Wednesday, December 12, 2007

Fed Still Learning to Talk ‘Transparency the Right Way’

FOMC Report
December 11, 2007
Fed Still Learning to Talk ‘Transparency the Right Way’
Martin McGuire

Executive Summary:
To have concluded at the last FOMC meeting that the risks between economic growth
and inflation were ‘roughly balanced’ was to have ignored financial market developments to that point. It appears that a deal of sorts was brokered between FOMC members where marked contract existed between those who saw greater and more immediate dangers from continued credit turmoil and those who felt an urge to bring someone to the woodshed.
To the former, I would congratulate and welcome you to a wider contingent of the rightthinking. To the latter, who I suppose eventually is looking to receive placards saying ‘I Stomped Out Moral Hazard’, I might caution they temper or grow beyond our base instincts. To be fair, there may be differing views on developing economic prospects coming into that meeting. The later group was likely giving greater weighting to unwelcome tail risk in forward inflation prospects.
Market participants disappointment in the Fed not having lowered the target rate further at that October FOMC meeting and sensing the Fed would eventually have to ease considerably more to ‘catch-up’, marked future implied rates lower by nearly 100 basis points (for September ’08 expiry Eurodollars) within the next month.
The market has priced in roughly a 30% chance for the Fed to ease Fed Funds 50 basis
points at the December 11, FOMC meeting. To ease any less than 50 basis points would
leave the Fed behind the curve and I would not be so confident as to say easing Fed
Funds 50 basis points here would bring the Fed out in front of the curve. The tail risk of more dramatic financial market dislocation and seriously weaker consumer confidence along with declines in spending is growing to the point where it can no longer be ignored.
I trust our academically minded FOMC leaders will search less for common ground and
more for common sense in deciding the appropriate policy response to current financial and economic discord. I would like to briefly address the wonderful stride the Fed has made in providing appropriate transparency. This compares quite favorably to the more than awkward most recent attempt at transparency in the ‘path-dependent restrictive policy directive.' Finally, I would point to three Fed members whose recent speeches give rise to greater prospects for a 50 basis point cut on December

Appropriate Transparency
I am most encouraged by the recent steps the Fed has taken to broaden communication
with respect to their expectations for economic growth, employment and inflationary
developments. Specifically, the Fed has increased the scope and frequency of their
published outlook (“Summary of Economic Developments”) on the quantifiable measures noted above as they relate to the Feds dual mandates. These efforts will go a long way toward providing the forward looking information market participants, businesses and households can use to make intelligent decisions. These stakeholders in the Feds action will have a better indication of what the Fed views as important developments and how they are likely to position monetary policy as a result. This acknowledgment and encouragement of Fed transparency may seem at odds with the consistent complaints I have lodged over the past year or so with regard to Fed efforts in what may now be forgiven as part of a rather drawn-out learning process by the Fed. There is however a big difference between the Fed providing near unmistakable instruction on the measure and timing of future policy initiatives during a tightening campaign and their current efforts in communicating economic projections. Frankly, the ‘path-dependent restrictive policy directive’, a phrase I coined, was the worst policy mistake I have seen in my years watching the Fed. I was not particularly delighted with the maniacal concern for deflation expressed toward early to mid ’03, but in hindsight, that concern appears prudent compared to falling asleep at the wheel of the most recent restrictive policy mistake.
The current problems with excessive liquidity having found favor in the housing market and the resultant and current financial market distress is largely attributable to the Fed having not taken a more deliberate attack at speculative excess when it sallied forth from what had eventually been recognized as an over accommodative position back in ’04. It was the path the Fed took and the advertising it did with respect to its policy intent rather than the starting point from which the Fed Funds target rate came or the time spent as such a low rate which allowed speculative fervor to get out of control. It allowed anyone with the capacity to follow a most simple pattern and had an interest in leveraging risky positions to remain ahead of the Feds well advertised initiatives.
It is highly more likely that the general disregard given the Fed’s steady plodding toward 5.25% Fed Funds target is the real reason for the build-up of excess liquidity and continued extraordinary leveraging of ill-advised investments seen during 2005 through early 2007. It was only after longer than normal delays when the impact from higher policy rates found the marginal borrower unable to obtain funds from the marginal lender. From that point, it was easier for all to recognize the excesses which had built. I look forward to analyzing through time, the new ‘Summary of Economic Projections’. The Feds base case as well as its insight into growing and lessening concerns will provide for interesting read. The weighting of risk associated to views on the expected path for variables will provide queues as to which incoming data will be most influential in forthcoming policy decisions. Under such constructs for communicating the essence of the decision tree relating to the implementation of monetary policy, it will be difficult to find fault in these Fed efforts outside of outright lies or gross misunderstanding of macroeconomic and monetary policy conduct. This then, is indeed a welcome advance from the ill-advised ‘hand holding’ communication efforts during the restrictive policy attempt which brought us to these trying times.

Setting the Stage for 50 Basis Point Rate Cut
Recent public statements made by three Fed officials has given rise to greater expectations for generally more accommodative policy action and in particular to the
prospects for a 50 basis point ease at the December 11 FOMC meeting. These three key
Fed members are Mr. Kohn, Mr. Bernanke and Ms. Yellen. Mr. Kohn addressed the hot, but cooling topic of moral hazard in a speech on November 28 in New York (1). Mr. Kohn acknowledged the benefit derived in terms of productive employment of financial resources when investors are allowed not only enjoy the rewards of their right decisions, but also allowed to suffer from ill-advised investments. Mr. Kohn followed by saying: ‘At the same time, however, in my view, when the decisions do go poorly, innocent bystanders should not have to bear the cost.’ There are some hardnosed individuals out there who have called for the Fed to refrain from reacting to this credit crunch because people who have made poor decision should be made accountable for their actions. We hear ‘It’s not the Feds job to bail them out.’ Thankfully Mr. Kohn is more sensible than this and advises: ‘To be sure, lowering interest rates to keep the economy on an even keel when adverse financial market developments occur will reduce the penalty incurred by some people who exercised poor judgment. But these people are still bearing the costs of their decisions and we should not hold the economy hostage to teach a small segment of the population a lesson.’
We can see how these expressed sensibilities by Mr. Kohn, a most pragmatic and influential Fed Vice Chairman, would prompt not only the listening public, but also some of the less senior FOMC members toward recognizing the benefit of more forceful policy accommodation. The Statement following the last FOMC meeting in late October indicated the Fed believed the risks for economic growth and inflation were roughly balanced. Mr. Bernanke made an important step away from that conclusion when he advised in his recent speech: ‘In sum, as I have indicated, we will be receiving a good deal of relevant information in the coming days. In making its policy decision, the Committee will have to judge whether the outlook for the economy or the balance of risks has shifted materially. In doing so, we will take full account of the implications for the outlook of both the incoming economic data and the ongoing developments in the financial markets.’(2) With this acknowledgement Mr. Bernanke opened the door to more aggressive pricing of policy change on December 11 and the market responded.
Finally, Ms. Yellen was very straight forward in her assessment of economic prospects relative to that which she perceived more likely only weeks ago. (3) She made important allowances for the prospects that consumer spending may have deteriorated: ‘Recent data on personal consumption expenditures and retail sales are not that encouraging. They have begun to show a significant deceleration—more than was expected—and consumer confidence has plummeted. Reinforcing these concerns, I have begun to hear a pattern of negative comments and stories from my business contacts, including members of our Head Office and Branch Boards of Directors. It is far too early to tell if we are in for a sustained period of sluggish growth in consumption spending, but recent developments do raise this possibility as a serious risk to the forecast.’
Again with respect to GDP in general, Ms. Yellen allowed that growth may come in
lower than previously thought: ‘To sum up the story on the outlook for real GDP growth, my own view is that, under appropriate monetary policy, the economy is still likely to achieve a relatively smooth adjustment path, with real GDP growth gradually returning to its roughly 2½ percent trend over the next year or so, and the unemployment rate rising only very gradually to just above its 4¾ percent sustainable level. However, for the next few quarters, there are signs that growth may come in somewhat lower than I had previously thought likely. For example, some of the risks that I worried about in my earlier forecast have materialized—the turmoil in financial markets has not subsided as much as I had hoped, and some data on personal consumption have come in weaker than expected. I continue to see the growth risks as skewed to the downside in part because increased perceptions of downside economic risk may induce greater caution by lenders, households, and firms.’
Finally, I would like to applaud Ms. Yellen’s effort in incorporating an excellent summary of the outline and usefulness of the new “Summary of Economic Projections”
within her speech. She took a very encouraging step forward in acknowledging the
evolving nature of her own economic and financial market expectations and therefore has made it easier for other Fed members to become less guarded in their communication with the public.

What May Go Wrong
One concern that I have for the prospects for continued reductions in the Feds policy rate is the Feds stated expectation for lower inflation readings over the coming quarters. For many months now I have anticipated forthcoming lower inflation readings. These expectations have more recently begun to be realized. The Fed is now projecting lower core PCE inflation expectations for ’08 than was forecast in June and substantially lower overall PCE inflation is projected for ’08. While I should be satisfied that the Fed is seeing and acknowledging that which I have seen forthcoming, I cannot help but feel some odd discomfort.
The Fed also sees the upcoming rate of GDP growth below currently recognized longterm potential. This again is consistent with my view. Of most concern however is the
Fed may expect declining inflation prospects because they intend to drag their feet on monetary policy initiatives which would otherwise provide the backdrop for GDP growth nearer to potential. If the Fed drags their feet on easing their monetary policy stance,they will achieve lower levels of inflation indeed, but at what cost?

My concern for the Fed moving too slowly toward lowering the target rate is that they
will increase the ‘fat tail’ risk of a much weaker economy. They may have already
ventured too close to allowing a free fall in economic activity resulting from a new and more temperate view of the appropriate level of risk individuals, businesses and market participants should prudently be willing to accept.

Current Fed Rate Expectations:
FOMC Date Funds Target Risk Assessment
December 11, 2007 4.00% Slow Economy
January 29-30, 2008 3.75% Slow Economy
March 18, 2008 3.50% Slow Economy
April 29-30, 2008 3.25% Slow Economy
June 25, 2008 3.00% Balanced
August 05, 2008 3.00% Balanced

(1) Vice Chairman Donald L. Kohn
C. Peter McColough Series on International Economics, Council on Foreign Relations, New York, New
November 28, 2007
(2) Chairman Ben S. Bernanke
National and regional economic overview
At the presentation of the Citizen of the Carolinas Award, Charlotte Chamber of Commerce, Charlotte,
North Carolina
November 29, 2007
(3) Speech to the Seattle Community Development Roundtable and the Seattle Chamber of Commerce
Board of Trustees
Seattle, Washington
By Janet L. Yellen, President and CEO, Federal Reserve Bank of
San Francisco
Monday, December 3, 2007

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