You have got to hand it to Ben Bernanke, who stepped into some oversized, perhaps even overrated, shoes when he succeeded Alan Greenspan as Federal Reserve (Fed) chairman in early 2006.
In some circles, the Princeton professor was considered too naive for the task. An academic for most of his career, Bernanke studied and wrote about the Great Depression, which is a lot different from steering the economy through one, or walking financial markets back from the brink.
Bernanke faced the first real test of his chairmanship earlier this month, when the world’s financial markets came unglued for a few days as lending to everyone except the US government seemed to dry up.
He proved himself to be cool under pressure and measured in his response, addressing the immediate need forliquidity by providing more of it—on demand.
On 17 August, the Fed lowered its discount rate by 50basis points to 5.75%, which is still above the benchmark interbank rate, but offers depository institutions a guarantee of 30-day financing, no stigma attached. For institutions that were shut out of the commercial paper market or wanted to lock in funding for more than one day—the term eurodollar market was frozen—opening the discount window wide was a good, albeit unconventional, idea.
But then again, we were all conditioned to expectGreenspan’s type of parenting—giving the child what it wants even if, in the long run, the treatment does more harm than good.
By the time the Fed lowered the discount rate 11 days ago, financial futures and options markets were well on their way to pricing in several rate cuts by the end of the year. The Fed’s statement, released in conjunction with the discount rate cut, represented a 180-degree turn from its assessment two weeks earlier. That seemed to validate expectations which, in turn, got more aggressive.
I suspect the Fed will have to lower its benchmark rate within the next few months—not to calm markets or to address short-term funding issues, but to prevent the economy from further deterioration as the effect of tighter credit starts to manifest itself. For the moment, Bernanke has demonstrated that he is his own man with his own style—and definitely his own footprint.
The Bernanke Fed is working hard to disabuse investors of the notion that market turmoil translates into an immediate rate cut. As Jim Grant wrote in an 26 August op-ed in The New York Times, maybe Greenspan’s successor “is seeing the light that capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich.”
As for the real economy, the ultimate recipient of policy actions, evidence suggests rate cuts will be forthcoming.
Defence exhibit No. 1: the yield curve
If you gave a kindergartner a box of new Crayola crayons and a clean sheet of graph paper, and told her to mark an X to correspond to the yield on treasury securities of various maturities, what would she observe? Starting with the Fed-determined funds rate and going out to the 30-year bond, our five-year-old would see that one rate is out of whack. That’s the funds rate.
The Fed is artificially holding the rate it targets above market, or natural, rates. Policy, in other words, is too tight. The five-year-old can see it; many economists can’t. At least they don’t, or won’t, see it until the effects become apparent. Historically, yield-curve inversions are resolved by the Fed lowering the funds rate, not by the rest of the yield curve shifting up.
Defence exhibit No. 2: the economic backdrop
Today’s credit squeeze has been compared to 1998, when Russia defaulted on its debt and Long-Term Capital Management saw its relative-value trades lose value, both relatively and absolutely. Greenspan diagnosed a market seizure and rode to the rescue with three 25-basis-point rate cuts in rapid succession.
The economy was booming in 1998, with real gross domestic product (GDP) averaging 4.5%. It’s growing much more slowly now, with GDP growth averaging 1.8% in the last four quarters.
The stock market bubble was inflating back then; today’s housing bubble has burst, with far-reaching effect on homeowners, lenders, mortgage securitizers and investors.
Defence exhibit No. 3: bubble history
Whether it is financial assets, real estate or some exotic item (tulip bulbs in 17th century Holland) the public will pay seemingly any price to own, bubbles don’t end well. At some point there is no greater fool to take the overpriced asset off the last buyer’s hands. The jig is up. Prices collapse.
The 21st century’s first real-estate bubble has an added feature, or kicker. The bad loans aren’t just a matter between borrower and lender. The loans have been packaged, pureed and processed as complex credit derivatives, marketed and sold with a good dose of leverage.
The ultimate effect of all this financial engineering gone awry is, as they say in the mortgage-backed securities market, “TBA,” or to be announced. BLOOMBERG
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