A recent article by Justin Lahart in the Wall Street Journal raises the possibility that the Fed will run out of tools for combating the unfolding financial crisis, and incipient recession.
A lot of this is reminiscent of the discussion back in 2003 – and that discussion was of course reminiscent of the discussion of the tools that were available to the BOJ, but generally left unused. With the funds rate then down at 1%, and people were paying a lot of attention to “unconventional” monetary policy. Bernanke, then a member of the Board of Governors, even at one point suggested targeting or somehow influencing long-term bond yields. Two possibilities were being kicked around: (1) large-scale purchases of long-dated securities with no set targets, and (2) explicit targets for long-term term interest rates, like those in place before the Accord. Purchases of private-sector obligations were also being discussed, but there was some concern that this would overstep the Fed’s legal bounds. (A 2004 Fed working paper by Small and Clouse thoroughly reviews these constraints.) Nothing was ever done along these lines, but drawing on a highly influential paper by Woodford and Eggertsson, the FOMC eventually inserted the famous “considerable period of time” clause into its statement. It would be interesting to know whether any of these options are being dusted off.
There are some obvious similarities between now and 2001-03: (1) the weak real economy, and (2) the collapse of asset prices (stocks then, housing now).
But there are a couple of important differences too: (1) inflation pressure and the spike in commodity prices, and (2) the fragility of the financial system. In 2003, we were able to reassure ourselves that we were not “turning Japanese” because at least the financial system (banks in particular) seemed to be in good shape. Today, banks generally seem to be OK, at least for now – it’s everything else that seems to be coming apart. These are greatly complicating the Fed’s job: If it were just a soft economy and falling inflation, the Fed’s task wouldn’t be easy, but at least it would be relatively straightforward.
Thursday, March 27, 2008
Monday, March 17, 2008
Bailout or fire sale?
It can't be both!
The Fed is sure to take some heat over Friday's decision to extend an emergency loan to Bear Stearns (via JP Morgan), and last night's decision to open the discount window to primary dealers. Terms like "bailout" will inevitably be used to describe what the Fed is doing.
But in defense of the Fed, there are good reasons to think that the Fed acted appropriately in its capacity as lender of last resort. In that role, the Fed's job is to lend funds to solvent institutions, which, for whatever reasons, are experiencing a liquidity crisis -- i.e., a "run". And that's probably a reasonable description of the situation Bear Stearns found itself in on Friday. Why? How do we know Bear wasn't also insolvent? For the simple reason that somebody, namely JP Morgan, was willing to buy it. And, the fact that the $2/share price was viewed as a "fire sale" price suggests that the company was worth substantially more -- maybe not the $50-plus per share price of last Thursday, but something well above zero. Had Bear actually been insolvent, there would have been no buyer at any price.
And what about opening up the discount window to primary dealers? Yes, that sets a very interesting precedent, but it was probably a good idea. After all, "surprise" loans to financial institutions experiencing a liquidity squeeze do absolutely no good: it's the commitment of the central bank to step in and lend during a run that will avert the run. The loan to Bear Stearns obviously suggested an implicit commitment; the Fed has now simply made that explicit. If the policy succeeds, other dealers will never need to avail themselves of the facility.
For commercial banks, the price paid for access to the discount window has been regulatory oversight, the idea being that if the institution is regulated, the Fed will be in a good position to gauge its solvency. The open question now is whether, in opening the discount window for other institutions, the Fed will expect those institutions to a comparable degree of scrutiny. In light of recent events, that might not be such a bad idea...
The Fed is sure to take some heat over Friday's decision to extend an emergency loan to Bear Stearns (via JP Morgan), and last night's decision to open the discount window to primary dealers. Terms like "bailout" will inevitably be used to describe what the Fed is doing.
But in defense of the Fed, there are good reasons to think that the Fed acted appropriately in its capacity as lender of last resort. In that role, the Fed's job is to lend funds to solvent institutions, which, for whatever reasons, are experiencing a liquidity crisis -- i.e., a "run". And that's probably a reasonable description of the situation Bear Stearns found itself in on Friday. Why? How do we know Bear wasn't also insolvent? For the simple reason that somebody, namely JP Morgan, was willing to buy it. And, the fact that the $2/share price was viewed as a "fire sale" price suggests that the company was worth substantially more -- maybe not the $50-plus per share price of last Thursday, but something well above zero. Had Bear actually been insolvent, there would have been no buyer at any price.
And what about opening up the discount window to primary dealers? Yes, that sets a very interesting precedent, but it was probably a good idea. After all, "surprise" loans to financial institutions experiencing a liquidity squeeze do absolutely no good: it's the commitment of the central bank to step in and lend during a run that will avert the run. The loan to Bear Stearns obviously suggested an implicit commitment; the Fed has now simply made that explicit. If the policy succeeds, other dealers will never need to avail themselves of the facility.
For commercial banks, the price paid for access to the discount window has been regulatory oversight, the idea being that if the institution is regulated, the Fed will be in a good position to gauge its solvency. The open question now is whether, in opening the discount window for other institutions, the Fed will expect those institutions to a comparable degree of scrutiny. In light of recent events, that might not be such a bad idea...
Tuesday, January 22, 2008
Not euphoria, but better than the alternative
In the US, the market's reaction to today's 75 bp rate cut (a decline of about 1%) was somewhat short of euphoric, but presumably it was better than it would have been otherwise. (The reaction here in Australia was positively exuberant, however: equities up over 6% as of 11 a.m.!)
The closest recent parallel to today's Fed action is probably the surprise October 1998 rate cut, which was an effort to restore confidence in the wake of the LTCM and Russia debacles. In that case, the market's 4% gain could have been described as euphoric -- and that was how Bernanke and I described it in our 2005 Journal of Finance paper (quoted here in the Wall St. Journal's Real Time Economics blog). In both cases, it seems the Fed's main motivation for the rate cut was more a concern for financial stability than any new information about the macroeconomy.
Leaving aside the question of whether this was the right thing to do (see the previous post, "Too much, too late?" by Adam Posen), based on my work with Bernanke, one would have expected to see an actual increase in stock prices. The link between the two is not perfect, of course -- that's why regressions have error terms. And in this instance, the error term contained news about yesterday's global selloff.
The closest recent parallel to today's Fed action is probably the surprise October 1998 rate cut, which was an effort to restore confidence in the wake of the LTCM and Russia debacles. In that case, the market's 4% gain could have been described as euphoric -- and that was how Bernanke and I described it in our 2005 Journal of Finance paper (quoted here in the Wall St. Journal's Real Time Economics blog). In both cases, it seems the Fed's main motivation for the rate cut was more a concern for financial stability than any new information about the macroeconomy.
Leaving aside the question of whether this was the right thing to do (see the previous post, "Too much, too late?" by Adam Posen), based on my work with Bernanke, one would have expected to see an actual increase in stock prices. The link between the two is not perfect, of course -- that's why regressions have error terms. And in this instance, the error term contained news about yesterday's global selloff.
Too much, too late? Guest post by Adam Posen
I've been down under at the Reserve Bank of Sydney for the past three weeks, anxiously watching yesterday's market meltdown and today's Fed's reaction. Here's what my co-conspirator Adam Posen, Senior Fellow at the Peterson Institute, had to say about recent developments:
Today's 75 bp surprise rate cut will in the end probably prove to be too much, rather than too little. At present, however, the point is to get in front of events and financial market panic rather than to fine tune to the forecast. The lesson of Japan in the 1990s is in the forefront of the FOMC's collective mind -- that is, one has to be activist and take downside risks seriously rather than being paralyzed by inflation risks and ending up with a worse outcome.
There is a communications issue here, created by the FOMC's decision to cut rates between meetings rather than waiting until next week's regularly scheduled meeting. It makes it look as though stock market fears are driving the Fed to action. Because a sharp decline in asset markets, particularly if synchronized outside of the US, could have effects on the real economy, it is reasonable for the Fed to try to stave off such a self-fulfilling prophecy. But now they risk being seen as bailing out equity investors (rather than responding to the forecast or liquidity needs) and being seen as ineffective if the markets continue to fall in the immediate period.
I don't envy being in their position as of 7 a.m. this morning, but ideally I think they should have issued a statement indicating that they would cut big on Jan 29/30 as expected, but that there was/is no new negative information besides the equity market moves themselves. Or if they had new information (which the statement seems to imply about housing markets even though the recent Beige Books and moves in spreads seem to give a more balanced picture), they should have spelled out what that new information was. In the end, this kind of timing and communications issue will not matter much.
The outlook is still not as bad as people seem to think, and we're still looking at either slow growth in first half of 2008 with no recession or a mild brief recession. I put my money so to speak on the former, and the combination of monetary ease and fiscal stimulus being quite effective over the next several months to rule out the downside risks. The bipartisan principles on the fiscal stimulus package (temporary, targeted, ~1% of GDP and high-multiplier form) are the right ones - especially if direct rebates to low-income people (instead of tax credits) accompany small business favoring investment tax credits. I have no idea what the "markets" are talking about suggesting they expect this to be ineffective - as Ken Kuttner and I showed, fiscal stimulus did work in Japan in the 1990s when tried, and there the financial system was in much worse shape and monetary policy was going in the opposite direction.
So I expect us to see the Fed having to reverse its cuts by year-end of 2008. That means I expect the US to be heading back close to trend growth (now 2.5% real year-over-year) in the second half of the year, with core inflation above 3%. Unemployment will be a lagging indicator, as usual, and so will creep up towards 6% months after the economy turns around, making it politically difficult for the Fed to raise rates. But the new President will likely be fortuitous in her/his timing, with perceptions of the economy hitting a nadir around June, and evidence of a recovery becoming clear around the time of her/his first budget if not State of the Union address.
Today's 75 bp surprise rate cut will in the end probably prove to be too much, rather than too little. At present, however, the point is to get in front of events and financial market panic rather than to fine tune to the forecast. The lesson of Japan in the 1990s is in the forefront of the FOMC's collective mind -- that is, one has to be activist and take downside risks seriously rather than being paralyzed by inflation risks and ending up with a worse outcome.
There is a communications issue here, created by the FOMC's decision to cut rates between meetings rather than waiting until next week's regularly scheduled meeting. It makes it look as though stock market fears are driving the Fed to action. Because a sharp decline in asset markets, particularly if synchronized outside of the US, could have effects on the real economy, it is reasonable for the Fed to try to stave off such a self-fulfilling prophecy. But now they risk being seen as bailing out equity investors (rather than responding to the forecast or liquidity needs) and being seen as ineffective if the markets continue to fall in the immediate period.
I don't envy being in their position as of 7 a.m. this morning, but ideally I think they should have issued a statement indicating that they would cut big on Jan 29/30 as expected, but that there was/is no new negative information besides the equity market moves themselves. Or if they had new information (which the statement seems to imply about housing markets even though the recent Beige Books and moves in spreads seem to give a more balanced picture), they should have spelled out what that new information was. In the end, this kind of timing and communications issue will not matter much.
The outlook is still not as bad as people seem to think, and we're still looking at either slow growth in first half of 2008 with no recession or a mild brief recession. I put my money so to speak on the former, and the combination of monetary ease and fiscal stimulus being quite effective over the next several months to rule out the downside risks. The bipartisan principles on the fiscal stimulus package (temporary, targeted, ~1% of GDP and high-multiplier form) are the right ones - especially if direct rebates to low-income people (instead of tax credits) accompany small business favoring investment tax credits. I have no idea what the "markets" are talking about suggesting they expect this to be ineffective - as Ken Kuttner and I showed, fiscal stimulus did work in Japan in the 1990s when tried, and there the financial system was in much worse shape and monetary policy was going in the opposite direction.
So I expect us to see the Fed having to reverse its cuts by year-end of 2008. That means I expect the US to be heading back close to trend growth (now 2.5% real year-over-year) in the second half of the year, with core inflation above 3%. Unemployment will be a lagging indicator, as usual, and so will creep up towards 6% months after the economy turns around, making it politically difficult for the Fed to raise rates. But the new President will likely be fortuitous in her/his timing, with perceptions of the economy hitting a nadir around June, and evidence of a recovery becoming clear around the time of her/his first budget if not State of the Union address.
Tuesday, December 18, 2007
This just in: markets fail
The Fed today unveiled a set of proposed amendments to Regulation Z, the collection of rules intended to ensure "truth in lending." Why is this big news? Mainly because it is the Fed's long-awaited response to the unfolding subprime debacle. Many have been highly critical of the Fed for failing to take proactive steps to curtail abuses in subprime lending. (See this article in today's New York Times.) And many will surely be critical of the Fed's proposed amendments as "too little, too late."
Still, the Fed's document is groundbreaking in at least one respect: it explicitly acknowledges the problem of market failure in the business of loan origination, and it even uses that term repeatedly in giving the background for the proposed changes. Manifestations of these market failures include the "yield spread premiums" paid to mortgage brokers, the failure to escrow tax and insurance payments--and even the coercion of appraisers. This represents a real shift from the Fed's more laissez-faire policy of recent years. Even more remarkable is that the person leading the effort to overhaul Reg Z was governor Randy Kroszner--a University of Chicago professor with ties to the American Enterprise Institute. Economists with Kroszner's background tend to emphasize the power of markets, rather than their limitations. So give the Fed, and Kroszner, credit for recognizing that markets can, and do fail. That's cold comfort to those who have already been burned in the subprime debacle, of course. Let's just hope that, by making markets work better, tinkering with the obscure provisions of Reg Z will help avert the next catastrophe.
Update: another five seconds of fame! Check out my sound bite on this evening's edition of Marketplace.
Still, the Fed's document is groundbreaking in at least one respect: it explicitly acknowledges the problem of market failure in the business of loan origination, and it even uses that term repeatedly in giving the background for the proposed changes. Manifestations of these market failures include the "yield spread premiums" paid to mortgage brokers, the failure to escrow tax and insurance payments--and even the coercion of appraisers. This represents a real shift from the Fed's more laissez-faire policy of recent years. Even more remarkable is that the person leading the effort to overhaul Reg Z was governor Randy Kroszner--a University of Chicago professor with ties to the American Enterprise Institute. Economists with Kroszner's background tend to emphasize the power of markets, rather than their limitations. So give the Fed, and Kroszner, credit for recognizing that markets can, and do fail. That's cold comfort to those who have already been burned in the subprime debacle, of course. Let's just hope that, by making markets work better, tinkering with the obscure provisions of Reg Z will help avert the next catastrophe.
Update: another five seconds of fame! Check out my sound bite on this evening's edition of Marketplace.
Risky Business
In a recent Wall Street Journal interview, Philadelphia Fed President Charles Plosser expressed concerns about the FOMC's "balance of risks" statement, saying that it can "put the committee in an awkward position. Markets often use our balance of risks to infer something about what they think the path of the funds rate is going to be..."
Plosser makes a good point: ideally, the FOMC's statement should communicate a sense as to how the Fed would respond to new information, rather than drop hints about the next change in the target rate. The FOMC's old "asymmetric directive" with its "woulds and coulds" was abandoned precisely because it was widely believed to provide a good forecast of the next rate change. It was hoped that the "balance of risks" formulation would address Plosser's concerns, but clearly it hasn't: instead, it seems to have become a substitute, at least in the minds of market participants, for the "tilt" in the asymmetric directive.
Probably the only way to deal with the problem is to increase the bandwidth of Fed communication. Fedwatchers will always be in the business of forecasting the FOMC's next move, of course. But so long as the FOMC's announcements are accompanied by brief, formulaic statements, Fedwatchers will interpret even the smallest changes in the wording of those statements as a signal of -- or worse, an implicit commitment to -- future target rate changes.
Plosser makes a good point: ideally, the FOMC's statement should communicate a sense as to how the Fed would respond to new information, rather than drop hints about the next change in the target rate. The FOMC's old "asymmetric directive" with its "woulds and coulds" was abandoned precisely because it was widely believed to provide a good forecast of the next rate change. It was hoped that the "balance of risks" formulation would address Plosser's concerns, but clearly it hasn't: instead, it seems to have become a substitute, at least in the minds of market participants, for the "tilt" in the asymmetric directive.
Probably the only way to deal with the problem is to increase the bandwidth of Fed communication. Fedwatchers will always be in the business of forecasting the FOMC's next move, of course. But so long as the FOMC's announcements are accompanied by brief, formulaic statements, Fedwatchers will interpret even the smallest changes in the wording of those statements as a signal of -- or worse, an implicit commitment to -- future target rate changes.
Wednesday, December 12, 2007
Buzz Cut
Give the Fed credit: today, the central bank announced a new and innovative mechanism of getting more "liquidity" into the banking system, what they're calling a term auction facility. Basically, you can think of this as a new and improved discount window -- another way for the Fed to fulfill its function as "lender of last resort."
This kind of facility can come in handy when fundamentally sound banks experience a liquidity crisis: think of Jimmy Stewart's old Building and Loan in It's a Wonderful Life. Banks, many of which can't liquidate their assets quickly enough because the markets for those assets have dried up, will now be able to use them as collateral for borrowing from the Fed. This will allow them to go about their business as usual, and pay off any nervous depositors. In theory, the discount window already serves this purpose -- but banks have historically been shy about discount window borrowing on the grounds that this sends a bad signal about their underlying strength.
Good idea -- but two questions that come to mind are: (1) What exactly are these assets that are going to be pledged as collateral? Are these going to be exactly the same opaque, impossible-to-value CDOs that landed banks in trouble to begin with? If so, what "haircut" will the Fed take (i.e., how much of the asset's supposed value will the Fed lend against)? The advice from the standard central bank playbook on this matter, Bagehot's Lombard Street, is to lend only against good collateral, and only in situations where liquidity -- not solvency -- is the issue. And (2) why would banks prefer to use the term auction facility instead of the more conventional discount window?
In the end, one has to wonder whether the Fed's liquidity enhancing actions can, innovative as they are, really solve the underlying problem: billions and billions of dollars of nonperforming assets. Clearly, there are some serious credit problems out there, and all the liquidity in the world won't solve them. Just ask the Bank of Japan: in its efforts to counter the effects of the collapse of its banking system in the 1990s, the BoJ progressively expanded the range of assets it would accept as collateral for its lending operations. These measures did little to solve the banking problem, of course; that only came with the workout or liquidation of the nonperforming loans. There's no reason to think the U.S. would be any different.
This kind of facility can come in handy when fundamentally sound banks experience a liquidity crisis: think of Jimmy Stewart's old Building and Loan in It's a Wonderful Life. Banks, many of which can't liquidate their assets quickly enough because the markets for those assets have dried up, will now be able to use them as collateral for borrowing from the Fed. This will allow them to go about their business as usual, and pay off any nervous depositors. In theory, the discount window already serves this purpose -- but banks have historically been shy about discount window borrowing on the grounds that this sends a bad signal about their underlying strength.
Good idea -- but two questions that come to mind are: (1) What exactly are these assets that are going to be pledged as collateral? Are these going to be exactly the same opaque, impossible-to-value CDOs that landed banks in trouble to begin with? If so, what "haircut" will the Fed take (i.e., how much of the asset's supposed value will the Fed lend against)? The advice from the standard central bank playbook on this matter, Bagehot's Lombard Street, is to lend only against good collateral, and only in situations where liquidity -- not solvency -- is the issue. And (2) why would banks prefer to use the term auction facility instead of the more conventional discount window?
In the end, one has to wonder whether the Fed's liquidity enhancing actions can, innovative as they are, really solve the underlying problem: billions and billions of dollars of nonperforming assets. Clearly, there are some serious credit problems out there, and all the liquidity in the world won't solve them. Just ask the Bank of Japan: in its efforts to counter the effects of the collapse of its banking system in the 1990s, the BoJ progressively expanded the range of assets it would accept as collateral for its lending operations. These measures did little to solve the banking problem, of course; that only came with the workout or liquidation of the nonperforming loans. There's no reason to think the U.S. would be any different.
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