Tuesday, March 27, 2007

The Fed is only Publishing Short Stories

FOMC Report
March 20-21, 2007

The Fed is only Publishing
Short Stories

Martin McGuire

Executive Summary:

* The Fed may change the FOMC statement to suggest uneven but moderate economic growth is expected, including in the area of housing, rather than ‘firming growth’ over the coming quarters. Because it is a given that the Fed will provide an accommodative response to any severe financial market dislocation it need not adjust its statement regarding ‘some inflation risk remains’ and ‘The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook…’

* There is a tendency for some economists to look for economic developments to advance at a faster pace than is possible. Because of the growing immediate availability of endless detailed economic information, economists have had a hard time sticking with the weakening housing story and instead have come back to it only more recently.

* The Fed has been coming to the rescue far too soon and has promoted an excessive risk appetite. It has been a long time since the economy and financial markets have experienced the cleansing effects of a complete economic cycle that includes some hardships.

* The Fed is using transparency as a ‘quasi-tool’ to refrain from using some of its more blunt instruments such as targeting Fed Funds more often. Transparency during the ‘path-dependent restrictive monetary policy directive’ insured a situation where speculative excess prevailed despite higher target rates.

* The odds have grown for a more dramatic unwinding of the repercussions of excessive an risk appetite. The Fed itself has fostered the current level of speculation by its transparency in its most recent restrictive monetary policy directive. The lagged effects from prior rate hikes are coming to bare at a time when the Fed would otherwise choose to allow inflation pressures to continue to recede. It may instead be forced to react to upcoming developments.

The FOMC Statement and Possible Changes:

The statement may point to an uneven economic growth path which is still expected to expand at a moderate pace over the coming quarters rather than suggest indications of firmer economic growth as in the last statement. The Fed is likely wishing it had not described the housing market as having shown some tentative signs of stabilization in the last statement. The Fed could point to the housing market as one particular area of the economy which has shown uneven signs of growth.

We should understand it as a given that the Fed stands ready to react to financial market distress, allowing the availability of funds if there is a hard and fast negative shift from the current relatively benign environment (subprime spill-over). Therefore, the Fed at this time should not change the statement, ‘The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.’

If the Fed were to ‘neutralize’ this statement at this time by giving an indication that they stand ready not only to fight inflation, but also to provide accommodation in the event weaker financial market conditions prevail, the Fed would draw unwanted and possibly unwarranted attention to the dislocation in the mortgage market.

The Pace of Economic Development in the Information Age:

There appears to be a growing tendency on the part of many economists and market watchers to expect economic developments to proceed at a pace which has rarely if ever prevailed. It may be that as information about economic developments becomes more readily available at a moments notice, many are less willing to accept the premise that economic developments are not necessarily sped along as a result of greater familiarity or a more immediate understanding of forces which come to bare on those developments.

Certainly the recognition of a weaker housing market was an old, tired and forgotten story by late last year. Six months ago, many analysts were warning of dire consequences from a weaker housing market. However, only a few of these many were willing to carry the charge into the more recent decline in the subprime mortgage market. It seems odd that so many, having recognized a problem in the housing market, could so quickly abandon their concerns and virtually forget about the situation within months.

The reason may be that the story was no longer new and interesting. It seemed few wanted to be the one standing alone and talking about a housing market problem when the masses moved on to concerns of the Yen carry trade issue. When the Fed suggested they were seeing signs of stability in the housing market, the majority of these economists moved their sites to some other, seemingly more pressing concern. Clearly, in today’s click and reveal times, a story grows tarnished with age much more rapidly as we know all eyes are upon and all remedies applied at a moments notice.

However, macro economic developments don’t move at that pace. It may even be argued that as a result of the immediacy of information, economic developments can take longer to mature. We have becom more aware of the growing arena in which we operate and the limits therein seem to be pushed further out as we come to understand the minute details of differing systems. Therefore, it might be argued that with the growth in information and the immediacy of its availability, there is more room at times for exaggeration of economic developments. The housing market through the sub-industries of mortgage markets and home construction come most immediately to mind as possible victims of exaggerated development as a result of comfort in the extent and immediacy of available detailed information about those areas.

The Fed is Only Publishing Short Stories:

It is incredible that after all that was known about the level and growth of indebtedness of consumers and the increasing use of mortgage equity withdrawals (mew) to finance a lifestyle which a shrinking middle class had accepted as a birthright, we had become tired of a story which by all accounts should have been recognized as having only proceeded through the first chapter. The story is still unfolding, and while it is not necessarily a horror story, we should expect at least a chapter or two where the plot gives us reason to wonder if things will turn out well in the end. Those chapters may be playing out now.

In relation to economic cycles, the Fed has only been publishing short stories over the last 20 years. Just as we get to the part of the story where a tragedy is about to befall our heroine, the Fed comes to rescue the heroine from a nadir which he would have otherwise eventually risen anew, complete and better equipped to carry the next hardship. One of these times, we will get past the truncated short stories and embrace an economic cycle which unfolds in all its glorious drama. Such a story will include those chapters describing the wayward, uncaring and frivolous and their unkind end. It too describes those who get knocked back a peg, some for the first time and how some of these then strive as never before to take a straight and enlightened path.

I have felt a growing concern that some structural instabilities have crept into the economic and financial markets as a result of the speed at which the Fed has come to the rescue at times when excesses in risk appetite has finally been called into question.

A New Tool in the Fed’s Bag:

Despite this new wealth of timely information, the Fed is left with the same old blunt instruments which they have wielded for generations. These tools such as reserve margins, discount rate and most importantly the federal funds rate are used to sculpt a monetary policy with which economic growth can be expected to advance at a pace consistent with its long run potential. This set of tools is also expected to shape a construct which fosters a benign, low and minimally varying level of inflation.

The Fed has added a ‘quasi-tool’ to their bag. Any good craftsman knows that a new tool used in production should be used sparingly at first and with care until its action and the reaction of materials with which it comes in contact is better understood. The quasi-tool that the Fed has been using with increasing regularity is called transparency. Where there was once very little, there is now an abundance of transparency into the inner workings of the Fed. The Fed is using transparency to guide market participants toward understanding how and when they might use the more blunt instruments at their disposal. Obviously, if the Fed has directed market participants wisely through the use of transparency, they will find themselves needing to use the blunter instrument of Fed Funds target less frequently. Generally, I would say transparency on the part of the Fed is a good thing in these times of enlightenment.

The benefits of transparency in the form of assurances that funds would be made available would be comforting to lending institutions in a time when economic prospects look bleak and lending standards are rather tight. A Fed making transparent its intention to make funds more available or further to make assurances that it intends to conduct policy in a way which provides for lower policy rates going forward could certainly provide the backdrop for greater economic growth. This describes an accommodative monetary policy directive and transparency works quite well in this instance. We can see that under these conditions, transparency could foster economic growth.

However, there is a point I want to emphasize. Only one of the Feds primary mandates is well served by Fed transparency in general and most particularly during a ‘path-dependent monetary policy directive’(1). Transparency is simply not well suited to a monetary policy which is expected to remove speculative zeal, curb excessive liquidity or in general help redirect funds away from less economically viable alternative (bubbles).

It should be clear that transparency does not lend itself toward the removal of speculative fervor which drives bubbles, inflation and instability. The most recent restrictive monetary policy directive prompted me to coin the phrase ‘path-dependent restrictive monetary policy directive’. By this I mean the Fed allowed for a very exact understanding of the path of policy in both the extent and timing of the Feds intended restrictive policy measures. As such, the Fed’s efforts did little to remove the excesses these policy actions are normally designed to accomplish.

More recently, the lagged effects of the prior rate hikes are coming to bare against a financial system where its participants have largely maintained their appetite for risk throughout the path-dependent restrictive policy directive. What would have historically been a more steady process of risk reduction as market participants adjusted to the Fed initiating a more restrictive policy stance has not occurred as the result of Fed transparency. Instead, systemic risk has grown. There is currently a greater risk for a more dramatic and immediate unwind of these speculative excesses which has in large part been driven by a long standing surplus of liquidity.

The Fed was transparent to the extent where it drove neither liquidity nor stupidity from the financial markets in its last endeavor in moving the target rate from 1% to 5.25%. Had it moved in a less orchestrated, deliberate, advertised and transparent manner, the Fed may have found market participants less willing to accept historically tight spreads for taking on risk. Transparency in a ‘path-dependent restrictive monetary policy directive’ simply does not work.

The Fed needs to revise their operations during restrictive policy initiatives. There will always be room for transparency in the accomplishment of the Feds mandates. They simply need to be less forthcoming with respect to the extent and timing of restrictive policy measures so as to allow for the proper alignment of the cart and the horse.

If the financial markets are at such a delicate state that there is no room through time for the Fed to raise rates when liquidity becomes excessive without being as forthcoming as to the details of its policy intent, then we should expect Fed policy to continue to foster an environment where speculative excess is not only tolerated, but encouraged.

It is Not the Result of a Lack of Liquidity:

When excessive liquidity chases an inadequate level of viable economic alternative, it is but a matter of time till these funds, through some conduit, find a home in a bubble. Most recently, ill-advised investments have been found in the housing market. While it is most obviously at the moment in the subprime lending market, it is likely that other parts of the housing market have attracted excessive funding and we will see further fall-out from these sectors. It is likely too that the speed at which a subprime mortgage could be applied for and accepted, prompted a greater interest from available funds than did construction which has a slower turnover.

If the Fed comes to the rescue as a result of this latest round of repercussions from ill-invested surfeit of available liquidity, then it will cut short another self correcting completion of an economic cycle. The short story version does not allow for the excesses of speculation to be wrung out and thus force monies to be directed more judiciously toward economically viable pursuits. Instead, the short story version lends itself only to the repositioning of ill-directed ‘investment’ toward another unsuitable ‘investment’.


The odds have grown for a more dramatic unwinding of the repercussions of excessive risk appetite. The Fed itself has fostered the current level of speculation by its transparency in its most recent restrictive monetary policy directive. The lagged effects from prior rate hikes are coming to bare at a time when the Fed would otherwise choose to allow inflation pressures to continue to recede. Because the Fed had not removed the excess liquidity during the last restrictive phase, it may have to cope with a severe dislocation in the financial market as the current, only slightly restrictive monetary conditions force the unwinding of some ill-advised leveraged investments. This then may induce the Fed to take up once again an accommodative monetary stance for a time.

FOMC Date Funds Target Risk Assessment

March 20-21, 07’ 5.25% Tightening Bias
May 9, 07’ 5.25% Balanced
June 27-28, 07’ 5.00% Slow Eco-Low Infla
August 7, 07’ 4.75% Slow Eco-Low Infla September 18, 07’ 4.50% Bal-Low Inflation
October 30-31, 07’ 4.50% Balanced

While I believe this describes the likely prospects for the Fed, there is also a real risk of a rapid unwind of leveraged positions over the next several months which may result in an emergency ease by the Fed.

(1) I have been writing about a ‘path-dependent restrictive monetary policy directive’ and its implications for some time now:
Excerpts from Pre-FOMC Report March 27-28, 2006; Low Term Premiums Not Supported by Non-Linear Monetary Policy despite Transparent Fed:

Low Term Premium - A Misinterpreted Benefit from Fed Transparency

…We would be remiss if we did not try to understand what has been the reason for the fall in macroeconomic volatility, and a heightened willingness by investors to accept risk - which has resulted in lower term premiums. Certainly, economic volatility has been markedly lower than in past cycles and inflation has been well contained over the recent past. First the Fed has become increasingly transparent and monetary policy has been path dependent for the last 7 quarters. Even before the current series of 14 consecutive 25 basis point rate hikes the Fed was showing an elevated level of transparency as it moved away from its heightened deflationary concerns.

Because monetary policy has been so predictable over this period, the higher level of risk aversion that has accompanied restrictive monetary policy periods in past cycles has been absent this time around and economic growth has thus benefited. At the onset of restrictive policy directives in the past there was a much greater urgency felt by investors toward taking a large step closer to risk aversion.

What has happened is that the path dependent monetary policy short-term benefits to economic growth, which is largely misunderstood, have led market participants to extrapolate the perceived benefits from Fed transparency into lower long-term risk premium. However, with the Fed no longer working within a path dependent framework, transparency at the Fed will no longer translate as easily into increased visibility. This has been the real reason for excess assumption of risk and the associated low term premium.

The Fed will soon finish raising the funds target and when it does, market participants will experience a steepening of the yield curve and a widening of credit spreads. This is the typical reaction to the conclusion of a tightening campaign. When market participants view the Fed as having finished a tightening campaign, concerns of an overshoot arise and the risk shifts to a weaker economy resulting from excessive monetary policy restraint. As such, concerns for economic weakness and accompanied credit downgrades and defaults grow.

What will surprise this time around is the extent to which term premiums will increase and credit spreads will widen…


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