Thursday, September 20, 2007

Path-Dependent Monetary Policy Directive - Reload

FOMC Report
September 18, 2007
‘Path-Dependent Monetary Policy
Directive’- Reload
Martin McGuire

I have read and heard repeatedly over the last days, predictions of what changes the Fed
may make to the fed funds target rate when they meet on Tuesday. There has also
occasionally been a brave soul who attempts to predict what change if any there will be to
the discount rate. In nearly every instance however, the would-be provider of insight
leaves the reader or listener with the caveat that it will be the statement which market
participants will most closely follow. Instead of providing any direction there, the
authors noted above have more generally punted. Chickens!
It behooves me then to take that leap and attempt to provide for you a look to what the
upcoming statement will provide. I will endeavor not only to share the likely gist of the
upcoming statement, but the reason and likely success of the Fed strategy. Being as
important as so many say, and I would definitely agree, the statement will be covered
here as the main course and the rate decision(s) rather as a side dish.
Summary Fed Call:
The Fed will give the market the guidance found most helpful during the last tightening
campaign. The Fed will give the market a modicum of easier policy measure in the form
of a 25 basis point rate cut in the target fed funds rate, but more importantly, the Fed will
provide once again a ‘path-dependent policy directive’. The Fed’s transparency will once
again be valued by market participants because it will be accompanied by a defined path
the Fed intends to follow. This will replace the most recent forecast based approach to
monetary policy where incoming data was scrutinized to foretell likely forthcoming
economic prospects.
In short, the Fed will design its statement to convey its intention to provide additional
small increments of easier monetary policy initiative (a series of 25 basis point cuts in the
fed fund target) at subsequent FOMC meeting dates. By doing this, the Fed will intend to
provide a calming effect on credit conditions by providing insight into a greater piece of
the time line for interest rates. This should encourage some downward pressure on the
wider fed funds to libor yield spread. If the Fed is as smart as their written work
suggests, they will even bring back the term ‘measured pace’. That way, it will be nearly
impossible to misinterpret the pace and timing of the Feds new ‘path-dependent easier
monetary policy directive’.
Faithful and I should hope aptly rewarded readers will recall the phrase I coined for the
most recent restrictive policy directive. The ‘path-dependent restrictive monetary policy
directive’ concluded with the 17th consecutive and widely advertised increase in the Fed’s
target fed funds rate to the level of 5.25%. More surprising than anything the Fed had or
had not done over that time period, was the historic change in the way monetary policy
was applied. The lack of quality research attempting to assess the likely impact from
\such a change in policy application is surprising. In fact, it appears to date that not only
has the significance of the change not been examined, but that the Fed adopted a different
approach toward restrictive policy implementation itself also went widely unnoticed.

The Fed, by operating under extreme transparency during what should have been a
‘restrictive’ policy initiative, promoted an escalation of, rather than a reduction in, the
level of risk market participants were willing to assume. Simply, market participants
learned rather early in the string of 17 rate moves the timetable and numeric amount
(each FOMC meeting and 25 basis points) of forthcoming higher target rates.
If you would rather, consider the Fed as having lowered perceived risk premium by
advising the world of the path monetary policy would be taking (‘path-dependent’).
Knowing a greater portion of the time line for the risk-free rate convinced market
participants that there was room to reduce the amount of risk premium demanded and
thus a willingness to accept a level of risk that would have previously commanded higher
By the time the Fed had finished raising the fed funds rate to 5.25%, credit spreads were
at historically low levels. Many observers pointed to the diversification and dispersion of
risk and the sophistication of financial instruments, models and participants as the root
cause for the inordinately tight credit spreads rather than the historic undertaking of the
Fed’s new transparency during a ‘restrictive’ policy directive.
I am confident that transparency works better in achieving the goals of monetary policy
when it is subscribed to during easy monetary policy initiatives rather than restrictive
ones. This is true because an easier monetary policy is more closely aligned with the
Feds mandate to maximize employment. Transparency is suited more aptly to
conveyance of assurances that the Fed stands ready to take the necessary steps to provide
ample market liquidity in times of distress or a widening gap between existing and longrun
potential economic growth. A restrictive policy directive had until recently been
expected to be more aligned with the other of the dual mandates, which is that of
maintenance of stable inflation.
Moral Hazard:
I find it quite interesting that some, apparently including Mr. King of the Bank of
England, call for the Fed to be mindful of the ‘moral hazard’ involved with lowering
target rates at this juncture, as it may encourage resumption in the excessive risk taking
which arguably brought us to these current conditions. Where were these calls when the
Fed was failing in providing appropriate disincentive for extreme risk-taking during the
most recent restrictive policy directive? Credit spreads tightened and the amount of
excess liquidity expanded while market participants, quite often in an effort to maintain
market share, moved en masse toward accepting lower levels of return for greater levels
of risk assumption.

The moral hazard argument is best addressed at a time when the Fed is fighting a
resurgence of inflation (actual or that of climbing expectations) and more preferably at a
time when the economy is rather well placed.
Normalization of Fed Funds to Libor Spread:
A starting point in this discussion is what would be the appropriate definition of a normal
spread between fed funds and, say, three month libor. Should this spread be nearer to
11.5 basis points, the level which prevailed for most of the period from December ’06 to
early August ’07 or rather closer to or beyond the 25 basis points spread which was more
the norm in decades past?
As I write, FFU7 trades to 95.015 which implies a fed funds target of slightly less than
5%. We recognize the target rate to be 5.25% currently. Three month libor fixed this
morning at 5.5975. Therefore three month libor stands 34.75 basis points above the
current target. More meaningful however is that three month libor currently stands 59.75
or 84.75 basis points above what is widely expected to be the target fed funds rate by
tomorrow afternoon (5% or 4.75%).
Next, let us postulate on what the Fed might consider to be a more appropriate spread
between fed funds and three month libor. This spread is a somewhat important indication
of the disquiet in the financial markets. It is, more specifically, an indication of the
current concerns about the lack of transparency in the assets held and lines of credit
extended by potential counterparties in this term-lending environment. While it is far
from a Fed mandate to insure this spread trades to more narrow levels, the fact that it is
currently quite a bit wider than it has been over the last decades is disquieting for the Fed.
Some I believe correctly argue that a moderate move of the target funds rate is not in
itself likely to bring this spread to more narrow levels. One may argue that a series of
rate moves which brings lower the target rate to levels that will substantially ease the
‘burden’ of adjustable rate commitments, will decrease the concerns for counterparty
risk. A dramatic and immediate move toward lower rates may reduce the aforementioned
burden. However, such a move would carry the risk of leaving market participants
concerned that they may not understand, as the Fed surely must, the extent of current
financial and economic problems. The resultant financial market dislocation could then
become severe.
Time and the reduction in uncertainty will provide the backdrop for a smaller yield
spread between the fed funds target and three month libor. I believe that while the Fed
will not openly set a level at which they would like to see this spread trade to; they will
consider a sustained spread of 30-35 basis points or lower to indicate a gross
improvement in the markets perception of counterparty risk. Any time spent where the
yield spread between the target rate and libor is near 30-35 basis points will itself go a
long way toward normalizing financial markets. We have seen what even a slight easing
in this spread has meant to market psychology over the last week. While it will take a
considerable amount of time to repair the damage to the financial markets, the journey
seems to have begun and I believe the Fed would rather not upset this small but important
start with an oversized reduction in the target fed funds rate.

Likelihood for ‘Path-Dependant Approach to Work:
Below I set out expectations for a series of 25 basis point rate reduction over the next six
FOMC meeting. This is my best guess at the moment. I had considered and still would
give good odds to the possibility that a series of cuts as predicted below will not be
enough to keep the economy from falling into more than a mild recession. One scenario I
could build is for the Fed to move at 25 basis point clips over the next few meetings and
find that this will not have been enough and thus find they are responding to worsening
economic conditions with more forceful 50 basis point move(s).
That said, a lot of exogenous variables will provide pulls and pushes for and against the
normalization of financial market conditions and the retardation of the expected decline
in economic activity going forward. Additionally, I would say that much of my above
analysis and forward looking rate calls are aligned with my expectation that there are
cyclical pressures coming to bear, which will push realized inflation lower than seen on
average over the last two years.
To be so Fortunate Going Forward:
I have been very fortunate to have correctly anticipated and reported in advance of
forthcoming FOMC meetings, the rate decision which would be made at each of the last
26 FOMC meetings since May ’04. At times over this period, I had correctly anticipated
the FOMC rate decision well in advance of the event. There is a chance my string of
successes may end today.

Current Fed Rate Expectations:
FOMC Date Funds Target Risk Assessment
September 18, 2007 5.00% Slow Eco-Low Infla
October 30-31, 2007 4.75% Slow Eco-Low Infla
December 11, 2007 4.50% Slow Eco-Low Infla
January 29-30, 2008 4.25% Slow Eco-Low Infla
March 18, 2008 4.00% Slow Eco-Low Infla
April 29-30, 2008 3.75% Slow Eco-Low Infla

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