Monday, July 21, 2008

When the Only Tool Left Is A Fire Extinguisher

FOMC Report
April 29-30, 2008





When the Only Tool Left Is
A Fire Extinguisher






Martin B. McGuire
(Chicago)


It could be said that the Fed took a gamble in waiting as long as it had in attending to deteriorating credit conditions. It is easy however, to criticize from the safe distance of a comfortable armchair. In fairness, the Fed has shown ingenuity in resorting to a plethora of remedies, the likes of which have never together been applied, in an effort toward providing a backstop against the dissolve of a highly complex and interconnected financial credit system. These efforts are to be applauded. To date however, it has not proven enough in creating the conditions necessary to guide either the financial system or the economy beyond its cycle trough.

There is a dynamic process that is overwhelming in its influence on current perceptions, which in turn factor most heavily in the valuation of security prices and current and future expected interest rate levels. That dynamic in brief is a focus shift away from expected, but as yet unseen, dire consequences on the economy from the precipitous financial market disruption. Instead, focus has shifted toward the expectation for a more immediate return to brighter economic prospects. It is said, where there is a will there is a way. It could well be said that when the need is great enough we will engineer a plausible fantasy.

Until most recently, it was widely believed that the Fed would continue to use its primary policy tool in concert with the other liquidity enhancing measures in place to right the credit markets. At present, helped by some more vocal Fed officials, the market has re-priced so as to express the consensus view that the Fed will finish affording greater amounts of accommodation (to 2% fed funds) at this present meeting. Current fed funds futures prices indicate a consensus view that the Fed will revert to removing accommodation as early as year end. Until this re-pricing I had considered myself an optimist, but I cannot hold a candle to those who would expect a need for the Fed to tighten by year end as a result of stronger growth prospects.


Shifting Dynamics and an Over Reliance on the Precedent

There is little to go on save our imaginations and historical precedent when divining the prospects for monitary policy following the most recent shoring up of financial market equilibrium. When dollars and cents are at play, we tend to allow the left side of our brain to take charge. Our left-brain is that half where reasoning or logical construct is assimilated in decision making. We seem to be favoring this half as we shuffle through historic gems which may lend themselves to understanding the next phase of the current credit market plight. Below we will examine some areas where creative thinking may help us avoid adherence to reasoning with excessive adherence to historic precedent.

My concern is for the tendency to take what appears to be a logical step toward expecting brightened economic prospects based on several promising developments. We will look in turn at three different developments of late which are held by some as confirmation of more immediate return to substantial economic improvement.

First, the current level of historically low real policy rates should be expected to loosen the reins of financial conservatism, which through otherwise higher rates, dampens both consumers willingness to spend and raises the hurdle by which corporate expenditures are measured. However, within periods of risk aversion and I would argue that we are closer to entering that forest than exiting; there is a tendency to hold onto liquidity at the expense of almost all, including even the most glaringly obvious profitable adventure. Low rates, nominal or real, do not prompt expenditure and risk taking in the absence of what John Maynard Keynes called ‘animal spirits’. Those spirits ran wild only a short time ago and the length of time they were on the move suggests a more extended period of rest forthcoming. We should therefore not expect the currently prevailing, historically low rear policy rates to increase risk appetite either in consumers or businesses.

Secondly, the period where the severity and consistency of escalating financial distress has been, at least temporarily, forestalled. With such promising improvement we can be tempted to fly to the conclusion that we are quickly passing the nadir in a V-shaped recovery. We cannot at this point however safely put any such letter shaped visual, be it ‘V’ or ‘U’ to that which continues to play out as rival to any period of financial distress, including ‘the great depression’ of the 1930’s, as witnessed by any living person.

We can be too ready to take our queues from business cycles over the last 25-35 years. Transitions from minute disruptions in economic growth during elongated business cycles since the early ’80 or even the early ‘70’s may not be indicative of the likely duration of the current unrest. Rather, we would be wise to recognize these small interruptions in unrelenting growth and declining economic volatility as an important element in the process which allowed such extraordinary excess to develop until mid-‘07.

It would indeed be optimistic to expect a recovery consistent with that which transitioned following the mild recessions ending in March of ‘91 or November of ’01 which formed their troughs only 8 months after the cycle peak. While not likely, if we are to find this current situation transitions from peak to trough consistent with that of ’91 and ’01 we should not be encouraged. Instead, we must then recognize the current disruption is not the conclusion in this super-cycle, but rather just part of its process. I shudder to think of what might be the conclusion of trend which is punctuated by, rather than culminated in, that which has transpired since mid of ‘07.

Finally, we are guided by historical precedent when we look to those events which marked the end of disappointing economic trends of old. Known sometimes as catalysts, they are used as easily recognized signposts of yesteryear which have come to mark climactic conclusion of a trend. Few events even as extraordinary as the failure of Continental Bank or the Russian default mark accurately the actual timing of the sea change in events.

So too, we might take heed and recognize the Fed sponsored purchase of Bear Sterns by JPMorgan Chase as a mere scene in the current play. We should not be too quick to expect a curtain call from this as a final act. There may be quite a few more such catalysts which will mark further progress in this most wicked unwind of excess. Some years from now we will comfortably know if it is this or some much more spectacular signpost which will mark the pages of history as the supposed low point of this adjustment.

The importance attached to the aforementioned developments and the widely held perception they evoke prompted many to adjust their view on how and when the current credit market unrest and economic decline will abate and return to credit creation and economic growth. I am encouraged by these developments and as well by the infusion of new capital into banks and some merger activity. It is however aggressive to expect such an immediate reversal of fortune which would imply a need for the Fed to discontinue moves toward still greater accommodation through the fed funds policy tool.


Current Fed Rate Expectations:

FOMC Date Funds Target Risk Assessment

April 29-30, 2008 2.00% Slow Economy
June 25, 2008 1.75% Slow Economy
August 05, 2008 1.50% Slow Economy
September 16, 2008 1.50% Balanced
October 29, 2008 1.50% Balanced
December 16, 2008 1.50% Balanced

End

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