The Fed’s Job
By BRIAN S. WESBURY
Blaming monetary policy for
economic and financial market
turmoil is a time honored tradition.
Maybe the most famous bashing was
in 1896 when William Jennings
Bryan, an original populist, ranted
against hard money and for inflation:
". . . we shall answer their demands
for a gold standard by saying to
them, you shall not press down upon
the brow of labor this crown of
thorns. You shall not crucify
mankind upon a cross of gold."
Monetary policy makes an easy
scapegoat because printing money
(like drinking a cup of coffee) is an
easy way to give an economy a
temporary boost. But if what ails the
economy or markets was not caused
by tight money in the first place, a
temporary boost will not help. It may
cover up the symptoms temporarily,
but in the end it does not solve the
underlying issue (a lack of sleep).
In fact, easy money always leads to
greater problems down the road --
either rising inflation, or a reduced
sensitivity to risk, as markets come
to expect rate cuts to bail them out.
Lately, modern-day William
Jennings Bryans have been loudly
calling on the Fed to cut interest rates
and inject cash into the banking
system. They believe more money
would stop financial markets from
seizing up any further.
This would make sense if money was
already tight -- or to put it another
way, if a lack of liquidity was the
real issue. But trades are clearing,
banks are well capitalized,
commercial and industrial loans are
growing, credit-worthy borrowers are
getting mortgages, and the economy
is still expanding.
This was not the case after 9/11,
when communication lines were cut
to the Bank of New York, a key
clearing house for bond trades. Then,
liquidity injections were clearly
needed. Trades failed and overdrafts
mounted, forcing the Fed to inject
hundreds of billions of dollars into
the banking system.
In contrast, the current turmoil in the
financial markets has nothing to do
with a lack of liquidity. More
importantly, there is little hope that
any liquidity the Fed would inject
into the banking system would
actually get to the sectors of the
market where only sporadic, fire-sale
pricing of securities is taking place.
Some are arguing that a sharp decline
in the three-month Treasury bill
yield, to 3.85% from roughly 5%
during the past few days, shows the
need for a huge infusion of cash that
would force the federal funds rate
down. But the drop in T-bill yields is
a reflection of three issues: a flight to
quality, a guess that the Fed will
lower rates at its next meeting and a
very liquid market.
First, fear and panic has increased
demand for rock-solid Treasury
debt, driving prices up and yields
down. Second, expectations of Fed
rate cuts always push short-term
rates down. But it's a circular
argument to say falling short-term
rates, due to an expectation of Fed
rate cuts, is any reason to cut rates.
Finally, the liquidity already
sloshing around in the banking
system must go somewhere and
right now it is going into the T-bill
market. Low T-bill rates are a
reflection of the liquidity already in
the system, not a clarion call for
more.
The real problem with the financial
markets is that extreme leverage
and extreme uncertainty have met
in the subprime loan market. No
one knows how many loans will go
bad, who owns these mortgages and
what leverage they have applied.
We do know that subprime lending
is just 9% of the $10.4 trillion
dollar mortgage market, and
delinquencies are running at about
18%. The Alt-A market is about 8%
of all mortgages and about 5% of
this debt is delinquent.
As an example, let's take a very low
probability event and assume that
losses triple from here. Let's
assume that 54% of all subprime
loans and 15% of all Alt-A loans
actually move to foreclosure. Then,
assume that lenders are able to
recover 50% of the value of their
loans. In this scenario, total losses
in the subprime market would be
27%, while total losses in Alt-A
would be 7.5%.
From this we can estimate a price for
the securitized pools of these assets.
Without doing any actual adjustment
for yields, or for different tranches of
this debt, the raw value of the
underlying assets would be 73 cents
on the dollar for subprime pools and
92.5 cents for the Alt-A pools.
Getting a bid on this stuff should be
easy, right? After all, the market
prices risky assets every day.
But this is the rub. A hedge fund, or
financial institution, that uses
leverage of 4:1 or more, would be
wiped out if it sold subprime bonds
at those levels. A 27% loss on Main
Street turns into a 100% loss on Wall
Street very easily. But because hedge
funds can slow down redemptions, at
least for awhile, and because they are
trying desperately not to implode,
they hold back from the market. At
the same time, those with cash smell
blood in the water, patiently wait,
and put low-ball bids on risky bonds.
The result: No market clearing price
in the leveraged, asset-backed
marketplace.
Additional Fed liquidity can't fix this
problem. An old phrase from the
1970s comes to mind -- "pushing on
a string." In the 1970s, no matter
how much money the Fed pushed
into the system, it could not create a
sustainable economic recovery that
did not include a surge in inflation
because high tax rates and significant
government interference in the
economy prevented true gains in
productivity.
There is a lesson here. Populism is in
the air these days, and the threat from
tax hikes, trade protectionism and
more government involvement in the
economy, is rising. This reduces the
desire to take risk. Congress is
working on a legislative response to
current mortgage market woes as
well. And as with the savings and
loan industry (forcing S&Ls to sell
junk bonds at fire-sale prices), and
Sarbanes-Oxley, the legislative
response almost always compounds
the problems.
The interaction of an uncertain
regulatory and tax environment with
a highly leveraged, illiquid market
for risky mortgage debt creates
conditions that look just like an
economy-wide liquidity crisis. But
it's not. A few rate cuts will not help.
What can help is more certainty. Tax
cuts, or at least a promise not to raise
taxes, and immunity - or at least a
safe harbor from criminal
prosecution for above-board
institutions in the mortgage business
- could help loosen up a rigid market
in a more permanent way than
sending out the helicopters to dump
cash in the marketplace.
The best the Fed can do is to stand at
the ready to contain the damage. In
this vein, their decision to cut the
discount rate and allow a broad list
of assets to be used as collateral for
loans to banks, was a brilliant
maneuver. It increases confidence
that the Fed has liquidity at the
ready, but does not create more
inflationary pressures. It was a
helping hand, not a bailout.
It also buys some time, which is what
the markets need. Every additional
month of payment information on
mortgage pools, and every mortgage
that is refinanced from an adjustable
rate to a fixed rate, will increase
certainty and provide more clarity on
pricing.
Even though many, including Alan
Greenspan, continue to argue that the
excessively easy monetary policy of
2001-2004 was necessary, it was this
policy stance that caused the
problems we face today. The current
financial market stress is a result of
absurdly low interest rates in the
past, not high interest rates today.
In fact, current interest rates are still
low on both a nominal and real
basis. Cutting them again causes a
further misallocation of resources,
and makes the Fed an enabler of the
highly leveraged.
What William Jennings Bryan was
really complaining about in 1896
was falling commodity prices,
especially falling farm prices. What
he and the other populists ignored
was that these prices were falling
because of productivity, not tight
money. His "Cross of Gold" speech
was a clear stepping stone to the
creation of the Fed in 1913. Since
then, inflation has been much
higher than it would have been
under the gold standard. But all that
inflation never did save the family
farm.
Similarly, even very easy money
today can't put off the day of
reckoning for subprime mortgage
holders who bought homes with no
money down and thought interest
rates would stay low forever. It
can't help overly leveraged
investors who thought they were
getting risk-free 20% annual
returns. Providing enough liquidity
to allow markets to function, while
keeping consumer prices as stable
as possible, is the best the Fed can
do. It should be all we really ask.
Mr. Wesbury is chief economist at
First Trust Advisors L.P. in Lisle, Ill.
Reprinted with permission of the
Wall Street Journal © 2007 Dow
Jones and Company, Inc. All
Rights Reserved.
