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Posted by warren mosler (65.113.90.26) on 12:12:30 11/29/07
'People can misinterpret almost anything so that it coincides with
views they already hold. They take from art what they already
believe.' -SKubrick
Financial Markets and Central Banking
I thought it might be useful to start this session with a few thoughts
on some of the issues facing central banks as they deal with the
consequences of the recent turbulence in financial markets.1 This
list is not comprehensive: I have concentrated on the issues
associated with our roles as monetary policy makers and providers of
liquidity--and even in that category I cannot address all the issues
in the short time allotted.
Like every other period of financial turbulence, this one has been
marked by considerable uncertainty. Central banks, other authorities,
and private-market participants must make decisions based on analyses
made with incomplete information and understanding. The repricing of
assets is centered on relatively new instruments with limited
histories--especially under conditions of stress; many of them are
complex and have reacted to changing circumstances in unanticipated
ways; and those newer instruments have been held by a variety of
investors and intermediaries and traded in increasingly integrated
global markets, thereby complicating the difficulty of seeing where
risk is coming to rest.
Operating under this degree of uncertainty has many consequences. One
is that the rules and criteria for taking particular actions seem a
lot clearer in textbooks or to many commentators than they are to
decision makers. For example, the extent to which institutions are
facing liquidity constraints as opposed to capital constraints,
YES, HE RECOGNIZES THE DIFFERENCE. LENDING IS NOT CONSTRAINED BY CAPITAL.
or the moral hazard consequences of policy actions, are inherently
ambiguous in real time. Another consequence of operating under a high
degree of uncertainty is that, more than usually, the potential
actions the Federal Reserve discusses have the character of "buying
insurance" or managing risk--that is, weighing the possibility of
especially adverse outcomes.
INFLATION RISK WHICH THEY BELIEVE HURTS LONG TERM OPTIMAL EMPLOYMENT
AND GROWTH VS SYSTEMIC RISK WHICH THEY HAVE CALLED 'MARKET
FUNCTIONING' RISK.
THIS IS SOME KIND OF UNKNOWN CATASTROPHIC SHUTDOWN OF THE REAL ECONOMY
DUE TO DEPENDENCE OF THE REAL ECONOMY ON THE FUNCTIONING OF THE
FINANCIAL SECTORS. THIS RISK IS BOTH NEBULOUS AND OUTSIDE OF
MAINSTREAM MODELS, HENCE THE RADICALLY ELEVATED UNCERTAINTY THAT LED
TO THE LAST TWO CUTS AS 'INSURANCE' AGAINST THIS 'MARKET FUNCTIONING'
RISK.
FROM THE STATEMENT AFTER THE OCT 31 MEETING THE INFLATION RISK AND THE
MARKET FUNCTIONING RISK WERE 'BALANCED.' THIS MEANS THE ELEVATED
MARKET FUNCTIONING RISK WAS BALANCED BY THE ELEVATED INFLATION RISK.
The nature of financial market upsets is that they substantially
increase the risk of such especially adverse outcomes while possibly
having limited effects on the most likely path for the economy.
THIS REFERS BACK TO THE 'NEUTRALITY OF MONEY' THEOREM WHICH SAYS THAT
IN THE LONG RUN THE ECONOMY IS SUPPLY SIDE CONSTRAINED AND MONETARY
POLICY IS NEUTRAL FOR LONG TERM GROWTH AND EMPLOYMENT, PROVIDED THE
FED KEEPS INFLATION EXPECTATIONS 'WELL CONTAINED.' IF EXPECTATIONS
ARE ALLOWED TO BECOME ELEVATED, THEY BELIEVE THE REAL LOSSES ARE FAR
HIGHER THAN ANY SHORT TERM REAL LOSSES DUE TO A SLOWDOWN OR RECESSION.
Moral Hazard
Central banks seek to promote financial stability while avoiding the
creation of moral hazard. People should bear the consequences of
their decisions about lending, borrowing, and managing their
portfolios, both when those decisions turn out to be wise and when
they turn out to be ill advised.
'PEOPLE' HERE FOR THE MOST PART MEANS SHAREHOLDERS AND OWNERS. THAT
IS THE SOURCE OF THE 'MARKET DISCIPLINE' THAT REGULATES THE RISK
COMPANIES AND INDIVIDUALS TAKE.
At the same time, however, in my view, when the decisions do go
poorly, innocent bystanders should not have to bear the cost.
In general, I think those dual objectives--promoting financial
stability and avoiding the creation of moral hazard--are best
reconciled by central banks' focusing on the macroeconomic objectives
of price stability and maximum employment.
THAT IS HIS ANSWER TO MORAL HAZARD. AND HE BELIEVES THAT PRICE
STABILITY IS A NECESSARY CONDITION FOR OPTIMAL LONG TERM GROWTH AND
EMPLOYMENT, WHICH IS THE CURRENT 'MAINSTREAM' ECONOMIC THOUGHT AS
SUPPORTED BY ALL OF THE WORLD'S CENTRAL BANKERS AND MAJOR
UNIVERSITIES.
THIS IS A DIRECT STATEMENT AS TO THE IMPORTANCE OF NOT LETTING
INFLATION EXPECTATIONS ELEVATE.
Asset prices will eventually find levels consistent with the economy
producing at its potential, consumer prices remaining stable, and
interest rates reflecting productivity and thrift.
CONTINUATION OF THE NEUTRALITY OF MONEY IDEA- MARKETS WILL ADJUST IN
THE LONG RUN TO THE ECONOMY'S OPTIMAL OUTPUT AND EMPLOYMENT, AS ABOVE.
Such a strategy would not forestall the correction of asset prices
that are out of line with fundamentals or prevent investors from
sustaining significant losses. Losses were evident early in this
decade in the case of many high-tech stocks, and they are in store for
houses purchased at unsustainable prices and for mortgages made on the
assumption that house prices would rise indefinitely.
WITH THIS STRATEGY- "central banks' focusing on the macroeconomic
objectives of price stability and maximum employment" SHAREHOLDERS AND
OWNERS WILL TAKE THE LOSSES, NOT THE GOVT.
To be sure, lowering interest rates to keep the economy on an even
keel when adverse financial market developments occur will reduce the
penalty incurred by some people who exercised poor judgment. But
these people are still bearing the costs of their decisions and we
should not hold the economy hostage to teach a small segment of the
population a lesson.
THIS IS JUSTIFYING THE PREVIOUS CUTS. HE IS SAYING THE FED CUTS WERE
IN LINE WITH ITS MACRO OBJECTIVES. THIS IS MOVING A BIT INTO THE
'REINVENTING MONETARY POLICY' REALM, AS ABOVE, AS THE SYSTEMIC RISKS
THEY FEAR ARE NOT IN THEIR MODELS NOR IN MAINSTREAM CONSIDERATIONS.
ADDITIONALLY, THERE IS NO IDENTIFIED 'CHANNEL' FOR THE RATE CUTS TO
ALTER 'MARKET FUNCTIONING' APART FROM 'PSYCHOLOGICAL' CONSIDERATIONS,
WHILE THE FED IDENTIFIES SEVERAL 'CHANNELS' THAT CONNECT RATE CUTS TO
HIGHER INFLATION.
THAT'S WHERE ALL THE TALK OF 'BEING QUICK TO TAKE THE CUTS BACK' COMES
FROM FROM SEVERAL FED PARTICIPANTS.
The design of policies to achieve medium-term macroeconomic stability
can affect the incentives for future risk-taking. To minimize moral
hazard, central banks should operate as much as possible through
general instruments not aimed at individual institutions. Open market
operations fit this description,
CORRECTLY AFFIRMING OPEN MARKET OPERATIONS ARE NOT 'BAILOUTS' BUT NOT
GOING SO FAR AS TO EXPLAIN HOW THE MERELY 'OFFSET OPERATING FACTORS.'
PROBABLY NOT ENOUGH TIME TO GET ALL THAT IN.
but so, too, can the discount window when it is structured to make
credit available only to clearly solvent institutions in support of
market functioning.
THIS READS TO ME LIKE A PRELUDE TO A DISCOUNT RATE CUT AND REMOVAL OF
THE 'STIGMA' AS WE RECOMMENDED LAST WEEK. THE FIRST STEP IS TO
RECOGNIZE THAT IT'S OPERATIONALLY IN NO WAY A BAIL OUT FOR WEAK OR
INSOLVENT BANKS. NOR DOES IT HELP THEM ECONOMICALLY IN ANY WAY BUT
ONLY AIDS MARKET FUNCTIONING.
The Federal Reserve's reduction of the discount rate penalty by 50
basis points in August followed this model. It was intended not to
help particular institutions but rather to open up a source of
liquidity to the financial system to complement open market
operations, which deal with a more limited set of counterparties and
collateral.
AS ABOVE.
The Effects of Financial Markets on the Real Economy
Related developments in housing and mortgage markets are a root cause
of the financial market turbulence. Expectations of ever-rising house
prices along with increasingly lax lending standards, especially on
subprime mortgages, created an unsustainable dynamic, which is now
reversing.
HE RECOGNIZES IT IS INDEED REVERSING.
In that reversal, loss and fear of loss on mortgage credit have
impaired the availability of new mortgage loans, which in turn has
reduced the demand for housing and put downward pressures on house
prices, which have further damped desires to lend. We are following
this trajectory closely,
YES, AND FOR QUITE A WHILE. NOTE THE WORD 'TRAJECTORY' AS A DOWNWARD
PATH WAS BUILT INTO THE OCT 31 STATEMENT.
but key questions for central banks, including the Federal Reserve,
are, What is happening to credit for other uses, and how much
restraint are financial market developments likely to exert on demands
outside the housing sector?
LOOKING FOR 'SPILLOVER.'
Some broader repricing of risk is not surprising or unwelcome in the
wake of unusually thin rewards for risk taking in several types of
credit over recent years. And such a repricing in the form of wider
spreads and tighter credit standards at banks and other lenders would
make some types of credit more expensive and discourage some spending,
developments that would require offsetting policy actions, other
things being equal. Some restraint on demand from this process was a
factor I took into account when I considered the economic outlook and
the appropriate policy responses over the past few months.
THEY HAVE ALREADY FORECAST SOME 'RESTRAINT ON DEMAND.'
An important issue now is whether concerns about losses on mortgages
and some other instruments are inducing much greater restraint and
thus constricting the flow of credit to a broad range of borrowers by
more than seemed in train a month or two ago.
RIGHT, HAVE THINGS GOTTEN WORSE SINCE OCT 31?
In general, nonfinancial businesses have been in very good financial
condition; outside of variable-rate mortgages, households are meeting
their obligations with, to date, only a little increase in delinquency
rates, which generally remain at low levels. Consequently, we might
expect a moderate adjustment in the availability of credit to these
key spending sectors. However, the increased turbulence of recent
weeks partly reversed some of the improvement in market functioning
over the late part of September and in October. Should the elevated
turbulence persist, it would increase the possibility of further
tightening in financial conditions for households and businesses.
THERE IS A POSSIBILITY OF TURBULENCE RESULTING IN FURTHER TIGHTENING
OF FINANCIAL CONDITIONS. THIS IS NOT STATED AS A CERTAINTY.
Heightened concerns about larger losses at financial institutions now
reflected in various markets have depressed equity prices and could
induce more intermediaries to adopt a more defensive posture in
granting credit, not only for house purchases, but for other uses a
well.
AGAIN, 'COULD' BE A SOURCE OF REDUCED DEMAND. AGAIN NOT A CERTAINTY.
Liquidity Provision and Bank Funding Markets
Central banks have been confronting several issues in the provision of
liquidity and bank funding. When the turbulence deepened in early
August, demands for liquidity and reserves pushed overnight rates in
interbank markets above monetary policy targets. The aggressive
provision of reserves by a number of central banks met those demands,
and rates returned to targeted levels. In the United States, strong
bids by foreign banks in the dollar-funding markets early in the day
have complicated our management of this rate.
NOTE THAT IT IS EURO BANKS THAT HAVE BEEN BIDDING UP LIBOR.
And demands for reserves have been more variable and less flexible
in an environment of heightened uncertainty, thereby adding to
volatility.
THIS IS A WEAKNESS IN THE NY FED'S 'TOOL BOX' THAT HE KNOWS ABOUT BUT
DOESN'T WANT TO DIRECTLY CRITICIZE. INSTEAD HE OFFERS REMEDIES.
In addition, the Federal Reserve is limited in its ability to
restrict the actual federal funds rate within a narrow band because we
cannot, by law, pay interest on reserves for another four years.
SUPPORTING THE MEASURE NOW BEFORE CONGRESS TO ALLOW THE FED TO PAY
INTEREST ON RESERVES. THIS WOULD ASSIST THE NY FED IN KEEPING THE
FUNDS RATE AT THE TARGET SET BY THE FOMC.
At the same time, the term interbank funding markets have remained
unsettled. This is evident in the much wider spread between term
funding rates--like libor--and the expected path of the federal funds
rate. This is not solely a dollar-funding phenomenon--it is being
experienced in euro and sterling markets to different degrees. Many
loans are priced off of these term funding rates, and the wider
spreads are one development we have factored into our easing actions.
DEFENDING PAST EASINGS ON THE NOTION THAT EVEN THOUGH FED FUNDS ARE
LOWER, TO MANY THE COST OF FUNDS IS BASED ON LIBOR WHICH HASN'T GONE
DOWN AS MUCH AS THE FUNDS RATE.
Moreover, the behavior of these rates is symptomatic of caution
among key marketmakers about taking and funding positions, and this is
probably impeding the reestablishment of broader market trading
liquidity.
THE FED FUNDS/LIBOR SPREAD IS PART OF THE LIQUIDITY PROBLEM.
Conditions in term markets have deteriorated some in recent weeks.
The deterioration partly reflects portfolio adjustments for the
publication of year-end balance sheets. Our announcement on Monday of
term open market operations was designed to alleviate some of the
concerns about year-end pressures.
YES, MUCH OF THE SPREAD IS NOT A YEAR END ISSUE.
The underlying causes of the persistence of relatively wide-term
funding spreads are not yet clear. Several factors probably have been
contributing. One may be potential counterparty risk while the
ultimate size and location of credit losses on subprime mortgages and
other lending are yet to be determined. Another probably is balance
sheet risk or capital risk--that is, caution about retaining greater
control over the size of balance sheets and capital ratios given
uncertainty about the ultimate demands for bank credit to meet
liquidity backstop and other obligations. Favoring overnight or very
short-term loans to other depositories and limiting term loans give
banks the flexibility to reduce one type of asset if others grow or to
reduce the entire size of the balance sheet to maintain capital
leverage ratios if losses unexpectedly subtract from capital.
Finally, banks may be worried about access to liquidity in turbulent
markets. Such a concern would lead to increased demands and reduced
supplies of term funding, which would put upward pressure on rates.
This last concern is one that central banks should be able to address.
The Federal Reserve attempted to deal with it when, as I already
noted, we reduced the penalty for discount window borrowing 50 basis
points in August and made term loans available.
THAT WAS A FEW DAYS AFTER WE SUGGESTED IT.
The success of such a program lies not in loans extended but rather
in the extent to which the existence of this facility helps reassure
market participants. In that regard, I think we had some success, at
least for a time.
YES, KEPT SOME SORT OF A LID ON FF/LIBOR OF AROUND 50 BP PLUS THE
'STIGMA' EXPLAINED BELOW.
But the usefulness of the discount window as a source of liquidity has
been limited in part by banks' fears that their borrowing might be
mistaken for accessing emergency loans for troubled institutions.
This "stigma" problem is not peculiar to the United States, and
central banks, including the Federal Reserve, need to give some
thought to how all their liquidity facilities can remain effective
when financial markets are under stress.
A PRELUDE TO REMOVING THE 'STIGMA' AS WE ALSO SUGGESTED A FEW DAYS AGO.
Conclusion
In response to developments in financial markets, the Federal Reserve
has adjusted the stance of monetary policy and the parameters of how
we supply liquidity to banks and the financial markets.
IN THIS 'CONCLUSION' HE TURNS ATTENTION TO *HOW* THEY SUPPLY LIQUIDITY.
These adjustments have been designed to foster price stability and
maximum sustainable growth and to restore better functioning of
financial markets in support of these economic objectives. My
discussion today was intended to highlight some of the issues we will
be looking at in financial markets as we weigh the necessity of future
actions.
WEIGH THE BALANCE OF RISKS, AND HOW TO ADDRESS THEM.
We will need to assess the implications of these developments, along
with the vast array of incoming information on economic activity and
prices, for the future path of the U.S. economy. As the Federal Open
Market Committee noted at its last meeting, uncertainties about the
economic outlook are unusually high right now. In my view, these
uncertainties require flexible and pragmatic policymaking--nimble is
the adjective I used a few weeks ago. In the conduct of monetary
policy, as Chairman Bernanke has emphasized, we will act as needed to
foster both price stability and full employment.
TO ME THIS SPEECH ADDS UP TO A DISCOUNT RATE CUT AND REMOVAL OF THE
STIGMA TO FOSTER LIQUIDITY AND MARKET FUNCTIONING.
PRICE STABILITY MEANS NO FF CUT- THE 75 BP 'INSURANCE' HAS ALREADY
CARRIED WHAT THEY SEE AS A HIGH PREMIUM AS INFLATION RISKS HAVE
ELEVATED SUBSTANTIALLY SINCE OCT 31, AND CPI WILL LIKELY BE GOING
THROUGH 4% YEAR OVER YEAR A FEW DAYS AFTER THE MEETING.
FULL EMPLOYMENT ALSO MEANS PRICE STABILITY, AS PRICE STABILITY IS A
NECESSARY CONDITION FOR MAX LONG TERM EMPLOYMENT.
COMMENTS WELCOME- PLEASE SENT TO OTHERS FOR THEIR COMMENTS AS WELL.
THANKS,
WARREN
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