Less Than Respectful Commentary on the Fed Put and Fiscal Rescue Efforts

It wasn’t enough that the Administration’s fiscal stimulus plan announced last Friday was sufficiently off beam so as to precipitate a global stock market rout. The Fed then put its credibility and some of its remaining firepower on the line to try reverse the gap-downward stock market opening with the in-panic-mode pre-session 75 basis point cut in the Fed funds target rate. But what the hell is the Fed doing meddling with the stock market? Find me anywhere in the Fed’s charter or subsequent legislation that makes it the custodian of national wealth, which seems the role it has now decided to assume.

What bothers me is the de facto declaration that stock markets are to be a low (or contained) risk zone. I started out in the securities industry in 1980, when most sensible people thought equities were speculative the infamous Business Week “Equities are Dead” cover ran in 1979, and the bull market did not begin until 1982). Stagfation meant that stocks had been a great place to lose money. My father’s options in Boise Cascade, one of the go-go companies of the 60s, had an exercise price of 32. He cashed them in when the stock was 64. It went to 8. That was not an uncommon trajectory in those days.

Peter Lynch, the revered manager of the Magellan Fund, said something roughly like, “Equities are the best investment when they are seen as very risky, and are most perilous when they are widely seen as safe.” Stocks have been seen as one of the very best places to put money for well over a decade. Enthusiasts like to remind they nay-sayers that buying on market declines has proven to be a great strategy. The Fed seems to have become an enabler of the notion that equities are a lower risk asset class than they really are.

Back to the sightings of the day. My favorite, told by a buddy, was that Henry Paulson, apparently making informal remarks after his speech today, commented on “lack of regulatory fiber” and noted that some institutions are overseen by multiple regulators, while other by none at all. Wonder how many years it took him to figure that one out.

There has been quite a bit of commentary on the what wound up being joint fiscal/monetary moves, much of it ranging from not very impressed to downright caustic. I’ll turn the mike over to some of the worthy observations (and be sure to read the last one):

Fiscal Stimulus Skeptics

From an unexpected source, Greg Mankiw, in “a strategy of desperation“:

My favorite book by Paul Krugman is Peddling Prosperity, which I once assigned in a course and still often recommend to students. A reader recently reminded me what the book says about the use of fiscal stimulus (page 32):

When monetary expansion is ineffective, fiscal expansion…must take its place. Such a fiscal expansion can break the vicious circle of low spending and low incomes, “priming the pump” and getting the economy moving again. But remember this is no by any means an all-purpose policy recommendation; it is essentially a strategy of desperation, a dangerous drug to be prescribed only when the usual over-the-counter remedy of monetary policy has failed.

From the Economist’s Free Exchange, “Overstimulated“:

In olden times, a week and a half ago, the Washington Post argued persuasively that perhaps the politicians ought to just leave economic stimulus to the Fed. That’s a good idea. Last week, the Cato Institute’s Tom Firey reminded us of Christina and David Romer’s fine 1994 paper, “What Ends Recessions?” [$$$] Great question! What does? Not discretionary fiscal policy gimmicks, like cutting checks to voters. What tends to work, Mr and Ms Romer find, are monetary policy, like the big suprise rate cut we got this morning, and automatic fiscal policy, like the increase in unemployment and welfare disbursements that tend to follow a downturn.

So, given the fact that we just had the biggest interest rate cut in over 20 years–which will do the trick if anything will–do you suppose the vote-grubbers will now pack in their various demand-side performance art proposals and just go with what’s proven to work? I wouldn’t bet on it. Neither would Bryan Caplan, who does a nice job explaining why in this NPR interview: rational politicians coming up to an election fear they will be punished unless they make a show of doing something, and not-so-rational voters are too dense to know it won’t really help.

Aside: while I am not a fan of Cato Institute, that doesn’t mean that everything they put out is wrong.

The real ire, however, cane from the Fed’s capitulation. Even the Wall Street Journal started a page one story today with “Ben Bernanke blinked“. Martin Wolf has taken to the theme of bankers holding central banks hostage, knowing that the regulators will ride to their rescue. If there was ever any doubt that that applied to markets too, it was dispelled today.

Rate Cut Critics

Interfluidity has a very good post, “The ‘Fed put’ in action,” which takes its cue from the lone dissenter, St. Louis Fed’s William Poole, the lone dissenter in the Fed vote today who spoke on the very subject of the Fed put in November :

Poole is at pains, throughout his talk (whose theme is moral hazard) to claim that stabilization policy uses the stock market as a instrument of policy, but that this does not imply that the stock market can use the FRB as a backstop or guarantee… But, if the Fed must intervene to prevent “panics”, it has placed itself in the role of a parent habitually blackmailed by a self-destructive adolescent. “If you don’t give me what I want want Mommy, I’ll cut myself and maybe I’ll die!” …it’s… obvious that this is a bad dynamic, one that shouldn’t be lauded as the cutting edge of “intelligent macrofamilial stabilization policy.” It’s not a particular policy action that’s bad, it’s the macroeconomic game that we’ve settled into that has to be changed if we want markets that aggregate external information and make wise allocation decisions rather than focusing on intrafinancial Kremlinology.

I’m not optimistic that the current Fed will transcend heroics and push towards a new dynamic. The Great Depression haunts the Fed chairman like the memory of an older sibling’s suicide. The troubled younger child will be coddled and indulged, and fingers will be wagged only when it is very safe to do so. But, tragically, indulgence and capitulation don’t always work, what appears to be the least risky course can sometimes be a sure route to escalation and destruction. When the last child died, it was blamed on tough love. But that might not be right, or if it was, it might say little about what this child needs.

The family metaphor points up another dynamic: regulators as indulgent boomer parents, who set children’s expectations too high, overreward and underdiscipline them.

From “Cracks in the Foundations” by John Quiggin:

The decision of the US Federal Reserve to cut interest rates by 0.75 per cent is as clear a sign of panic on the part of the monetary authorities as we’ve seen since the 1987 stock market crash. It’s not entirely coincidental that it followed a dreadful week on Wall Street, and a couple of awful days on world stock markets while the US was closed for the long weekend.

Still, stock markets have fluctuated quite a bit in the last 20 years without producing this kind of reaction. The really alarming events have been happening in bond markets and, in retrospect, the most alarming happened just over a month ago.*
That’s when Standard and Poors cut the credit rating of ACA Financial Guaranty Corp from AAA (the best possible) to CCC (just about the worst kind of junk) in one move. This event showed the weakness of two of the most important defences against the kind of credit derivative meltdown that market bears have been worrying about for years.

First up, it’s yet more evidence that, when it comes to systemic risk, credit rating agencies like S&P are either asleep on the job or, worse, incapable of performing it. They are fine at the day-to-day job of comparing different assets of the same kind, for example, estimating which companies are more or less likely than others to default on their corporate bonds. But when it comes to assessing the risks of whole asset classes, particularly new and ‘innovative’ asset classes, they’ve proved themselves to be hopeless.

They were caught napping by the Asian financial crisis. They gave high credit ratings to dotcoms with no earnings and in many cases no revenues. And they have been centrally implicated in the crisis that began with the repacking of subprime loans into bundles of securities, many of which were given AAA ratings on the basis of dubious projections of default rates.
But the failure to detect problems with bond insurers like ACA is far more serious. As I said in the 2002 post I linked above,
The starting point [for a possible financial meltdown] is a crisis in derivatives markets arising when ‘counterparties’ (those owing money on the transaction) … refuse to pay up…the possibility of large-scale failure in bond and credit derivative markets, now all to real, could bring an end to the long period of global prosperity that began with the end of the last big global recession in the early 1990s.

From Nils Pratley, “Bernanke is risking his moral capital.” The Guardian:
I

nterest rate changes take six months to be felt in the real economy, it is reckoned. So why would the US central bank make its most radical cut in decades only eight days before a regular policy-setting meeting? We know why: the US Federal Reserve was so panicked by the prospect of a 500-point fall in the Dow Jones industrial average that it felt it had to move now.

his is an extraordinary development since it implies that power to set interest rates has been hijacked by the markets. If markets shout loudly enough, it seems they can get whatever tonic they desire, whenever they wish. If you follow this logic to its conclusion you might wonder why we bother with central bank policy-setting committees at all. We could take the latest reading in the futures market instead.

As it happens, the markets have already decided that they like the game so much they’ll play it again. A further 0.25 point cut at next week’s regular Fed meeting is priced in, and the futures imply a 60% chance of a 0.5 point reduction.

But we’ve saved the most colorful and excoriating for last. From Willem Buiter, “The Bernanke put: buttock-clenching monetary policymaking at the Fed“:

It is bad news when the markets panic. It is worse news when one of the world’s key monetary policy making institutions panics. Today the Fed cut the target for the Federal Funds Rate by 75 basis points, from 4.25 percent to 3.50 percent. The announcement was made outside normal hours and between normal scheduled FOMC meetings.

This extraordinary action was excessive and smells of fear. It is the clearest example of monetary policy panic football I have witnessed in more than thirty years as a professional economist. Because the action is so disproportionate, it is likely to further unsettle markets. Even the symptoms of malaise that appear to have triggered the Fed’s irresponsible rate cut, the collapse of stock markets in Asia and Europe and the clear message from the futures markets that the US stock markets would follow (a 500 point decline of the Dow was indicated), are unlikely to be improved by this measure and may well be adversely affected.

In the absence of any other dramatic news that the sky is falling, I can only infer from the Fed’s action that one or both of the following two propositions must be true.

•The Fed cares intrinsically about the stock market; specifically, it will use the instruments at its disposal to limit to the best of its ability any sudden decline in the stock market.
•The Fed believes that the global and (anticipate) domestic decline in stock prices either will have such a strong negative impact on the real economy or provides new information about future economic weakness from other sources, that its triple mandate (maximum employment, stable prices and moderate long-term interest rates) is best served by an out-of-sequence, out-of-hours rate cut of 75 basis points.

The first proposition would mean that the Fed violates its mandate. The second is bad economics.

This panic reaction is destabilising in the short run because it is likely to spook the markets. When the Fed loses its nerve, “things fall apart; the centre cannot hold”. In the medium term it subordinates the price stability target to the real economic activity target. It also lays the foundations for the next credit bubble, after the recession of 2008 has become a distant memory.

It would have been far preferable, particulary because the stock market decline is a global phenomenon, to have a coordinated modest rate cut of, say, 25 basis points, by all leading central banks at some later date, when this would not look like a collective knee-jerk response to a fall in global equity prices.

With this irresponsible act, the Fed has just become part of the problem. Interesting times indeed.