The Fed Now Needs to Deal With the 'Crazy Uncle'
By Jim Griffin
Special to TheStreet.com
Originally posted at 10:00 AM ET 6/24/01 on RealMoney.com
The market has acted lugged down and heavy as we approach the end of the quarter. Confession season may be a partial explanation, as companies get out in front with the bad news that they won't meet previous guidance. Portfolio rebalancing and window dressing may also play roles, as volume has picked up in the last two weeks. And the macro environment is nothing to brag about. But I wonder if it's possible that there may be a new game at work already in the market. Could it be that the stock market has learned to game the Federal Open Market Committee in a manner similar to the way the bond market once dealt with Treasury refundings?
The FOMC will conclude its deliberations on Wednesday, and the betting now is that another 50 basis-point reduction in the fed funds target will be announced. If so, that will make it six this year. Until recent days, one prominent school of thought had held that the Fed would do only 25 basis points this time, in order to signal that it believes it has now done enough to be effective. But the weight of opinion has now come down on the side of 50. Why? Primarily, it seems to me, because the market remains inconsolable.
The FOMC meeting schedule is a matter of public record; everyone knows when these chin-scratching sessions are at hand. In a world in which you can't know much about the future, this schedule is a rare fixed point. In that way, it bears a similarity to the Treasury's refunding schedule. In the once and future time that the Treasury had a new load of bonds to sell to the public on a recurring basis, it so happened that bids tended to soften in the days before the auctions were held. Nothing sinister here; the market knew there was fresh supply coming and acted accordingly. Prices tended to recover as the new merchandise got distributed.
Currently, the stock market "knows" that it is a critical factor in the deliberations that take place inside the temple: The market is an important argument in the outlook. If the outlook is weak, the case for ease is strengthened. More ease and lower interest rates are known to be good for the market -- ergo, call in sick.
One of these days the macro environment will be much better and the market won't be able to fake it, but for now its watery eyes and droopy tail may tend to induce the assembled governors and presidents to put another tasty nugget in its dish.
It was not too many years ago that Federal Reserve officials never had a word to say about the stock market. It was treated like a crazy uncle -- something to be patiently tolerated. But the market has become the squeaky wheel that insists on being oiled, and the Fed now pays solicitous attention. And for good reason.
Prior to the 1990s, the lion's share (i.e., virtually all of it) of nonfederal financing activity took place through banks and thrift institutions. These were the Fed's transmission mechanism, its distribution system for getting its policies through to the economy. But tighter capital standards for banks, the rise of IRAs and defined contribution pension plans, and the booming growth of the mutual fund business has meant that the capital markets, direct and unintermediated as they are, have taken share from bank lenders. The Fed's transmission, to push the metaphor, is much less automatic than it once was; now it is a much more hands-on, high effort manual-shift affair, and one with tricky gears.
Nothing much is accomplished by revving the engine if the transmission is not engaged. If the Fed eases, but the banking system does not -- as in the "50 mph headwinds" days of the early 1990s when banks were painfully restoring their own capital -- then the economy languishes. Analogously, if the Fed eases and the capital markets do not rally, then from the perspective of the economy, the ease is more apparent than real.
John Berry, who covers the Fed beat for The Washington Post, last week reported that some Fed officials are becoming worried that the economic response to their efforts so far might be much weaker than they had expected. The reasons cited were: One, the dollar hasn't fallen, as it often has done during periods of ease; two, lower rates usually augment equity values; and three, lower short-term rates tend to bring down long-term rates. In each case, these market adjustments have been weak or nil. The medicine isn't getting through to the patient.
If this is no longer your father's financial system, then the notes from your Money and Banking 201 course are out of date, perhaps dangerously so. The Fed is confronted with new challenges for getting its intentions effectuated in the economy. After all, what good does it do you or your business if the Fed changes the rates it charges? Do you have an account at the Fed? If the banks or the markets, where most of us find our financing resources, won't follow the Fed's lead, then we -- and the rest of the economy -- get a face full of head winds.
The implication is that the Fed will ease and ease again, until it force-feeds its policy through a balky and imprecise transmission mechanism. As a result of institutional changes in the mechanisms of finance, the Fed now has to deal with the crazy uncle it once had the luxury to ignore. The "animal spirits" of the markets are key to the success of the Fed's stimulative purposes, and nothing succeeds like excess.
While some members of the FOMC have muttered that they would like not to overdo it, not to keep easing so aggressively that they set in motion conditions that later will require them frantically to reel in excess slack, they may be suffering from nostalgia for the simpler system that has been deregulated away.
I have been working in recent weeks on the postulate that we now live in an inherently more volatile financial system. This has been another iteration of the case. If the Fed is going to attempt to offset this volatility in order to stabilize the system, it's likely to have to behave in a more volatile manner itself. Tighten in 2000. Ease in 2001. Tighten again in 2002? Maybe not, but don't too lightly discount the possibility.
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