to occur in the first place:

Fast forward one year, the crisis is still going strong, the villains are still under attack, yet something curious has happened: The policies and actions responsible for the economy’s illness are now being prescribed as cures.

I think it is easy to sympathize with Baum’s position; I was particularly stymied by the path of policy in the first half of 2008, which appeared directed at doing everything and anything to prevent an unstoppable adjustment away from externally supported growth. I thought the Fed was pursuing a questionable policy path especially considering superheated global growth. In the end, the Fed likely threw fuel onto one final bubble – commodities – before the whole house of cards came crashing down. The degree to which this bubble (and the concurrent destabilizing dollar carry trade) worsened the domestic and global situations will be a matter for the historians.

Now it is difficult to argue that policymakers actually believe that they can recreate the conditions that brought the housing bubble to fruition. Federal Reserve Chairman Ben Bernanke does not appear to be under any delusions:

The proximate cause of the crisis was the turn of the housing cycle in the United States and the associated rise in delinquencies on subprime mortgages, which imposed substantial losses on many financial institutions and shook investor confidence in credit markets.  However, although the subprime debacle triggered the crisis, the developments in the U.S. mortgage market were only one aspect of a much larger and more encompassing credit boom whose impact transcended the mortgage market to affect many other forms of credit.  Aspects of this broader credit boom included widespread declines in underwriting standards, breakdowns in lending oversight by investors and rating agencies, increased reliance on complex and opaque credit instruments that proved fragile under stress, and unusually low compensation for risk-taking.

I tend to believe the key to reigniting the credit bubble – if at all possible – is the last sentence. Lower rates, in and of themselves, cannot compensate for tighter underwriting standards. And those tighter standards, such as a reversion to making home mortgages based upon a reasonable percentage of income, are likely more permanent than temporary. Until the government is ready to revert to encouraging lending practices where everyone with a pulse gets a jumbo loan, tighter credit is simply the new reality.

So if the Fed cannot recreate the credit bubble, what are policymaker’s trying to accomplish with all of their financial machinations? Rather than focus on the individual types of assets supported, we can first simplify the Fed’s goal as attempting to provide the support necessary to keep the economy at full employment (alternatively, the prevention of deflation if you prefer that framework).

But what about patterns of demand at full employment? The main criticism of the current economic regime is leveled by Baum:

The government wants to ensure that consumers, whose spending accounts for about 70 percent of gross domestic product, can borrow and spend. This makes as little sense as using easy money and housing incentives to cure the effects of easy money and over-investment in housing.

I think many believe that the US economy is fundamentally out of balance. Too much consumption, too little investment, too much dependence on foreign production. Sustainable growth requires an adjustment, and the government should support that adjustment, not prevent it (I have been particularly worried about the consequences of the failure of the external accounts to adjust). Here though, is where the Fed has run into trouble by supporting markets for such things as housing and consumer debt. The Fed in these examples appears to be supporting a specific pattern of economic activity, rather than being agnostic about the composition of activity under full employment. Hence the charge that policymakers are attempting to maintain a broken system. From their perspective, the credit crunch does not swallow those still willing and able to borrow, regardless of the ultimate demand supported.

Ultimately, however, if there are questions about the patterns of economic activity, these are best suited for fiscal policymakers to address. Which underscores the importance of fiscal policy – not only is the Fed’s effectiveness at supporting full employment in question, but it lacks the tools to both support growth and cushion any structural adjustment. The fiscal authority, in contrast can cushion the increase in saving by providing public investment where the private investment opportunities are currently insufficient (the economy will not shift patterns of activity overnight). That doesn’t mean the fiscal authorities will get the job done perfectly right (I still think that tax cuts have an outsized place in the stimulus package), but it is their job, performed through the political process, not the Fed’s.

In short, I have come to view Fed policy as less of an attempt to maintain the status quo and more of a series of desperate acts to prevent the system from outright collapse. They will slowly try to extricate themselves from financial markets as opportunities arise, and act to hold rates low across the yield curve, buying longer dated Treasuries if necessary. Beyond that, the heavy lifting is left to the fiscal authorities. Hopefully, the combination will allow the economy to move sideways while consumer and banking balance sheets heal. If that healing does not occur, then the Fed would be forced to step back front and center with a plan for outright inflation. Hopefully we don’t have to go there.