The Prisoner of Wall Street

I’m talking about the Fed. The Fed is highly likely to cut, later today, the target for the Federal Funds rate by somewhere between 75 basis points and 100 basis points, bringing it down to 2.25 percent or 2.00 percent. How do I know this? I look at what the Federal funds futures market has priced in. On 17 March 2008, the 30 day Fed Funds futures contract with expiration date April 8, 2008, traded at 98.055, implying a Federal Funds rate of 1.945 percent after today’s meeting.

The fact that the market expects the Fed to change rates by a given amount and that the Fed validates that expectation does not tell us whether the markets or the Fed are the tail or the dog, or indeed whether either one is either.

It is possible that the Fed’s behaviour is independent of what the market believes and that the markets correctly anticipate this behaviour. It is also possible that the Fed validates through its policy actions the most current expectations of the markets, whatever these are; the Fed effectively treats (wishful) market expectations as exogenous and just aims to minimize the risk of surprises (deviations of actual policy actions from the anticipated policy actions priced by the futures markets).

Finally, it is possible that the Fed decides on its policy actions in the light of its macroeconomic objectives (maximum employment, stable prices and moderate long-term interest rates) and of its view of the transmission mechanism of monetary policy (its ‘model’ of the economy), which will include market expectations of future Fed behaviour as one of its building blocks. These expectations can be anything from arbitrary and uninformed to highly informed, model-consistent or ‘rational’. If both the Fed and the markets are well-informed and acting rationally, we would see no systematic deviations between the anticipated future Fed actions priced into the futures markets and other contingent claims markets, and the subsequent actual actions of the Fed. There would be no dog or tail – both the markets and the Fed would be driven by the shared knowledge of the Fed’s objectives and a common view of the transmission mechanism, which includes market anticipations of future Fed behaviour as an important component.

This third scenario is what we hope for. I fear we are getting something closer to the second scenario where the markets are engaged in myopic wishful thinking and the Fed is afraid to disappoint the markets.

The kind of Federal Funds rate cut the markets are anticipating and which I too expect the Fed to deliver (I only hope against hope that they will not) , risks doing much more damage than good to the US and global economies. It is a continuation of the myopic pain minimization strategy that the Fed adopted under Greenspan and has continued to pursue under Bernanke.

The US, and to varying degrees other countries in the North Atlantic area and beyond, are suffering from an acute liquidity crisis superimposed on an underlying insolvency crisis for many highly indebted households and some highly leveraged financial institutions. The ranking of the degree to which different countries are exposed to this insolvency crisis closely follows the ranking of these countries by the extent to which their financial sector follows the transactions-based or capital market model versus the relationships-based or traditional banking model. The US is therefore the most exposed and vulnerable nation, followed by the UK, then the rest of Western Europe, then Central and Eastern Europe and finally the BRICS and other emerging markets.

Since 2000, the North Atlantic region has seen an orgy of undisciplined credit expansion and an explosion of leverage, mainly in the financial sector and the household sector. There was a proliferation of opaque complex securitised financial instruments often held by opaque off-balance sheet vehicles in the lightly regulated or unregulated shadow banking sector, whose relationship to the regulated commercial and investment banks was often not well understood even by the sponsoring banks themselves. Risk was globally underpriced – across the board. This era of return-seeking, risk-ignoring or denying intermediation led to the balance sheets of banks, shadow banks and households being stuffed with overpriced, low quality, high credit risk assets, including overvalued real estate (mainly residential but in the UK, Ireland, Spain and parts of CEE also commercial and industrial).

This situation is now unwinding, as the underpriced credit risk materialises in a rash of arrears, delinquencies, defaults, non-performing loans and the writing down or writing off of assets. Fortunately, the credit boom of 2000-2006 did not lead to much excess capacity creation outside the residential construction sector and the financial sector. These are the sectors that are now getting hammered – as they must. Central banks should prevent unnecessary collateral damage resulting from the necessary and inevitable deleveraging of the financial sector and the household sector and from the unavoidable contraction and consolidation of the financial and construction sectors.

The value of the US residential housing stock has fallen by some $2 trillion or so since the beginning of 2007. It could fall by another $4 trillion before house prices stabilise. Much of this capital loss will be suffered by home owners. Where home-owners borrowed against the collateral of residential property, some of the loss will be shifted to the owners of the banks and other mortgage lending institutions, if the mortgage borrowers default and there is negative equity. A further pyramid of inside financial assets and liabilities was built on these mortgages, through securitisation, tranching and a variety of enhancements.

The collapse in the valuation of RMBS and similar asset-backed securities itself does not destroy net wealth – those who issued the securities gain what those who hold them lose when their valuation goes down. However, because of the asymmetric reality of default and insolvency, the asymmetric responses to large capital gains and large capital losses, mean that a disorderly deleveraging (contraction of both sides of the balance sheets of a host of financial institutions) can be disruptive and can spill over into the real economy through the cost and availability of credit channel.

So central banks, including the Fed, should stand ready to act as market maker of last resort, accepting a wide range of private securities as collateral in repos (or purchasing such securities outright) from a wide range of counterparties at a wide range of maturities. Likewise, individual systemically important financial institutions should have recourse to lender of last resort facilities, including the discount window.

The Fed has recently extended access to its discount window to the 20 (or is that now 19?) primary dealers. Other non-deposit-taking institutions will no doubt be granted the same privilige before long. The restriction of the new PDCF to overnight finance only should also be lifted. The same terms as those available to deposit-taking institutions (up to 90 days) should be available. Provided the collateral is priced appropriately (which means the prompt abandonment of the approach outlined on the Fed’s website that “…the pledged collateral will be valued by the clearing banks used by the primary dealers to access the new facility, based on a range of pricing services.” – an invitation to stuff the Fed with fools’ gold priced as bullion), this will stop the unavoidable and fundamentally warranted solvency problems of a number of households and financial institutions from triggering a system-wide liquidity crisis and a system-wide fundamentally unwarranted solvency problem, and will do so with minimal damage in terms of moral hazard.

Further cuts in the short risk-free rate of interest will not, however, serve the cause of systemic financial stability. No doubt a number of individuals and institutions heavily exposed to short-term funding needs and to capital losses on interest-sensitive assets will welcome and clamour for a cut in rates. But the short risk-free rate is already very low at 3.00 percent. The short risk-free real interest rate is around zero, which is clearly expansionary.

Further cuts in the risk-free nominal rate aimed at boosting the balance sheets and cash flows of the financially wonky will further postpone the day that irrecoverable losses are recognised and reported. This may lead to higher credit risk spreads that could well prevent private borrowing rates from declining when the official policy rate is cut. We are seeing this now in the US at the short end. We have seen it for quite a while at the long end of the maturity spectrum, for all but default-risk free securities – US Treasuries.

I fear that the kind of further aggressive cuts the markets are anticipating and the Fed is likely to deliver will now lead to higher long-term risk-free rates, both nominal and real. This is both because it will confirm the market’s view that the Fed has given up on controlling inflation and because of the need to maintain US dollar bond yields in relation to those obtainable abroad, especially in the Euro Area. Further major cuts in the Federal Funds rate could turn the recent dollar slide into an avalanche. US real long-term rates are set by the global capital markets, not by the Fed or the US government. The point at which a rush out of dollar securities will begin cannot be far ahead. The US economy, which has benefited from the US beggar-thy-neighbour expansionary monetary policy through exchange rate depreciation, could end up being hurt more by high long-term interest rates than it is helped by a further weakening of the dollar.

Foreign exchange market intervention will probably be invoked if the combination ‘US dollar collapse – US TB market collapse’ were to materialise. Uncoordinated intervention is spitting against the wind. Coordinated intervention, involving at least the Euro Area, Japan and China is argued to have worked in 1985 and 1987. I have my doubts even about those two episodes, and the world has changed a good deal since then. But if it doesn’t help it won’t hurt much either. All that central banks have to lose in unsuccessful foreign exchange market intervention is tax payers money and their own reputations. And the Fed does not have a lot of reputation to lose any longer, if it keeps cutting rates to try to forestall the inevitable and necessary.

Keeping the Federal Funds target constant today would cause popping blood vessels throughout the financial market community. It would, however, be a five-minute wonder – a storm in a tea cup. The authorities should never deliberately wrong-foot the markets – I have never had time for central bankers keen to ‘teach the market a lesson’ or to stage an ambush. But if what the markets expect is not what the central bank considers optimal (even allowing for the economic effects of the market’s wrong expectations and its response to a policy surprise), policy makers should not think twice about surprising the markets. If there is any change of the markets learning from their mistakes (a dubious proposition), the case for doing the right thing regardless of what the markets think (although allowing for what the markets think and for their response to a policy surprise) is reinforced by a market learning motive. If only.

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