Friday, February 29, 2008

What About Inflation and the Dollar?

Paul Volcker, former Chairman of the Federal Reserve System, has written that “a nation’s exchange rate is the single most important price in its economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity.” (Paul Volcker and Toyoo Gyohten, Changing Fortunes, Times Books, New York, 1992, page 232.) If “a nation’s exchange rate is the single most important price in its economy” one really has to be concerned that the United States has allowed the value of the dollar to decline so precipitously over the past six years or so. Volcker alludes to all kinds of things that can happen to the nation that lets its exchange rate decline, but he doesn’t even mention one other possibility, a situation that has arisen since he wrote the quotation presented above, and that is the situation, like the one that has arisen, in which a country’s assets become so cheap that foreign interests can acquire them at historically low prices.

It is important to see just how badly the United States Dollar has declined in value to get some appreciation for the problem. From the year 2001 through the year 2007, the Dollar has declined at a compound rate of over 7% per year to the Euro. In terms of the British Pound, the Dollar has declined at a compound rate of over 5.5% per year. The same is true of an index of major currencies against the Dollar as compiled by the Federal Reserve System. An index that includes a broader range of currencies produced by the Federal Reserve shows a more moderate rate of decline of about 3.3% per year. However you measure it, though, the United States Dollar has not fared well in world markets during much of the Bush Administration.

These market results are important because they indicate how world financial markets are betting on relative rates of inflation in the different countries. If one works with what is called the Purchasing Power Parity (PPP) Theory for exchange rates in its pure form, one can argue that the change in any nation’s currency against the currency of another nation can be represented by the difference in the expected rates of inflation between the two countries. In this were the case, it could be argued that the difference in expected rates of inflation between the United States and England is in excess of 5.5 percentage points. That is, whatever the market expects the rate of inflation to be in England, they expect the rate of inflation in the United States to be 550 basis points higher.

Since the PPP Theory does not work exactly, we cannot just extrapolate the figures presented above and apply them to differences in expected rates of inflation. However, we don’t need to do this. We can just argue that the differences presented above provide some ballpark ‘guesstimate of anticipated relative rates of inflation. If one argues in this way, the conclusion can be drawn that, whatever the real estimates are, participants in world markets believe that inflation in the United States is much worse than it is in other countries or areas in the world. If the differences were just 1% to say 1.5%, it could be argued that the differences were non-existent or too small to worry about since the PPP Theory was not exact. However, at the magnitudes that have existed over the past six years, the differences, I believe, cannot be ignored. Market participants believe that inflation is expected to be much worse in the United States than it is in other areas of the world! The only country that is not listening to this is the United States.

Why is this happening to the value of the United States Dollar?

Let’s step back for a minute. At one time it was assumed that the United States government could run any kind of economic policy that it wanted and not have to pay for it to any degree in world financial markets. The reason for this was that the United States was a ‘big’ country and was not subject to the same pressures that ‘small’ countries were. Much of International Macroeconomic Theory relates to ‘small’ countries, but theorists and practioners, historically, have generally argued that because of its dominating size, the United States could act in a way that the ‘small’ countries of the would could not. They could get by doing what they wanted to do without much regard to international financial markets.

What happens to the ‘small’ countries when they try and do this? Well, they were kept in hand by that amorphous, unidentifiable, shady group of people called ‘international bankers’. If a ‘small’ country conducted its fiscal policy in a way that ran substantial deficits (for that county) and did not have an independent central bank, thereby increasing the possibility that the inflation rate in the country would rise, these ‘international bankers’ would sell the currency of that country in the foreign exchange markets, the foreign exchange rate would decline and the government would have to back track and reduce or eliminate the deficit and make its central bank independent of the national government.

The argument was put forward that this clandestine band of ‘international bankers’ usurped the sovereignty of nations so that the nations could no longer run their own economic policies. During this time we saw leaders, like Francois Mitterrand of France, a militant socialist, back off from combating the ‘international bankers’. They made their central banks independent of the government and began to conduct a more conservative fiscal policy. For example, Mitterrand freed the central bank of France making it independent of the national government. And, in the 1990s and the early 2000s, many other nations followed suit, making their central banks independent and mandating inflation targets for the conduct of monetary policy. But, these were all ‘small’ countries.

Now we come to the United States. After balancing the Federal budget, the United States Government, under the leadership of President George W. Bush, created massive Federal deficits through the implementation of major tax cuts and the expenses related to fighting a foreign war. In addition, the Federal Reserve System, led by Alan Greenspan, acted as a complacent component of the Federal Government and kept its target for the Federal Funds rate below 2% for over two years and at 1% for approximately a year during this time. In the past, the United States government could ignore the ‘international bankers.’ No more!
Just like any ‘small’ country in a similar situation, the international bankers’ began to sell Dollars and continued to sell them as the large deficits persisted. Yet, the Federal Reserve remained seemed to ignore the decline. The result? The United States does not seem to be a ‘large’ country anymore! Globalization has come back to hit the United States!

Still the price indices produced in the United States do not reflect this perceived inflation…at least up to this time. But, there are those that believe these price indices understate the true rate of inflation. See, for example, the perceptive article “Inflation May Be Worse Than We Think” by David Ranson of H. C. Wainwright & Co.: Furthermore, we see in the commodity markets that wheat, oil and gold have all hit new highs. And, the Euro rose above $1.50 for the first time. Maybe the United States needs to put aside ideology and listen to what the market is telling us.

And, there is one piece of anecdotal evidence that maybe needs to be mentioned. In the early 1920s, John Maynard Keynes wrote about the ‘profit inflation’ that existed in England. This was a situation where profits had risen but the real wages of the worker had not. He was concerned with the restlessness in the country that had arisen due to the resulting redistribution of incomes. What I would like to point out is that all of the major candidates campaigning to become the Democratic nominee for President of the United States have taken a more and more populist position on economic policy as the campaign has progressed. Ohio is a prime example of how this message has resonated with a fairly large portion of the population. The question therefore is…has inflation really been a problem for the United States over the past several years? The magnitude of this inflation has not yet surfaced in the statistics, but it may have been experienced and felt by participants in the financial markets and by workers and by households.

Thursday, February 28, 2008

More Concern over Sovereign Wealth Funds

The United States is concerned over the investments of Sovereign Wealth Funds in the United States. (See my post of February 26, “Bad Policies Eventually Catch Up With You.”) We now learn that the European Union is looking into voluntary codes of behavior for Sovereign Wealth Funds who invest in European companies. (See the February 28 article in the Wall Street Journal:

Yes, the problem is now being recognized, but the bull has already been released into the china store. The question is “Will these funds voluntarily behave over time or will nations have to legislate how Sovereign Wealth Funds should behave, and thereby put up barriers to free and open global trade?“ The Wall Street Journal article says that “Germany said yesterday it would push ahead with its own legislation aimed at shielding companies from unwanted foreign takeovers.” The United States has prevented some investment into areas that are related to national security. These may seem to be minor efforts, but once begun they can always be used as examples to push legislation a little further and then even a little further.

There is one important question and one fact that needs to be assessed relative to the situation the United States now finds itself in. The question is: “If globalization is good for our expansion throughout the world shouldn’t globalization be allowed to return to our shores with the expansion of other countries into the United States?” The fact is: the United States is now a ‘small country’ in terms of economics and finance and cannot just follow any fiscal or monetary path that it desires. Other sizeable countries in the world learned this about themselves in the 1980s and 1990s. The United States is learning this right now!

Tuesday, February 26, 2008

Bad Policies Eventually Catch Up With You!

There were the headlines, right on the front of the February 26 Wall Street Journal: “U. S. Pushes Sovereign Funds to Open to Outside Scrutiny.” We are told that “Seeking to head off a political backlash against huge investments in Western companies by Asian and Middle Eastern government-run investment funds, the U. S. is prodding two of the biggest funds to embrace a set of promises that they won’t use their wealth for political advantage.” The request: Please don’t act in your own interest.

The economic policy of the previous seven years, the Bush/Greenspan version, has come home to haunt us and the U. S. is now pleading with offshore interests to “be gentle with us.” The monetary and fiscal policies of the past seven years have resulted in an almost constant decline in the value of the U. S. dollar. American assets have never been available at such cheap prices and, due to other policies, such as those related to energy, offshore interests have the wealth to scoop up these assets. Furthermore, the same governmental policies that resulted in the weak dollar also helped to underwrite inflationary financial relationships. As a result, not only is the dollar weak, but many of our major institutions are weak so that they ‘need’ the infusion of funds from offshore to keep them healthy.

It is interesting to hear the candidates running for President of the United States talk about all that they are going to do economically when they are elected. Much of what they are promising, I believe, will have to be put on the shelf for a later time until some balance is restored to our basic monetary and fiscal policies.

Monday, February 25, 2008

The Solvency Issue

Something new seems to be happening in this current period of financial dislocation. It appears to me that banks and other financial institutions are responding to their portfolio problems more rapidly this time around than they did in the past. If this is true, in my estimation it is all to the good! The reaction may result in a sharper reduction in lending in the short run than would occur otherwise, but it will mean that the system will be moving onto the future more quickly. Within such a scenario, the concern is that if all adjustment takes place at relatively the same time, financial markets could be overwhelmed. I am not expecting this…just pointing out the downside concern.

In the past, banks and other financial institutions have responded relatively slowly to problems in their portfolios primarily because many of the problems occurred in loans and other debt arrangements that were just between the banks and their customers. The assets under consideration were not market related. In the present case, many, if not most, of the financial assets that are having problems are market related. That is they are securities connected with subprime loans, collateralized debt obligations (CDOs) and structured investment vehicles (SIVs) among other things. In most cases the institutions holding these assets did not originate them but in some way acquired them from a third party.

Why does this make a difference? Loans and other debt relationships that are directly made between two parties and where the lender holds the paper on their balance sheet as an asset generally have no ‘market’ in which the asset can be traded and a value can be determined. Since the relationship is a direct one, when the borrower runs into some kind of operational difficulty in which the terms of the loan cannot be fully met, the lender and the borrower attempt to work things out. Lenders are not under a great deal of pressure to ‘pull the plug’ on the relationship and admit that the asset on the books may be overvalued. In fact, the tendency is for borrowers to take an optimistic view of things and believe that things will work themselves out. Thus, it may take a sometime before the seriousness of the situation to be recognized and accepted. Of course, the examination of assets by regulators or accountants may speed this process along but this only takes place with a lag.

In an environment like the one just described the truth about a portfolio comes out slowly and charge offs may only come in bits-and-pieces over an extended period of time. In situations like this, Presidents and CEOs remain in place as do their management teams with the hope that everyone on board will be able to ride out the storm. But, when management stays in place there is not much incentive to change the way things are done. The status quo is maintained. Keeping things in place and hoping that the assets will begin to perform is the norm.

If things continue to go bad for the institution, eventually the organization will be acquired or a new leader will be retained to do a ‘turnaround.’ The good thing about a turnaround is that by bringing in someone entirely new, there will be no investment in what had previously been done. The goal of the person brought in to execute the turnaround is to get rid of all that is bad, bring in capable new people, scale back to what might be called the basic franchise, and then execute a new game plan built upon solid fundamentals. Since the turnaround person has nothing vested in the old way the company had been run, he or she pretty well can do what is required to change the organization. This is my experience in the three (successful) turnaround situations I have led.

These kinds of turnarounds are usually done with the same ownership. Of course, there are vehicles that have become more important in recent years that can perhaps ‘save’ an institution earlier in the firm’s downward cycle. Although these have not been used frequently with banks or other financial institutions, their methodology is instructive. These are the hedge funds or buyout funds that specialize in buying companies that are not using their basic franchise as well as they could in order to redirect them…and, in the process, make a lot of money. Whereas the turnaround specialist brought in by a troubled Board of Directors does not have the ownership control, the private equity fund or the hedge fund that buys a distressed company has absolute control. They can do what they want…change management, sell assets, close operations, restructure, and so forth. And, the organizations can do these things rapidly because they own the place and there are no governance issues that have to be dealt with.

In the current situation we have seen a much quicker response to asset difficulties in banks and other financial institutions. The reason being that the assets in question have not been originated by the organization that is holding them and there has been some kind of market in which the assets have been traded. The consequence of this, in my view, is that managements have had to recognize earlier than before the problems being experienced in these asset categories and have had to act more quickly. The result has been that the difficulties being experienced by these organizations have surfaced much earlier in the cycle that they have in the past.

In addition, Boards of Directors have not been as passive as they have been historically. The information concerning charge offs have gotten into the press earlier than ever before and the magnitude of the charge offs have made for sensational headlines. Boards could not sit idly by. They, too, had to act and the actions they took were to remove the person in charge of the organization, the CEO. I don’t believe that we have ever seen so many top executives of important companies relieved of their position in such a short time as we have seen over the past three months or so. And, in my opinion…this is good!

There is also a cumulative effect at work in this process. This is because it is easier to do something when many others are doing the same thing. It is easier to recognize losses in asset portfolios if almost everyone else is also recognizing losses. It is easier to be severe in finding losses if almost everyone else is also being severe in their judgments. It is easier for a board to remove its CEO if other boards are removing their CEO. It is easier to make major changes and restructurings as the new CEO if other CEOs are doing the same thing. Of course, one of the dangers in ‘herd’ mentality is that the ‘herd’ will go too far in the direction in which it is heading. Right now, I don’t see this happening.

What does this mean for the current situation? From my experience recognizing and disclosing problems earlier rather than later is a good thing. In a troubled time, it is good to be relatively severe in the analysis of the value of your portfolio. It is also good to replace those that have a vested interest in the current portfolio with people that do not have a vested interest in it. And, it is a good thing to restructure an organization, returning it to its basic franchise so that it can focus on what it does best. To me, the economy goes through more pain for a longer period of time if people are slow to accept that they have problems, move only slowly to correct the problems, and fail to get back to the basics of their business and proceed into the future on a sound fundamental basis. It seems to me that this time we are moving through this stage of the cycle more rapidly than before.

The assets of concern have caused people to address things earlier in this phase of the economic cycle than in the past, but these assets have some problems of their own that are creating other difficulties. One problem of major concern is how to determine the value of the securities in question. The securities themselves are very complex instruments, which mean that there are only a limited number of people that fully understand them. Also, the markets in which these securities are traded are not very active so that prices are not very reliable measures of value. An additional uncertainty is that it has not always been easy to identify the originator of the assets backing the security thereby limiting the ability of either the original borrowers or the ultimate holders of the asset to resolve problems. How these problems will be resolved is uncertain at this time. Stay tuned!

Wednesday, February 20, 2008

Consumer Prices

The figures just released show that the Consumer Price Index rose by 4.3% in the year ended January 2008. The rate of increase in the core inflation rate, the CPI excluding increases in the cost of food and gasoline, rose at an annual rate of 2.5%.

This latter figure is above "the comfort zone of the Federal Reserve" which has been said to be 2.0%.

Two thoughts: first, the Fed is in the space labeled "Damned if you do...damned if you don't!"; and second, the 2.5% rate of increase is only slightly higher that the longer run expectation of the market on inflation.

The Fed has had to deal with financial market dislocation and the fear of a recession. It also has the falling value of the dollar to deal with. What is the Fed to do? Lower rates to combat the problems in financial markets lessen the impact of a recession or raise rates, hopefully slow down inflation and support the value of the dollar. Oh, and there is an election coming up this year...but there is no incumbent running. Can't win?

As reported yesterday, the market's estimation of inflationary expectation is around 2.3% over the longer run. Thus, the 2.5% posted is not that far out of line with market expectations. The question must be...with this new information will market expectations for inflation be revised. Question weak is the economy and how weak will it become? What are your expectations?

Tuesday, February 19, 2008

Market evaluation of Inflationary Expectations and Credit Risks

With all that has been happening in the financial markets over the past six months or so, it is worthwhile to check in from time-to-time to see what is happening to market expectations of inflationary expectations and credit risk. During this time the Federal Reserve has substantially lowered its target for the Federal Funds rate and has provided liquidity to the banking system in order to contain a liquidity crisis in world financial markets and perhaps to lessen the magnitude of any economic slowdown that might be forthcoming.

The growth of aggregate monetary and reserve statistics has remained steady. The narrow measure of the money stock (M1) continues to decline by about 0.5% year-over-year and the broader measure (M2) continues to rise at about 6.0% year-over-year. Total reserves in the banking system also continue to decline through January, 2008 at a 0.9% rate, year-over-year. This latter decline reflects the outflow of funds from transactions accounts (reflected in the decline in the narrow measure of the money stock) into time and savings accounts (that are still within the definition of the broader measure of the money stock). So, not much has changed even with all the other things going on in the financial markets.

In terms of expected inflation, little has changed over this time period. The measurement I am using is the difference between the rate on 10-yer US Treasury constant maturity bonds and the rate on 10-year inflation indexed bonds. In August, 2007, inflationary expectations were approximately 225 basis points and toward the middle of February, 2008, inflationary expectations were approximately 230 basis points. The average over this time period was roughly 230 basis points. Thus, even though the Federal Reserve has, arguably, loosened up, the market has not translated the Feds actions as worsening the possibility that inflation will rise in the foreseeable future.

There has been a shift in attitudes toward credit risk over this time period. In August and September 2007 the difference between Moody’s Baa and Aaa bond yields averaged around 85 basis points. In November 2007 this spread started to rise and reached about 120 basis points in January 2008. In the middle of February 2008, the difference has averaged around 130 basis points. Market participants have become more concerned with credit risk over the past six months and this attitude has been built into current yield spreads.

Conclusions: Market participants are not concerned that the recent actions of the Federal Reserve will have much long term impact on the rate of inflation; however, they are increasingly concerned about the credit crisis and the solvency issue.

Monday, February 18, 2008

The Fed: A new operating tool--the TAF--and a Liquidity Crisis

The February 11 post reviewed the operations of the Federal Reserve in 2007. The analysis stopped short of the full year because of the innovations that the Fed introduced in December. This post picks up the story. On December 12, 2007, the Federal Reserve announced, along with the Bank of Canada, the Bank of England, the European Central Bank (ECB), and the Swiss National Bank (SNB) “measures designed to address elevated pressures in short-term funding markets.” The actions taken by the Federal Reserve included the establishment of a temporary Term Auction Facility (TAF) and the establishment of foreign exchange swap lines with the European Central Bank and the Swiss National Bank. Under the TAF program, the Federal Reserve auctions term funds to depository institutions against a broader range of collateral than under normal open market operations. The effort is to “help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress.” In effect, the Federal Reserve used the TAF to supply reserves to the banking system for terms of roughly one month while reserving the use of its standard tools— repurchase agreements and reverse repurchase agreements—for shorter term reserve adjustments. The temporary reciprocal currency arrangements with the ECB and the SNB will provide dollars for these organizations to use for supplying liquidity within their jurisdictions. The swap lines were approved by the Federal Open Market Committee of the Federal Reserve System for up to six months.

One can observe the use of these facilities on the Federal Reserve release H.4.1, Factors Affecting Reserve Balances of Depository Institutions. The Federal Reserve release can be obtained from the website of the Federal Reserve under “Economic Research and Data” and then “Statistical Releases and Historical Data.” There is a new line item on this release called TERM AUCTION CREDIT: an increase in Term Auction Credit supplies reserves to the banking system. The information on the swap lines is a little more difficult to come by…it is aggregated in the line item labeled OTHER FEDERAL RESERVE ASSETS. The only thing one can say about this line item is that it usually does not change very much. The swap transactions with the ECB and the SNB are usually relatively large and hence can be estimated by the magnitude of the changes in Other Federal Reserve Assets. An increase in Other Federal Reserve Assets supplies reserves to the banking system.

Now, let’s review Federal Reserve actions for the period that includes December 2007 through the most recent statistical releases. I will divide this period up into the time before the banking week ending January 23, 2008, the banking week ending January 23, and the time period after this. The crucial date in all of this is January 21, 2008 which is the day that information became available about the $7.2 billion write-off to be taken by a French bank due to the actions of one of its traders. This knowledge and the fact that the bank was trying to sell off the positions established by this trader led to a ‘liquidity crises’ in world security markets. The next morning the Federal Reserve announced that it was lowering its target Federal Funds rate by 75 basis points, an extraordinary amount. But, let’s go back to early December.

Up through the banking week ending January 16, 2008, two factors dominate the statistics. First, there is the normal Christmas season/end-of-year swing in various items that are a part of the Fed’s basic operations. Currency in circulation always increases in the holiday season and then declines right after the first of the year. This season was no exception and was handled in the usual way. Second, however, there was the introduction of the TAF. The first auction settled on December 20 and was for $20.0 billion; the second auction settled on December 27 and it, also, was for $20.0 billion. These can be seen clearly on the H.4.1 for the banking weeks ending December 26 and January 2. One can also notice from these releases that OTHER FEDERAL RESERVE ASSETS increase by $14.3 billion and $11.2 billion, respectively. We assume that these increases reflect the use of the swap lines set up with the ECB and the SNB. The Federal Reserve offset these increases by allowing parts of its Treasury bill portfolio to mature without being replaced ($29.0 billion) along with a decline in repurchase agreements ($16.0 billion). Roughly, the Federal Reserve added $65.5 billion in reserves to the banking system through the new measures announced on December 12, 2007, and allowed $45.0 billion in securities to run off which reduce reserves in the banking system. The difference between the two offset other factors influencing bank reserves with nothing else out-of-the-ordinary occurring. Thus, the initial implementation of the new facilities seemed to go ahead without any disruption to the financial markets.

World financial markets dropped precipitously on Monday, January 21, a day which fell into the banking week ending January 23. On that Monday afternoon members of the FOMC got together by phone and voted to reduce the Fed’s target Federal Funds rate by 75 basis points. The Fed had already injected the third round of TAF funds into the banking system on January 17 in the amount of $30.0 billion, $20.0 to replace those funds maturing from the first auction plus an additional $10.0 billion. The financial markets stabilized: the only market comment being on the size of the reduction of the target rate. In terms of the statistical data, even with all the turmoil in the world markets, there was very little movement in the Fed’s major operating areas.

Three important things events took place in the next three banking weeks. First, at the January 29 meeting of the FOMC, the committee lowered the target Federal Funds rate another 50 basis points, bringing the total reduction to 125 basis points in ten days. This was huge, historically! Second, the Fed held another auction on January 28 for $30.0 billion, $20.0 to replace the funds maturing from the second auction and another $10.0 million in new auction funds. Third, in the banking week ending January 30, the Fed put about $8.0 billion of reserves into the banking system by means of repurchase agreements. These were allowed to expire in the banking week ending February 6 along with another $3.3 billion of repurchase agreements that expired in the banking week ending February 13. One can assume that these repurchase agreements had provided liquidity to help settle the market turmoil mentioned above and as the disruption receded the Fed just allowed these positions to unwind.

The market sell-off on January 21 represented a true liquidity crisis. Here a banking organization HAD to sell securities. The bank was identified and the market realized that A LOT of securities had to be sold. As has been described in earlier posts, this meets the definition of a liquidity crisis where the question becomes, “Where should market prices be?” Until the market is able to answer this question sellers in the market tend to outnumber buyers and prices continue to fall. The classic response of the central bank is to provide liquidity to the marketplace. And that is what the Federal Reserve did.

Operationally, the Federal Reserve seems to have acted quite well during this whole period. It handled the normal seasonal swings without any trouble. It also proceeded with the transition to the TAF and the swap agreement without difficulty. Basically, the Fed put $60.0 billion in Term Auction Funds into the banking system while allowing $65.0 in it holdings of US Treasury securities to mature without replacement. Finally, here we are four weeks after the ‘liquidity scare’ and markets are functioning without problems. Yes, there are still solvency problems that must be resolved, but that is another story, a longer-term story. One can argue that the Fed’s actions in January and beyond helped to short-circuit the liquidity crisis which is exactly what a central bank is supposed to do.

People in the financial markets, as well as analysts, still have some questions about the leadership of the Fed. Many market participants feel that last fall there was a disconnect between what the Fed said and what the Fed eventually did. Also, the substantial drop in the target interest rate raised a flag about the stability of Fed decision making. Concerns like these contribute to a lack of complete confidence in the abilities of those currently guiding the Fed. Public officials, until their credibility is proven, always face confidence issues early on in their tenure.

Thursday, February 14, 2008

Bernanke's Fate

The Chairman of the Federal Reserve System is one of the most prominent targets of pundits on the planet…even though the public may not show much name recognition. Once again question marks are being raised about the tenure of Ben Bernanke, both for now and in the future. Particularly in times when financial markets are unsettled and there is substantial uncertainty about the future course of the economy, the Fed Chairman becomes the focal point of almost all points of view. This just goes with the job. See for example, “Bernanke’s Fate May Hang on Economy” in the Wall Street Journal (

It is true, as stated by Douglas Holtz-Eakin, economic advisor to John McCain, that the actions of the Fed Chairman can only really be judged in hindsight. Thus, although Alan Greenspan was highly praised for much of his term as the Fed Chairman, he has come under increasing criticism as his leadership has been reviewed since leaving the position. (See for example, Greenspan’s Bubbles, by William Fleckenstein.) Still, close scrutiny of the current Chairman will continue to remain intense.

In terms of real-time operating performance, however, the most important thing a Fed Chairman must possess is trust. And, trust must be earned. Every Fed Chairman comes to the position with the good will of all…even Bill Miller (who?) was wished well when Jimmy Carter appointed him. Being in such a powerful position and being so exposed to the analysts usually means that the trials begin relatively soon for a new Chairman.

One could argue that, up to this point, Bernanke has not earned that trust. It has not helped that he and the Fed made statements that seemingly reversed themselves in the fall within relatively short periods of time, even though the reversals may seem to have been rather small. Also, it seems as if financial market participants were a little unnerved by the January performance of the Fed in which the target for the Federal Funds rate was dropped by 75 basis points, twice in eight days. The bottom line is that people are not seeing consistency in performance and, hence, trust remains elusive, and criticism grows.

Market participants want to trust Bernanke…he needs to give them reason to do so.

Wednesday, February 13, 2008

Policy Imbalances

David Brooks in “When Reality Bites” discusses the reality that exists when the policies of one administration cannot be ignored by the administration that succeeds it. You can find this article at ( In this article Brooks discusses the war in Iraq and the agenda for domestic spending.

I would like to include a third area that I believe is as important or even more important than the other two. I quote from my comments on the political situation (

“There are times when the imbalances (in policy) leave an irreconcilable dilemma as is the current situation with respect to economic policy. At present it appears as if the American economy is going into a recession. To lessen the severity of recession the government can execute a combination of monetary and fiscal actions. In early 2008 we see the Federal Reserve lowering the target interest rate it uses to conduct monetary policy and the Bush Administration and Congress creating a fiscal stimulus package. The Federal Reserve has had to lower its interest rate target because of dislocations in the financial markets. The fiscal stimulus package resulted from the game playing of the President and Congress, both of whom could not do ‘nothing’ in fear of facing massive criticism in upcoming elections. The dilemma is that these policies are exactly the opposite needed in order to stop the decline in the value of the dollar which has been declining for over five years. The decline in the value of the dollar can be attributed to the deficits created by the tax cuts enacted early-on by the Bush Administration and low interest rate policy followed for two years by the Greenspan led Federal Reserve.”

Whoever is elected this year is going to have to face this dilemma…fight the recession and let the dollar continue to decline in value…or risk a longer or deeper recession and work to stop the depreciation of the dollar. If we continue to let the dollar slide…American assets get even cheaper to foreign wealth.

Monday, February 11, 2008

Should Bernanke and the Fed Have Moved Sooner?

The posting for February 4 ended with a concern shared by many, that Bernanke and the Fed did not act in 2007 soon enough or with enough force to advert a major economic or financial dislocation. This week we take a closer look at the accusation. First, let me say that it is important to know how people and agencies have responded in the past so that we can have some view as to how they will act in the future. Learning about how the Federal Reserve acted in 2007, might help us to anticipate what could happen in 2008 or beyond. We still have to be cautious, however, because making monetary policy is an art and not a science and no two market situations are ever exactly alike.

Furthermore, we must continually realize that there is only so much a central bank can do. It needs, in a sense, to ‘keep its powder dry’ so that it can act when it is really needed. If it is always chasing the latest statistic or piece of market psychology then it will not be as effective when its actions are really needed. So, in setting the stage for a review of some of the events that took place in 2007 we must remember that through most of the year the economy seemed to be growing at a relatively decent pace and the rate of inflation experienced tended to be slightly higher than the Federal Reserve had stated was desirable. The value of the United States dollar continued to decline and there was concern that it would decline further in 2007 and 2008. In summary, it seemed as if there was less risk of economic growth declining, especially in the first three quarters of the year, than there was of the possibility of inflation remaining too high and the dollar declining further. Federal Reserve policy statements reflected these factors.

In terms of financial markets, the first real information that became public about the problems in the housing market and in subprime lending came about in February, 2007. I remember the first time information on this really caught my attention. It was early in February when I picked up a small article buried in the third section, the Money & Investing section, of the Wall Street Journal. I began to pay attention to similar articles and I tracked the news as it moved from deep in the third section of the paper to nearer the first page of the third section to the first section, second page and so on. Knowledge of the problems in these areas was limited, little alarm was raised, and that alarm was often dismissed.

As new information on the situation continued to surface, the Federal Reserve had to incorporate this new information into its analysis of the performance of financial markets and the real economy. But, concerns over these two areas were only a small part of the total picture the Fed had to keep track of.

The liquidity of the financial markets is really the first thing that the Fed pays attention to. Why? The Fed is a participant in the money markets because it has to operate in these markets on a daily basis. Thus, the traders on the Open Market Desk in New York have the first knowledge of whether or not the money markets are experiencing a change in liquidity. This is where the story usually begins.

To examine the year 2007, let’s start out with what occurred in the banking system. Here one finds some counter-intuitive results: Total Bank Reserves and Nonborrowed Reserves declined throughout the year on a year-over-year basis. The initial interpretation of these data is that the Federal Reserve was tightening up on bank reserve positions. Digging deeper we see that Required Reserves in the banking system declined as well. The year-over-year rate of decline of Required Reserves was around 4.0% in the first half of the year and around a 2.0% rate of decline in the second half. This seems to re-enforce the interpretation that the Fed was tightening throughout the year. Furthermore, we see that the narrow measure of the money stock, M1, also declined throughout the year. The year-over-year rate of change of this measure was negative throughout the year except for the months of September and October when the rates of growth were modestly positive.

The picture begins to clear up when we examine the year-over-year rate of growth of the broader measure of the money stock, M2, which was positive throughout the year, growing at a rate between 5.3% and 6.4%. The conclusion one draws from this is that people were moving funds from transactions deposits at banks that required bank reserves to time and savings deposits that required few or no bank reserves. That is, bank reserves were being released throughout the year as a result of people moving their financial resources around within the banking system.

The Federal Reserve responded to this release of reserves by reducing the amount of reserves in the banking system. Operationally, the Federal Reserve does not like ‘sloppy’ money markets because it cannot tell where the market is if it is not ‘taunt.’ Therefore, it removed these excess reserves as they were released. This seemingly caused no harm to the money markets. The escape valve for the banking system experiencing undue pressure is the Federal Reserve’s Discount Window. Primary borrowings at the Discount Window remained very low during this time with not much variation up until August. The only conclusion I can draw from this is that through July 2007, the Federal Reserve perceived no extraordinary liquidity pressures in the money markets. Hence, no overt action was needed.

What happened in August and September? The Federal Reserve sensed some pressure in the money markets and wanted to maintain the “orderly functioning” of these financial markets. On August 17 there was a reduction in the Fed’s discount rate to avoid “deterioration of financial markets.’ Looking at the data from the Federal Reserve statistical release H.4.1, Factors Affecting Reserve Balances, we see a jump in Loans to Depository Institutions of about $1.2 billion for the week ended August 22 and these loans stayed near the same level until they jumped another $1.6 billion in the banking week ended September 12 indicating some pressure was being felt within the markets. But, two other things were also happening. First, there was the usual seasonal increase in currency outstanding for the Labor Day weekend which the Fed generally supports with repurchase agreements (Repos). Repos are used because this movement reverses itself once the weekend is over. Second, there was a reduction in Treasury securities held outright of about $10.0 billion through the end of August into early September. The conclusion one can draw is that any pressures that were experienced at this time were relieved.

The target Federal Funds rate was lowered on September 18, to “avoid disruptions to the financial markets” and the discount rate was also dropped at the same time. Loans to Depository Institutions dropped back to a relatively insignificant amount while the Fed conducted repurchase agreements to smooth financial market adjustments during the week ending September 26. Whatever market pressure existed during late August through early September were satisfactorily relieved, for there appear to have been no further operational changes at the Fed through the month of October.

The Federal Funds target was dropped again on October 31 (along with another cut in the discount rate) but nothing out of the ordinary can be seen in the November data only the usual seasonal rise in currency in circulation related to the Thanksgiving/Christmas holiday season. This increase was underwritten, as usual, by a rise in repurchase agreements. So we come to December but this month, along with early 2008, needs its own post. This is because of all the “new” things that occurred, especially the introduction of the Term Auction Credit facility that was begun in that month.

The basic conclusion I draw from reviewing the data from 2007 and the actions taken by Bernanke and the Federal Reserve is that financial markets were reasonably benign. Concern arose about possible ‘disorderly markets’ in late August and early September, but this period passed without any major disruption taking place. The Fed seemingly performed well. Should the Fed have been more concerned about a looming crisis? To me, it is hard to develop an argument for a more active central bank during 2007. Apparently, Bernanke and the Fed did not make any major mistakes during the year. There was no indication at any time that a major liquidity problem was brewing…this was to come in early 2008.

Monday, February 4, 2008

Can Interest Rates Resolve a Solvency Crises?

In recent weeks, we have heard a lot about something called a Solvency Crises. In this number I discuss is meant by a Solvency Crises and differentiate it from a Liquidity Crises. A central bank has to be concerned about both types of crises, but it has to be able to distinguish one from the other because the monetary authority must respond differently to each kind.

A Liquidity Crises is a short term phenomenon that arises because someone must relieve themselves of some financial assets. The recent example is that of the French bank which had to unwind a securities position that had been established by a trader working at the bank. The bank had to sell off the position in order to minimize any further losses it might have to take. The amount of the securities that were involved in the position was estimated to be around $75 billion, so we are talking about a substantial amount of securities that must be sold within a relatively short period of time.

In normal times for markets that are relatively liquid, the bid-ask spread between what people will buy a security for and what they will sell the security for is relatively narrow. That is, I can buy a security and then turn around and sell the security and will only lose a small amount of money. The narrow bid-ask spread is an indicator that the market is relatively liquid. Less liquid markets experience bid-ask spreads that are more or less wider depending upon the illiquidity of the market.

If the seller of a security has to sell a noticeably larger amount of securities within a relatively short period of time, potential buyers may reduce the ask price somewhat, but the increased discount is not unusually large. If the discount is not large, this is used as evidence of the liquidity of the market. In other words, if a sizeable amount of a security can be sold relatively quickly without much concession in price then the market is termed a liquid market. Liquid markets are, of course, very important for financial (and other) organizations because securities that trade in liquid markets can be used to adjust portfolio positions under normal circumstances with little or no penalty in terms of price concessions to the market.

However, if a large amount of securities must be sold within a very short period of time, even liquid markets can experience liquidity problems. This is what is termed a liquidity crisis. What happens in these cases is that market participants know that the securities must be sold and they know that a large amount of the securities must be sold. Very often market participants will even know which institution has to sell the securities. Under such circumstances the problem becomes one of price.

In a normal situation when a larger block of securities is sold, potential buyers know that this sale is just a ‘bump’ in the market and that the market will return very quickly to the range that this type of security had been trading within. Thus, market participants know where the market is and they are willing to continue to ‘make a market’ in the security.

In a liquidity crisis this is not the case. Market participants know that price concessions must be made but because of the quantity of the securities that must be sold on the market and the short time span over which they must be sold, confidence wanes as to where the market will continue to trade. Buyers become unsure…sellers become desperate! The problem, therefore, switches to the buy side. Buyers don’t want to buy a security, even if the seller is willing to give up a substantial discount, if there is a concern that they, the buyer, will soon be holding a security for which they overpaid. Buyers withdraw…they head for the sidelines…they go and play golf. And, buyers will stay on the sidelines until the markets exhibit some kind of stability and they can become confident about where prices should be.

The job of stabilizing the market in a liquidity crisis is that of the central bank. There are two actions that the central bank can take that are the classical responses of central banks to such a market situation. Putting these responses within the structure of the Federal Reserve System we call them the lender of first resort response and the lender of last resort response. In terms of the former, the Federal Reserve reduces the operating target for the Federal Funds rate, which, in essence means, that the Fed will become a buyer of securities at a set price so that the market knows there will be a buyer for their securities…hence, institutions that need to adjust their portfolios know that they can sell to the Federal Reserve. The latter response has to do with the Borrowing window at the Federal Reserve. In the case of a liquidity crisis, the Fed, for a short time, will throw open the borrowing window so that banks can borrow funds from the Fed and not have to sell securities into a declining market. In both cases, the Federal Reserve, in classical central banking style, provides liquidity to the money markets in order to stabilize markets and keep buyers at their trading desks. This is how a liquidity crisis can be stemmed.

It is time to get back to the problem of the solvency crisis. The problem of solvency occurs when there is a decline in the value of assets that are being carried on the balance sheet of an organization. Solvency can be an issue within the context of a liquidity crisis when the securities on, say, a bank’s balance sheet lose market value. However, the problem becomes of much greater concern if the institution, the bank, experiences a decline in the value of other assets on its balance sheet, say in its loan portfolio. Here the difficulty may be the ability of the borrower to repay the loan that they have outstanding with the bank. In these cases, the bank knows that it will not receive back the total amount of the loan outstanding and, therefore, must write down the value of the loan.

The concern here is that when asset values on a balance sheet are written down the impact ultimately impacts the capital position of the organization. When we write off a loan, for example, we write it off against income reducing profits, which means that the increase in net worth will be less than it otherwise would be, or, it the charge-offs result in a loss, net worth would actually decline. If the capital position of the bank gets too low, then the bank will have to raise more capital, sell itself to another financial institution, or close. When many banks have this kind of problem there is a solvency crisis!

Raising capital is the only long term way to resolve a solvency problem and there are basically two ways to raise capital. First, over time, profits will increase the level of capital that an organization will have. This takes time and is the solution to the crisis only if institutions have sufficient remaining capital to replenish capital by means of longer run profitability. Second, the institution must go out and obtain capital from other sources. The availability of capital is dependent upon two things…that there are pools of capital available for investing…and that the institution has sufficient viability to justify investors risking their funds by investing in that institution. The Sovereign Wealth Funds have provided the pools of capital required to meet at least some of the needs of the current solvency crisis. One presumes that these Funds have done their due diligence and hence believe that their investments have long term viability.

The Federal Reserve cannot resolve a Solvency Crisis. That is, a central bank is not in a position to inject capital into banks or other organizations in order to resolve this kind of crisis. If there are not pools of funds available to put capital into troubled institutions then the solvency crisis can cumulate and spin out-of-control like it did in the Great Depression of the 1930s. The only thing the central bank can do is to help create a favorable environment so that the economy can grow and sufficient profits can be generated to replenish capital in this way. But, this takes time and patience…it cannot be done quickly.

It has been argued that Ben Bernanke and the Fed failed to realize the severity of the economic problem soon enough and did not act quick enough to lessen its impact. In my next post I am going to look at the operational behavior of the Fed in 2007 in an attempt to discern whether market conditions existed during 2007 indicating the existence of a liquidity crisis. If a liquidity crisis did not take place in 2007, then this may explain why the Fed did not want to take any precipitous action during that time when the extent of the problem was not obvious…particularly when there were other issues on the table like the decline in the value of the US dollar and the inflation being slightly above the range acceptable to the policymakers.