Why did the Federal Open Market Committee drop its official target rate for overnight bank loans on October 31? If it was a plan to head off a stock market sell-off, it went awry. The Dow fell by 362 points on November 1.
The obvious answer is that the FOMC feared a turndown in the economy. But minor decreases in the federal funds rate will not head off the recession. Greenspan’s boom is turning into Bernanke’s bust. A fraction of a percentage point’s decline will not alter the economic fundamentals.
In August, the Dow fell by over 10%. A rebound came only because investors believed that Bernanke’s tough talk to Congress about the reasonably strong economy was so much piffle. They believed Jim Cramer’s August tirade. They also believed that Cramer and his peers would get the ear of the FOMC, no matter what Bernanke says about an independent Federal Reserve System. The FED may be legally independent of Congress. It is not independent of the howls of agony from Cramer and his peers. The Supreme Court follows the election returns, as Mr. Dooley said so long ago. Similarly, the FED follows the stock market.
Why should the FED care? Because the FED is the front for the banking cartel. The banks have loaned money by the hundreds of billions to borrowers who then put the money into arcane debt instruments that are now visibly unraveling. The bankers have no clue as to how they can get their money back if these debt instruments become insolvent. These instruments are part of the carry trade: borrowed short and lent long. This is what brought down the savings and loan industry in the 1980’s. It threatens to bring down the banks today.
So, Bernanke must talk calmly to Congress in order not to spread panic. He must also take symbolic steps to keep Jim Cramer from going on TV and throwing another tantrum. Why? Because if Cramer is scared, his capital management peers are scared. If his peers are scared, investors who bankroll these carry trade schemes will stop putting in their money. This will end the trade. The banks will then get stiffed.
This almost happened in 1998. The New York FED called in the major banks that had lent Long Term Capital Management its money, which LTCM then had used as margin money in the futures market. The FED strongly suggested that the banks pony up another $3.5 billion to keep LTCM from being forced to unload their positions at fire sale prices. The banks did what was suggested.
This time, the FED is not facing one lone company whose leveraged positions have gone south. The FED is facing an entire segment of the U.S. capital market, which soon may not be able to raise money to keep its CDO (collateralized debt obligation) projects officially solvent. As long as these projects are solvent, the banks don’t have to write off the loans.
The banks are in a situation eerily similar to the Japanese banks in 1992. They are sitting on top of visibly bad loans, but they are allowed by bank regulators to keep these bad loans on their books at face value. This lets them stay in the lending business.
BERNANKE HAS SOUNDED NO ALARM
Let me review briefly what should be familiar to you.
On October 15, he declared confidently,
It does seem that, together with our earlier actions to enhance liquidity, the September policy action has served to reduce some of the pressure in financial markets, although considerable strains remain. From the perspective of the near-term economic outlook, the improved functioning of financial markets is a positive development in that it increases the likelihood of achieving moderate growth with price stability.
He said he was worried about the "moral hazard" problem: the creation of an expectation that the FED will protect investors’ assets. He did not want the FED to convey the wrong impression. There would be no "Bernanke put" to bail out a falling stock market.
However, in such situations, one must also take seriously the possibility that policy actions that have the effect of reducing stress in financial markets may also promote excessive risk-taking and thus increase the probability of future crises. As I indicated in earlier remarks, it is not the responsibility of the Federal Reserveu2014nor would it be appropriateu2014to protect lenders and investors from the consequences of their financial decisions.
Yet what the FOMC did on October 31 is nothing less than a stock market bailout "to protect lenders and investors from the consequences of their financial decisions." The market had been rising for two weeks. In an October 26 report issued by MarketWatch, we read:
Investors widely expect that the U.S. Federal Reserve will lower its federal funds rate from 4.75%. Markets have fully priced in a quarter-percentage rate cut at next week’s Federal Open Market Committee policy meeting, and some believe another half-point cut is possible.
"A 25-basis point rate cut is the consensus expectation for next week’s FOMC, according to our survey median, as well as the Fed funds futures market," wrote analysts at Action Economics.
"We don’t believe another rate cut is necessary at all, though the lack of protests from policymakers to consensus expectations of a rate cut probably makes the move a fait accompli," they said.
But, Bernanke asked rhetorically, what if, in certain special cases, the financial markets look as though they are coming unglued? Then the FED will act.
But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy. In particular, as I have emphasized, the Federal Reserve has a mandate from the Congress to promote maximum employment and stable prices, and its monetary policy actions will be chosen so as to best meet that mandate.
The FED acted. Conclusion: "economic effects felt by many outside the markets" were about to become very painful.
The next day, they became painful, to the tune of 362 points.
What was his concern? Officially, the FED’s mandate "to promote maximum employment and stable prices." But prices have been stable: rising more slowly than a year ago. So, that was not the problem facing the FED. This leaves "maximum employment." That means economic growth.
But hasn’t he assured everyone that there is no problem here? Of course he has. He has smooth-talked Congress in a way that Greenspan didn’t. He has talked clearly about an economy that is not facing a setback.
Then why did the FOMC cut rates? Twice?
The FED is trapped by the stock market, with Cramer as its vocal spokesman. He called for a "Bernanke put" back in August, and Bernanke gave it to him. Twice.
Bernanke is acting as all FED chairmen and all FOMCs act. He cut rates when there was a mere 10% decline in the Dow Jones Industrial Average.
Stock market bulls discounted a quarter-point cut. They bought shares. Why? On the assumption that the FOMC would cut the FedFunds rate. This forced the FOMC’s hand. It did exactly what the forecasters had said it would, and had run up the market in anticipation.
Let’s look at the press release that accompanied the FOMC’s action.
Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.
What is the focus here? The financial markets, not the underlying economy, which is said to be "solid." This is consistent with the FED’s real purpose in life: to protect the banking cartel. The banking cartel has loaned a lot of money to the financial markets. The symbol of these markets is Merrill Lynch, which just lost $8 billion in subprime loans and whose chairman is about the get fired (and take away $159 million for his trouble). The press release continued:
Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.
"Some inflation risks remain." This was Greenspan’s mantra. He said it over and over for 18 years. Then the FOMC increased the money supply, year by year, so that consumer prices had doubled by the time Greenspan returned to the land of the coherent. So, as it turned out, his warning was right. It was a warning against his policies.
The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.
Interpretation: "The committee hasn’t any idea what it will do." This statement is seen as some sort of semi-assurance not to reduce the target rate again. It is no such thing. It is the FED’s standard "we continue to keep all options on the table."
THE OUTSIDE PRESSURE TO INFLATE
On August 20, Bloomberg ran a story on Bernanke that went straight to his academic ego. It described him as a rookie.
Federal Reserve policy makers, who declared that inflation was their paramount challenge just two weeks ago, have been forced to make financial-market stability the trigger for changes in interest rates.
By lowering the discount rate and issuing a statement conceding threats to the economy, Federal Open Market Committee members effectively ripped up the economic-outlook statement from their Aug. 7 meeting. Some economists describe the about-face, coming after months of assurances that the subprime-mortgage rout was contained, as Chairman Ben S. Bernanke’s first serious error since taking office last year.
"It was a rookie mistake," said Kenneth Thomas, a lecturer in finance at the University of Pennsylvania’s Wharton School in Philadelphia. The Fed "underestimated liquidity needs" of investors and the fallout from the housing recession, he said, adding, "This demonstrates the difference between book-smart and street-smart."
The spin was obvious. Bernanke, as an academic, was holding to a moderately inflationary policy, not goosing the stock market with a rate cut. What an academic thing to do, what with Jim Cramer going berserk and everything. What Bernanke needed to do was listen to the likes of Jim Cramer.
Then, again, maybe it really was a crisis.
"Sometimes, the dynamics change very, very quickly," said former Fed governor Laurence Meyer, who voted for the three reductions in 1998 after currencies in Asia, Russia and Latin America tumbled. Bernanke’s shift "tells us how difficult it is to translate financial turbulence into the macroeconomic forecast."
The piling-on continued. Martin Feldstein, a Harvard University economist, testified to FED members at their all-expense-paid annual retreat at Jackson Hole, Wyoming. Feldstein is a heavy hitter. He is the CEO of the private research organization, the National Bureau of Economic Research. It is this august body that announces in retrospect years later when a recession began and ended. He was also Reagan’s early Chairman of the Council of Economic Advisers. He told the FED audience that it was time to lower the FedFunds target rate. A Bloomberg report summarized his message.
The economy could suffer a very serious downturn. . . . A sharp reduction in the interest rate, in addition to a vigorous lender-of-last-resort policy, would attenuate that very bad outcome.
He called for a cut to 4.25%. That would have been a major cut, for the rate was at 5.25%. Bernanke wasn’t in the room to hear this, but other FED members were.
Feldstein outlined a "triple threat" from housing: a "sharp decline" in home prices and construction; higher borrowing costs and a "freeze" in credit markets stemming from subprime-mortgage losses; and fewer home-equity loans and refinanced mortgages, leading to less consumer spending.
Bernanke blinked. He buckled. He rolled over and played dead. He and the FOMC lowered the target rate to 4.75%. Then they did it again.
What thanks did they get? None. The next day, the Dow fell by 362 points. Once again, the rule holds: "Buy on the rumor. Sell on the news."
The economy is facing the prospects of drip-drip-drip bad news from the housing sector. It is also facing similar bad news from what I call the carry-trade sector: borrowed short, lent long. The lure of Greenspan’s low interest rates did to the domestic debt market what the lure of Japan’s low interest rates did to the worldwide bond market. The smart money borrowed short and bought long-term income streams. Now the flow of short-term money has stopped because of fear regarding the solvency of the organizations created to serve as the middlemen.
Because the reduced flow of investment money into subprime mortgages, the mortgage market is in turmoil at the margin. The same is true of the CDO market. Nobody knows what the market value is for the high-risk portions (tranches) of these broken-up credit instruments. The investors played "street smart" for years. They never asked what the exit strategy was, or what discount the secondary market would impose when it was time to run toward the exit.
Investors are now asking about the exit strategy. There isn’t one. There is no phone call from the New York FED over the weekend to put together a bailout plan for a single overextended firm. There are too many overextended firms.
The FED is now learning that fooling around with the FedFunds rate is not going to solve the solvency problem.
It will be six weeks until the next FOMC meeting. If it intervenes ahead of time, this will send a loud signal: "It’s panic time!"
There are far more reasons for the stock market to go down than up. The FED has shot its wad. It was a pellet gun fired at a charging elephant. Now the bears take over.
The economy will not be far behind.
November 3, 2007