Saturday, October 06, 2007

Is Wall Street Now Conducting Monetary Policy?

From Larry Kudlow's very interesting column today "Anatomy of a Fabulous Fed Flip-Flop":

On the afternoon of Aug. 7, the Federal Reserve chair was an inflation hawk -- according to the unchanged FOMC policy statement -- fearful of adding liquidity to the markets. By day's end on Aug. 9, however, he was leading the liquidity charge, initiating a process that would help unlock the credit seize-up that started in late-July.

Using the Freedom of Information Act, Ken Thomas, researcher and lecturer at the University of Pennsylvania's Wharton school, was able to get Bernanke's calendar of phone calls and meetings at the time the flip-flop occurred.

Over the next few weeks, Bernanke participated in no fewer than 35 separate conference calls with fellow Fed operatives -- a complete departure from his earlier no-conference-call style. And he got the liquidity ball rolling. As we now know, the Fed started pouring liquidity into the system on Aug. 9.

Exhibit A: See the chart above (click to enlarge) showing the significant drop in effective Fed Funds rate on August 9 to 4.68%, at a time the official target rate was 5.25%. During the entire month of August the effective Fed Funds rate was 5.02%, almost a quarter point below the official target. Simply put, the Fed implemented an unannounced "secret" rate cut to 5% in August, under pressure from Wall Street.

But is this a good outcome? Kudlow seems to think so, and says that "the academic Bernanke became a hands-on market participant through his contacts with Rubin, Paulson, the hedgies and others. He reached out to savvy financial-market players, who put him in touch with the real world."

Doesn't this call into question the concept of "central bank independence?" Most economists consider it desirable to have central bank decisions insulated from political pressure from politicians seeking short-term political goals, so that the central bank can do what is best for the economy in the long run. But shouldn't the central bank also be insulated from pressure from hedge fund managers and investment bankers on Wall Street, which is apparently exactly what happened in August? Wouldn't an official inflation target insulate the Fed from Wall Street pressure?

Comments welcome.


At 10/06/2007 12:52 PM, Blogger happyjuggler0 said...

(Long post warning)

It might be nice if the fed only had one job, namely controlling inflation. It could then try to set a policy course that kept inflation within a narrow band of not too much inflation and not too much deflation. In the US anyway is it presumed that deflation is a heious monster that needs to be slayed ASAP, if not sooner, therefore the Fed seems to have an actual target of 2% annual inflation, as opposed to perhaps a 2% upper bound.

However this isn't actually why the Fed was created. It was created because J P Morgan (the person, not the company) told the US government he didn't want to be lender of last resort (during panics) any more, they had to figurwe out how to do it. Hence the Fed was born.

So the Fed really ahs two duties, which from time to time may well conflict with each other. Its normal job is to control inflation, and its emergency job is to try to prevent a third party meltdown that would destroy the financial system and plunge the US into a depression.

With that idea in mind I don't see a problem with the fed talking to "the Street" to find out what is going on. With bank to bank lending drying up due to opaqueness regarding other banks liabilities, and with uncertainty as to how much exposure to possibly worthless subprime derivitaves "your" own customers had, each bank simultaneously decided that it needed to keep as much cash on its books as possible.

At the same time, it wasn't just subprime that was blowing up. Banks, and their investment bank clients, had commitments for takeover finance that were "covenant light", which is to say "stupidly exposed to the downside".

Finally, with all this credit repricing going on, all kinds of seemingly reasonable risky paper no longer seemed as reasonable, people panicked, and nonbank (i.e. bonds, and private placement of shoter term paper too) lending dried up to all kinds of companies that had no exposure to either of the above two widespread "temporary insanities" listed above.

Who else is the Fed going to talk to to find out who has possibly bad paper on their books and who doesn't? Or, perhaps more importantly, to find out who still has a considerable positive net worth but due to suddenly unavailable short term credit finds themselves in a dangerous situation where they may soon be unable to meet their short term obligations?

I think it would be irresponsible of the Fed to not talk to Wall Street during a credit panic that may or may not lead to the exact type of third party defaults leading to systemic meltdown that is at the core of the Fed's functions.

I also think it is reasonable to think that the Fed chairman is worldly enough to realize that everyone in the markets that he talks to is going to try to paint things in such a way that the Fed would be more likely to act in a manner to their liking. I don't think that this constitutes undue pressure from Wall Street, or is synonymous with Wall Street Now Conducting Monetary Policy.

I am a minarchist libertarian, and I can understand why some libertarians (and others for that matter) might not want the Fed to have a lender of last resort function, or to even not exist at all. But a potential systemic meltdown moment is not the time to try to abolish the Fed, or to curtail its responsibilities.

If one were to abolish the Fed, or to take away its lender of last resort function, the way to go about that would be to wait til there is quiescence in both the economy and the credit markets, and to announce it far enough in advance so that everyone can strengthen their balance sheets and make, or restrict, mutual credit commitments for what to do during times of crisis.

Unfortunately I don't think the US, or pretty much anyone else for that matter, is libertarian enough to make curtailing or abolishing the Fed a good idea. Sooner or later there would be a panic, and I'd expect the first one after such Fed curtailment or abolition would be a doozy due to uncertainty. Under the current political environment it is a virtual 100% certanity that there would be call for the US government "to do something, anything", and that these calls would be heeded. I find it awful hard to believe that that "something, anything" I just mentioned would be anywhere near as good as what the Fed would do if it still existed, or still had power in this realm.

At 10/06/2007 12:57 PM, Anonymous Anonymous said...

Anyone watch the financial stocks the day of the last FED cut would have seen the run up before the announcement which led to a large rally in the equites that day. The fix was in and front run by these firms, I have pulled all of my capital out of the US as I see this as blatant manipulation. I will not return to these markets. I also view the oil price drop when this rally started as manipulation by Goldman Sachs with a wink and a nod from Hank Paulson shortly after his apointment.

At 10/09/2007 1:43 PM, Anonymous Anonymous said...

I am not sure how Fed understands the inflation. The tuition for my kid's daycare went up 10% and my rent went up 10% while being a prudent buyer not buying into 100% mortgage financing.
Fed is for wall street. I hoped that new Fed chief is not biased but I was wrong again.


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