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The “Federal Reserve Miracle”?
There is a prevailing school of thought today that holds that the Federal Reserve has won the war against inflation – Mission Accomplished. This noble cause was commenced by the courageous Paul Volker, carried forward, we are to believe, to its successful conclusion by a masterful and determined Greenspan Federal Reserve. Despite powerful forces and divergent crises and systemic shocks, policymaking has been nothing short of miraculous. Well, I find such analysis absolutely ridiculous, yet curiously consistent with infamous end-of-cycle bluster that trumpeted the “Massachusetts Miracle,” the “Japanese Miracle,” the “Asian Tiger Miracle,” the “U.S. Miracle Economy,” and so forth.
I read today that we have “reached the promise land of effective price stability.” Having achieved this goal, we are now to enjoy the fruits of a more patient and accommodative central bank. But how can this be? Is “effective price stability” consistent with today’s capricious reality – is it in accord with an environment where California housing prices inflate 22% in 12 months; compatible with surging gas, energy and commodity prices; consistent with strong inflation in medical care, tuition and insurance costs? Does it make sense to talk of “effective price stability” in the ongoing tumultuous financial environment dominated by boom and bust dynamics, extraordinary volatility in currency values, and general financial instability? It does not.
My analysis leads me in a much different direction. Yes, the gutsy and principled Mr. Volker did bring the economy to its knees and, in the process, broke the back of key inflationary processes and perceptions. But following the 1987 stock market crash, the Greenspan Fed became especially mindful of the needs and desires of the financial sector and markets. Volker’s fight was forever compromised. And while the Fed did move to rein in late-eighties excesses, the genie was out of the bottle. A particular virulent strain of asset inflation, financial speculation, and leveraging was taking hold. Asset-based lending, the GSEs, and Wall Street Finance were assuming a prominent role in financial – and, therefore, economic – evolution.
The subsequent early-nineties bust, with attendant financial impairment and deflationary forces, fostered a wholesale abandonment of the Fed’s inflation focus. While the public talk of inflation vigilance was as loud as ever, the Fed’s covert intent was to ward off deflationary pressures and avoid debt collapse. Three percent Fed funds were a godsend to the fledgling leveraged speculating community in the early nineties.
For more than a decade, the Fed has alternated between accommodative monetary policy and extraordinarily accommodative. Such an environment has nurtured an historic ballooning of the global pool of speculative finance. In the process, unprecedented liquidity has played a pivotal role in financing massive global investment in manufacturing capacity. This “globalization,” along with similarly historic technology developments and industry super-boom, profoundly impacted the underlying structure of global economies. Goods supply and demand relationships were altered immeasurably, and in the process the structure of economies and inflationary manifestations were changed as well. Inflationary forces found a home in the U.S. Service sector – with atypical and undiscerning manifestations. Inflationary psychology was remade, especially with the recognition that greatest gains potential existed in financial asset markets. It was not a case of winning the war of inflation, as much as it was hastening its transformation.
I have written on and on about how the Fed’s response to the early-nineties banking system impairment incited the 1992/93 bond (and Mexican) Bubble. And how the Mexican collapse and hedge fund deleveraging – and the aggressive subsequent Mexican bailout and GSE expansion - impelled the SE Asian/emerging markets Bubbles, leveraged speculating Bubbles, Wall Street Finance, and risk-taking generally. The Fed’s aggressive response to the Russian and LTCM collapses then inflamed parabolic excess encompassing the telecom debt/technology/stock market Bubbles. By that time, Bubble dynamics were so dangerous and conspicuous that the Greenspan Fed felt compelled to forewarn the markets of the inevitable tech/stock market bust – and its planned response. This was an historic policy blunder, as technology and the stock market were only off-shoots of the greater Credit Bubble – that the Fed was poised to hyper-accommodate and was happy to telegraph as much.
Knowing how the Fed would respond, the entire global speculator community was keen to play the collapse in U.S. yields, thus provoking the blow-off stage of King Dollar excess. And while massive liquidity flowed into agency and mortgage securities, the gross dimensions of previous excess proved too much for the fragile corporate bond market. An unfolding corporate debt collapse was beginning to impact markets in consumer debt obligations. The Fed, mumbling about deflation risks, stooped to unprecedented accommodation, provoking the blow-off stage of the great U.S. Mortgage Finance Bubble and a virulent global reflation.
As bad as things were in 2002 – with a faltering U.S. Bubble Economy and Acute Financial Fragility - the Fed had one major “asset” working in its favor: an enormous and robust leveraged speculating community (it had nurtured for a decade) unlike anything the financial world had ever experienced. The speculators were keen to play the Fed largesse game and only lacked clear instructions. They were forthcoming.
This was really an anomalous situation and certainly not obvious. Yet, despite the huge technology/stock market bust, extreme Fed accommodation had generated extraordinary profits throughout the Treasury/agency/MBS marketplace (as I wrote above, stocks/tech were almost a sideshow in comparison what was transpiring throughout U.S. debt markets). Moreover, the nature of market dynamics (the proliferation of hedge funds, derivatives, proprietary trading, “market neutral” strategies, etc.) provided the Fed the powerful capacity to dictate major market developments. This was accomplished by the relatively simple mechanism of inciting the reversal of bearish trades, and the Fed took full advantage. As I have written previously, with determined talk of “printing presses,” “helicopter money,” “unconventional” and reflationary measures, virtually overnight market participants were impelled to cover their shorts in, say, tech stocks, Ford debt, junk bonds and Credit default swaps, and go long. More buying power was unleashed as hedges against systemic risk were unwound. It was a spectacular case of “Reflation on Demand.”
I would imagine that even the Fed was surprised by the ease with which reflationary forces were set in motion. Again, never before had such a massive pool of global speculative capital existed. What’s more, the Fed’s accommodation of truly egregious Credit and speculative excess was enough to depose King Dollar. And in another anomaly of contemporary Global Wildcat Finance, a major decline in the dollar had absolutely no restraining affect on U.S. Credit and speculative excess. Indeed, the entire global financial system was quickly acclimatized to reflationary forces. Especially throughout Asia, the massive dollar flows (unprecedented current account deficits along with a major reversal of speculative flows) were quickly accommodated by ballooning central bank dollar holdings. The Great Reflation “Trade” has been something truly amazing to have witnessed, and it will certainly be the subject of considerable study and debate for decades to come.
There are myriad problems associated with central bankers using speculative finance as the key monetary transmission mechanism. For one, in certain circumstances it can work all too well. Inciting speculation and leveraging will foster asset inflation, liquidity excess, and only greater speculation, inflation and excess. Markets boom, spending booms, and profits boom. Speculators, investors, businessmen, bankers, consumers, politicians and central bankers then think and do silly thing. The Fed took a massive and increasingly unwieldy global leveraged speculating community and gorged it with the steroid of easy gains. And despite the conspicuousness of a major ensuing domestic and global reflation, the Fed stuck with the steroid i.v. (intravenous). Things got completely out of hand.
First, major speculative flows to non-dollar assets set in motion booming global debt and equity markets, as well as inciting a bull market in commodities. The Great U.S. Credit Bubble Went Global. A global collapse in yields and unprecedented liquidity created a wall of speculative finance hankering to play the China and Asia booms (markets with the strongest inflationary biases). Here at home, financial speculation and leveraging went to only greater extremes. Throughout mortgage finance (the sector with the strongest inflationary bias), unbelievable excesses ran uncontrolled. An historic buyers panic and inflation in California housing (and elsewhere) adds only greater risk to a fragile financial system and imbalanced Bubble economy. Surging global energy and commodities prices are rapidly altering inflationary psychology. And the powerful China boom, fueled by virulent Global Wildcat Finance as well as domestic lending excess, has become increasingly destabilizing for China, Asia, and for many global markets.
Well, a particular problem with leveraged speculative finance as a key monetary transmission mechanism is that it does come to an end. At some point, as we are seeing these days, inflationary manifestations are transformed from the seeming benign to the abruptly problematic. In many markets, prices rise to unsustainable levels. Bond players get nervous, and begin to reduce leverage at the margin. A few players in various markets will move to be the first to the exits. And, importantly, when markets turn vulnerable, the enterprising speculator may this time decide to reverse his long position and go short.
Abruptly, market dynamics have changed. And as much as authorities would wish to control the process, they struggle with the late-stage reflation reality of wildly divergent pricing environments, erratic market behaviors and disparate economic impacts. Always with aggressive leveraged speculation, there is a very fine line between runaway boom and unmanageable bust.
It appears today that the Great Reflation Trade is sputtering, perhaps badly. We’ve witnessed various market convulsions. Currencies markets turned tumultuous, with a modest dollar rally nonetheless inflicting punishment upon exposed traders and derivative hedgers. Over the past several weeks, bond yields have moved sharply higher – another bout of painful market discipline. Some key commodity prices have turned down over the past couple of weeks. And this week, the speculators have been hurt – and the general environment destabilized - by sinking stock prices and losses in emerging debt markets. A combination of (“reflation”) trades that had been so neat and profitable for months has all the sudden turned into a losing proposition. We could now be in an inhospitable circumstance where selling in one market leads to lower prices, speculative losses, angst and liquidations in other markets. Greed has turned to fear.
What appeared not all too many weeks ago a brilliant global reflation sanctioned by the Federal Reserve, Asian central bankers, and Chinese authorities, is all the sudden looking a lot less clever. What made the reflation trade so “great” was that everyone was on board – all aggressive long. Today, it appears that there has been an important breaking of the ranks. To what extent players within the massive speculating community will scurry to take profits, hedge myriad risks, and deleverage, will play a critical role in determining the longevity of what has been in the neighborhood of 18 months of extraordinary global liquidity excess.
And let’s return to the issue of “effective price stability.” Well, my analytical framework leads me to expect that we have now entered a period of Extraordinary Price Instability. The Great Reflation Trade appears in trouble, and if the nervous crowd rushes to the exit, we could have some serious financial convulsions in various markets. If the crowd is determined to stick with the Reflation Trade, there will be only less intense convulsions. It’s an enormous crowd and the Fed enticed them to use enormous amounts of leverage.
Yet, I will for now assume that it will take some time for booming economies to cool down. In the past, when commercial lending and the corporate and junk bond markets played a major role in financing the real economy, it was not an extended period between the arrival of faltering markets and reduced debt growth. Today appears different. Mortgage and government debt are financing the latest unsound boom, and I would today expect that it will require major financial tumult to severely restrain these powerful Monetary Processes. But this is not really good news. Booming real demand may likely further tax various markets and foster further price instability. Central bankers – heads moving as if watching a ping-pong match – will nervously contemplate the appropriate policy stance for tumultuous and acutely fragile financial markets, on one side, and unwieldy boom-time economies and pricing pressures, on the other. For those over-anxious to celebrate some type of Fed “victory,” well, I would hold off for now. The real war could begin anytime now.
I fully expect financial and economic crisis to leave the Greenspan Fed and its New Age Notions of Central Banking fully discredited. In stark contrast, I could not be more impressed with what the ECB has created and what they are accomplishing – adept, disciplined and professional central banking. They provide a model of what we can hope for from a post-Greenspan Fed.
ECB Chief Economist Otmar Issing spoke on the subject of monetary policy this week at a symposium sponsored by the Federal Reserve Bank of Chicago. After listening to a recording of his talk, I thought a significant excerpt was appropriate. Once again, Dr. Issing illuminates the current extraordinary contrast between the sound and well-grounded framework and analysis adopted by the ECB and the inconsistent, improvised and imprudent guesswork expressed by our Federal Reserve.
From Dr. Issing: “In confirming the quantitative definition of price stability, the governing council made it clear that – over the medium term – its monetary policy would seek to achieve an inflation rate of below but close to 2%. This takes all the factors sufficiently into account, which would require to aim at a small positive inflation rate. In view of the uncertainties mentioned at the beginning, the strategy had to provide a sound and systematic framework for conducting internal analysis and decision making. This framework was also needed as a basis of how to communicate our decisions to the public. A price stability oriented policy must always take account of the nature and size of economic shocks from which risks to price stability can emerge, and how these shocks affect the expectations of economic agents. This requires a comprehensive and systematic use of all relevant information based on a diverse set of indicators and models.
“In this vein, the Governing Council’s strategy review confirms that its assessment of risk to price stability encompasses two complimentary prespectives, an economic and a monetary analysis which has become known as the two pillars of the ECB strategy. The economic analysis focuses mainly on the assessment of current economic and financial developments from the perspective of the interplay between supply and demand in the goods, services, and factor markets. In this respect, the macro economic projections serve to structure and synthesize a large amount of economic data. Despite this, they cannot be regarded as an all-encompassing tool for the conduct of monetary policy. The monetary analysis serves as a means of cross-checking from the medium to long-term perspective - the short-to-medium term indications coming from the economic analysis.
“In October 1998, the Governing Council assigned a prominent role to money, in recognition of the fact that in the medium-to-long-run monetary growth and inflation are closely related. This provided with key information for a time horizon stretching beyond those usually adopted for the construction of central bank inflation projections. The prominent role for money in the ECB’s strategy is signaled by the announcement of a reference value for monetary growth. Monetary analysis, however, inside a comprehensive analysis of the liquidity situation, goes far beyond an assessment of monetary growth in relation to the reference value.
“For good reasons, the ECB has chosen a strategy which does not focus exclusively on either a single indicator or a single analytical tool, be it money or an inflation forecast. By contrast, the strategy offers an appropriate means of bringing together different analytical perspectives and of using all the information relevant to decision-making in a systematic way. The advantages of this approach are increasingly being recognized not least from the perspective of the relationship between monetary and credit developments and asset prices.
“The appropriateness of inflation-targeting strategies has especially come under scrutiny in the context of the share price booms witnessed in the nineties, the subsequent collapse and the effects that this had on the financial system. If financial imbalances accumulate and there is for example a sharp, broadly-based increase in asset prices, there is little sense in continuing to pursue an inflation forecast of consumer prices over a horizon of one to two years. In such circumstances, it may instead be advisable to set interest rates to a view of a time-frame extending well beyond conventional forecast horizons – that is in the face of substantial uncertainty about the sustainability of asset price movements.
“With its medium-term orientation, the ECB pays due attention to the need to take into account the entire horizon over which monetary policy impacts the state of the economy. Here, the preemptive role of the monetary analysis has also been acknowledged. Growth rates of money and credit which are persistently in excess of those needed to sustain economic growth at non-inflationary levels may, under certain circumstances, provide early information on emerging financial instability. Such information is of relevance for monetary policy because the emergence of asset price bubbles could have a destabilizing affect on activity and, ultimately, prices in the medium to longer-term.
“The Maastricht Treaty assigned to the Euro system the unambiguous responsibility for the maintenance of price stability. And it has granted the ECB full political independence in pursuing this goal. The independence of the ECB and the need for transparency and accountability go hand in hand. Given its European mandate and independent status, the ECB is accountable to the European public and its elected representatives for the fulfillment of its mandate. This requires transparency in all the areas relevant for the fulfillment of the mandate and the willingness to convey in a systematic and consistent way to the public all information relevant to its decision-making. Transparency is also crucial for the effectiveness and success of the ECB’s monetary policy. It should contribute to anchor inflation expectations and minimize expectation errors about policy responses on the part of financial markets and the wider public. For these purposes, the monetary policy strategy has been a key device. It clearly specifies how the ECB’s policy objective is to be understood, and it provides a clear and coherent framework to structure information and the decision-making process internally and explain it to the public externally…to avoid misunderstandings and expectation errors, it has been a particular challenge to send clear and coherent messages to the markets and the wider public, and to strive towards clarity in our communications through a consistent use of language over time.”
“In line with the medium-term orientation of the ECB’s monetary policy, interest-rate adjustments in response to economic shocks have generally been made gradually, thereby avoiding frequent shifts in the ECB’s policy stance. This non-activist policy has contributed strongly to stabilizing medium-term interest-rate expectations at the level appropriate to the circumstances. It has also ensured that, in the face of strong share price fluctuations resulting from the international new economy of euphoria and the subsequent disillusionment, monetary policy has not itself become a source of destabilizing expectations. This has helped to anchor long-term inflation expectations at levels consistent with price stability.”
Also this week, ECB President Jean-Claude Trichet spoke before the Economic Club of New York, with a presentation titled “Issues in Monetary Policy: Views from the ECB.” I hope from my excerpts readers can further appreciate the ECB’s exceptional analytical framework.
From Dr. Trichet: “I intend to focus my remarks on the challenges of executing monetary policy in such a rapidly changing world. A world in which high-speed structural change – whether spurred by spontaneous economic forces or institutional evolution – may put time-tested economic models at risk, and defy policy-makers’ search for easy policy recipes…
"The task of policy-makers is further complicated if they suspect that customary cyclical movements are compounded by an ongoing change in the deep structure of the economy…in case a structural change is truly under way, macroeconomic relationships derived from empirical regularities and historical averages are bound to lose significance. A new set of relationships would need to be estimated and tested…
"On this side of the Atlantic, the policy debate has primarily focused on technological innovation, the spread of information technology, and globalisation. Many distinguished analysts have identified in the combination of these three dynamic factors the main structural force behind the reduction in economic frictions and the narrowing of the ability of any single market player to influence prices and dictate market conditions domestically…
"Faced by an environment characterized by an exceptional measure of uncertainty, the ECB identified three principles for an efficient monetary governance. These three principles, stability, comprehensiveness, and transparency have been incorporated in the monetary policy concept that has guided our course since 1999.
"There is, today, a general recognition that price stability is highly desirable from an economic standpoint. It preserves an environment conducive to the optimization of resource allocation and therefore permits to foster sustainable growth and job creation. There are several other reasons why price stability is a public good of great value: In particular, preserving the purchasing power of the citizens, including the most vulnerable, and preserving the correct functioning of the democratic institutions. In a world of accelerated changes, the concept of stability is even more of the essence. The central bank has responsibility to be an anchor of stability, price stability being the ultimate goal and one of the preconditions for financial stability.
"Second, immunizing monetary policy against short-termism by solidly anchoring it on a medium-term perspective. Constantly bombarded by economic news, a central bank risks being swamped by the latest indicator and by its conjectures concerning markets’ likely reaction to the latest indicator. This mechanism can lead monetary policy gradually astray from its foremost role of providing a firm medium-term anchor for the economy. The ECB has built into its strategy a mechanism against short-termism by adopting a “keeping its composure” approach to countering shocks…
"Sometimes, notably if there is suspicion that asset prices are moving substantially up or down, it pays to look even very far ahead, beyond the average lag of monetary transmission…In all events, the central bank has to preserve its credibility, ensuring that expectations remain consistent with its declared policy objective.
"From the beginning, the ECB felt the need to endow itself with a conceptual framework that could help it sort through a wealth of conflicting statistics, and organize the various pieces into a reliable road map for internal analysis and communication with the public. This called for the adoption of a framework that concentrated more on picturing the economy as a large, complex and permanently evolving system, rather than trying to condense this complexity into too simple summary statistics and models.
"There are, therefore, merits in cross-checking the indications for the monetary stance that emanate from the shorter-term “economic analysis” with those stemming from the monetary analysis. Monetary analysis constantly reminds the central bank of the fundamental principle that, while responding to economic developments as they unfold, it must never lose sight of the fact that, over sufficiently extended horizons, the rate of money growth must be consistent with its price stability objective…
"Especially in the face of substantial uncertainty about the sustainability of asset-price developments, it may instead be advisable to set interest rates with a view to a time frame extending well beyond conventional forecast horizons.
"More generally, the existence of uncertainty requires central banks to put strong emphasis on the robustness of their decisions, which implies that a good monetary policy strategy needs to perform as well as possible across a variety of empirically plausible models and scenarios. And it is in particular our view that the complexity with which monetary policy-makers are faced with should be presented to the public in a transparent manner…
"There are many challenges that central bankers face in relation to the links between monetary policy and asset prices. To name a few: Should central banks react to asset-price movements? How to identify the insurgence of dis-equilibrium in asset prices when the equilibrium level is unknown? How to avoid a moral hazard problem? How to communicate with the public in case of asset-price bubbles?
"First of all, the overriding objective of price stability, which monetary policy should be geared to, makes clear that asset prices cannot be a target for a central bank…
"In addition, it is widely recognised that the central bank’s focus on the overriding objective of price stability helps to reduce investors’ misperceptions about future return possibilities and alleviates the problem of asymmetric information between borrowers and lenders. At the very least, even though price stability cannot guarantee financial stability in all circumstances, it is clear that the absence of price stability would only exacerbate the problems associated with asset-price misalignments…
"Movements in asset prices that astray from their fundamental value, so-called asset-price bubbles, pose specific and additional challenges for monetary policy. The first – and already very big – challenge is to detect in real time whether a bubble is developing.
"This does not mean that a central bank is left all by itself in the face of major asset price movements. For example, some simple measures for identifying overly optimistic expectations in the valuation of stocks seem to have been reliable indicators on quite a few occasions in the past.
"Moreover, apart from significant deviations of asset prices from past trends or from model-based predictions, it appears that it is also useful to look at developments in credit and monetary variables in order to identify bubble phenomena in real time. In this respect, we have gathered some evidence that growth rates of money and credit which are persistently in excess of those needed to sustain economic growth at non-inflationary levels may, under certain circumstances, provide early information on emerging financial imbalances. Incidentally, this is another important argument for devoting systematic attention in our analysis to the monitoring of money and credit developments in our monetary policy strategy. Finally, careful analysis of the balance sheets of the different sectors of the economy may also be able to provide early signals regarding the formation of bubble phenomena and financial imbalances in real time…
"It is often argued that a central bank in such circumstances should carefully tighten its monetary policy at an early stage in order to suppress the bubble process before it escalates to disproportionate dimensions. If a bubble exists, a somewhat tighter policy along the build-up phase – so the argument goes – may help to avoid that even larger imbalances may develop down the road.
"However, a bold opposite view has also found some supporters among economists. This alternative policy option would tend to suggest that, due to the rather long lags in the operation of monetary policy impulses, the central bank should consider loosening – rather than tightening – its policy in anticipation of the bubble collapse. This would cushion the negative effects of the expected economic downturn in a forward-looking manner. There is a very strong argument against this policy option because, when a bubble process emerges, it is then almost impossible for the central bank to predict the timing of the turnaround in asset prices. And if the central bank cannot be sure that the bubble will burst of its own accord, a loosening of policy will further strengthen the bubble process.
"But the dilemma – where not only the measure of misalignments, but also the sign of the monetary policy response to it is somewhat controversial – exemplifies the amplitude of the policy dilemma.
"If and when the bubble bursts, there is a dimension of strategic interaction that a prudent policymaker cannot ignore. This offers a rather strong argument in favour of symmetry in the central bank’s behaviour in boom and bust periods. If a central bank were to react in an asymmetric manner, namely only with looser policy at times of asset price busts but not with tighter policy when asset price bubbles emerge, the central bank may create through its own behaviour a moral hazard problem among market participants. It is crucial for a central bank to avoid this, since a perception that it insures investors against the risk of large losses could easily contribute to the formation of new bubbles in the future…”
Good stuff! |
