January 22, 2008
The Bernanke put: buttock-clenching monetary policymaking at the Fed
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.
Taking an overview of the Fed’s record over the last twelve years, it is hard to see why the FOMC has any reputation left to be undermined by today’s decision. They have let two asset price booms get out of control, put the brakes on too hard in 2000 and left them on slightly too long last summer. The emergence of a Bernanke Put has already been speculated upon; and sure enough , here it is.
Posted by: Graham | January 22nd, 2008 at 6:32 pm | Report this commentI agree with Prof. Roubini’s analysis (NYU), not Prof. Buiter’s (LSE). Both the stock markets & the Fed are belatedly facing the reality of a deep recession in the US. Ambac and MBIA will soon lose their AAA ratings, and the money center banks will have to write down even more bad loans (that were theoretically insured). Thanks to reserve requirements, that will worsen the “credit crunch.” Combined with slowing US consumer spending, the US is headed into a deep recession. Oil prices are falling - inflation is not a risk now.
Posted by: Pangloss | January 22nd, 2008 at 7:56 pm | Report this commentthe ‘authorities’ have no balls.
Posted by: ian r watts | January 22nd, 2008 at 8:02 pm | Report this commentsound money is all that matters.
cycles are the result of tinkering last time round.
tinkering creates greater costs than benefits-
except, ex ante, for politicians/ parties
running behind in electoral races.
and those chancers who based their well thought-
out strategies on , in part, their assessment of the likelihood of a baleout
The Fed decision puts pressure on the BOE to lower UK rates because we are already in recession. Likewise the ECB needs to follow suit. Any economic growth may prove to be a very elusive commodity. What is the underlying situation? Transfers of money to the $100 per barrel oil producers. Today Kazachstan billionaires buy houses in London for £50 million with another £30 million for repairs like gold bath taps. SWF save wall street investment banks…maybe we are all caught in a vortex?
Posted by: musgrave | January 22nd, 2008 at 8:27 pm | Report this comment“It also lays the foundations for the next credit bubble, after the recession of 2008 has become a distant memory”
Willem, Isn’t that the whole idea of 21st century US monetary policy? Take a look at Feb 2008 Harper mag piece by Eric Janszen: “the next bubble”
Posted by: groucho | January 22nd, 2008 at 8:54 pm | Report this commentIn response to Musgrave, the correct action is to build nuclear power plants in the west, use electric cars and quit burning things in the air besides the occasional fireplace.
Posted by: Clyde Jorgensen | January 22nd, 2008 at 9:02 pm | Report this commentProf Buiter’s comment misses the point, in my opinion. The Fed has acted exactly according to Mr Mishkin’s latest speech, concerning how to react in case of a market disruption. I would be more interested in his reaction to the reasoning - in terms of monetary economics - behind the argument in that speech.
Posted by: geh | January 22nd, 2008 at 9:10 pm | Report this commentI thought Prof. Krugman’s analysis today on his blog was also quite interesting, thinking the Fed’s action today reflected the need to retain an inflation buffer and avoid a liquidity trap.
Posted by: ag | January 22nd, 2008 at 9:31 pm | Report this commentThe fact that this post and this entire blog read like the Book of Revelations is probably a pretty good ‘buy’ signal for American stocks. (If you just huffed “Nonsense!” try to remember that the journalistic consensus–not to mention the economists’ consensus–is more often wrong about these things than not.) It’s easy to take pot shots at the Fed, perhaps well-deserved, but I suspect two years from now we may be lamenting the fact that the geniuses at the ECB & BoE didn’t act more decisively early on. It wouldn’t be the first time that a seemingly ’sound’ European economy fell into a deeper, and longer recession than the US. I was in Italy in 1992 after the US S&L crisis. It was much uglier in Napoli and Rome than it was in Los Angeles or even Chicago. I suspect, given a couple of years to play out, it could be much the same this time round. If nothing else, it may thin out the foot traffic in London a little and maybe put a lid on Eurocrats / pundits who are currently gleefully giving the US all the advice we can stomach.
Posted by: David | January 22nd, 2008 at 11:22 pm | Report this commentThe reason for the “shocking” Fed action is that they had no choice but to cut rates.
Following Friday’s Ambac downgrade, and Monday’s broad-based decline in the stock markets, demand for short term commercial credit weakened substantially, to such an extent that in order for the Fed to defend their 4.25% target rate for o/n borrowing, they would have been forced to drain such an enormous amount of liquidity from the banking system as to make one or more banks functionally insolvent.
So rather than proceed with the drain and set off the nuclear bomb, they simply cut the target rate down to where supply/demand for overnight borrowing was fairly balanced.
This is evidenced by the fact that despite the 75bps rate cut, the Fed has not been required to add any significant liquidity to the banking system in order to bring rates down to the new target.
Simple, basic, obvious - when you think about it.
Posted by: bsb | January 23rd, 2008 at 12:07 am | Report this commentMonetary “stimulus” is a contradiction in terms. You can’t make any headway with monetary policy, you can only screw things up. Trying to create stimulus with monetary policy is, in fact, the *cause* of the current problems. The latest events have only proven as much for the how manyeth time, now? To get ahead, there must be real, long-term, pro-growth, smaller-government, fiscal policy. That means lower taxes and fewer regulations.
Ask yourself which is better: how the markets are reacting to continued, desperate interest rate cuts and the lame excuse for a temporary stimulus–or how markets would react if they knew they were going to get long-term sound money and structurally lower taxes over the long term. If you have to think about this for more than about a microsecond you are part of the problem.
Alas, the chance that the correct solution will be tried is close to zero.
Posted by: Robert P. Churchill | January 23rd, 2008 at 3:39 am | Report this commentI perfectly agree with prof. Buiter’s comments.You don’t treat a sick man by just feeding him more food.That is the recipe for someone hungry.It is a fact that Uncle Sam is indeed sick and in the process of getting sicker.Under the circumstances, tightening of lending standards(prime cause of sub prime),accountability of the raters(coconspirators)and a mild dose of recession is the medicine a sick Sam requires to be healthy again.Against this, what he is getting from Dr. Bernanke, is just more diet.What say prof. Buiter?
Posted by: Puneet Kumar Jain | January 23rd, 2008 at 8:27 am | Report this commentHere’s the thing the Fed must have known that the 75bp cut yesterday would be seen as a sign of panic. Wall Street is already a pessimistic place, there’s not a trader who does not think the Fed has acted quickly enough, so as far as those guys were concerned, this cut was overdue. And I kind of feel, if the Fed was planning a cut of this magnitude in 10 days’ time, why wait?
But this whole discussion about appropriate monetary policy is somewhat beside the point. The much bigger issue is that the transmission mechanism for monetary policy - the banking system - has its own serious problems, and it is thus a cause as well as a symptom of the slowdown. As such it is hard to see what the Fed can do, either through OMO or rate cutting, that will impact the real economy.
And that is the dilemma facing Bernanke, who as far as I am aware has spent a lifetime studying recession economics - that the best anti-recession medicine the Fed can prescribe isn’t going to be able to treat the decline in economic activity.
Posted by: Ed | January 23rd, 2008 at 10:51 am | Report this commentThe balloon is out of air. Inflation is not the worry, re-inflation to normalcy is what we need. We need to end the indentured servitude of tens of millions of american families and increase their wages dramatically to allow consumption to make up for a dearth of investment and to allow increased savings and debt take downs to provide more resources to get investment up. One way to do that is to have the Fed, Treasury and the Congress apply pressure on credit card companies and unsecured loan companies to slash their extortionate rates to better correspond with market reality and give the indentured consumer some slack. Also, we need a law to prevent inherent conflicts of interest at the top. How can a nation so dependent on oil have oilmen at the helm ?! This is a recipe for disaster. Without Bush / Cheney the federal government could easily put a solar panel on every roof in America and smash the dominance of big oil and the OPEC cartel. It might also save us from extinction as well. God forbid the indentured public did’nt have to feed the beast every month when the pointless oil / gas utility bill needs to be paid. Why are the capitalists so afraid of freeing the public ? The public won’t bite. If you don’t free them though, they may. We are less a democracy than a nation ‘of the coporations, by the corporations, for the corporations’.
Posted by: stephen barry | January 23rd, 2008 at 11:29 am | Report this commentWhat do you mean Prof Buiter? You are not supporting the ROB (Raise Our Bonuses) movement? You are so out of touch with the times…
Posted by: Domi | January 23rd, 2008 at 12:01 pm | Report this commentBurning the Field by Marc F. Brocato
The American Cash Cow - ALL BULLS OUT.
Back in the old days, before fencing had subdivided and cordoned off the once opened areas of land throughout the south, the farmers and cattlemen of the day would burn off the fields and woodlands. During the summer, vegetation in the forms of grasses, briars, and various shrubs would grow in the open fields and meadows. These plants were a source of nutrition for livestock and a major food supply for the herds which where allowed to roam freely. In the fall of the year, winter would set in and the summer growth cycle would end. With the onset of cold winter weather, the grasses and other vegetation would die, leaving the landscape lifeless and brown. The purpose of burning the woods were twofold. First, the fire had a cleansing effect by clearing the ground of useless and unwanted debris. Secondly, nutrients where returned to the soil, making them available for the next succession of growth. One could look north and south, east and west, and see the numerous columns of smoke rising into the sky.
The yearly roundup took place in the fall, at which time the cattle were gathered together. The ranchers collected their ( cash ) cows, some were sold at auction and others where put in places of safe keeping (Euro’s, Swiss franks, Yen…. ). Not until all the cattle where herded together and relocated were the fields and woods set on fire. This was the economic cycle that reoccurred year after year, a necessary evil of the day and was eventually outlawed.. Thousands of independent ranchers would be replaced by the large cooperate cattle companies. And so it is with food and many other good and services today, from the hands of the thousands who established the market, whatever that market might be, into the hands of the few who now control it. But that’s not the end of this story, it’s far from over. Apply these same principles and methods to the national and global economy. It appears as if the industrialists and financiers who control the economies of the world have been moving their cash cows out of the U.S. .for a long time in advance of a controlled burn or just maybe wildfire. The crash of the ‘30’s was such an action, however, every major market on the face of the earth will be effected this go round. A well planned choreography of events will reshape the global economy in ways which the average individual cannot comprehend. When the fires are out and the smoke clears, the result will be an empty shell of a country, with an economic landscape barren and ready for the next season of growth.
Enjoy your freedom and rights, savor them as you would your favorite meal. Life in the United States, as we know it, shall soon go through quiet a transition. Similar circumstances have overtaken unsuspecting populations in the past, but never the entire world, as it will this time. What shall be used as the form of ignition? Will it be a manipulated economic disaster, or some fabricated terrorist act. Perhaps an unexpected act of God that was not a part of man’s planning. Maybe those in Washington will legislate the country out of existence by executive order, it’s amusing to think a thing like that is possible.
The surest way to prevent seditions is to take away the matter of them; for if there be fuel prepared, it is hard to tell whence the spark shall come that shall set it on fire. - Bacon.
Posted by: marc brocato | January 23rd, 2008 at 1:19 pm | Report this commentI usually find myself in agreement with Professor Buiter’s views. On this occassion, however, I am obliged to dissent.
Real asset prices are too high; adjustment is both inevitable and desireable. The question is how best to engineer a smooth, stable adjustment process. There is a danger of a free fall in housing prices as a deflation psychology sets in: why buy now, if by waiting six, 12, or 24 months I might buy the same house for 15, 20, or 30% less? Of course, if enough potential buyers think in those terms, the decline in housing prices become self-fulfilling.
Falling nominal housing prices destroys the value of collateral in the banking system (which is already suffering from insufficient capital as SIVs come back on balance sheets) and impairs bank capital. We are now looking at a situation in which homeowners whose equity is gone are walking away from their commitments.
We are also looking at a whole generation of consumers that had been planning to spend their housing wealth in their retirement. Those consumers are now reoptimizing with the result that either current consumption will be reduced to restore asset levels, or future consumption spending will be revised down to reflect the lower income stream on housing.
That mix of a monetary mechansim that isn’t responding and consumption paths that have been revised down is a recipe for the monetary transmission mechanism to seize up and a return to Depression Economics.
We have seen this movie before–it was the real estate monster that ate Tokyo’s banks. After the fact, the BoJ was severely critised for responding too slowly, too “prudently” to emerging signs of trouble; Japanese banks for not acknowledging their bad loans up front.
Keynes argued that inflation was one means of resolving the coordination failure in rigid nominal wages. Better a little inflation that restores full employment than the prolonged unemployment (and social disruption) that would otherwise be required to bring nominal wages down. In the 1930s, the link between consumption and wages was very tight. In 2008, with greying populations in the “mature” economies, the link between consumption and the income stream from assets is growing in importance.
Rather than panicking, the Fed may be looking at the very real risks ahead and taking determined, prescient action to avoid them. In hindsight, Chairman Bernanke may be heralded as the guy who prevented a lost decade.
Posted by: Ricardo Smith-Keynes | January 23rd, 2008 at 3:17 pm | Report this comment“Whether or not Peak Oil Imminent, Bush’s Allusion to it heightens chance of ‘Peak Shock’ on Wall Street” - http://energytechstocks.com/wp/?p=765
I guess the Fed has read this article!
Posted by: Alfred | January 23rd, 2008 at 3:30 pm | Report this commentProfessor Buiter,
It looks like Bernanke took offense to your statement: http://www.newsgroper.com/ben-bernanke/2008/01/23/hand-chains-cruel-invisible-hand-market-spanked-wall-street/
Do you have any response?
Posted by: John Greenberg | January 23rd, 2008 at 11:10 pm | Report this commentThe Fed is literally between a rock and a hard place. Does it not cut rates and ignore the obvious slowing of the U.S. economy. Or does it cut rates and forget about those small nuisances of inflation, moral hazard and, most importantly, that easy money got us into this mess in the first place.
I’m not an economist, nor do I invest via fundamentals. I’m a technical trader, but from my vantage point, it seems that the Fed is doing what is has done for the past 20 years; prop up American asset prices. Tuesday’s 75 bps cut is indeed a sad commentary but an all-too predictable one as well. As has been cited in the comments above and by people such as Marc Faber, it is pure insanity to think that the problems facing the U.S. economy can be cured by the medicine that caused the problem in the first place: easy money.
The U.S. is not good at deal with chronic problems; it only deals with acute problems, the solutions to which are often drastic, short-sighted and ignorant of the longer-term issues. Add in an election year and you have a recipe for some potentially disastrous fiscal and monetary policies.
U.S. policymakers are also backed into a corner. Inflation is high; the consumer is spent out; the government is running world-record levels of debt and trade deficits; the dollar is in trouble; and its economy has been supported by a credit bubble composed of over-leveraged and intertwined derivatives of bad loans. Oh, and I almost forgot: a stretched military occupying a hostile nation in the heart of the source of energy to which it is held economic hostage.
Such times call for bold, innovative solutions. Unfortunately, such solutions are now in the hands of tentative, unimaginative politicians who will likely try to pull yet another rabbit out of the same old bag of tricks.
Posted by: Peter Davis | January 24th, 2008 at 5:22 am | Report this commentI agree that the Fed is walking right into the markets hands. The Fed rate cut does not have a prayer. Greenspan took all the inflation fighting juice out of the economy in the 90’s while igniting the momentum of debt. In any case, we are all in trouble. We are in trouble because our farms are no longer so close by; we are in trouble because we use too much expensive energy to import things that we used to produce close by; we are in trouble because our government and armed forces are huge and are a ton of mouths to feed. We are in trouble because our federal government currently “guarantees” the obligations of Fannie Mae, Freddie Mac, and Sallie Mae. We are in trouble because Wall Street liquidated the entire value of the economy x 10 (assuming 10:1 leverage) through these credit “derivatives”. But what to do? We certainly can’t blaim Bernanke or Paulson, although faking that they know what they are doing is not helping. The economic system is broke, and we better fix it.
Obviously we need to make sure our trains are in good working order since oil and the automotive industry will surely not be the wave of the future. Energy efficient urban downtowns and villages will continue to grow and a continued investment in them will certainly make sense. We must also invest heavily to increase the diversity of our farms for obvious reasons. The healthcare system is a derivative of a healthy or unhealthy economy. Only time will tell whether we can bring nutrition to our health care system. The list certainly goes on and on.
But most importantly, we will soon have an immediate need to generate a lot of new jobs as so many tied to the housing industry are lost. Unemployment feeds on itself, so we can not afford to give it any momentum. So what should be our next growth engine that supplies these jobs and how can we make this one last? It is widely believed that energy will determine our future. So why not make it renewable. Imagine if the Keynesian theory of economics was sustainable, where “priming the pump” actually generated net equity every step of the way. Renewable energy produces jobs while progressively lowering the cost of labor time (as a derivative of scarce land value). Imagine home mortage companies turned into renewable energy mortgage companies. Imagine our automotive industry turned into solar panel manufacturers and retailers. Imagine the home construction industry evolved into the renewable energy construction industry. And who better to lead the Renewable Energy Revolution in innovation than “Silicon” Valley (Silicon makes Solar Panels and is the 2nd most abundant element on earth). Imagine a fiscal stimulus that actually had a long-term goal.
Posted by: Doug Wolkon - Author of The New Game | January 24th, 2008 at 2:56 pm | Report this comment