Tuesday, March 18, 2014

The Fed in 2008

There have been some good reviews of the Fed in 2008, since the transcripts have been published.  Matthew O'Brien at the Atlantic has a very good review of the transcripts of the meetings over the summer & fall.

Marcus Nunes builds on that here.  From his post:
Plosner (July 22): Keeping policy too accommodative for too long worsens our inflation problem. Inflation is already too high and inconsistent with our goal of — and responsibility to ensure — price stability. We will need to reverse course — the exact timing depends on how the economy evolves, but I anticipate the reversal will need to be started sooner rather than later. And I believe it will likely need to begin before either the labor market or the financial markets have completely turned around.
Hoenig (July 16): “While the comparison to the ´70s can be useful(!), the present economic situation is also different…
However, like the 1970s, monetary policy is currently accommodative(!)…In this environment there is a significant risk that inflation and inflation expectations could move higher in coming months.
Thus, it will be important for the Federal Reserve to monitor inflation developments and inflation expectations closely, and to move to a less accommodative stance in a timely fashion”.
Scott Sumner has some posts, including this one.  There have been many others.

I don't have much to add, but I tried to pull details and dates out of these posts and the sources they link to, to construct a timeline of late summer 2008.  Normally, a pithy narrative develops as I put these things together.  That hasn't come to me yet, but I thought some of you might find the chart I put together useful.


Notes:
1) It is amazing how well markets held up in mid-September 2008, considering the sheer number of catastrophic economic events that happened in succession.  And this was after nearly a year of financial disruptions.  The Ted Spread exploded in the days after the quick succession of financial crises, but the S&P 500 and inflation expectations held up pretty well for another couple of weeks.

2) 129 mentions of inflation and 4 mentions of systemic risk at the September 16 meeting?  I don't have words.  For nearly a year, the Fed balance sheet had been accumulating unconventional assets.  And, the day before the meeting, Lehman had failed.  The 2 days after the meeting, AIG & the Reserve Primary Fund need capital and Bernanke tells Congress "we may not have an economy Monday".

3) The market expected inflation to average 1% for the next 5 years as they sat in that meeting discussing inflation 129 times.  Between then and Nov. 5, the Fed decided it would be a good time to institute a new policy to pay banks to hold excess cash reserves.  By the end of November, expected 5 year inflation was -2%.  During this period, they did lower the federal funds target rate, however their treasury holdings declined during this period.  There is no sign that the targeted rates were accommodative.

4) They held the Federal Funds rate target at 2% at the September meeting, and signaled that rate increases were around the corner!  The effective Federal Funds rate went haywire until the October 8 meeting, when they lowered the Fed Funds target while initiating interest on excess reserves.  At that meeting Timothy Geitner scolded members who dared to take responsibility for an erosion of confidence!

5) It looks to me like the Fed had been sterilizing unconventional asset
accumulation by selling treasuries, since late 2007.  During this time the monetary base was flatlining.  And, again, while QE1 was purportedly an injection of liquidity into the economy, the Fed balance sheet did not expand from the level it stood when QE1 was announced.  At best, QE1 was reinjecting liquidity into the economy as the Fed unwound other unconventional assets.  While inflation expectations did increase from their deflationary levels of late 2008, they remained below the 2% level throughout QE1.

While the EMH is generally a good starting point for looking at financial markets, our money supply is not the product of a market.  The Fed seems to be operating with the understanding that their actions in 2007 and 2008 were reasonable.  They also seem to continue to have excessive fear of inflation, and they associate this fear with increasing real estate prices.  As long as this is the perspective they hold, going forward, carefully taking prospective positions that would capture extraordinary gains during disruptive deflationary episodes is probably warranted, for either speculative or hedging purposes.

PS.  ....From the September 16, 2008 FOMC meeting.
Mr. Dudley, Manager, System Open Market Account (pg. 26-28 of transcript):

If I could add a few thoughts on market expectations about this meeting—I think it looks as though easing is priced in for two reasons. One, dealers do expect the federal funds rate to trade soft as we add excess reserves, so I would not take the softness in the September federal funds futures contract as indicative of necessarily expecting an easing. Two, I think it is important to recognize that the rates embodied in those fed fund futures contracts are means not modes. So I would characterize the market expectation as either that things get very, very bad and the FOMC cuts rates significantly or that the FOMC does nothing.
I think that actually a 25 basis point cut is probably the least likely outcome that the market anticipates. As evidence of this, a couple of dealers yesterday did change their forecast to a 50 basis point rate cut. I’m not aware of anybody who has changed to 25. Probably people like that are out there. I know that my colleagues at Goldman Sachs, where I used to work, are saying that they think the FOMC is going to keep rates unchanged today but, if they were to move, it would be 50.

That gives you a sense that it’s really a bimodal kind of view and that putting different probabilities on 50 and zero gives you some easing priced into the federal funds rate futures market. So I think the consensus view still in the marketplace is that the Fed probably will not cut rates today. That would be a disappointment to a degree because there’s some probability placed on the idea that the Fed might do 50, but that’s how I would interpret what’s priced into the markets today....
....I think on Friday the mood was basically that the funds rate was going to be flat for a long time. Probabilities placed on either easing or tightening were quite low, and since then the probability of easing has gone up fairly significantly. But I think it’s hard to interpret because it’s really not about 25 versus zero. It’s really about zero versus 50 or maybe even 100 as you look out longer term. Either the financial system is going to implode in a major way, which will lead to a significant further easing, or it is not.


Here is a good example of the content of the meeting.  This is from Sandra Pianalto, head of the Cleveland Federal Reserve Bank:

I am hearing that credit is harder to come by for many borrowers who in the recent past would not have thought twice about their creditworthiness.....One of my directors, who heads a very large regional banking organization, reported at our board meeting last week that many banks are shedding assets and that in some cases they are walking away from longstanding customer relationships in order to do so. He said that investors are very skeptical about putting new equity into banking deals and that those who have done so in the past vow not to be burned twice, let alone a third time.  
Of course, inflation remains an important issue as well....most of my contacts agree that the commodity price environment has stabilized considerably, making me more confident that core inflation will gradually slow over the next couple of years. (Even so, she favored leaving the Fed Funds Rate at 2% and waiting some more to see how the economy performed.) 



I don't blame the committee members.  Having a committee manage a monopoly in cash is ludicrous.  They are bound to fail.

The failure of the committee itself isn't even the most damning aspect of this system.  The most damning thing is that the Lehman Bros. collapse was the product of poor Fed policy leading up to September 2008, and the Fed just kept moving along with the same policy.  The Fed was taking a billy club to the shins of the financial sector without even knowing it.  Even after the banks absorbed a 25% decline in home prices over nearly two years, the Fed plunged us into deflation.  And, in the aftermath, the standard story is that the heroic Fed saved us from falling off the economic precipice, but that we're all supposed to be a little upset because they "bailed out" the banks - the banks that were sitting on balance sheets loaded with receivables backed by collateral measured in nominal values based on the one and only thing the Fed is supposed to produce - those lucky, lucky banks.  This is mass insanity.

2 comments:

  1. Great post.

    Loved this part:

    "2) 129 mentions of inflation and 4 mentions of systemic risk at the September 16 meeting? I don't have words. For nearly a year, the Fed balance sheet had been accumulating unconventional assets. And, the day before the meeting, Lehman had failed. The 2 days after the meeting, AIG & the Reserve Primary Fund need capital and Bernanke tells Congress "we may not have an economy Monday".

    3) The market expected inflation to average 1% for the next 5 years as they sat in that meeting discussing inflation 129 times. Between then and Nov. 5, the Fed decided it would be a good time to institute a new policy to pay banks to hold excess cash reserves. By the end of November, expected 5 year inflation was -2%. During this period, they did lower the federal funds target rate, however their treasury holdings declined during this period."

    People say I am an extremist, that I want too-aggressive a monetary policy, that I would risk inflation.

    But read these FOMC meetings! 129 mentions of inflation at the Sept. meeting?

    You can ask n economist what is wrong with the FOMC, but at this point I think we need to bring in teams of psychiatrists and sociologists.

    One last complaint.

    FOMC members often tell anecdotes, about a banker they talked to, and what they said.

    They never start off an anecdote this way: "I walked down to the unemployment office and asked around if you guys could get work. I applied for six jobs myself using a phony resume, to see if I would get any responses. I ran a job ad on Craigslist to see how many responses I would get."

    BTW: Yes, I would risk inflation to get the economy smoking again. In life, one has to take risks. The Fed's position is clear: They will never get anywhere near 2 percent inflation, as that is too much of a risk by their sights.

    And congrats on being one of the very, very few people to notice that Fed shrank its balance sheet from $800 billion to $400 billion----going into 2008.

    I have to stop writing now as really only a string of profanities and expletives is useful at this point.....

    btw, see my last post at Marcus Nunes'


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    1. Great points. Thanks for your comment.

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