Monday, July 21, 2008

FOMC Report
June 24-25, 2008

Engineering Stability Through a ‘Path-Dependent Monetary Policy Directive’

Martin B. McGuire

Because current financial and economic conditions are, in many respects new to all, it is difficult to express with confidence what should be expected of the Fed going forward. Because the FOMC statement is the sole focus of market participants at this juncture, it behooves us to study the prospects and implications for varied statement results. I will examine the forthcoming statement with respect to Fed intent and suggest what they may highlight in order to express a view and impact an outcome through subsequent price discovery.

There is little doubt that the Fed will leave policy rates unchanged at this meeting. Therefore little benefit would come to analyzing what may happen in the case of a surprise move other than to say that it would be disruptive and not conducive to economic growth in general or Fed creditability in particular.

Let us turn then to the upcoming statement and examine three possible approaches the Fed may take in these difficult times. After a discussion of the prospects for the Fed statement, I will endeavor to express an approach toward monetary policy which may serve better than when last used. Where it lacks in novelty, it makes up for in providing much needed visibility.

The FOMC Statement:

Case I: The Fed to Indicate the Removal of Accommodation in August

If the Fed wishes to ready the market for rate hikes as soon as the next meeting, it will need to heighten its stated concern for the inflation, both as a trend in place today and in the prospects for that trend to remain unacceptable or become increasingly less favorable. They could do this by stressing headline inflation results over core readings and using some year over year or month over month statistic which grounds their case. In addition the Fed might bolster a case for an August hike by emphasizing the second round effects of increases in food and energy prices.

Finally, should the Fed want to convenience market participants that it will raise rates as soon as August, it will need to indicate economic growth is currently firming and will continue to firm. Mr. Bernanke recently (June 9 - Boston) said the risk of a substantial downturn had diminished. He is therefore only one bold step away from indicating expected increased growth prospects.

To my reckoning, this approach would be a bit too heavy handed for the market to easily adjust. Markets would begin to price the removal of as much as 75 basis point ‘emergency eases’ as soon as at the August meeting and likely an additional removal of another 75 basis points, possibly as soon as at the September meeting. It is hard to imagine the foundation of the financial market being sturdy enough at this point to accommodate such pressure.

Case II: The Fed to Imply a Steady Policy through the August Meeting

Should the Fed wish to imply it intends to maintain a steady policy directive through the August meeting, it has several ways it may move. Most importantly, it will need to emphasize inflation expectations instead of actual inflation. If the wants to avoid having to talk the market away from pricing in a rate hike in August, it will need to refrain from voicing disapproval at the current trend of inflation. The Fed will need to be careful with their words. Given the heightened inflation rhetoric in the intra-meeting period, Fed watchers will be prone to more hawkish interpretations.

Some more adherent inflation hawks at the Fed might disapprove of a FOMC statement which does not indicate dissatisfaction with the current state of inflation or its prospects. They would as well be rightly concerned about a perception of questionable dedication on the part of the Fed in maintaining low levels of inflation. A strongly expressed concern for the mooring of inflation expectations may not be enough for Fed bank president’s Fischer and Plosser.

If Mr. Bernanke wishes to prevail in softening the tone of the FOMC statement away from outright dissatisfaction with inflation, he may broker a deal, so to speak, which would strengthen the rhetoric on growth expectations, thus balancing the scales somewhat. By further indicating the diminished risk that the economy has entered a substantial downturn, as he did in a recent speech, the Fed Chairman may be able to add just enough to the scales to temporarily placate Fed hawks.

Should the Fed move in this fashion, there need not be a wrenching market reaction to the statement. There may be some slight easing of yields in two year treasuries and shorter date securities. In that, there may be some widening of the yield curve as ten year yields remain stable for the time being.

Case III: Fed to Imply a More Protracted Neutral Policy Stance:

My inclination is still toward giving greater weighting, than the majority of market participants are willing, for the chance that the Fed’s next policy rate change to be easier on the back of still greater deterioration in economic growth or a more pronounced disruption in financial markets. The timing is not right however, for the Fed to indicate anything more dovish than a neutral policy stance at this point.

Even an indication that the Fed was neutral in their policy stance might cause some considerable realignment of interest rate pricing. There would be a rather immediate move toward the removal of any rate hikes priced till next year. The yield curve may stand to widen as ten year Treasury yields push toward 4.25-4.35% (from 4.1%) even as two year yields soften toward 2.65-2.75% (from 2.90).
The timing is not particularly attractive for the Fed to make strong implications that the policy stance is on hold for a considerable period, even if that is to be the case. If however, the Fed wanted to indicate a stable policy for the next months they might retain much of the last paragraph used in the April FOMC statement: ‘The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.’ To insure that everyone ‘gets-it’, they could include a sentence indicating they believe the risk between inflation and growth are balanced risks. This I don’t think is likely however. The Fed does not seem ready at this time to tie these risks together.
My best guess is the Fed favors an approach more consistent with Case II above. This will leave the Fed the necessary room to move in either direction going forward while at the same time add some bite to intra-meeting inflation rhetoric.

Path-Dependent Policy and how it Might now be a Fit:

The alternatives to a mild but elongated period of economic growth below its long run potential appear few and entirely less favorable. The prospects for continued inflationary pressures haunt Fed officials and limit their choice of policy electives. In a broad sense, the Fed has achieved much in repairing the mechanics of lending facilities. It is however the extraordinary reversal in the appetite for risk which is hampering the Fed’s ability to convert a working system into an engine for growth.

Hampered by the loosened moorings of inflationary expectations on the back of higher food and energy prices as well as the accompanying weaker currency, the Fed’s primary policy tool of targeted fed funds change may have to be left in the tool box for a while.

A theory which I developed has thus far gained little traction in the market place. My theory is that there were profound implications for the ‘path-dependent monetary policy directive’ under which the Fed operated until June of ‘06. I have argued that this was the policy directive, although not stated by the Fed, which accompanied the move in policy rates from 1% to 5.25% starting in June of 2004. By moving in such an orchestrated and telegraphed manner, using the term ‘measured pace’ and following with a 25 basis point rate hike at each and every FOMC meeting, the Fed provided the market with a considerably lengthy view of the forward Fed Funds time line.

This extraordinary visibility, provided in the form of a greater piece of the time line, is responsible for the failed monetary policy and the root cause for the last innings of the housing bubble and credit boom. Most Fed watchers argue that it was the extent of time the Fed held fed funds at 1% which was the reason for the a destabilized system and cause for excess liquidity. This is not likely because it was a more widely held view at the time that deflation was a real threat and concerns for such do not lend themselves to excessive risk appetite and liquidity.

I believe an appropriate definition of excess liquidity is as follows: That amount of money remaining when all economically viable investment alternatives have been fully subscribed. By telegraphing its rate moves, the Fed put liquidity in the hands of players who had neither a practical use for such funds nor the inclination to refrain from playing the ‘greater fool game’.

I was startled enough when I read the speech Mr. Bernanke recently gave in Barcelona that I actually wrote ‘Laughable’ in the margin. I would like to share a part of this speech which followed Mr. Bernanke’s recognition of ‘several longer-term factors’ (housing boom, broader credit boom and unprecedented growth in emerging markets) that were largely responsible for the ‘severity of the financial stresses’ which ‘became apparent only in August’.

Mr. Bernanke went on with this disclaimer of Fed culpability: ‘To be sure, the large inflows of savings and low global interest rates presented a valuable opportunity to the recipient countries, provided they invested the inflows wisely. Unfortunately, this did not always occur, as an increased appetite for risk-taking--a "reaching for yield"--stimulated some financial innovations and lending practices that proved imprudent or otherwise questionable.’

I have italicized for emphasis. Please remember my definition of excess liquidity. The Fed set the stage for too much liquidity by providing a road map in the form of a large piece of the forward fed funds time line. Mr. Bernanke would now have us believe that something strange or unexpected happened when large inflows of savings made their way to our shores; that it could not have been anticipated that few viable economic opportunity still existed when this excess liquidity ran rampant in the system.

It is not at all strange, it should have been expected and it will happen again in some form if there is no concern for the central bank to hike in a less obvious and/or more forceful manner. Transparency is wonderful, but it has a price like everything else. That price can be too cautious an approach to monetary policy initiatives because transparency gives room for greater chances of reversals in stated expectations.

A restrictive monetary policy implies an intention to temper a natural impulse in good time toward animal spirits. By working in a path-dependent rather than a data-dependent or even an objective-dependent monetary policy directive, the Fed added fuel to a fire which was burning quite nicely on its own. In not taking responsibility for this mistake, which I have no doubt they will eventually be more widely called to do, they set themselves up to make the same mistake again.

A Time and Place for All under the Sun:

Even as the recent ‘path-dependent monetary policy directive’ was arguably the worst policy mistake by the Fed in many years, that is not to say that a path-dependent policy directive cannot find a more appropriate place and time. Consider the current state of affairs with its high level of uncertainty, lack of visibility and credit destruction. Contrast this with that the period where the Fed was last ‘tightening’ in 25 basis point increments between mid-’04 and mid-’06. Looking back, it is hard to remember during that period much in the way of market disruption which might indicate market participants were lacking a requisite amount of natural visibility in order to conduct business.

If you can recognize that some visibility was afforded market participants with the Fed in a ‘path-dependent’ mode in ’04-‘06, you might as well identify current conditions as likely to benefit from some level of additional visibility by way of a return to a ‘path-dependent’ policy directive. This approach might help to shore up the fragile financial market conditions. The beauty of this approach is that it could be initiated without the need for a great deal of explanation. If the Fed were to say today that they were planning to remove accommodation at a measured pace, market participants would immediately recognize the Fed was going to initiate a series of 25 basis point rate increases at regularly scheduled FOMC meetings.

Added visibility brought on by a return to a ‘path-dependent monetary policy directive’ may not induce borrowers to borrow or lenders to lend. They will decide for themselves if they are ready to accept greater risk given greater visibility. At the margin, and that is where everything starts, I believe a ‘path-dependent monetary policy directive’, if initiated no later than the first quarter of ’09, would add to financial market stability. If initiated, the problem would then be a case of when to wean the junkie from the narcotic.

Current Fed Rate Expectations:

FOMC Date; Funds Target; Risk Assessment

June 25, 2008; 2.00%; Balanced
August 05, 2008; 2.00%; Balanced
September 16, 2008; 2.00%; Balanced
October 29, 2008; 2.00%; Slow Economy
December 16, 2008; 1.75%; Slow Economy
January, 2009; 1.50%; Slow Economy

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