Monthly Archives: January 2008

And a rude awakening it has been.

The Fed cut the target for the Federal Funds rate again, this time by 50 basis points.  The data released earlier today confirm that the Fed has given up on inflation control: headline CPI inflation was still humming along at 4.1 percent year-on-year in December 2007.  Even the misleading ‘core’ inflation indicator favoured, for no good economic or statistical reason, by the Fed registered a 2.7 percent increase. 

Much was made in the media of the fact that real GDP growth for Q4, 2007 was only 0.6 percent, the lowest quarterly increase since 2002.  This (in my view erratically) low figure should be juxtaposed, however, to the (in my view equally erratically) high figure of 4.9 percent in Q3.  The markets had been expecting 1.2 percent for Q4.  Looking slightly further ahead than the length of the median FOMC member’s nose would have revealed that inventory decumulation reduced GDP growth by 1.3 percentage points in Q4. This reduces expectations of further inventory disinvestment and is a positive for future GDP growth.

The payroll data were much stronger than expected, with 130,000 jobs added (against market expectations of a gain of 40,000).  Together with the buoyant durable goods orders data a few days ago, the balance of the recent real economy information has been stronger than expected.  Inflation data have come in both rising and higher than expected.

So what possesses the Fed?  Has it become a single mandate central bank, with just the maximisation of short-run real growth and employment, regardless of their sustainability, as its objective? 

By now, the neglect by the Fed of the price stability leg of its mandate no longer comes as a surprise.  But even fully anticipated mistakes hurt.  The US and the world economy will pay the price when, in due course, the Fed has to clean up the mess it is creating by its reckless pursuit of the maximum employment objective.

I have a dream. In that dream I see the Chairman of the Federal Reserve Board, surrounded by the rest of the voting members of the FOMC, all wearing dunce caps except for Bill Poole.  The Chairman reads out the following prepared statement:

"Oops! We goofed last week. Clearly, being alone in the office on an official holiday is not conducive to producing the right mind set for rational decision making.  Also, that man Noyer at the Banque de France failed to inform us on Monday that SocSec was unloading the massive long equity position built up by that other perfidious Frenchman, Kerviel.

We now have had time to sleep on it.  It is obvious that we overreacted.  The economy is slowing down but not collapsing. The 75 basis points cut does more damage through the up-side risk to inflation it creates than it does good by reducing the risk of a prolonged, deep recession.  "Risk management" therefore requires that we minimize the risk of getting stuck with persistently higher underlying inflation.  Consequently we have decided to raise the target for the Federal Funds rate by 50 basis points with immediate effect.  We have also decided to raise the primary discount rate by 100 basis points, to restore the normal 100 basis points penalty associated with discount window borrowing, although we will apply a wider definition of eligible collateral.

We all make mistakes.  Better to recognise them and correct them immediately, than to sit tight and hope a low-probability scenario with low inflationary pressure and a collapsing real economy materialises that will appear to justify ex-post a decision that clearly made no sense ex-ante.

During future official holidays, the Fed will be closed, except for security personnel and guard dogs."

Then I wake up.

It is now clear beyond a reasonable doubt that the Fed wants to prevent sudden sharp drops in the stock market.  It has not, however, drawn the logical conclusion from this endogenous widening of its mandate.  So instead of pussyfooting around with 75 basis point cuts in the target for the Federal Funds rate, I propose that the Fed put its money where its heart is by engaging in outright open market purchases of US stocks and shares.

By intervening through the purchase of the most broadly-based value-weighted index of US stocks, e.g. the Wilshire 5000 Total Market Index, any unlevelling of the playing field between listed stocks can be avoided.  I would prefer the Fed to acquire only non-voting shares, or to put any shares it acquires in a blind trust, to avoid any temptation to micro-manage the enterprises whose shares it purchases.  On January 25 the Wilshire 5000 index stood at 13,423.62.  The 52-week peak was  on October 7, 2007 at  15,806.69.  Let’s split the difference and request the Fed to put a floor below the Wilshire 5000 at, say, 14,500.00.  If the Hong Kong  Monetary Authority can make large-scale domestic equity purchases during the Asian Crisis in 1998, the Fed can make large-scale domestic equity purchases during the North Atlantic  Financial Crisis in 2008. 

What I propose is effectively the same as the Fed attaching a free put option  to every equity share in  a US-registered and-listed enterprise.  It would  put paid forever to all those jokes about the Greenspan  put and the Bernanke put.

Let’s do it!

In a Senate Finance Committee hearing held Tuesday, January 22, Jim Bunning, R.-Ky., exploded after Congressional Budget Office director Peter Orszag noted that "Chairman Bernanke and many economists" believe that the risk of a recession in 2008 "is substantially elevated relative to normal conditions." Bunning bellowed: “Please don’t bring Chairman Bernanke into this, because he’s been wrong so many times … Chairman Bernanke and his predecessor put the U.S. economy in this situation by their monetary policy. And now they are getting into the business, the Federal Reserve, into advising the Congress on fiscal policy, which is none of their darn business. So, I get a little upset sometimes when our Federal Reserve gets into our job, which is to try to stimulate the economy if we think it’s in dire straits.”

Senator Bunning has a point.  To borrow a felicitous phrase of Alan Blinder: central bankers should stick to their knitting.

Chairman Bernanke has played a prominent, high profile public role in gathering support for a fiscal stimulus package to counteract the US slowdown/recession.  On Thursday, January 17, for instance, in testimony to the House Budget Committee, he backed calls for a fiscal package to stimulate economy, but stressed such a plan should be "explicitly temporary." … "Any program should be explicitly temporary, both to avoid unwanted stimulus beyond the near-term horizon and, importantly, to preclude an increase in the federal government’s structural budget deficit," He went on to say that the nation faced daunting long-run budget challenges associated with an aging population, rising health-care costs, and other factors, and that a fiscal program that increased the structural budget deficit would only make confronting those challenges more difficult. "Fiscal action could be helpful in principle, as fiscal and monetary stimulus together may provide broader support for the economy than monetary policy actions alone," .

Even with a few days worth of hindsight, the Fed’s out-of-sequence, out-of-hours 75 basis points cut in the target for the Federal Funds rate continues to look extraordinary and deeply misguided. Indeed, it looks less and less like a decisive pre-emptive move in response to unexpected bad news designed to meet the Fed’s triple mandate of maximum employment, stable prices and moderate long-term interest rates, than a knee-jerk panic reaction to a global stock market collapse.

Did the sharp global decline in stock values at the beginning of this week reflect a rational re-assessment of fundamentals? The only two candidate explanations I have heard are (a) that the collapse was probably triggered by concerns about the financial viability of the monolines and (b) that it was intensified by the unwinding by SocGen of the long equity positions taken by its employee of the year (not!). I find neither explanation convincing. If the collapse was a spurious, non-fundamental event, there is no reason for the Fed to react to it. The ability of the Fed to meet its fundamental objectives is seriously undermined if it is perceived as the poodle of the equity markets.

It is bad news when the markets panic.  It is worse news when one of the world’s key monetary policy making institutions panics.  Today the Fed cut the target for the Federal Funds Rate by 75 basis points, from 4.25 percent to 3.50 percent.  The announcement was made outside normal hours and between normal scheduled FOMC meetings.

This extraordinary action was excessive and smells of fear.  It is the clearest example of monetary policy panic football I have witnessed in more than thirty years as a professional economist.  Because the action is so disproportionate, it is likely to further unsettle markets.  Even the symptoms of malaise that appear to have triggered the Fed’s irresponsible rate cut, the collapse of stock markets in Asia and Europe and the clear message from the futures markets that the US stock markets would follow (a 500 point decline of the Dow was indicated), are unlikely to be improved by this measure and may well be adversely affected.

In the absence of any other dramatic news that the sky is falling, I can only infer from the Fed’s action that one or both of the following two propositions must be true.

  • The Fed cares intrinsically about the stock market; specifically, it will use the instruments at its disposal to limit to the best of its ability any sudden decline in the stock market.
  • The Fed believes that the global and (anticipate) domestic decline in stock prices either will have such a strong negative impact on the real economy or provides new information about future economic weakness from other sources, that its triple mandate (maximum employment, stable prices and moderate long-term interest rates) is best served by an out-of-sequence, out-of-hours rate cut of 75 basis points.

The first proposition would mean that the Fed violates its mandate.  The second is bad  economics.

This panic reaction is destabilising in the short run because it is likely to spook the markets.  When the Fed loses its nerve,  "things fall apart; the centre cannot hold".  In the medium term it subordinates the price stability target to the real economic activity target. It also lays the foundations for the next credit bubble,  after the recession of 2008  has become a distant memory.

It would have been far preferable, particulary because the stock market decline is a global phenomenon, to have a coordinated modest rate cut of, say, 25 basis points, by all leading central banks at some later date, when this would not look like a collective knee-jerk response to a fall in global equity prices.

With this irresponsible act, the Fed has just become part of the problem.  Interesting times indeed.

Black January?

Stock markets are tanking everywhere. In the senile industrial countries (SICs), except for the US where stock markets were closed because it was Martin Luther King Jr. day, broad-based stock market indices fell by five to seven percent in a single day on Monday, January 21 – the largest one-day decline since 9/11/2001 – after an extended period of more gradual weakening. Interestingly, this weakening of stock markets has now also spread to the BRICs and other emerging markets, some of which experienced stock market declines that were significantly larger proportionally than those seen in SICs.

There has been a swelling chorus of requests, indeed demands, for decisive central bank action (i.e. large cuts in official policy rates) in response to these stock market declines. Some of this came from persons and institutions ‘talking their positions’; anyone long stocks knows that a rate cut won’t hurt and will probably help; only those short equity would not like a rate cut. Of course, just because an argument is self-serving does not mean that it cannot be right. Should central banks pay attention? Should they cut because stock markets are crashing all around the world?

I must start this blog (like the previous one), by stating that I am a part-time Advisor to Goldman Sachs.  Goldman Sachs advise the UK government on its financial strategy as regards Northern Rock, including the proposed bond issuance discussed below. I am not involved in any way with the Northern Rock-related advisory activities of Goldman Sachs, and have no inside information on these activities.  This blog represents my personal views only.

The Liquidity Support Facility under which the government lends, through the Bank of England, to Northern Rock, has provided around £ 26 billion so far. In addition the government guarantee around £ 30 billion of Northern Rock deposits and other liabilities. The clock is ticking on, at least, the Liquidity Support Facility. Under EU law and rules governing state aid, this financial support will have to stop no later than the end of February 2008. Northern Rock pay a fee for the deposit guarantees offered by the government. Since we don’t know the size of this fee, or the manner in which it was determined, we cannot be sure whether there is a element of subsidy involved in the deposit guarantee also. With what I know of the history of the Northern Rock debacle, and of the main players involved, I would be staggered if there were not a significant subsidy from the tax payer to Northern Rock involved in the deposit guarantee arrangement – a subsidy that also would become illegal after February 29 under EU law on state aid. I hope that when (if?) there is a full audit of the financial transactions involving the government and Northern Rock, we will be able to uncover all the facts. 

The government are about to propose an arrangement, prepared with the assistance of Goldman Sachs, for a massive extension beyond the end of February 2008, of the period for which the government will offer financial support to Northern Rock. They must believe that the proposed arrangement will not fall foul of the Brussels rules against state aid.

 

I must start this blog (like the previous one), by stating that I am a part-time Advisor to Goldman Sachs.  Goldman Sachs advise the UK government on its financial strategy as regards Northern Rock, including the proposed bond issuance discussed below. I am not involved in any way with the Northern Rock-related advisory activities of Goldman Sachs, and have no inside information on these activities.  This blog represents my personal views only.

The Liquidity Support Facility under which the government lends, through the Bank of England, to Northern Rock, has provided around £ 26 billion so far. In addition the government guarantee around £ 30 billion of Northern Rock deposits and other liabilities. The clock is ticking on, at least, the Liquidity Support Facility. Under EU law and rules governing state aid, this financial support will have to stop no later than the end of February 2008. Northern Rock pay a fee for the deposit guarantees offered by the government. Since we don’t know the size of this fee, or the manner in which it was determined, we cannot be sure whether there is a element of subsidy involved in the deposit guarantee also. With what I know of the history of the Northern Rock debacle, and of the main players involved, I would be staggered if there were not a significant subsidy from the tax payer to Northern Rock involved in the deposit guarantee arrangement – a subsidy that also would become illegal after February 29 under EU law on state aid. I hope that when (if?) there is a full audit of the financial transactions involving the government and Northern Rock, we will be able to uncover all the facts. 

The government are about to propose an arrangement, prepared with the assistance of Goldman Sachs, for a massive extension beyond the end of February 2008, of the period for which the government will offer financial support to Northern Rock. They must believe that the proposed arrangement will not fall foul of the Brussels rules against state aid.

 

I must start this blog (like the previous one), by stating that I am a part-time Advisor to Goldman Sachs.  Goldman Sachs advise the UK government on its financial strategy as regards Northern Rock, including the proposed bond issuance discussed below. I amnot involved in any way with the Northern Rock-related advisory activities of Goldman Sachs, and have no inside information on these activities.  This blog represents my personal viewsonly.

The Liquidity Support Facility under which the governmentlends, through the Bank of England, to Northern Rock, has provided around £ 26billion so far. In addition thegovernment guarantee around £ 30 billion of Northern Rock deposits and other liabilities. The clock is ticking on, at least, theLiquidity Support Facility. Under EU lawand rules governing state aid, this financial support will have to stop nolater than the end of February 2008. Northern Rock pay a fee for the deposit guarantees offered by thegovernment. Since we don’t know the size of this fee, or the manner in which itwas determined, we cannot be sure whether there is a element of subsidyinvolved in the deposit guarantee also. Withwhat I know of the history of the Northern Rock debacle, and of the mainplayers involved, I would be staggered if there were not a significant subsidyfrom the tax payer to Northern Rock involved in the deposit guaranteearrangement – a subsidy that also would become illegal after February 29 underEU law on state aid. I hope that when(if?) there is a full audit of the financial transactions involving thegovernment and Northern Rock, we will be able to uncover all the facts. 

The government are about to propose an arrangement, preparedwith the assistance of Goldman Sachs, for a massive extension beyond the end ofFebruary 2008, of the period for which the government will offer financialsupport to Northern Rock. They mustbelieve that the proposed arrangement will not fall foul of the Brussels rules against state aid.

 

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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