Thursday, January 31, 2008

Fed Needs to Restore Confidence

FOMC Report
January 29-30, 2008

Fed Needs to Restore Confidence
Martin B. McGuire
(Chicago)

It is easier by far and likely wiser to have more questions at this juncture than certainties regarding the Federal Reserve’s likely reaction to the changing state of the economy and financial markets. While it is a growing sport to give definitive reasons for the recent intra-meeting move, it is rightly more difficult to be concrete in ones view of what the Fed might do over the coming months. It is likely also that you are reading this report with an interest in better understanding the probable course of the Federal Reserve policy.
As such, I will get right to this endeavor. While I am continually amazed by the events unfolding in the marketplace and on the economic battlefield, we do well to see how we got to where we are so as to better understand where it is we are headed. I fear the Fed has played a large part in getting us to where we are today and for the current market distress. The onus for righting this situation rests too squarely on the Feds shoulders for my comfort.

First, I have long argued that the way the last restrictive monetary policy campaign was waged was conducive to increase in levels of risk assumed across all facets of the financial markets. This ill-timed augmentation to already heady levels of liquidity had a dramatic, though ill-fated, impact on the level of real economic growth (largely, but not limited to housing, construction and their related markets). Secondly, the Fed might have guessed at some point in the implementation of its ‘path dependent restrictive monetary policy directive’ that the inversion of the treasury yield curve was not only due to Asian Central Bank hunger for Treasuries or muted economic volatility resultant from right minded central bank policies. It was in part a flat to inverted curve because the Fed gave the markets a very big piece of the forward looking timeline for base rates (Fed Fund policy rates).
Finally, when the extended lag times of policy initiation from the restrictive phase eventually came to bear on the financial market, the Fed was slow to react. This is, in part, how we got to where we are. It is from this vantage point that the Fed will respond to the continued reallocation of investment toward a new understanding of appropriate risk.

What has gone before us over the last several tremulous months is merely the result of a
move closer to a more historic and cautious view of appropriate risk assumption. I have argued for some time that the Fed was behind the curve with respect to initiating a more accommodative monetary policy initiative. Members of the FOMC apparently finally agreed when they lowered their policy rate only a week before they were scheduled to meet. I found this neither heroic, flexible, timely nor constructive. The time for surprise is not during financial market distress. Rather this is a time for coordination and an orderly discharge of expected policy initiatives. When there is market turmoil, a surprise rate move brings about some additional measure of confusion. Confusion and uncertainty are not beneficial to enterprise which stimulates economic activity.

People are saying they have lost confidence in the Fed. The surprise 75 basis point rate cut was not a confidence builder, but rather a disquieting event which proves the Fed was behind the curve. This move does not put the Fed out in front of the curve however. Rather, the result is that there were more questions asked than answered by this move and a market in turmoil looks for answers. As the upcoming FOMC meeting came to within 2 weeks of happening, there were few left who envisioned the Fed conducting an intra-meeting move. As one of those who thought this action ill-advised, I would say the move may prove less beneficial than the Fed had hoped. There is little need for market surprises when everywhere credit is being destroyed. Rather, the Fed should move more openly as would be the case at regularly scheduled FOMC meetings. It would be so much more appropriate now for the Fed to give indications that they intend to adjust monetary policy at a very well understood ‘measured pace’. I would recommend that this language be used following a slightly more aggressive rate cut this week than is currently anticipated. By doing such, the fed will not have disappointed those most desperate for immediate rate relief while giving direction, confidence and visibility to all market participants. This of course will have a dampening effect on volatility in the marketplace to the extent to which the market participants believe the Fed will have the ability to conduct a more accommodative policy directive at a ‘measured pace’.
The ‘measured pace’ language used during the ‘path-dependent restrictive monetary policy directive’ from June ’04 – June ’06, is arguably the largest mistake made by the Fed in modern times. When the Fed was ‘tightening’ monetary policy (that is really a laugh, because the whole time they were really helping to create excess liquidity) they did so by instructing the public on their intentions with respect to forthcoming rate decisions. The Fed made its intention so clear that the extent and timing of its rate decision was so fully anticipated that you could literally set your clock to the 25 basis point rate hike at 2:15 EST on FOMC dates. This went on ad nauseam. Fully 17 times the Fed force-fed the market visibility in the guise of transparency.

A quick digression is in order.
There is a difference between transparency and visibility, but sometimes we mistakenly look at them as interchangeable. It is important in this respect to understand that a central bank can be very transparent without adding to market participant’s visibility. If the central bank has no clue as to what is forthcoming, even with respect to their own actions, their transparency can offer no benefit to our visibility. If you would, imagine a transparent Fed as a clear windshield on a vehicle you are piloting which is approaching an unknown sharp turn on an unfamiliar highway. It matters not how clear the windshield is when we cannot see around the curve. We will adjust our speed in accordance with the risk associated with the unknown curve (visibility), not the clarity of the safety glass (transparency). The Fed like all of us is adjusting to a new financial market arena which has its own new set of rules. Some of these rules will follow similar guidelines from prior economic and credit cycles and others will not. If the Fed cannot see how these present financial market conditions will play out any more clearly than we can then Fed transparency is
without use; correct?

I would argue that Fed transparency can be beneficial in two ways. First, with respect to the now more regularly (quarterly) published ‘Summary of Economic Projections’, we will have the opportunity going forward to understand in a much more timely manner what the Fed considers as central tendencies. We will also receive information concerning the confidence they have in their expectation and direction of expected error. This transparency will allow us to generate a reaction function for forthcoming monetary policy decisions based on divergence of actual economic data from central tendency expectation. This by itself is invaluable if used properly.
Lastly, there is a chance that the Fed can convince the market that they will ease at a measured pace. This could give back to the market a larger piece of the timeline that was so beloved in the ‘path-dependent restrictive monetary policy directive’. If the Fed can be seen as determined and able to carry out a ‘path-dependent ACCOMODATIVE monetary policy directive’ at a ‘measured pace’, they will be once again adding visibility through their efforts in transparency. Going back to the earlier example; the Fed transparency here is again the clear windshield. The visibility provided however, is now a huge billboard on the side of the road which says that the road ahead is marked with 25 basis point rate cuts at each of the next three FOMC meetings. All else equal, I would argue that the reintroduction of ‘measured pace’ language at this stage would be beneficial in giving market participants some level of comfort. Any reasonable introduction of certainty at this juncture could temper forthcoming financial market dislocation. Credit and time represent the most important variables when an individual or collective considers its want for taking on more or less risk. Helpful then in the analysis of market reaction to the visibility afforded by the Fed, we look back to the prior instance of visibility added in the latest ‘restrictive’ policy directive. In that ‘path-dependent restrictive policy directive’ the Fed added visibility in the form of providing the public greater understanding of the Fed Funds timeline (through the ‘measured’ language). With this more confident view of the forthcoming timeline, there was a tendency to be less risk adverse. All else equal, any point on the credit spectrum is marginally more attractive when the Fed’s fund rate timeline is believed more fully visible going forward.

If there is any chance for normalcy to return any time soon, a heavy dose of what was illadvised during a restrictive campaign is just what the doctor orders for the current malaise. The extent to which the Fed can add a sense certainty back into the marketplace, they will be moving a long way toward creating a backdrop for the return of the Keynesian ‘animal spirits’. The journey from risk taking to risk avoidance that consumers and entrepreneurs have only just begun may prove to be a very long road. Even now, travelers on this road are tentative and their numbers are few. In time, if I am correct in my expectations that credit conditions will continue to deteriorate, this road will become congested just as it had been in the opposite direction. Rather than intra-meeting rate moves, the Fed would be advised to suggest very strongly a path that they are likely to take in moving to a more accommodative policy stance. By doing this, the market will once again feel that they have been given a piece of the timeline which all else equal will encourage risk taking and possibly temper the move toward further credit destruction.

Current Fed Rate Expectations:
FOMC Date _____| ______Funds ____| _________Target Risk Assessment
January 29-30, 2008_____ 3.00%_______________Slow Economy
March 18, 2008_________2.75% _______________Slow Economy
April 29-30, 2008 _______2.50% _______________Slow Economy
June 25, 2008 __________2.25% _______________Slow Economy
August 05, 2008 ________2.00% _______________Balanced
September 18, 2007 _____2.00% ________________Balanced
End

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