Wednesday, December 12, 2007

How the Grinch Stole Christmas!

A day later, the Fed's policy own goal continues to baffle Macro Man. Why would the Fed disappoint market expectation when there was little risk of negative macroeconomic consequence from delivering the expected 0.50% reduction in the discount rate?

Regardless, the market impact of the 25/25 decision was not difficult to forecast, and now 1450 on the S&P 500 is literally closer to current levels than 1550. Coincidentally, the Federal Reserve is in the process of updating the official portraits of all key staff. On an exclusive basis, Macro Man is pleased to reveal Ben Bernanke's new official picture, shown to the left.

What's troubling about yesterday's announcement is that it suggests one of the following three statements is true:

1) The Fed was unaware of the policy action that was expected by markets, e.g. a 50 bp cut in the discount rate.

2) The Fed was aware of market expectation but intentionally decided to disappoint that expectation on the basis of moral hazard issues, despite the fact that current discount window borrowing is now not noticably higher than it was before the money market crisis kicked off.

3) The Fed was aware of market expectation and did not wish to disappoint it, but prefers to provide liquidity in a dripfeed fashion with incremental changes to the window rate, the term of loans offered at the window, and the acceptable collateral that can be tendered.

None of these options inspires much confidence, does it? Indeed, the Bernanke Fed is swiftly coming to resemble the Duisenberg ECB, which itself resembled nothing so much as the proverbial troupe of clowns packed into a Volkswagen Beetle. While it is admittedly easier for those of us in the peanut gallery to lob criticisms at policymakers than it is to actually bear the responsibility for making decisions, on an objective analysis the Bernanke Fed would appear to score relatively low on market nous and credibility.

Rumours are now swirling that the Fed will do something to amend the functioning of the discount window, with both the FT and WSJ suggesting that further action could happen as early as this week. But this begs the question of why, if the Fed has been carrying this policy option in its locker, did it not unveil it last night? It's not as if there isn't abundant evidence that cuts in the funds rate are not easing financial conditions, which is presumably the aim of cutting rates in the first place.

A full 100 bps of easing in the Fed funds rate has taken 1 month LIBOR down a whopping 15 bps from the levels prevailing at the end of July. Yippie-kai-yay!

Similarly, corporate boprrowing rates have no come lower in nominal terms, and have obviously blown out in spread terms. The Moody's Baa index has shown a sharp rise in borrowing costs recently, with nominal yields now higher than they were in late July. Admittedly, some of this may be driven by the poor quality of the ratings themselves, but the message is clear: what the Fed has done to date is not easing conditions, and as such will not have the desired impact of supporting moderate economic growth.
Now obviously, if the Fed were to announce sweeping changes to the current liquidity structure, then confidence might be shored up and financial conditions ease. After all, even the Grinch relented in the end and celebrated Christmas with the Whos. But when your central bank is being run by a character from Dr. Seuss, it seems fair to suggest that the problems cannot be banished in one fell swoop, and that volatility will remain aa theme into 2008.

No P/L today due to IT issues.


Gooner said...

A touch unfair me thinks. ---

Ben has probably done the right thing so far. This after all is not his mess, but a combination of Greenspan's mess, and over eager lending and credit practices by Wall St instituions, who have done very nicely out of this over the past few years.

History will be the ultimate judge of Ben. - If he continues to play the role of 'Bitch' to the market, like big Al did, then the USD and the US economy is ultimately doomed. As will be any assessment of his tenure at the helm.

It is almost unanimously agreed that the greatest Fed chief of recent decades was Paul Volcker. However, I'll lay odds that in the early 80s with Fed Funds hitting 20%, and the US deep in recession, he had few if any fans.

Macro Man said...

Gooner, I'd agree that the mess that BB currently faces was Greenspan's creation. However, that doesn't give him a free pass in how he deals with it.

BB's policy of actively encouraging FOMC members to say what they want creates confusion rather than gives transparency.

I agree that BB shouldn't be a bitch...but then again, just because someone asks you to do something is no reason to categorically refuse, if it's the right thing to do. That was the problem with the Duisenberg ECB.

Whatever you might think of the money markets and the economy, it seems to me that the current policy setting is inappropriate for either.

I'd personally prefer to see less done on the funds rate, but a more active provision of liquidity in money markets to ease what seems to me to be a microeconomic, rather than macroeconomic, problem.

ULtimately, of course, you're right: history will be the true arbiter of Bernanke's reign. Based on the performance of his first two years, however, he is looking more like an academic than a policymaker, which isn't what you want from a CB governor.

mOOm said...

I'm confused. Everywhere I was reading that the futures market showed a higher probability for a 0.25% cut. I wonder why they didn't cut the discount rate more, say bring it down to the FFR.

Anonymous said...

Ask and ye shall receive, Mr Man.

Maedhros said...

Yeah, can you spell markets manipulation?

As for the first cut in the discount rate this year: just in an expiration day.

What a bunch of criminals legally authorized!

Any clue about BOE not joining the Fantastic Trio?

Jin said...

Someone said that Fed might actually target at a slow growth rate for the next few years, according to Oct.'s projections. But the market fails to appreciate this expectation. Thus, it is why there is this sudden reaction. Fed must face hell lots of pressure now.

"Cassandra" said...

"Junkies" (this is such a visceral, colourful, word, no?) cannot be true "friends" with their dealers. It's simply not possible for the relationship is irreparably polluted by ulterior and disingenuous motives.

Bernanke, will, I suspect - in time - learn that the Street are NOT his "friends" , and they've been playing upon his bearded academic seemingly rural disposition for all its worth. Didn't Shakespeare say something like "Heaven has no rage like love to hatred turned,
Nor hell a fury like an appointed Central Banker scorned." ??!?

Macro Man said...

C, the issue is not that Bernanke views the Street as his buddies, as far as I can make out. It's that he views the Street as a Princeton economics department case study.

The driving philosophy behind Fed policymaking at the moment appears to be "Gee, I wonder what will happen if we do this?

The crux of the issue is that certain markets are not functioning as designed, and babies are being chucked out with bathwater. The policy program announced today is something that probably should have emerged some time ago, once it become apparent that money markets were seriously impaired.

Had that been done, then the Fed could, and indeed should, have stood firm on Fed funds, given inflationary pressures in the system.

"Cassandra" said...

Oh, I so agree with you! I apologize being too tongue-in-cheek about things so important, but its irresistible. But already, the BB school, and my Python/Jiminez School (or M. Luther School) of central banking are so far removed, I find myself always backsliding into cynicism when confronted by nuances of the reality of the BB School.