Wednesday, October 31, 2007

'Trick or Treat:' Moral Hazard v. Economic Prospects

FOMC Report
October 31, 2007
‘Trick or Treat?’

Moral Hazard v. Economic Prospects
Martin McGuire
October 30, 2007

A Good Run:
When you enjoy what you are doing, it’s not considered work. Often too, with passion,
comes success. I have had a rather fortunate string of success in correctly anticipating the direction and the measure of Fed rate policy change in 26 straight FOMC meetings from May 2004. At the September 18th FOMC meeting I had again anticipated correctly the direction of policy change. While the prospect for a strong response was addressed, I chose to favor the likelihood of a 25 basis point reduction in the target fed funds rate.

Once Bitten Twice Shy:
I give the Fed its due in moving aggressively at the September meeting. Still, there are questions as to the reason the Fed responded in such a forceful manner when the market had expected and priced only a quarter point ease. Mr. Bernanke is on record for favoring more rather than less transparency and considering the success of Fed
transparency as measurable by the movement in the fed funds futures prices on the day of the FOMC rate decision. No move in the fed funds futures would indicate the market
understood the Fed’s intent and the Fed was transparent. A large move, like the one
following the September FOMC rate decision, is indicative of an unexpected rate
decision and thus a lack of transparency. As such, the Fed would get an F for
transparency in its decision at the last FOMC meeting.

I am concerned that the Fed may fail once again in providing market participants with
enough information to properly predict the Fed’s intent at the meeting tomorrow. Oddly, it may be their intention to be vague. As I said years ago when the Fed was ramping up their transparency; ‘the problem with too much Fed transparency is that the Fed will alternately succumb to removing one foot from its mouth to allow room for the other.’ It may be the Fed is intentionally withholding transparency because uncertainty leaves them searching the final scraps of potentially revealing data prior to determining a rate decision.

The Fed had managed to move apace over the last few years avoiding the dreaded ‘hoof
in mouth’ disease by subscribing first to a path for rates with all else set aside. In August ’06 the Fed chose to advise market participants that it would determine the appropriate monetary policy directives based on the prospects for economic growth and inflation as implied by the forward looking nature of forthcoming economic data. Basically, that means that your guess is as good as theirs. This approach was fine for that period until the long delayed impact from the prior 17 rate hikes and other factors finally came to bare on the market.

It was not so much the single factor of the lagged effects from prior rate hikes which entangled credit markets. Rather, many factors contributed over a long period of time to support and promote greater levels of risk appetite. For years now we have read about the ‘great moderation’ where seemingly economic contractions were turned into mere bumps in the road. To this, more stable and generally declining inflation was said to allow businesses and households alike to make longer range plans believed likely to be uninterrupted by the inefficiencies of varied and heightened inflation.
Further, we were well aware of the contribution of financial acumen in the shaping of
products which would not only differentiate all manners of risks, but allow for the wider diffusion of those risks throughout as-to-for disinterested classes of risk holders at greatly expanded geographic dispersion. Additionally, we note the value of open trade and the general notion that more trade is better than less as it allows those areas with a competitive advantage to produce goods and services more cheaply for the betterment of the whole. This notion admittedly is more palatable to those who receive a regular paycheck than those who are not so favored.
All of the above factors elevate the general level of productivity of this planet. Granted not all have thus far shared equally in this benefit. Still, many grand developments have come to pass which has allowed the backdrop for heightened interest in accepting risk. Finally, the Fed could be accused of ‘piling on.’ What I mean here is that just as all else was going well and globalization, financial innovation and the great moderation were bringing home the goods, the Fed chose to throw some gasoline on the fire. Instead of raising rates to slow the economy and adjust for the excesses embedded in the system, the Fed passed out road maps and time tables for how it would adjust policy at a ‘measured pace’. It did not take the most clever guys and gals in the room to recognize a pattern after the first few meetings where ‘measured pace’ was accompanied by a 25 basis point rise in the fed funds target.

Instead of tightening, the Fed gave away a larger piece of the timeline. Combine
transparency with a big chunk of the fed fund target policy timeline and you have
maximized your visibility to the extreme. We’re talking Superman, look through your
clothes kind of visibility here. Excess liquidity on steroids is what we ended up with. When the Fed finished in June of ’06, the target rate stood at 5.25% and stayed there till last month. There are several reasons it took so long to find the excesses that were (and still are to be) inevitably found. All the other factors discussed above were still very much in play. Open trade, moderate and stable inflation, globalization and quite importantly financial innovation were in full swing and adding less to economic growth and more to excess liquidity by the day.
In conclusion, market participants came to rely on the Fed’s transparency. Somehow the Fed had not only softened the impact from gradually raising the policy rate, it had also elongated the timeframe for the lagged effects from the policy shift. When I was without that hairless spot on the top of my head, which on sunny days demands attention, and rather carrying thick textbooks across university campus, I remember 9-18 months being bandied about as lagged with respect to Fed initiatives. I did the math in my last report, but suffice to say that the ‘path-dependent restrictive monetary policy directive’ which kicked off with a rate hike of 25 basis points in June of ’04’, showed its first significant lagged effects in the August of ’07 with the near unraveling of the credit markets. What the Fed lost in immediacy, it certainly made up for in impact.

I do not subscribe to the notion that the Fed policy rate is useless in advancing the central bank’s monetary policy mandates of full employment and stable prices. Rather, I suggest that the Fed consider in its deliberations the value of transparency in the attainment of those mandates. Clearly, transparency works best in promoting economic growth and full employment. Not necessarily stable or lasting full employment, but maybe I am being too demanding here. Going forward, the Fed should consider using less transparency when conducting policy intended to dampening inflation and thus temper a monetary environment where funding is abundant and increasingly used for non-economically viable investment. At such a time and for at least a while, transparency might take a backseat to more decisive and less advertised monetary policy response.

While the Pot Was on the Boil:
I want to digress for a moment and share the gist of a conversation I had with a very talented and up and coming executive at a conservative global money center bank. This
gentleman and I had a discussion in the early stages of financial dislocation which
became visible some months ago. His bank had in place general policies to safeguards
against excessive risk taking. We went on together trying to imagine a likely endgame or for that matter, even a possible mid-game for the recent and growing credit crunch. I’d say we put some good ideas on the table, but the reason I bring this up is the notion my friend wanted to impart toward the end of our conversation. He advised that it is a mistake to look at recent developments with an eye toward lining up all participants on opposite sides as either good guys or bad guys. Rather, it is important to understand that as credit spreads continued to narrow and once sufficient margins in lines of business shrank to a level which almost guaranteed problems would arise for some, it was more a matter of protecting market share than greed which prompted some to accept greater risk for no additional reward.

I thought long and hard on this and must say that I understand how protecting market
share appears more wholesome than grabbing all that one can because financing is cheap. However, one thing is certain. No one can make you take risk that you know is
inappropriately priced. We all have to decide daily what risk we are willing to take. We can all walk away as so few individuals and institutions did when they recognized
increasing uncertainty in their ability to profit from progressively tighter margins in lines of business.

When margins become too tight and lowering standards to maintain market share is the
only option to save that business, we need ask ourselves if we are truly investing in the right lines of business. If not, we should not be risking client’s monies and cheapening our fiduciary responsibilities. Finally, my friend advised that it is not as simple as pointing to those who suffered as having been primary culprits in the advancement of poor judgment. Rather, it is like unsorted laundry where stained and regular articles are put in the same wash. While some of the clothes were relatively pristine before the wash, all will come out with spots. This we can all understand.

On the Prior Rate Decision:
There are, as I like to say, two camps. One camp sees the Fed as having responded on
September 18th only to the financial dislocation and the seizure in term money lending. The other camp argues that the economy had already shown signs of weakening and with inflation and inflation expectations both in check, the Fed had responded to the prospects for below trend growth going forward. One way to view the ‘moral hazard’ argument is that the current dislocation in the financial markets hangs like the proverbial albatross around the Fed’s neck. The Fed recognizes signs of a slowing economy and would prefer to act to forestall or temper what might otherwise turn into a more severe deterioration in economic growth prospects. However, preventing or at least causing some distraction from employing these measures are the numerous calls for letting the wicked perish. There are more than a few who believe that those who chose wrongly by partaking in ill advised and risky investments should have to sort themselves out without a bail-out by the Fed. I guess I lean more toward the ‘tough love’, but am mindful of taking the baby out before discarding the bath water. Still, if the economic prospects are the problem, the Fed is mindful of this and will allow the market to sort out the ‘bad guys’ in time. Clearly, credit spreads are still wide, but they have narrowed from more extreme levels.

More exotic and opaque instruments still command a surcharge not much different from
that of a month or so ago. More judicious temperament has guided purchase of securities of late and this is a fine and natural development. There has been some movement in term money, where only weeks ago, there was a virtual lock-down in the interbank term lending market. The extent to which ‘normalization’ returns to the financial markets, the Fed will be rightly less concerned with being called out for pandering to the whims of wayward, risk-junky malcontents. Has normalization returned to the extent to which the Fed can ease aggressively and safely avoid the mud slinging of the ‘moral hazard’ crowd? It’s a tough call. Merrill and Banc of America sent out some rather disappointing quarterly earnings reports recently. Other financial institutions are sure to show less spectacular earnings for some time.

Still, money is moving and price discovery is providing greater visibility by the day. I apologize if I am starting to sound like I believe all is well. I don’t. There does appear however a better backdrop for the Fed to respond to a growing sense that economic prospects have deteriorated considerably and a more forceful monetary policy response is warranted.

What of Tomorrow:
Recent increases in equity, oil and gold prices as well as a major decline in the value of the dollar, the reason for which I believe are interrelated, have lessened my enthusiasm for expectations for a 50 basis point rate cut in the target fed funds to 4.25% tomorrow. While expressing this increased trepidation, I will retain that expectation for a 50 basis point ease. The Fed needs to address the prospects for a weakening economy in an environment of cyclically declining inflationary pressures. The Fed moved at the last FOMC meeting to get out in front of the curve and it is still chasing that objective. I think the Fed knows this.

Current Fed Rate Expectations:
FOMC Date Funds Target Risk Assessment
October 30-31, 2007 4.25% Slow Eco-Low Infla
December 11, 2007 3.75% Slow Eco-Low Infla
January 29-30, 2008 3.75% Slow Eco-Low Infla
March 18, 2008 3.75% Slow Eco-Low Infla
April 29-30, 2008 3.50% Slow Eco-Low Infla
June 25, 2008 3.25% Slow Eco-Low Infla

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