Today's Surprise Fed Funds Rate Cut

I find today's fed funds rate cut troubling. Since when does the Fed's mandate cover activity in global stock markets? And no, I do not buy the argument that the fall in global stock markets somehow represents brand new information--that did not exist a few days ago--about the possibility of a U.S. recession. The market sell off was pure panic driven and the irregular timing of this rate cut makes the Fed look panic driven too.

I really like Ben Bernanke, but this response blows my mind away. The only reasonable justification for such action is that the Fed knows something the markets do not know. If so, then the markets have even more reason to panic and sell off.

So how does Wall Street feel about this move? CNBC did a quick survey today and found,

"Nearly 75 percent of Wall Street pros responding to the CNBC Trillion Dollar Snap Survey think the Federal Reserve did the right thing by cutting interest rates by three-quarters of a point, to 3.5%, this morning."

Surprise, surprise. Stepping away from Wall Street, where the intoxicating influence of liquidityholics like Jim Cramer is hard to avoid, one can find more thoughtful observers. For example, Willem Buiter of the London School of Economics writes in Financial Times the following:

"It is bad news when the markets panic. It is worse news when one of the world's key monetary policy making institutions panics. Today the Fed cut the target for the Federal Funds Rate by 75 basis points, from 4.25 percent to 3.50 percent. The announcement was made outside normal hours and between normal scheduled FOMC meetings.

This extraordinary action was excessive and smells of fear. It is the clearest example of monetary policy panic football I have witnessed in more than thirty years as a professional economist. Because the action is so disproportionate, it is likely to further unsettle markets. Even the symptoms of malaise that appear to have triggered the Fed's irresponsible rate cut, the collapse of stock markets in Asia and Europe and the clear message from the futures markets that the US stock markets would follow (a 500 point decline of the Dow was indicated), are unlikely to be improved by this measure and may well be adversely affected.

In the absence of any other dramatic news that the sky is falling, I can only infer from the Fed's action that one or both of the following two propositions must be true.

(1) The Fed cares intrinsically about the stock market; specifically, it will use the instruments at its disposal to limit to the best of its ability any sudden decline in the stock market.

(2) The Fed believes that the global and (anticipate) domestic decline in stock prices either will have such a strong negative impact on the real economy or provides new information about future economic weakness from other sources, that its triple mandate (maximum employment, stable prices and moderate long-term interest rates) is best served by an out-of-sequence, out-of-hours rate cut of 75 basis points.

The first proposition would mean that the Fed violates its mandate. The second is bad economics."

Another example comes from Felix Salmon:

"There's nothing in there to justify a huge rate cut in the week before a regularly-scheduled meeting. Tighter credit for some households? Come on. 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.

Now the Fed is charged with keeping employment high and inflation low; it's not charged with protecting the capital of investors in the stock market. So this 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."

Sigh...

The Housing Recession Hits Home

Readers of my blog know I have taken a hard line against Fed interventions during the past few months. For example, in "Sound Policy or Liquidity Addicts" I took the Jim Cramer's of the world to task for their calls for a Fed bailout of financial markets. Some readers may read postings like that and conclude that I am just another out-of-touch academic spouting painful policy prescriptions from the comfort and safety of my ivory tower. If this thought has crossed your mind then this posting is especially for you.

Yes, I have been prescribing painful economic medicine, but this advice has not been in my own self-interest. This past summer I moved from Southwestern Michigan to Central Texas. As part of this move, I put my home on the worst national housing market in the past 40 years. What made my life even more interesting is that my house was placed on one of the worst state housing markets as well. Consequently, my home has been getting few bites and I have been making two home payments. Two home payments for our one-income family have been painful. Questions about this arrangement persisting for some time--some observers are predicting the housing recession will continue through 2009--has also been troubling. To add some perspective to this discussion consider the two figures below. These figures show the growth rates of the OFHEO housing price index for the nation, the state of Michigan, and South Bend, Indiana. The latter one is included because my home was not too far from South Bend, Indiana. The first figure shows the growth rates of housing prices unadjusted for inflation:

This figure shows the Michigan housing has had some big swings in the past and currently is declining in current dollar terms. Moreover, the figure indicates that Michigan and South Bend housing markets never really were part of the housing boom during the 2003-2005 period. The bottom line from this figure is that I bought a home in a particularly weak housing market... not very promising. But wait, there is more to this story. The above figure does not adjust for inflation. What has been the real return for houses in Michigan over this time? The next figure, which takes the OFHEO index and deflates it with the PCE deflator, answers this question:

This figure is striking: the growth rate of real home prices in Michigan has been declining since 2001 and turned negative in 2005. The South Bend, Indiana housing market is slightly better than the Michigan housing market, but still is relatively flat compared to the national average. Some caution should be taken in evaluating this figure: the regional housing price indices were deflated with a national price index. I am not sure, though, that the outcome would be much different if a regional price index were used.

Now back to my world. This week my wife and I finally received an offer on our home. We gave a counter offer and the prospective buyers accepted. Our counter offer requires us to bring money to table. We are glad to be paying this amount just to unload our home. So, we too have been hit by this housing recession. I would like to think that makes me an academic who has not lost touch with the real world

Update
I redid the second figure with the PCE deflator. The results seem more reasonable than what they were using the CPI as the deflator.

Roben Farzad's Enertaining Look at a Market Bailout

A great tounge-in-check perspective on a government bailout of the markets by Roben Farzad of BusinessWeek. I hope Jim Cramer and the othe liquidity addicts of the world are reading this piece.

Dude, Where's My Bailout?

An open letter to Fed Chairman Ben Bernanke, Treasury Secretary Henry Paulson, and Senate Banking Committee Chairman Chris Dodd Honorable

Public Servants: As you know, the conflagration in the subprime mortgage market is beginning to singe the very fabric of the American dream, by which I mean life, liberty, and the pursuit of home equity. I was elated to hear everyone from bond guru Bill Gross to Democratic Presidential hopefuls endorsing the idea of a government bailout of homeowners facing foreclosure as the payments on their zero-money-down mortgages soar.Bad credit? No credit? No problem! Uncle Sam has your back.I don't have a mortgage, much less one that's about to blow up. But I have no shortage of other losses, some of them quite painful, from the many well-considered investments I've made over the years. Therefore, under the equal protection clause of the U.S. Constitution, I'm entitled to a bailout as well. At least that's what my law school buddies tell me.Here's an annotated invoice:

STOCKS. In the dot-com heyday, I had the misfortune of buying shares of two companies that went poof within 12 months: Excite@Home, the residential high-speed Internet provider, and Allied Riser, a commercial broadband startup. (I was diversified—homes and offices.) Subtotal: Seven long years of regret and pitiful looks from my CPA have encouraged me to repress the exact sum of my capital losses, but for expediency's sake let's put it at $60,000.

MUTUAL FUNDS. I also invested in a tragicomic Putnam fund that somehow managed to lose an average of 44% a year between 2000 and 2002. It turns out that Putnam Investments was also at the heart of the market-timing scandal. Yet I never got any checks in the mail from Eliot Spitzer or from the investment pros who all but forced me to buy the shares. Subtotal, including compounded pain and suffering: $10,000.

PERSONAL RELATIONSHIPS. At about the same time, I was getting irrationally exuberant about a beautiful brunette, spending my paper stock gains on a series of expensive dates in Manhattan. There were mezzanine seats at Broadway plays, candlelit dinners in Greenwich Village, and enough orders to 1-800-Flowers to line the streets of Pyongyang on Kim Jung Il's birthday. Oh, and cab fares. Lots of those. Then, sometime between NASDAQ 5000 and the end of the Elián Gonzáles saga, said brunette dumped me. She broke my heart, but only after she broke my bank account. Subtotal: About $3,000, including $1,000 in self-prescribed Johnnie Walker Blue.

COLLECTIBLES. Twenty years ago, I was the last kid on my block to score a coveted "first series" Garbage Pail Kids trading card, for a total consideration of $25 in cash, three bags of Doritos, and the guitar Dad bought me in the second grade. Then the Garbage Pail market crashed. But the Los Angeles Dodgers dramatically won the '88 World Series, and my enthusiasm shifted to baseball. By 1990, with bar mitzvah winnings in hand, I shelled out for a José Offerman rookie card. Fifty bucks bought me the Lucite-encased visage of this dynamic Dodgers infielder, who knocked a home run in his first major league at bat. I figured it would double in price during every season of Offerman's promising career. Instead, his résumé came to entail mediocre stints with seven teams, culminating with the August clubbing of a pitcher in an independent-league game that invited two counts of second-degree assault. Subtotal: How can I attach a cold sum to the shattered dreams of a middle schooler? Sigh. $1,400.Please remit my $74,400 by check, money order, or PayPal. Rest assured that I will cycle the dollars back into economically vital investments. I hear some hedge funds are slashing their minimum buy-ins to $10,000, and that half-finished condos in Miami can be gotten for pennies on the original dollar. In any case, my efforts to bolster the U.S. gross domestic product could surely be strengthened by a series of interest rate cuts, so please see to those, too. After all, gentlemen, while intrepid investors like me crank the engine of American capitalism, times like these call for all of us to pitch in.

The Rest of Bernanke's Speech

In case you missed it, Ben Bernanke came out swinging at the liquidity addicts of the world in his speech Friday. To the Jim Cramers of the world he said,

"It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions."

Ouch...is that a bruised ego I see there Mr. Cramer? Ben Bernanke, however, did recognize the danger of contagion by noting,

"... developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy."

These words received the most attention in the media. A less noticed but nonetheless fascinating part of his speech looked at the history of housing. He specifically looked at five periods in housing finance history and its relation to macroecomic activity:

(1) Beginnings: Mortgage Markets in the Early Twentieth
(2) The New Deal and the Housing Market
(3) The Transmission Mechanism and the New Deal Reforms
(4) The Emergence of Capital Markets as a Source of Housing Finance
(5) The Monetary Transmission Mechanism Since the Mid-1980s

These five mini-chapters on the history of housing sector and its relation to the macroeconomy is the rest of the speech worth reading. Take a look for yourself at the speech.

Another Liquidity Addict?

Jim Cramer has found a new friend in Alan Mulally, the CEO of Ford. According the Financial Times, Mulally has come out calling for another liquidity binge to help get the U.S. economy through it current financial hangover. Alan needs to read the latest Economics Focus section in the Economist (discussed in my previous posting).

From the Financial Times:

Ford chief calls for Fed push on growth

The chief executive of Ford has joined calls for the Federal Reserve to stimulate the economy, saying the housing crisis and credit turmoil has made sustaining economic growth a ‘priority’. In an indication of the growing pressure on the Fed to cut rates, Alan Mulally said economic and credit conditions were a “big headwind” to his plan to turn round the carmaker, which last year lost $12.65bn.

“Something we are all concerned about is the macro-economy,” he said. “Especially right now in the US with subprime and [higher] fuel prices.”

Asked whether he backed a rate cut, Mr Mulally said: “It is a really important job to manage inflation and economic growth [but] focusing on economic growth appears to be a really important priority now.”

More on the Liquidity Addicts

In my previous post I spelled out a few reasons why the Jim Cramers of the world are liquidity addicts. Regarding these folks, I would be remiss not to point you to Dean Baker's posting, Wall Street Welfare Wimps Keep Whining, and the posting by Macro Man, 1-800-Bailout . Although the middle-of-roaders on this issue such as Mark Thoma and the Economist make good points about preventing contagion, I suspect that even they squirm uncomfortably when hearing the rants of liquidityholics.

Sound Policy or Liquidity Addicts?

What is the appropriate role of the Federal Reserve at this time? Most views on this question fall into one of three camps: (1) the 'inject much more liquidity now' view, (2) the 'inject some liquidy now to prevent contagion' view, (3) and the 'exercise monetary restraint now' view. What to make of these competing views? I want to focus in this posting on the 'inject more liquidity now' view. This group represents the Jim Cramers of the world who never tire of calling for more monetary easing whenver a finanical storm besets the markets. Below is an Op-Ed piece I wrote that addresses this very group.

Sound Policy or Liquidity Addicts?

"Ben Bernanke needs to open the discount window…He is being an academic! This is no time to be an academic. Open the darn discount window! ...My people have been in this game for 25 years. And they are losing their jobs and these firms are going to go out of business, and he's nuts! They're nuts! They know nothing! . . . The Fed is asleep…"
Jim Cramer on CNBC, August 3, 2007

Jim Cramer could not be happier. The Federal Reserve surprise discount rate cut of 50 basis points this past Friday spurred a brief recovery in markets and has created expectations of a Federal Funds rate cut in the September FOMC meeting. Jim Cramer and others like him who had been calling for an easing of monetary policy by the Federal Reserve surely feel vindicated by the market’s response on Friday and now are even more emboldened in their call for further interest rate cuts. But does this policy response make sense? Are these champions of interest rate cutting promoting sound policies that address the underlying problems or are they liquidity addicts simply begging for another shot of liquidity to get them through the hangover of the last monetary easing binge?

There are several compelling reasons to believe that these calls for the easing of monetary conditions are in fact nothing more than the cries of liquidity addicts hoping to avoid the needed correction in financial markets. First, the Jim Cramers of the world fail to recognize the difference between a liquidity crisis and an insolvency crisis. A liquidity crisis is when an individual, firm, or some sector of the economy is solvent but temporarily short of liquidity. For example, if an individual is unexpectedly hit with major medical expenses that he cannot pay out of pocket, but could pay once he sells some of his assets, such as land, then this individual is facing a liquidity crisis. However, if this same individual cannot pay out of pocket and has no assets to draw on then he is insolvent and facing an insolvency crisis. In the former case, extending credit or liquidity to this individual makes sense since he has assets to cover the new line of credit, but in the latter case extending credit would only postpone and maybe worsen the insolvency. This distinction is important because as Nouriel Roubini has shown the current turmoil in global markets is the result of an insolvency crisis not a liquidity crisis. Roubini notes in particular that this crisis stems from insolvencies and bankruptcies in mortgage-ladened households, mortgage lenders, home builders, and some hedge funds all of whom were driven by real economic distortions in the housing sector. These excesses in the housing sector simply cannot be waved away by some magical liquidity wand. This current insolvency crisis stands in stark contrast to a true liquidity crisis that emerged with the Long-Term Capital Management hedge fund debacle in 1998. Then, the Federal Reserve was able to successfully intervene and thwart a credit crunch, but it occurred in the context of a robust economy with no signs of broad insolvency. Believing that more monetary accommodation now will save the day misses this important distinction.

The Jim Cramers of the world also seem to forget what got us here in the first place: past monetary excesses. Following the recession of 2001 and the deflation scare of 2003, the Federal Reserve lowered it policy interest rates from a high of 6.5% in early 2001 to a low of 1% that was maintained through the summer of 2004. Although monetary policy began tightening in the second half of 2004, the federal funds rate was still lower than the year-on-year growth rate of nominal GDP through 2006. By keeping the interest rate below the growth rate of the economy for so long, there was every incentive for excessive leverage. Moreover, the lowering of interest rates in response to the deflation scare of 2003 looks to be particularly distortionary in retrospect. Rapid productivity gains appear to have been the source of the low inflation in 2003, but rapid productivity gains imply a higher policy interest rate, not a lower one, is needed for monetary policy to stabilize economic activity. It is no coincidence that these policy moves coincided with the housing boom and the related distortions in mortgage markets that are only now beginning to be worked out. The irony in all of this is that the Jim Cramers of the world are now calling for more of the same liquidity medicine that generated the financial imbalances in the first place—a surge sign of liquidity addiction.

Finally, the Jim Cramers of the world fail to grasp the implications of their policy prescriptions going forward. As has been discussed already on these pages, every time the Federal Reserve steps in to calm financial markets it creates less incentive for investors to be more careful next time. To the extent the Federal Reserve is setting a precedent in the mind of investors and creating moral hazard, it is perpetuating a culture of liquidity addiction. If the Federal Reserve continues to follow down this path of accommodating the markets, then we have not seen the last Jim Cramer rant against the Federal Reserve nor the last of the liquidity addicts. Another implication going forward of this policy prescription for more monetary easing is that it may put downward pressure on the dollar. To the extent the dollar has been overvalued this may be a good outcome, but ongoing interest rates cuts in the midst of market turmoil and could lead to an outright run on the dollar. Either the Jim Cramers of the world simply cannot see far foward enough to appreciate these dangers or they personally high discount rates.

The Jim Cramers of the world then are liquidity addicts who are prescribing the U.S. economy go on another Fed Spirits binge and put off the financial hangover until another day. The U.S. economy has been down this road before after the last asset bubble burst in the early 2000s. Here is hoping the Federal Reserve does not follow their policy recommendations, but allows the U.S. economy to finally sober up.