Thursday, October 26, 2006

The Dark Side of Fed Transparency

FOMC Report
October 25, 2006

The Dark Side
Fed Transparency

Martin McGuire

Not a Time to be Over Confident

No one should be overly self-critical if they have not foreseen with precision the evolution of the economy over the past several months. Those who have been more right than wrong may have, like a broken clock, merely been at the right place at the right time. I say these things both as an encouragement to those who are having difficulties divining economic prospects and as a warning to those who have come to believe that this game has become somehow easier.

First, the game has changed by nature of the growing interest in the Fed to provide increasing amounts of transparency. Generally, increased Fed transparency should be considered wholesome and beneficial in allowing for the proper allocation of economic resources. However, there has never before been such a well advertised policy path for monetary policy as that of the recent two years ending with the June 2006 FOMC meeting. This new era of Fed transparency along with all its well acknowledged benefits may carry as well some unforeseen baggage in a restrictive monetary policy regime.

What I like to call the ‘path-dependent restrictive policy directive’ came to an end with the return of a data-dependent policy initiative which publicly kicked off with the release of the June 06’ FOMC policy statement. I consider the most recent restrictive monetary policy stance path-dependent because the Fed was searching for neutral at a very understood pace of 25 basis points per FOMC meeting (without fail) for seventeen (17) consecutive meetings.

For many months, my interest has been directed toward the likely economic response to a change in Fed policy with the removal of this path-dependent regime and in its place, a data-dependent policy format. Intuitively, the change calls for greater uncertainty for any level of Fed transparency. As such, I have argued strongly that at the conclusion of the path-dependent policy directive, the risk for slower economic growth would rise as higher levels of uncertainty would bring about a reduction in risk appetite.

Because this is new monetary policy territory, I have tried to avoid the pitfall of overconfidence in my expectation for an economic slowdown resulting from heightened uncertainties. I have recognized that the Fed may have failed to remove excessive liquidity in the system because of the very nature of its historically unprecedented transparency during a restrictive policy directive. All interested parties were given ample time to ready themselves for successively higher Fed Funds, as such, allowing for the maximum amount of risk assumption to take place. This more than anything else may have been the root cause for the housing bubble.

So, with a great deal of sincerity, I can sympathize with someone who at this point in the current economic cycle is having difficulties maintaining a high level of confidence in their economic forecast. In fact, I would imagine a prudent individual will have more opportune instances for which to express greater levels of confidence than at this juncture in this unprecedented shift (pause) in monetary policy stance.

In my view, the more likely path going forward still appears to be toward slower growth with the risk toward a recession rather than above trend growth. My base case here in is that the economic dampening impact from reduced risk appetite resulting from greater uncertainty in a data-dependent Fed will outweigh any lagged or continued effect of the Feds inability to remove appropriate levels of liquidity in its most recent path-dependent restrictive policy directive.

However, I recognize that just as the Fed had forecasted slower economic growth correctly, they further forecasted a reduction in inflation along with a growing slack in resource utilization. The Fed has correctly forecasted the slower growth. I said initially, that economic growth statistics would be most important in understanding the prospects for Fed policy in the first months following the June FOMC statement as the slower expected growth had not yet been proved. It was also recognized at that time that if growth did slow, and should inflation not tame within 4-6 months following the June meeting, the Fed would become increasingly less patient that their second derivative diagnosis was correct. If inflation remains at or above 2.5% core by late this year, we might at that point expect further restrictive policy initiatives forthcoming.

The Limits of Fed Transparency

I see a growing challenge for both the Fed and market participants in light of an unprecedented level of transparency in the conduct of monetary policy. There may be unintended repercussions from this Fed transparency. Most assuredly, Fed transparency is more beneficial to one of the Fed’s dual mandates than it is to the other. It might even be argued that while Fed transparency benefits in nearly all respects the attainment of high levels of economic growth, it may actually at times impede the Fed from attaining its other stated goal of preserving the purchasing power of the dollar.

Not too long ago it was merely the prospects for a restrictive policy directive coming to pass which was enough to encourage market participants to take inventory of all levels of risk assumption and scale back in those areas which could not be justified under a tighter funding environment. The Feds process of becoming transparent has accelerated over the last couple of years and market participants are growing increasingly comforted by this approach to monetary policy. Certainly we can all recognize the benefits from the Fed providing transparency, guidance and comforting assurances when tolerance for risk is at extremely low levels and viable economic endeavors are forgone for fear of scarcity of funds available for loan. At such a time when economic growth is well below potential and inflation is well contained, Fed transparency, which takes the form of assurances to market participants that funds will be made available through time, can be a great tool toward the Fed stated goal of promoting maximum sustainable economic growth.

However, transparency which works against the very intent of a restrictive policy initiative seems to me somewhat troubled at the inception. Even a small amount of uncertainty can go a long way toward achieving lower levels of risk assumption. The Fed need not pull back the thick velvet drapes of old to their operations in order to extract some measure of reduction in risk assumption. By describing clearly the exact path the Fed would take in the removal of accommodation, the Fed insured that accommodation (liquidity) would be removed at a much slower pace than their stated goal as market participants stayed a small step in front of the Fed intentions.

While it is not absolutely clear that the Fed has finished with its restrictive policy measures in this cycle, we can expect some consideration to be given to the level of transparency afforded market participants at the initiation of the next, if somewhat distant, restrictive policy initiative.

Lower Term Premium as a Result of Fed Transparency

Long term interest rates and more specifically long term treasury rates had remained low during the most recent restrictive policy regime for many reasons. Some of the commonly cited reasons for lower long rates were: 1. Strong demand from Asian central banks, 2. Greater demand by pension funds, 3. A global savings glut, and 4. In general a demand which has outstripped a relatively small level of supply. While I have surely not named them all, my favorite reason for lower long-term treasury yields during the ‘path-dependent restrictive policy directive’ is the decline in the term premium.

Lower economic variance has been recognized as having positively impacted (reduced) the term premium. Part of the reduction in economic variance has been the result of this most recent prolonged economic expansion which might have otherwise been cut short with a more historic reaction to the introduction of a ‘traditional’ restrictive monetary policy initiative.

Earlier this year I met with Mr. Ray Stone of Stone and McCarthy research Associates and I asked him if he might give his opinion of my theory that market participants were taking on excessive levels of risk as they knew with near certainty what the prevailing level of Fed Funds would be well out on the time line. He asked at that point whether it was my view that the term premium was reduced as a result of the Fed’s transparency.

While I had been and remain more interested in what will be the repercussions or after-market from the highly transparent Fed in its most recent path-dependent restrictive policy directive, I am compelled, especially with more recent interest in this area, to describe how it is that a transparent Fed in the tightening mode might cause a reduction in the term premium.

If the uncertainty for future short-term interest rates is reduced, then we might expect this to lower the term premium. The Feds increased transparency has helped reduce uncertainty about future short-term interest rates. From June of 04’ through November of 05’ (at 12 consecutive meetings) the Fed described its intentions quite clearly as meaning it would hike 25 basis points at the next meetings by proclaiming; ‘accommodation can be removed at a pace that is likely to be measured’. During this ‘restrictive’ policy initiative where the Fed regularly stated its intention and gave clear guidance, market participants knew a much larger piece of what makes up long term interest rates(a bigger piece of the series of successive short term interest rates). Therefore the term premium was rightly reduced as well over this period.

To the extent this increased transparency was expected to continue to reduce uncertainty about short-term interest rates going forward, we should expect the market place to price these expectations into the term premium. Market participants may have been aggressive in expecting Fed transparency to continue to yield similar visibility (consistent with that seen during the path-dependent restrictive policy directive) as the Fed moved to the next policy cycle phase.

It is important that we understand that Fed transparency will not encourage the reduction of term premium during an accommodative policy directive as it had in its most recent restrictive policy directive and it will certainly not help lower the term premium in this current ‘neutral’ funds environment.

Imagine a situation where the Fed does not know what its future rate decisions will be. This is a good proxy for where we currently are within the Fed’s policy cycle. We must realize that any transparencies which the Fed allows at this point will only further our understanding that the Fed knows not which way it will lean next. How then can we expect Fed transparency at this point to provide for lower term premium? The answer is we cannot. Why then are long yields low and the yield curve inverted between 3 month money and 10 year bonds.

A surfeit of global savings, a high demand for long-dated securities by pension funds and a relatively inadequate supply of long-dated securities relative to demand doubtless still has an impact on long term yields. However, I would argue that at this point it is an overriding concern for slower economic growth rather than the Fed transparency induced reduction in the term premium which is now helping to keep long rates historically low and the yield curve inverted. Otherwise, we should expect a grand re-pricing as market participants come to realize that term premium cannot remain historically low in a neutral or a more accommodative Fed policy directive. Conversely, the market might be pricing the long end for a Fed return to a path-dependent restrictive policy directive, in which case the re-pricing will be at the front end of the curve (successively higher short rates).

Asset Bubbles and Fed Transparency

In the normal course of a monetary policy cycle, the Fed moves to eliminate excessive liquidity when growth exceeds its long-run potential. By doing such, the Fed removes from the system funds which would otherwise have found their way toward inefficient or ultra-risky enterprise backing.

I have argued that the Fed, by being more transparent than at any time in its 93 year history, and more importantly, during a ‘restrictive policy regime’, has in effect severely reduced the impact of the rate hikes which would more historically have removed greater amounts of excessive liquidity over a shorter time period. Some of my friends in the funding business for major money center banks constantly warn me that the Fed has done little to date to mop up excess liquidity. They are never short of current anecdote which helps demonstrate their point.

How could it be that the Fed having raised rates from 1% to 5.25% not had a greater impact on one of the most important variable of future inflation, namely excess liquidity? Those monies which are in want for a home, will find a home in time. The proper conduct of monetary policy helps to limit the likelihood of asset bubbles by helping to insure that the level of available funds are sufficient to the extent of providing funds for economically viable enterprise. As this is clearly not an exact science, the Fed must of course allow for some excess of funds because without their existence product as well as financial innovation would be severely curtailed.

Much has been made of whether or not the Fed should expend any energy combating asset bubbles. Asset bubbles cannot be avoided per say. They will happen when funds move away from viable economic enterprise toward assets, either physical or financial, which derive their value more from the expected continued ‘assessed’ value gains rather than from real economic value. This is what we commonly call the ‘greater fool theory’, where the asset buyer intends nothing but being able to deliver up the asset to a more willing buyer at a higher price within some short time horizon.

We can easily understand that it is a lot easier for funds to find their way toward asset bubbles when there is an excess of funds than when there is only ample funds for economically viable enterprise. In the case of the former, lenders for want of finding a home for their funds, mark down their standards in order to place the funds wherever they are demanded. To the extent there is excess liquidity, these funds will find their way toward increasing less viable economic enterprise (bubbles). In the latter, where there is little in excess funds, those looking to participate in ‘the greater fools game’ must either take from their own savings, sell off assets or pay ever more dearly for funds which have already found economically viable endeavors.

Again, there is nothing keeping asset bubbles from happening. If the Fed allows the existence of excessive funds in the system, there is a very easy mechanism for transmitting those available funds into the market for inflated or bubble assets. However, if there is little in the way of excess funds available, it is the costly and convoluted methodology necessary for transferring funds earmarked for viable economic enterprise into bubble assets which keeps these instances at a minimum.

The Fed then can and does fight asset bubbles. It does so most importantly at the base of its activities and in accordance with one of its dual mandates-maintain price stability. By allowing only the right amount of funds in the system, the chance for asset bubbles is particularly curtailed.

What then of the current situation. The housing market has widely been described as an asset bubble, whether in geographic specific locations, or more generally across the states. How could this have happened largely during a time when the Fed was in a restrictive policy regime? The answer lies where few Fed watchers are willing to venture. The Feds transparency in the path-dependent restrictive policy directive has allowed excess funds to remain in the system where they inevitably found their way to increasing less viable economic enterprise.

What Now?

Jack be nimble, Jack be quick. Jack jumped over the gulf between what is believed to be true now and what will be more certain within a couple of months. Earlier we took note that in June, the Fed expressed its expectation that economic growth would slow. Non-residential construction not withstanding, the Fed has been bang on with this call. Conditional on this economic slowing, the Fed also expressed the view at that time that they further expected inflation pressures to subside along with and partly the result of the expected slower economic growth. Should the fed prove correct only on the slower growth and not on the subsiding inflation, we should expect further rate hikes. Conversely, if inflation is quieted, we should expect a less restrictive monetary policy stance as early as the first quarter of 06’. It is now more important to watch after the inflation numbers than it is to watch the growth story.

Current Six Meeting Forecast for Fed Funds Target:

FOMC Date Funds Target Risk Assessment

October 24-25, 06’ 5.25% Bal-Slow Eco
December 12, 06’ 5.25% Bal-Slow Eco
January 30-31, 07’ 5.00% Slow Eco-Low Infla
March 20-21, 07’ 4.75% Slow Eco-Low Infla
May 9, 07’ 4.50% Bal-Low Inflation
June 27-28, 07’ 4.50% Balanced


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