Felix Salmon writes, regarding this morning’s heroic 75 bp rate cut:

Does this mean that all the talk of “Helicopter Ben” and the “Bernanke put” was justified all along? Well, yes… There’s one reason and one reason only that the Fed took this move, and it’s the plunge in global stock markets on Monday, along with indications that the US markets were set to follow suit…. [T]his action smells a bit like panic to me, and it might also have prevented the kind of stomach-lurching selling which could conceivably have marked a market bottom. I have to say I don’t like it.

James Hamiltion responds:

I doubt very much that anyone on the FOMC has much interest in protecting the investments of stock market participants. Instead, I suspect that the Fed is using equity prices just as I and many other economic analysts do, namely, as a useful aggregator of private and public information about near-term prospects for economic growth. All the recent indicators have suggested a significant deterioration of real economic activity over the last two months. I take the global stock market sell-off as one more confirmation of that assessment, and new information about the global scope of the problems we face.

Hamiltion’s interpretation is charitable, too charitable to fit the evidence. If the Fed were only using world equity prices as an indicator, and were not specifically concerned with altering US stock market outcomes on this day, Tuesday, January 22, 2007, they would not have scrambled over a holiday weekend, perhaps over a single long night, to put together a virtual FOMC meeting prior to market open on a cold, tired winter morning. Nor is this the first time the Bernanke Fed has behaved this way. By my count this is the third unexpected pre-market announcement issued by the Bernanke Fed following indications of turmoil in equity markets. [1]

Let’s recall what William Poole, President of FRB St Louis (and, interestingly, the only dissenter to this morning’s move) said in November, 2007 about the “Fed put”:

I can state my conclusion compactly: There is a sense in which a Fed put does exist. However, those who believe that the Fed put reflects unwise monetary policy misunderstand the responsibilities of a central bank. The basic argument is very simple: A monetary policy that stabilizes the price level and the real economy cannot create moral hazard because there is no hazard, moral or otherwise. Nor does monetary policy action designed to prevent a financial upset from cascading into financial crisis create moral hazard. Finally, the notion that the Fed responds to stock market declines per se, independent of the relationship of such declines to achievement of the Fed’s dual mandate in the Federal Reserve Act, is not supported by evidence from decades of monetary history.

Poole is quite clear that he believes it is within the Fed’s mandate to use monetary policy “to prevent a financial upset from cascading into financial crisis”. That’s a plausible view of what the Fed is after with its surprise, early morning interventions.

Poole goes on to say…

From time to time, to be sure, Fed action to stabilize the economy—to cushion recession or deal with a systemic financial crisis—will have the effect of pushing up stock prices. That effect is part of the transmission mechanism through which monetary policy affects the economy. However, it is a fundamental misreading of monetary policy to believe that the stock market per se is an objective of policy. It is also a mistake to believe that a policy action that is desirable to help stabilize the economy should not be taken because it will also tend to increase stock prices.

Reviewing these two snippets reveals what I think are fatal tensions in the Fed’s practice of asymmetric macroeconomic stabilization (stimulate busts but never prejudge a boom a bubble). Poole is at pains, throughout his talk (whose theme is moral hazard) to claim that stabilization policy uses the stock market as a instrument of policy, but that this does not imply that the stock market can use the FRB as a backstop or guarantee. In the question of who’s using who, Poole wants to make it clear that the FRB is the boss. But, if the Fed must intervene to prevent “panics”, it has placed itself in the role of a parent habitually blackmailed by a self-destructive adolescent. “If you don’t give me what I want want Mommy, I’ll cut myself and maybe I’ll die!” As too many parents know, it’s a bad situation, precisely because the threat of harm can be credible. One can’t condemn a parent for capitulating in any particular squabble. But, it’s also obvious that this is a bad dynamic, one that shouldn’t be lauded as the cutting edge of “intelligent macrofamilial stabilization policy.” It’s not a particular policy action that’s bad, it’s the macroeconomic game that we’ve settled into that has to be changed if we want markets that aggregate external information and make wise allocation decisions rather than focusing on intrafinancial Kremlinology.

I’m not optimistic that the current Fed will transcend heroics and push towards a new dynamic. The Great Depression haunts the Fed chairman like the memory of an older sibling’s suicide. The troubled younger child will be coddled and indulged, and fingers will be wagged only when it is very safe to do so. But, tragically, indulgence and capitulation don’t always work, what appears to be the least risky course can sometimes be a sure route to escalation and destruction. When the last child died, it was blamed on tough love. But that might not be right, or if it was, it might say little about what this child needs.

Anyway, I think recent events have shown pretty clearly that a Fed put does exist. The Fed can be counted on quite specifically to try to forestall extreme lower tail outcomes on very short period US equity returns. That doesn’t mean the Fed is setting a floor under long-term asset prices. They might soberly stand aside as markets fall by 60% over a period of months. But they don’t want it to happen in a day. Long-term, buy-and-hold investors should take little comfort. But short-horizon traders have every reason to truncate the lower tails of the subjective probability distributions that guide their moves.

Still, though Bernanke & Co may fully intend to try, there’s no guarantee that the Fed will succeed at preventing sharp drops or sudden stops. The Fed is doing its best to offer traders a put, but as markets are now learning, counterparty risk can be a bitch.

---

[1] The first surprise intervention was the announcement on August 17 of the cut in the discount window spread from 100 to 50 bps following an overnight crash on Asian markets. The second was the Fed’s announcement of the TAF and central bank coordination on December 12, following a disappointed reaction in equity markets to a fed funds cut of “only” 25 bps. The third intervention was today’s. The timing of the Dec 12 announcement may have been a coincidence not much related to equity prices behavior, but the Jan 22 and Aug 17 announcements were, in my opinion, clearly intended to affect US stock markets.

This entry was posted on Tuesday, January 22nd, 2008 at 10:10 pm PST.
You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.