re: Margin Concerns
Chaz, I don't have the link to the NY times article expressing margin concerns, but I have a link to a well written article in the new Barrons whereby Stephen Roach, chief economist at Morgan Stanley Dean Witter, recommends that the Fed raise margin requirements. It appears that the number of voices interested in this action is growing.
This link only works for subscribers, so I guess I will go ahead and paste in the full text. interactive.wsj.com
It's a Classic Moral Hazard Dilemma: The Fed Is
Part of the Problem It Wants to Resolve
By Stephen S. Roach
Five tightenings in nine months! What more could a monetary hawk want?
On the surface, the Federal Reserve seems determined and disciplined as it
goes about its unpopular task. But beneath the surface, some disquieting signs
fester. The U.S. economy remains far too hot and the financial markets are as
frothy as ever. Try as it might, the Fed isn't tempering the excesses it seeks to
control. That raises the obvious and important question: What will it take to
get the job done?
For starters, while the Fed has been tightening, it isn't tight. While this sounds
like a play on words, it is well grounded in the inflation-adjusted,
real-interest-rate metric that should be used to judge the efficacy of monetary
policy.
While the nominal federal-funds rate has gone up 1 1/4 percentage points
since July 1999, the real funds rate has remained essentially unchanged over
that period. That's because the inflation rate has accelerated from 2% to 3.2%
over that interval. Oil-shock-induced or not, the rise in headline inflation has
completely offset the increases in the nominal overnight lending rate. In the
aftermath of the March 21 rate hike, the real federal-funds rate, as calculated
on the basis of a 12-month trailing CPI, now stands at around 2.8% -- no
different than it was when the Fed began the current tightening campaign last
July.
Even if the oil shock were stripped out, Fed policy wouldn't be all that tight.
After all, the first three-quarters of a percentage point of the current tightening
campaign merely reversed the crisis-induced easing that was put in place in
late 1998. As crisis gave way to global healing, the Fed's first move was to
return nominal interest rates to pre-crisis settings. While this "normalization"
has long been completed in nominal terms, it is far from complete in real
terms. Indeed, at 2.8%, the inflation-adjusted federal-funds rate remains well
below the pre-crisis reading of 3.3% that prevailed in mid-1997, just before
the global currency crisis began.
Moreover, the real funds rate is still shy of the 3% "neutrality" benchmark -- a
level widely presumed to impart neither accommodation nor restriction on the
economy or financial markets. In short, easy money prevails while a fully
employed U.S. economy steams ahead by nearly 5% in 2000.
In the meantime, the ever-present wealth effect remains very much an active
force in shaping the excesses on the demand side of the U.S. economy.
Notwithstanding the recent rotational frenzy from the New-Economy Nasdaq
to the Old-Economy Dow, broad equity market gauges show little sign of
faltering; as of the close on March 23, the Wilshire 5000 was still 28% above
its year-earlier level.
This points to little slackening in a wealth effect, which Fed Chairman
Greenspan estimates has been boosting U.S. GDP growth by about one
percentage point annually for the past five years. That gets to the crux of the
Fed's dilemma: The one-percentage-point wealth effect is the functional
equivalent of the growth excess for the economy at large. Barring a
spontaneous slowdown, that puts the stock market smack in the middle of the
Fed's crosshairs.
Unfortunately, there's an even darker side to this tale. The latest wave of froth
in the U.S. equity market is being driven increasingly by heightened leverage.
Margin debt (see chart) has ballooned by 45% over the four months ending
February 2000 and now stands 87% above its year-earlier level -- literally
three times the average growth pace over the 1997-99 period. This paints a
worrisome picture. Investors are going farther and farther out the risk curve --
not just by upping the ante on overvalued technology stocks but also by
borrowing at an increasingly rapid rate to finance these plays. The footprints
of speculative excess are now painfully obvious.
And yet the Fed has chosen incrementalism to counter the very excesses it
has repeatedly warned of. This could be the fatal flaw in its approach. As a
surging Treasury bond market and an inverted yield curve suggest, financial
markets are convinced that the U.S. monetary authorities will finally succeed
in pulling off the ever-elusive soft landing. Investors went to sleep on March
21 believing they were one quarter of a percentage point closer to the
Promised Land. Little wonder the equity market surged on the heels of the
expected Fed action. For financial markets, it's a delicious "win, win"
proposition. If the Fed goes too far in pulling the market and/or the economy
down, expectations will shift toward an imminent monetary easing. And on
that cue, the dip-buyers will then move back in with a vengeance and take
both the markets and the economy right back up again. The Fed is a central
part of the very problem it wishes to resolve. It's a classic moral hazard
dilemma.
Yet there is a way out. It requires a major tactical adjustment on the part of
the central bank-moving away from reliance on one blunt policy instrument
(the federal-funds rate) and embracing nontraditional remedies that are
targeted more at the excesses of the stock market and its concomitant wealth
effect. There are a number of non-traditional options the Fed has at its
disposal. At the top of my list would be an increase in margin requirements --
something the central bank hasn't done in 26 years. Other options might
include altering collateral requirements for bank lending to the securities
industry or a Fed-led regulatory assault on the speculative excesses of
day-traders.
But a move on margin lending would be the cleanest of these market-specific
options. While the Fed remains firmly on record against such an action,
arguing that it would discriminate against individual investors, the emerging
excesses of margin debt argue for a serious rethinking.
The regulators recently have applied moral suasion in asking the securities
industry to tighten up on margin lending. However, the numbers speak for
themselves: A 45% increase in margin debt over the past four months
suggests that these pleas are falling on deaf ears. Moreover, a task force set
up by the National Association of Security Dealers is leaning toward
recommending a relaxation of margin requirements on day-trading firms. Just
a nod by the Fed in raising margin requirements would put investors on notice
that this policy lever is finally back in play. It would be an unequivocally clear
warning shot to an ever-exuberant equity market.
Market intervention doesn't sit well with me. But the alternative is far less
appealing. A blunt policy instrument such as the federal-funds rate simply
won't do the trick in the New Economy. Most importantly, it won't touch
either the supply or demand for information technology -- the driving force
behind the growth dynamic of the real economy and the equity market.
Courtesy of the explosive growth in e-commerce, the largely debt-free New
Economy is basically resistant to interest rate pressures. And Nasdaq-fixated
equity investors speak for themselves.
Eventually, the blunt-instrument approach will take a toll. But it would be a
price with a painful twist. Since the New portion of the economy is unlikely to
suffer much, if at all, from prospective rate hikes, the Old Economy can be
expected to bear the brunt of the impacts. With real interest rates still in an
accommodative position, the day of reckoning for the Old Economy is not yet
at hand. But if the Fed stays its present course -- and that certainly seems to
be the message from its March 21 action -- it's only a matter of time before
the music stops. Rest assured, the Fed would probably flinch should it turn
ugly. Real interest rate targeting leaves it with little choice. Back will then
come the dip-buyers, taking the market-induced excesses of the economy to
even more inflated levels. Such are the perils of the greatest moral hazard play
of all. It's high time for a new approach -- before it's too late.
STEPHEN S. ROACH is chief economist and director of global economics at Morgan Stanley
Dean Witter.
Best Regards, Huey |
