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Friday Notes

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The Sisyphean challenge of the Fed

Thu, Mar 20 2008, 13:34 GMT
by HVB Group Global Markets Research

UniCredit Group

Sisyphus. The Fed's efforts are reminiscent of Greek mythology: Every time it took the initiative in recent months, the central bank could impress market participants – if at all – only temporarily with its measures. This was not different on Tuesday – at least initially – since the 75 basis point cut failed to live up to expectations.

Rate cuts. A process of rethinking, however, appears to be setting in not only with the Fed. Even though one or two further rate cuts seem warranted to halt the economic slowdown, the Fed must be careful not to overstep: First, inflation expectations are rising and, second, the central bank could run out of ammunition (pages 4-8).

Shift of emphasis. The FOMC already indicated that it intends to slow the pace of rate cuts – also because interest rate policy is only suitable to solve macroeconomic problems but not capable of averting systemic financial crises. This requires efforts on other fronts, which the Fed and the US Administration now wish to press ahead with.

Possible solutions. We already got a taste of what's to come: First, the Fed will provide sufficient liquidity. Second, further bank consolidation à la Bear Stearns is unavoidable. Third, reliable numbers – however brutal – must be "put on the table". And finally, fiscal support may also be desirable, e.g. a Resolution Trust-style bailout and more financial aid for US consumers (Weekly Comment, page 2-3).

• Further topics:
  

  – Italy: A rate cut is only a question of time (page 9).

  – Data outlook: ifo business climate to decline (page 11).

  – Market outlook: EUR-USD to test 1.60 once more (page 18).

  – Data outlook: EMU purchasing managers more cautious (page 12).

Switching gears

The Fed cut rates by 75 bp, less than the market expected, with two members dissenting in favor of an even smaller cut, and flagged concerns about rising inflation expectations. This signals that the Fed and the US administration intend to switch gears, slowing the pace of rate cuts and accelerating efforts on other fronts – Bush spoke immediately after the FOMC decision, and pledged that further action to support the economy will come if and as needed. While the size of the cut is at face value a disappointment, I would expect that beyond the immediate reaction markets will respond positively to the signal of a broad and more balanced policy response, especially as monetary policy alone was already perceived as ineffective (Fed pushing on a string) and would risk becoming less and less credible as the Fed funds approached zero. Meanwhile, the market’s reaction to the Q1 earnings results of Lehman and Goldman suggests that some brutal mark-to-market, while imperfect and criticized, is restoring some measure of transparency – the information crunch might begin to ease, opening the way for the slow and painful exit from the crisis.

With a market fully primed for a 100 bp cut and some hope for even more, the Fed delivered only 75 bp, with two officials dissenting in favor of an even smaller cut (Fisher and Plosser). Moreover, the statement noted that inflation expectations have risen, and that uncertainty about the inflation outlook has increased – significantly more aggressive language than in January, when they said they expected inflation to moderate but that inflation developments would need to be monitored. At the same time, the statement also acknowledges that the outlook for growth has deteriorated further and downside risks to growth remain, and repeats that financial markets remain under considerable stress.

This, in my view, signals that the Fed and the US administration intend to switch gears, slowing the pace of rate cuts and accelerating efforts on other fronts, including liquidity provision, bank consolidation, and fiscal support. Other measures, up to a Resolution Trust Corporation-style bailout, will be deployed as needed, while the financial sector absorbs the pain of write-offs and shareholders of the most fragile institutions pay the heaviest price, as in the case of Bear Stearns. The policy response has already been quick and creative, and will remain so. Bush spoke immediately after the release of the FOMC statement, praising the swift actions of Fed and Treasury, and pledging that “more action” will come if and as necessary to support the economy.

The statement’s stronger emphasis on inflation risks represents a moral victory for the ECB, and is likely to strengthen its resolve to hold the line on interest rates – a resolve reiterated today by key ECB officials. However, I still believe weakening growth will trigger ECB rate cuts starting at midyear.

The Fed had struggled to make it all the way to Tuesday's FOMC meeting without another inter-meeting rate cut, and it needed two new financing facilities and Bear Stearns’ takeover to bridge the gap. The Q1 earnings results of Goldman Sachs and Lehman Brothers earlier on Tuesday brought some important and much-needed relief, as both banks beat expectations. Lehman’s share price had suffered a dramatic drop, in what looked ominously like a replay of Bear Stearns’ troubles. With concerns already rising about other brokers, and the rumor mill spinning at full speed, fears of a domino effect in the US financial sector were beginning to mount. Tuesday's earnings announcements arrested the slide in sentiment, allowing share prices to rebound – particularly Lehman’s.

The situation remains extremely fragile, and the risk of a selffulfilling crisis in the financial sector is still high. With financial institutions still highly suspicious of each other, we have already seen how concerns about counterparties and competitors can quickly translate into rising margin calls and closing credit lines. And we should also remember that fears about Bear Stearns’ solvency first surfaced last summer and then quickly faded – a sobering thought.

However, some measure of transparency is being restored – as the recent public debate on the virtues and dangers of marking to market shows. Bernanke has expressed concern that marking to market in the current environment of dislocation and illiquidity can lead to inflated losses and exaggerated write-offs. His thoughts have been echoed by the top executives of some financial institutions – unsurprisingly. While the argument against marking to market sounds selfserving coming from financial institutions, the main point is valid: if marking to zero today assets which are likely to be worth 100 in one year’s time can precipitate a meltdown, is it such a good idea? It’s a multiple equilibria argument: there is a “good” equilibrium where we all agree on a “realistic” value for the assets, markets stabilize and that realistic value then remains as liquidity is restored; and there is a “bad” equilibrium where everyone is forced to mark the assets to zero, the system implodes, and the assets do indeed end up being worthless. Marking to market, it is argued, can push us straight to the bad equilibrium.

I strongly believe that marking to market is the preferable solution, however painful. Uncertainty and lack of transparency have been at the root of this crisis from the very beginning, and restoring transparency, while painful, is key to solving the crisis. The fact that we see vocal opposition to marking to market is encouraging evidence that, even with all the difficulties posed by illiquid markets, an important measure of transparency is gradually being restored. The market’s reaction to the earnings results by Lehman and Goldman suggests that investors do believe that additional information is being revealed, and that we might have entered the crucial phase of the crisis where fundamental weaknesses and strengths are gradually unveiled, with insolvent players collapsing and the stronger ones recovering the markets’ trust. It is early days, and the financial sector still needs to deal with the adverse impact of a weakening real economy. But if the information crunch is beginning to ease, even if by brutal means, there is hope that we might be approaching the turning point – even if turning the corner will take time, and the recovery will be slow and painful.

Fed takes a stand Systemic risks key to Fed aid

The startling chain of events that led to the virtual collapse of Bear Stearns, a direct financial commitment of the Federal Reserve to encourage a JPMorgan acquisition of the troubled investment bank, and the subsequent further sharp reduction in the federal funds rate raises a number of questions about the specifically economic (rather than financial market) implications of these extraordinary developments.

First, are there are any relevant precedents and if so how did the involvement of the US authorities in avoiding a significant financial failure influence the course of key economic variables? Second, how did the economy turn out in the period after one or more failures of sizable financial institutions were not avoided? Third, what is the likely impact of the further reduction in the federal funds rate at a time of significant strain in the channels of credit creation?

The Precedents

Numerous observers have been quoted in recent days claiming that the current financial market difficulties that were spawned by the subprime mortgage fiasco and the collateralized debt obligations, CDOs, that bundled mortgage-backed securities based on subprime loans are “unprecedented” or “the worst financial crisis in 60 years” or similar expressions of alarm. Admittedly, there are unique elements, as there have been in other financial crises. In the current episode, particularly striking is the concentration of problems in a relatively small number of financial institutions, many of which are not depository institutions (commercial banks and thrifts) nor members of the Federal Reserve System. Mortgage bankers like the failed New Century Financial, which went into bankruptcy about a year ago, have no connection with the Fed and no attempt was made by the central bank to extend special credit to help them stay in business. To date, over 200 mortgage banks of varying size have gone out of business, and there is little hope that any will emerge from bankruptcy intact.

Another distinctive feature is that the problems associated with mortgage-backed securities and CDOs have been largely confined to the leading investment banks or the investment banking departments of large money-center banks. This naturally creates asymmetries in the treatment of different institutions that were essentially conducting the same types of business activities, namely, serving as the intermediary in the creation and distribution of mortgage-backed securities and CDOs based on them. Specifically, the Fed has no direct responsibility either for the regulation of investment banks or for their financial stability. It does have the authority to enforce the provisions of the Bank Holding Company Act, however. So it has a mandate to oversee what, for example, a Citigroup and a JP Morgan Chase do in their capital markets activities, but not a Bear Stearns or a Morgan Stanley.

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Published on  Mon, Mar 24 2008, 06:36 GMT