Flanked by Christopher Dodd, Chairman of the US Senate’s Banking Committee (and also a candidate for the Democratic nomination for the US Presidency) and by Hank Paulson, US Treasury Secretary, Fed Chairman Ben Bernanke looked more like a Taliban hostage than an independent central banker at his August 21 meeting in Dodd’s office. The letter from Chairman Bernanke to Senator Charles Schumer, circulated around Washington DC on Wednesday August 29, 2007, in which the Governor of the Federal Reserve offered reassurances that the Federal Reserve was “closely monitoring developments” in financial markets, and was “prepared to act” if required, reinforces the sense of a Fed leant upon and even pushed around by the forces of populism and special interest representation.
This is not a new phenomenon. With the explosion of operationally independent central banks since the New Zealand experiment of 1989, the US has become one of the least operationally independent of the central banks in the industrial world. Only the Bank of Japan is, I believe, even more readily influenced by political pressures from the Executive or from Parliament. Also, what operational independence the Fed has, is of relative recent origin. From 1942 until the Treasury-Federal Reserve Accord of 1951 released the Federal Reserve from the obligation to support the market for U.S. government debt at pegged prices and made possible the independent conduct of monetary policy, US monetary policy was made in the Treasury. For those 9 years, the Taylor rule was: i = 2%.
Even after the Accord, the fact that the Fed is a creature of Congress, and can be abolished or effectively amended out of existence with simple majorities in both Houses, has acted as a significant constraint on what the Fed can do and say. The strong populist, anti-banking currents in American politics in general, and in the Congress in particular, mean that the threat that what limited operational independence there is could be taken away is not perceived as an idle one by any Fed governor.
To illustrate the difference between the degree of operational independence of the Fed and the ECB, consider the inflation target. The ECB has price stability as its primary target. Without prejudice to price stability, it can pursue all things bright and beautiful, and is indeed mandated to do so. All this is in the Treaty. There is, however, no quantitative, numerical inflation target in the Treaty. Nor does the Treaty spell out which institution should set such at target, if there were to be one. So the ECB just went ahead and declared that an annual inflation rate of just below but close to 2 percent per annum on the CPI index, would be compatible with price stability. Neither the European Parliament, nor the Council of Ministers were consulted.
The Federal Reserve Act has stable prices as one of the three goals of monetary policy. The other two are maximum employment and moderate long-term interest rates. There is no quantitative or numerical definition of any of the three targets in the Act. Could the Fed do what the ECB did, and specify a numerical inflation target? Most certainly not. Congress would not stand for it.
Politically, the job of Chairman of the Fed is therefore much more difficult than that of the ECB or even the Bank of England. Strong Chairmen, like Paul Volcker and Ben Bernanke, manage to create a larger choice set for the Fed than a weak Chairman like Alan Greenspan, but even the most independent-minded and strong-willed Fed Chairman is much more subject to political influences and constraints than the President of the ECB or the Governor of the Bank of England.
Both populism and special interest representation are key driving forces in the US Congress. Preventing large numbers of foreclosures on madcap home mortgages taken out especially since 2003, unites the forces of populism and special interest representation, although they tend to part company when it comes to who will pay the bill for the bail-out.
Both the Congress and the Executive branch of government lobby mightily for Fed actions aimed at preventing or at least limiting the losses on highly leveraged bets taken by hedge funds, private equity funds and a large number and variety of other financial institutions and special purpose vehicles – ‘conduits’, ‘structured investment vehicles’; the names vary but the economic essence of highly leveraged open positions is the same. Appeals to safeguard systemic financial stability often obscure the obvious truth. The special interests that would benefit most directly from such actions as a cut in the Federal Funds rate – highly leveraged Wall Street firms and tycoons caught on the wrong end of the increase in credit risk spreads and the disappearance of liquid markets for structured products and other contingent claims –claims that had often been touted as the ‘techfin’ solution to the illiquidity of traditional forms of credit such as secured (mortgages) and unsecured (credit card debt) – rarely play a systemically indispensable role in the intermediation of saving into investment or in the efficient management of financial wealth. Were they to go bust and disappear, they would be missed only by their shareholders and other stakeholders, and those who had lent money to them. If these shareholders and creditors are systemically significant, one assumes that the prudential regulatory regimes they are subject to would have ensured sufficient portfolio diversification for them to be able to absorb the losses caused by the insolvency of a number of highly leveraged funds/institutions.
The response to financial turmoil, disorderly credit markets and the sudden illiquidity of assets previously deemed liquid, should not be a cut in the monetary policy rate – the short-term risk-free nominal rate of interest. It should not even be to provide liquidity in large amounts at the policy rate (in the US, to keep the Federal Funds rate close to the Federal Funds target, currently 5.25%; in Euroland, to keep the overnight interbank market rate near the ECB’s Main refinancing operations Minimum bid rate (currently at 4.00%); in the UK to keep the overnight interbank sterling rate near Bank Rate (the repo rate currently at 5.75%). Market participants should pay a penalty for being caught with their liquidity pants down.
In a credit crunch/liquidity crisis, the central bank should make funds available freely, but at a penalty rate and against collateral that would be good under normal circumstances, but may have become severely depreciated as a result of the liquidity crisis.
Bagehot in the 21st Century Both the Fed and the ECB failed to deliver the second part of Bagehot’s package: to lend at a penalty rate. One obvious way to provide liquidity at a penalty rate is to require banks and other eligible counterparties to access collateralised loans not at the policy rate, but at the discount rate. For the Fed, the primary discount rate used to be (until August 17, 2007), 1.00% above the Federal Funds target rate. Then, in response to the credit and liquidity crunch, the Fed, on 17 August 2007 lost its nerve and cut the primary discount rate from 6.25 percent to 5.75 percent. This reduction in the penalty for providing liquidity was the exact opposite of what Bagehot would have recommended. What is more, it is a recipe for increasing moral hazard without any appreciable gain as regards the provision of liquidity. The ECB kept its discount rate (the rate charged on its Marginal Lending Facility) at 100bps above its policy rate. It provided so much liquidity at the policy rate, however, that hardly any spontaneous takers turned up to rediscount eligible collateral at the Marginal Lending Facility. Only the Bank of England followed Bagehot’s nostrum,. Not only did it keep its discount rate (the rate on its Credit Facility) at an unchanged 100bps above its policy rate, it was quite willing to see the overnight interbank market rate rise towards the policy rate. It is not surprising that the least operationally independent of these three central banks, the Fed, bent furthest in response to financial market pressures for rate relief. It is surprising that the most operationally independent of the three, the ECB, was, in different ways, almost as accommodating as the Fed. The reason for this is probably lack of self-confidence by the ECB; they are the youngest and most untested of the three institutions. It looks as if they panicked and kicked the ball into touch by providing a massive (and excessive) injection of liquidity against high-grade collateral.
The central bank as Market Maker of Last Resort However, charging eligible counterparties during a credit crunch/liquidity crisis a penalty rate of 100bps over the policy rate is unlikely to be a sufficient deterrent to reckless and irresponsible risk-taking by these counterparties. There is a way in which the monetary authority can simultaneously address the core of the liquidity problem and provide the right incentives to encourage private financial institutions to manage their portfolios with greater regard to liquidity risk. That is for the monetary authority to act as Market Maker of Last Resort (MMLR) by expanding the range of assets eligible for rediscounting (or more generally acceptable as collateral in liquidity-providing open market purchases) to include illiquid assets, both investment grade and non-investment grade, but at a punitive price. This means that the net price received by the seller of the asset to the monetary authority represents a significant ‘haircut’ over what its fair or fundamental value would be under orderly market conditions. Operationally, this could, just to provide one example of a practical mechanism, be done through a Dutch Auction.
The monetary authority would first have to make it clear what kinds of assets (including possibly rather complex structured investment products) it is in principle willing to purchase in its auction. It would also have to specify the population of eligible counterparties. I would propose this be restricted to institutions accepting the appropriate degree of prudential regulation from the point of view of the Monetary Authority. Finally, given the eligible instruments and counterparties, the Dutch Auction could start. The central bank would announce that it would be willing to buy up to, say, $10bn (at notional or face value) worth of CDOs backed by impaired subprime mortgages. It would start the auction offering a buying price of, say, one cent on the dollar. CDOs offered at that price would be accepted, up to the total amount of the auction ($10bn face value). If the total amount offered at 1 cent on the dollar were to exceed $10bn face value, there would be pro-rata sharing among those making offers to sell. If less that $10bn face value were offered at one cent on the dollar, $ 2bn, say, the central bank would offer to buy up to $8bn at, say, 2 cents on the dollar, all the way up to 100 cents on the dollar. A further haircut could then be applied to the sequence of auction prices established through this mechanism.
Such a Dutch Auction is a price discovery mechanism. The central bank does not need to know the true value, it simply needs to have a mechanism for discovering the reservation prices of the private holders of the illiquid securities. The central bank has all it needs to conduct such an auction: deep pockets and the absence of a profit motive. It does not need superior information about the fair or fundamental value of what it buys.
Those who note that the central bank acting as Market Maker of Last Resort is effectively performing the role of a publicly-owned ‘vulture fund’, buying up distressed, illiquid assets from sellers keen/desperate to realise some value somewhere, are substantially correct. Those who then question why this job cannot be left to regular private vulture funds miss the key point about a liquidity crisis/credit crunch. If private vulture funds can do the job, so much the better: there would be no need for a market maker of last resort. Private vulture funds can do their job when there are orderly markets, generally good liquidity for most normally tradable assets, and selective, issuer-specific, solvency issues. There are times however, that waiting for private vulture funds to step forward and to what they are supposed to do risks creating an avalanche of illiquidity that creates unnecessary and socially costly defaults and bankruptcies, and in the limit risks undermining key payment, clearing and settlement mechanisms for which the banking system continues to be important. In such circumstances, only the central bank has the deep pockets at the right time – now – to act and make a market.
Policy rate cuts Policy rate cuts are justified if and only if the legally mandated objectives of the monetary authority require it. For the Fed these objectives are the triple mandate of maximum employment, stable prices and moderate long-term interest rates set out in Federal Reserve Act as amended in 1977. Credit crunches and liquidity crises therefore matter only to the extent that they affect these three goals, now or in the future. Fortunately, instruments exist with which credit squeezes and liquidity crises can be addressed effectively, and without creating moral hazard (such as the MMLR at punitive prices described above) that do not involve changing the monetary policy rate.
I hope and expect that if and when the Fed perceives that real economic activity is likely to weaken materially going forward and/or that inflation is likely to undershoot its comfort zone (wherever that may be), rates will be cut decisively and without delay.
I also fear and expect that, because of the relentless pressure being brought to bear on the Fed by all branches of the Federal Government (with the exception, as far as I know, of the Supreme Court), the Fed will be convinced to cut the Federal Funds target rate, probably as soon as the September meeting. I fear this could be not because this is the best way to guarantee the optimal trade-off between its three macroeconomic goals, but because this is the only way to salvage some measure of future independence for the Fed, in the face of irresistible pressure for a cut now from a lobby for a lower Federal Funds rate that includes special interests ranging from low income households unable to service their wildly inappropriate mortgages to extremely high net worth hedge fund managers facing massive losses and early retirement.
I hope I’m wrong on the last point.
© Willem H. Buiter 2007