Wednesday, September 19, 2007

Fed stuff

Some of my recent analyses of the Fed and the U.S. economy:
Business Times - 20 Sep 2007

Spectre of 'Bernanke Put' looms

Fed's half-point cut in federal funds rate also expected to produce new problems


CRITICS of Alan Greenspan have depicted what was seen as an attempt by former chairman of the US Federal Reserve Board, Alan Greenspan, to ensure liquidity in the capital markets by lowering interest rates as the 'Greenspan put'. According to this argument, during the Greenspan term in the Fed, investors operated under the expectations that disorder in the capital markets would make it more likely than not that the US central bank would lower interest rates.

Hence, this 'Greenspan put' may have created incentives for some investors out to engage in risky and irresponsible behaviour since they expected that lower interest rates would serve to bail them out. Their risky behaviour, in turn, would end up igniting more disruptions in the financial markets.

So against the backdrop of the crisis in the US housing market and the ensuing credit crunch, it was not surprising that financial analysts were wondering whether the current Fed chief, Ben Bernanke, would decide to pursue a different course than that of his predecessor, and send a signal to investors that the central bank would refrain from responding to every disruption in the capital markets by cutting interest rates and so change expectations among investors.

As they were waiting for Tuesday's decision by the central bank's Federal Open Market Committee, that scenario - a Bernanke playing the role of the anti-Greenspan - had probably caused sleepless nights to many investors. But Mr Bernanke - ironically just a day after Mr Greenspan's published memoirs, The Age of Turbulence: Adventures in a New World had hit bookstores - did not disappoint the anxious investors.

In a very Greenspan-like move, Mr Bernanke and the rest of the Fed's policy makers slashed the benchmark federal funds rate by a half-percentage point as part of an effort to contain the turbulence in the financial markets, taking the overnight rate down to 4.75 per cent, its lowest level since May of last year.

In fact, Mr Bernanke and his colleagues had only three policy options available to them. They could have done nothing, which would have produced hysteria not only on Wall Street but also in Washington where leading Republicans and Democrats - both political parties have close financial ties to the investment community - have been pressing the Fed to 'do something' to relieve the credit crunch.

Or the Fed's policymakers could have cut the key rate by a quarter of a percentage point. Indeed, analysts had speculated that that would be exactly what the Fed would do - while not closing the door for future interest rate relief. Such a decision could have struck the right balance between the current worries over the problems in the housing market and the capital markets on the one hand, and possible concerns over future inflationary pressures on the other.

Nevertheless, with growing indications that the 'real economy' was in bad shape, including the downturn in the housing market as well as well rising unemployment and lower consumer confidence, the expectations on Wall Street was that the Fed would have no choice but to cut the key rate by half a point.

If the Fed had refrained from taking that expected step, it could have created havoc in the financial markets and sent shivers through Washington, especially in the White House. After all, President George W Bush recalls that his father had blamed Mr Greenspan's decision not to cut interest rates for the economic recession that helped bring about his loss of the presidential re-election bid in 1992.

But Tuesday's decision is expected to produce new problems for Mr Bernanke. If the economy is indeed now in such a mess that it required a major cut in rates, why wasn't the Fed chief able to detect earlier the dangers showing on the horizon? There is also the threat of inflation that could spread across the economy, a point that Mr Greenspan made during a television interview to mark the publication of his autobiography. Reports in the press suggested that some members of the Fed's policy makers had opposed a steep cut in rates which could ignite inflation. And once again, the Fed would be seen as bailing out the greedy and reckless investors, creating the spectre of a 'Bernanke put'.

In a statement issued after its meeting, the Fed said that 'the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally' and that the rate cut was 'intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time'.

But the statement also included a warning about inflation, indicating that even though readings on core inflation 'have improved modestly' this year, 'some inflation risks remain', and stressing that the central bank would continue to 'monitor inflation developments carefully'. This warning might suggest that the Fed is not inclined to lower rates again.

While the Fed's decision helped ease concern among investors, it is not clear whether this aggressive move would revive the housing market and prevent the slowdown in growth which could lead to an economic recession. Hence, if the economy continues to plunge and/or if the inflation rate goes up, Mr Bernanke would have to defend Tuesday's decision in his memoirs.

Copyright © 2007 Singapore Press Holdings Ltd. All rights reserved.

Business Times - 11 Sep 2007

US politicians push their agenda as Wall St swoons

The economy could become a central issue in the coming political year


AS Wall Street was preparing for the Sept 18 meeting of the policymakers of the US Federal Reserve, most analysts speculated the release of bad news about the US economy - for example, rising unemployment - would help create a bullish mood among investors who would conclude that the Fed chairman, Ben Bernanke, and his colleagues would be inclined to cut interest rates.

But after the monthly jobs figures for August were released last week indicating that the American economy had lost 4,000 jobs last month, investors were anything but bullish, with the Dow Jones Industrial Average falling about 250 points.

Perhaps, the financial markets may have already discounted the expected cut in interest rates by a quarter of a percentage point even before the depressing estimate from the US Labor Department was issued last Friday.

Investors were operating under the impression that notwithstanding the housing crisis and the credit crunch, the economic fundamentals continued to be quite strong. In that context, the main purpose of a small cut in rates would have been to give a nice lift to the financial markets.

But in the aftermath of the bad unemployment news, the conventional wisdom is that the Fed could end up cutting rates by a half of a percentage point. As investors see it now, the number of jobs being created are much less than are needed to maintain a stable unemployment rate.

In practical terms it means that the rising number of jobless Americans is going to find it difficult to pay their mortgages, which could exacerbate the problems in the real estate market. Hence a larger than expected jobless rate could make the housing crisis more devastating.

Coupled with the worsening credit conditions, these developments suggest that the economic fundamentals - again, contrary to the earlier expectation - are weak and could lead to a recession.

In that case, even a large cut in rates may not revive the real economy. All of which explains the bearish sentiments on Wall Street.

Of course, it's quite possible that the weakness in the labour market is temporary and that the housing market could recover sooner than expected and that the impact on the rest of the economy would be minimal, which could strengthen the hands of those members of the Fed's policy committee who believe that the central bank should not rush to cut interest rates.

But notwithstanding the Fed's response, both the Bush Administration and the Democratic-controlled Congress are already operating under the assumption that - again, contrary to earlier expectation - the American economy could become a central issue in the coming political year that will lead to the 2008 presidential and Congressional elections.

The continuing economic anxiety that is going to be exacerbated by images of middle-class Americans losing their homes and jobs could certainly play into the hands of the Democrats.

Their leading presidential candidates have adopted an aggressive populist economic agenda which depicts the Republicans as the allies of greedy and irresponsible billionaires who are 'exporting' American jobs to China and India, exploiting inexperienced home buyers and credit-card holders, and winning more and more tax cuts that provide them with seven-figure salaries and bonuses.

President George W Bush and his economic aides have insisted that they will not bail-out the companies that are going broke as a result of the housing crisis and the credit crisis, but offered some government assistance to home owners who are in danger of losing their homes.

The Democrats, including presidential candidates Hillary Clinton and Barack Obama are urging that the government 'do more' by providing more funds to troubled borrowers who are behind on their payments, by fining some of the mortgage providers and by imposing more regulation on the industry.

Democratic lawmakers have also proposed new legislation that is aimed at curbing 'abusive mortgage lending'.

At the same time, the Democrats, as part of their populist economic campaign, are also studying ways to cut some of the tax perks enjoyed by the hedge fund industry, arguing that the present tax rules regarding hedge fund lending may deprive billions of dollars in taxes from the US Treasury.

Congressional Democrats have already introduced legislation that would oblige hedge fund and private-equity fund managers to pay ordinary income tax rates instead of lower capital gains rates.

These and other proposals are part of a package of tax reforms that the Democrats unveiled last week and which would provide relief for middle-class families, including by repealing some of the Bush Administration's tax cuts for the wealthy.

But Republicans warn that Congressional approval of such proposals would only create more anxiety in the financial markets and exacerbate the credit crunch. We will soon know who is right.

Copyright © 2007 Singapore Press Holdings Ltd. All rights reserved.

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