On August 7, the Federal Open Market Committee (FOMC) decided to keep its target for the federal funds rate at 5.25%, where it has been since June 29, 2006. The FOMC, the Fed’s policy arm, began restricting access to credit on June 2004, when it raised the fed funds rate from its historic low of 1%. Meeting every six weeks, the FOMC boosted the funds rate by another quarter of a percent 17 consecutive times. Towards the end of the process, in January 2006, Ben Bernanke succeeded Alan Greenspan as Chairman of the Federal Reserve and of the FOMC.
The rational for that first 2004 rate increase, quoted at left, was that the low interest rates then in effect were too accommodative; that is, they encouraged overly robust economic activity that could lead to inflation in the future. The inflation rate was low and expected to remain so, but the FOMC had to be vigilant in defense of its statutory requirement to keep prices reasonably stable.
At every FOMC meeting thereafter through Greenspan’s tenure, the FOMC reiterated this same concern, while conceding that inflation was and was likely to “remain contained,” to use one of the Committee’s pet phrases. Even in mid-2006, when energy and commodity prices rose, the FOMC stated that the effect on core inflation was “modest,” and that it expected future inflation pressures to be “moderate”.
In fact, the FOMC was correct. The rate of core inflation fell steadily from 2001 through the end of 2003. Even when it began to move higher in 2004, it barely got above 2%, peaking at 2.5%. It has been falling nicely for the last few months and is now below 2% again.
When the Fed first began raising rates, it was accused of “taking away the punchbowl” while the economic party was in still in full swing. This hackneyed metaphor meant that the Fed was trying to cool down an economy that had yet to overheat. In 1987, when the stock market crashed, in 1995 during the Mexican peso crisis, and again in 1998 with the Long-Term Capital Management collapse, the Greenspan Fed quickly reduced the fed funds rate target to reassure the markets and provide liquidity. In those instances, the Fed was accused of exercising what has since been called the “Greenspan put.” (The buyer of a put option has the right to sell an agreed upon quantity of a specific security by a certain date, thus protecting himself against a catastrophic fall in prices.) The “Greenspan put” was a way of saying that the Fed would always come to the market’s rescue when the going got rough.
“Taking away the punchbowl” and the “Greenspan put” were two pieces of the same strategy. The Fed under Greenspan was determined to be preemptive; that is, to take action before all the facts were in. The reason, as a large body of research has clearly demonstrated, is that monetary policy acts on the economy after a lag. It remains unclear if the lag is six months, a year, or even longer, but there is no doubt that the outcome of present Fed action only begins to be felt well into the future.
Whether the particular preemptive actions taken by the Greenspan Fed were the right ones can be debated endlessly, but the point here is that they were taken for rational, unemotional reasons. But the criticisms of preemption and especially of the Greenspan put were and too often still are of an emotional, moral nature. The Greenspan put is condemned for removing moral hazard from the market, for softening or forestalling punishment for immoral actions. Morality has an important place in the financial world, but the essential moral qualities are those concerned with honesty, straightforwardness, and transparency. The moral issues raised by providing markets with a safety net have their origins in two of our less admirable emotions. One is schadenfreude, a German word meaning joy at the misfortune of others. It’s what we feel when a comedian gets a pie in the face or an inordinately wealthy man loses money. The second is the comfort we take in believing that those who suffer must deserve it. Neither of these emotions belongs in free market finance, where the value of an asset is just what the next person will pay for it, no more and no less. The fact that, in 2001, some people paid $80 for shares for Cisco Systems that are worth $30 today should elicit in us neither glee at their loss nor relief that they, as compared to us, somehow deserved it. Market participants, collectively, simply decided that they had been mistaken in the valuation of Cisco and made the required correction.
Today, a similar process is underway. Market participants have concluded that certain types of securitized mortgage pools and other debt instruments were overvalued. They are attempting to determine what the proper valuation of these instruments should be. The process is messy because it involves thousands, perhaps millions, of people with very varied degrees of sophistication and competence, scattered around the globe. Many of the instruments being valued are complicated, leveraged, hedged, held in non-public funds, and otherwise impervious to easy analysis even by those capable of it.
The Federal Reserve was created to keep this kind of messiness from getting out of control and bringing the whole economy down with it. In 1907, a major financial panic was narrowly avoided when JP Morgan organized what would today be called a market bailout by the leading New York banks. Even more famously, the debonair Richard Whitney strolled onto the floor of New York Stock Exchange one afternoon in late October 1929 and offered to buy shares of US Steel at a higher-than-market price in an attempt to stem another, more desperate panic. Morgan’s nick of time success was the impetus for the first Federal Reserve Act. The Government realized that the potential collapse of the financial system was too important to be left in private hands. The failure of Whitney’s gesture, backed though it was by all the big Wall Street houses, proved the case.
That’s what’s at stake now. The use of the Greenspan put is not an attempt to “save investors’ hides” or cushion the fall of avaricious and predatory lenders. No one is proposing a candlelight vigil for hedge fund managers. But, as an example of one among many, consider the failure of American Home Mortgage. The company was not a subprime lender. It made mortgages to people with good but not stellar credit. When it filed for bankruptcy last week because its banks cut off its credit lines, more than 6,000 people lost their jobs. Hundreds of borrowers whose loans had been approved suddenly found themselves without a mortgage. It’s people like these we should be concerned about and who should be protected if possible. Their suffering is neither funny nor deserved.
And this brings us back to the FOMC meeting of August 7. Here are the key portions of the statement the FOMC issued explaining the decision not to adjust the fed funds target:
“Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.
Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.”
The first sentence sets the tone. It’s almost breathtaking in its understatement and appalling in the bloodless disregard of the human pain caused by the housing collapse. Ben Bernanke has been widely praised for not exercising the Greenspan put; that is, for taking the moral high road and not riding to the markets’ rescue. The rationale for not attempting to reassure the markets with a cut in the fed funds rate—or at least a nod in that direction—is in the second paragraph, the fact that the decline in inflation has not been “convincingly demonstrated.” Nothing, of course, could be less preemptive than a policy of waiting to change course until after the desired outcome of the previous course has been fully achieved. The country appears to be operating under a Fed that has both abandoned preemptive policy moves and adopted a very questionable moral stance.
Markets, ultimately, are vastly more powerful than any central bank or all of them put together. Enormous liquidity pressures forced the Fed, the European Central Bank and several Asian central banks to provide hundreds of billions in emergency liquidity last Thursday and Friday. Fed funds futures and similar indices have built in a near 100% probability of a cut in the fed funds target by the September FOMC meeting. Many traders don’t believe the Fed can wait even that long. They project a rare inter-meeting cut in August. My own belief is that the Fed erred by not easing credit conditions at least symbolically on August 7. I expect that they will soon have to reverse course, but only time will tell.
