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Archive for November, 2007

Q&A with Kohn

Posted by WARREN MOSLER on 30th November 2007

Kathleen Stephansen from Credit Suisse:
Just thank you very much for this very interesting speech. Just a question: You alluded to the discount rate and the stigma that it still carries. Would you think that if there was no spread between the discount rate and the Fed funds rate, whether that stigma would disappear?

Kohn from the fed:
I think if there were no spread, the economic incentives might overcome the stigma. I’m not sure that the stigma would entirely disappear.

Agreed.

But I think part of what we’re seeing — if I can sort of reframe your question — about the lack of use of the discount window is partly economic and partly non-economic or partly about the 50 basis points, but partly about the stigma. And obviously, if we take the 50 basis points away and you can simply borrow at the federal funds rate, in effect I think the funding market would come all into the Federal Reserve. I mean, everyone would be borrowing a lot, including people who don’t — it’s a very — it would be a very difficult thing to do.

Perhaps true, but not a ‘bad’ thing where the fed would be ‘broker of last resort’.

The question is, what is the further purpose of not doing it that way? What is gained by banks settling clearing residuals with each other rather than with the fed?

Net lending from the fed would be unchanged, as banks strive to minimize reserve balances in either case.

Real resources would be saved, as banks would not need to spend the time and effort trying to trade with each other.

The NY fed would have full control over the fed funds rate as it could keep the system modestly ‘net borrowed’ with open market operations as it did pre 2003.

The only possible value of the current arrangement would be if the employed market forces as a discipline on bank funding. But it doesn’t, so there is no advantage for the current set up that I can see.

There are people who don’t borrow at the federal funds rate, right — smaller, medium-sized banks. And if they saw this window, they would come in and borrow — basically, we would be giving them funds at a subsidized rate that people don’t ordinarily have access at the funds rate.

Point? Why should money center banks have access to cheaper funds than regional member banks? All carry the same deposit insurance, and smaller banks have higher percentages of insured deposits.

Doesn’t the fed desire the fed funds rate to be the universal cost of bank funds? If not, that can be addressed in other ways.

And we would be creating, I think, problems for the open markets, because they would have to anticipate how many reserves are going to be supplied through the discount window, which would be very hard to anticipate, and then drain those through open-market operations.

No, the NY fed would instead find its job far easier. Just keep banks net borrowed in any quantity. And if they over do it with excessive liquidity drains, it will only show up as increased window borrowings, not as a deviation of the fed funds rate from the target rate.

That’s not to say that circumstances might not dictate at some point that we do something more with that penalty. I don’t want to take that off the table. I think it’s fair to say — as I kind of hinted at in my little section on liquidity — that we’re looking at lots of different options about how to supply liquidity to the market. But I think we need to recognize that the one you came up with has some costs and some difficulties associated with it.

I see a reduction in costs and a reduction in the difficulties surrounding current policy.


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2007-11-30 US Economic Releases

Posted by WARREN MOSLER on 30th November 2007

Summary:Nothing particularly alarming regarding balance of risks.Personal income and spending lower than expected. Questions are whether exports will continue pick up and support gdp, and whether this is weaker than the Fed’s Oct 31 projection. Deflator and core pce also up a touch, and year over year deflator heading north. As Karim indicated, core is inside the Fed’s ‘comfort zone’ but moving slightly towards the upper bound.Chicago PMI up, prices paid up 74.7 to 76.2Milwaukee pmi down, prices paid up to 61 from 56Lots of month end ‘evening up’ in the markets that might be reversed Monday. Month end effects should be over by Tuesday.


Personal Income (Oct)

Survey 0.4%
Actual 0.2%
Prior 0.4%
Revised n/a

Personal Spending (Oct)

Survey 0.3%
Actual 0.2%
Prior 0.3%
Revised n/a

PCE Deflator YoY(Oct)

Survey 2.8%
Actual 2.9%
Prior 2.4%
Revised n/a

PCE Core MoM (Oct)

Survey 0.2%
Actual 0.2%
Prior 0.2%
Revised n/a

PCE Core YoY (Oct)

Survey 1.8%
Actual 1.9%
Prior 1.8%
Revised 1.9%

Chicago Purchasing Manager (Nov)

Survey 50.5
Actual 52.9
Prior 49.7
Revised n/a

Construction Spending MoM (Oct)

Survey -0.3%
Actual -0.8%
Prior 0.3%
Revised 0.2%

 



NAPM-Milwaukee(Oct)

Survey n/a
Actual 60.0
Prior 63.0
Revised n/a

2007-11-30 Mortgage Bankers Association Purchase Index SA

Mortgage Bankers Association Purchase Index SA


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2007-11-29 US Economic Releases

Posted by WARREN MOSLER on 30th November 2007

GCP Annualized (3QP)

Survey 4.8%
Actual 4.9%
Prior 3.9%
Revised n/a

Keeps coming in above expectations.


Personal Consumption (3QP)

Survey 2.9%
Actual 2.7%
Prior 3.0%
Revised n/a

A touch higher bust still seems very low.


GDP Price Index (3QP)

Survey 0.8%
Actual 0.9%
Prior 0.8%
Revised n/a

A touch higher bust still seems very low.


Core PCE QoQ (3QP)

Survey 1.8%
Actual 1.8%
Prior 1.8%
Revised n/a

Initial Jobless Claims (Nov 24)

Survey 330K
Actual 352K
Prior 330K
Revised 329K

Thanksgiving week. Next week’s number is more informative.


Continuing Claims (Nov 17)

Survey 2575K
Actual 2665K
Prior 2566K
Revised 2553K

Thanksgiving week. Next week’s number is more informative.


New Home Sales (Oct)

Survey 750K
Actual 728K
Prior 770K
Revised 716K

Up a touch from revised lower number, but still very low.


New Home Sales MoM (Oct)

Survey -2.6%
Actual 1.7%
Prior 4.8%
Revised -0.1%

Up a touch from revised lower number, but still very low.


Help Wanted Index (Oct)

Survey 23
Actual 23
Prior 24
Revised n/a

Thanksgiving week. Next week’s number is more informative.


House Price Index QoQ (3Q)

Survey -0.5%
Actual -0.4%
Prior 0.1%
Revised n/a

Moving lower.
Do you think any of this is below fed expectations as of October 31st?


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Review of Bernanke Speech

Posted by WARREN MOSLER on 30th November 2007

(prefaced by interoffice email)

> Key line is the Committee will have to judge whether the outlook
> for the economy or the balance of risks has shifted materially. This
> opens the door for changing the balance of risk at the next FOMC
> meeting (Towards weaker gwth in light of expressed concerns on
> markets). This could mean a cut with a changed bias, or no cut
> and a changed bias (less likely).

Yes, agreed, and the inflation risk has elevated as well.

If they are thinking of a discount rate cut to the fed funds rate they may do it before the meeting to see if it alters the fed funds/libor spread. If they do that and spreads do come in over year end (the current cause of higher short term non tsy rates as mentioned in some of the Fed speeches) that will tilt the balance of risks aways from ‘market functioning’ risks.

Worth looking at the entire speech..

Chairman Ben S. Bernanke
National and regional economic overview
At the presentation of the Citizen of the Carolinas Award, Charlotte
Chamber of Commerce, Charlotte, North Carolina
November 29, 2007

Good evening. I thank the Charlotte Chamber of Commerce for bestowing on me this year’s Citizen of the Carolinas Award. I deeply appreciate the honor, and I am grateful for the opportunity it gives me to speak to you this evening. I am also delighted to be here in Charlotte. My wife Anna and I are looking forward to visiting family and friends during our time here in the Queen City.

The focus of my brief remarks this evening will be the Charlotte region and how the area and the economy have changed since I regularly visited my grandparents here some four-and-a-half decades ago. First, though, I would like to share a few thoughts on the U.S. economy and the considerations that we at the Federal Reserve will be weighing as we prepare for our policy meeting on December 11, less than two weeks from now.

The Federal Open Market Committee (FOMC), the monetary policy making arm of the Federal Reserve System, last met on October 30-31. At that meeting, the Committee cut its target for the federal funds rate, the key policy interest rate, by 25 basis points (1/4 of a percentage point), following a cut of 50 basis points in September. Economic growth in the period leading up to the October meeting had proven quite strong, as confirmed by this morning’s figures on third-quarter gross domestic product (GDP). At its meeting, however, Committee members took the view that tightening credit conditions–the product of ongoing stresses in financial markets–and some intensification of the correction in the housing sector were likely to restrain economic activity going forward.

Potential ‘market functioning’ risk.

Specifically, growth appeared likely to slow significantly in the fourth quarter from its rapid third-quarter rate and to remain sluggish in early 2008. The Committee expected that economic growth would thereafter gradually return to a pace approaching its long-run trend as the drag from housing subsided and financial conditions improved. Inflation was seen as edging down next year, approaching rates consistent with price stability;

Implying it’s too high now.

however, the Committee remained concerned about the possible effects of higher energy costs and the lower foreign exchange value of the dollar, especially the risk that they might lead to an increase in the public’s long-term inflation expectations.

Yes, which led to a dissenting vote and six regional banks not wanting a cut.

How has the economic picture changed in the month since that meeting? As is often the case, the incoming economic data have been mixed.

This is the sum of data – not clearly worse and not clearly worse than forecast. My guess in Q4 is their Q4 forecast has been revised up, and the continual upward revisions of Q3 and now Q4 have to be influencing their view of Q1 forecasts and beyond as well.

In the market for residential real estate, indicators of construction and home sales have continued to be weak. In contrast, the labor market remained solid in October, with some 130,000 new jobs added to private-sector payrolls and the unemployment rate remaining at 4.7 percent. Claims for unemployment insurance have drifted up a bit in recent weeks, although, on average, they have remained at a level consistent with moderate expansion in employment. We will, of course, have the labor market report for November next week, and in the coming days we will continue to draw on anecdotal reports, surveys, and other sources of information about employment and wages. Continued good performance by the labor market is important for maintaining the economic expansion, as growth in earnings helps to underpin household spending.

Strong emphasis on employment data. It has probably been the most reliable indicator over the last six months. No one could ‘understand’ how employment remained high until after late numbers on exports came in, for example.

With respect to household spending, the data received over the past month have been on the soft side. The Committee will have considerable additional information on consumer purchases and sentiment to digest before its next meeting. I expect household income and spending to continue to grow, but the combination of higher gas prices, the weak housing market, tighter credit conditions, and declines in stock prices seem likely to create some headwinds for the consumer in the months ahead.

And ‘on the soft side’ is no reason to cut – especially with exports growing rapidly and supporting demand at high levels.

Core inflation–that is, inflation excluding the relatively more volatile prices of food and energy–has remained moderate.

But not moderated further.

However, the price of crude oil has continued its rise over the past month, a rise that will be reflected in gasoline and heating oil prices and, of course, in the overall inflation rate in the near term. Moreover, increases in food prices and in the prices of some imported goods have the potential to put additional pressures on inflation and inflation expectations.

He is stating directly the inflation risk has increased since October 31.

The effectiveness of monetary policy depends critically on maintaining the public’s confidence that inflation will be well controlled. We are accordingly monitoring inflation developments closely.

They believe they must have credibility to keep inflation expectations anchored.

The incoming data on economic activity and prices

Both – which includes CPI forecasts available before the December 11 meeting.

will help to shape the Committee’s outlook for the economy; however, the outlook has also been importantly affected over the past month by renewed turbulence in financial markets, which has partially reversed the improvement that occurred in September and October.

Partially. Being in the middle with active trading is perfectly acceptable. The concern is spreads will widen further/rapidly to the point trading ceases and real world lending ceases as a consequence, though the ‘channel’ for this is uncertain, and mainstream economic theory probably would say it’s a natural adjustment process that should be left alone for optimal long term outcomes.

Comments welcome on this point, thanks!

Investors have focused on continued credit losses and write-downs across a number of financial institutions, prompted in many cases by credit-rating agencies’ downgrades of securities backed by residential mortgages. The fresh wave of investor concern has contributed in recent weeks to a decline in equity values, a widening of risk spreads for many credit products (not only those related to housing), and increased short-term funding pressures.

All a repricing of risk.

These developments have resulted in a further tightening in financial conditions, which has the potential to impose additional restraint on activity in housing markets and in other credit-sensitive sectors.

But perhaps to where it ‘should be’ as the fed did not like it when risk was priced at zero. What they are watching closely is ‘market functioning’ and the risk of systemic failure.

Needless to say, the Federal Reserve is following the evolution of financial conditions carefully, with particular attention to the question of how strains in financial markets might affect the broader economy.

As above.

In sum, as I have indicated, we will be receiving a good deal of relevant information in the coming days. In making its policy decision, the Committee will have to judge whether the outlook for the economy or the balance of risks has shifted materially.

Implying so far it has not.

In doing so, we will take full account of the implications for the outlook of both the incoming economic data and the ongoing developments in the financial markets.Economic forecasting is always difficult, but the current stresses in financial markets make the uncertainty surrounding the outlook even greater than usual. We at the Federal Reserve will have to remain exceptionally alert and flexible as we continue to assess how best to promote sustainable economic growth and price stability in the United States.

Perhaps a reference to Kohn’s discount rate discussion where he discusses addressing liquidity vs. addressing the macro economy, a discussion which has gotten into the ‘stigma’ aspect of the discount rate that he felt was an obstacle to liquidity.

References
Employment Security Commission of North Carolina (2007). “Employment
and Wages by Industry, 1990 to Most Recent,”
www.ncesc.com/lmi/industry/industrymain.asp.

Hills, Thomas D. (2007). “The Rise of Southern Banking and the
Disparities among the States following the Southeastern Regional
Banking Compact (225 KB PDF),” Balance Sheet, vol. 11, pp. 57-104,
http://studentorgs.law.unc.edu/ncbank/balancesheet.

North Carolina Community College System (2006). “Get the Facts,”
press release, July 3,
www.ncccs.cc.nc.us/News_Releases/GetTheFacts.htm.

U.S. Census Bureau (2006). “2005 American Community Survey,”
www.census.gov/acs.


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Review of Evans Speech

Posted by WARREN MOSLER on 30th November 2007

November 27, 2007

Financial Disruptions and the Role of Monetary Policy*

Skipped the first part. It’s very good history and analysis.

With regard to shocks to the financial system, our concern is about the ability of financial markets to carry out their core functions of efficiently allocating capital to its most productive uses and allocating risk to those market participants most willing to bear that risk. Well-functioning financial markets perform these tasks by discovering the valuations consistent with investors’ thinking about the fundamental risks and returns to various assets. A widespread shortfall in liquidity could cause assets to trade at prices that do not reflect their fundamental values,

The fed’s concern is very well stated here. It’s about availability of credit:

impairing the ability of the market mechanism to efficiently allocate capital and risk. And reduced availability of credit could reduce both business investment and the purchases of consumer durables and housing by creditworthy households.

We clearly must be vigilant about these risks to economic growth. However, overly accommodative liquidity provision could endanger price stability, which is the second component of the dual mandate. After all, inflation is a monetary phenomenon. Indeed, one of the many reasons for the Fed’s commitment to low and stable inflation is that inflation itself can destabilize financial markets. For example, in the late 1970s and early 1980s, high and variable inflation contributed to large fluctuations in both nominal and real interest rates.

The above articulates that the inflation risk is also a risk to markets, as well as growth and employment.

The Fed has kept these various risks to growth and inflation in mind when responding to the financial turmoil this year. Importantly, we have taken a number of monetary policy actions to insure against the risk of costly contagion from financial markets to the real economy. On August 10, in response to a sharp rise in the demand for liquidity, the Fed injected $38 billion in reserves via open market trading. In one sense, this was a routine action to inject sufficient reserves to maintain the target federal funds rate at 5-1/4 percent—the non-routine part was the size of the injection required to do so. (Indeed, this was the largest such injection since 9/11.)

Kohn fully understands monetary operations and would not/did not make a statement like this.

On August 16, with conditions having deteriorated further, the Federal Reserve Board, in consultation with the District Reserve Banks, moved to improve the functioning of money markets by cutting the discount rate by 50 basis points and extended the allowable term for discount window loans to 30 days. The Board also reiterated the Fed’s policy that high-quality ABCP is acceptable collateral for borrowing at the discount window. At its regular meeting on September 18, the FOMC cut the federal funds rate 50 basis points and then lowered it another 25 basis points at its meeting in October. Related actions by the Board of Governors lowered the discount rate to 5 percent. Finally, just yesterday the Open Market Desk at the New York Fed announced that it will conduct longer-term repurchase agreements extending into January 2008 with an eye toward meeting additional liquidity needs in money markets.

Again, note the contrast with Kohn’s discussion of the ramifications of the discount rate moves.

After the October moves, the FOMC press release noted: “Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.” The Committee also assessed that “the upside risks to inflation roughly balanced the downside risks to growth.” My reading of the data since then continues to support this risk assessment. As of today, I feel that the stance of monetary policy is consistent with achieving our dual mandate objectives and will help promote well-functioning financial markets.

Meaning that if the meeting were today, he wouldn’t recommend a cut.

Indeed, the FOMC minutes released on November 20 included new information on economic projections for 2007-10. The committee will release updated projections four times a year. Both the range and central tendencies of these projections envision growth returning to potential in 2009 and 2010, and inflation being within ranges that many members view as consistent with price stability.

Again, current stance appropriate given the forecasts and current conditions.

The Outlook Going Forward

Of course, there is still a good deal of uncertainty over how events will play out over time, and we are monitoring conditions closely for developments that may change our assessments of the risks to growth and inflation. A number of major financial intermediaries have recently announced substantial losses, and housing markets are still weak and will continue to struggle next year. Home sales and new construction fell sharply last quarter, and prices softened. The only data we have on home building for the current quarter are housing starts and permits: These came in well below average in October. But these weak data were not a surprise — our forecast is looking for another large decline in residential construction this quarter.

Again, the economy would have to be worse than the October 31 forecast to consider another cut, and that forecast has a decline built into it.

Outside of the financial sector and housing, the rest of the economy appears to have weathered the turmoil relatively well. The first estimate of real GDP growth in the third quarter was a quite solid 3.9 percent, and private market economists think the revised number that will be released on Thursday will be close to 5 percent. So the economy entered the fourth quarter with healthy momentum.

However, our forecast is for relatively soft GDP growth in the current quarter. Private sector forecasts seem to be in the 1 to 2 percent range. And, not surprisingly, we have seen some sluggish indicators consistent with this outlook.

The current private forecasts have been revised up if anything since October 31.

Our Chicago Fed National Activity Index suggested that growth in October was well below potential. As I just mentioned, the housing numbers point to another large drag from residential investment. Manufacturing output has fallen in two of the past three months. Consumption—by far the largest component of spending—grew at a solid rate in the third quarter, but in October, motor vehicle sales changed little and sales at other retailers also posted pretty flat numbers. Consumer sentiment also is down. But we have also received positive news. Forward-looking indicators point to further increases in business investment and continued strength in exports.

Seems to emphasize these last two as forward looking is more important than rearview mirror observations.

Importantly, the job market remains healthy—nonfarm payrolls increased 166,000 in October. Over the past four months, job growth has averaged about 115,000 per month, down from the 150,000 pace over the first half of the year, but still in line with demographic trends and an economy growing at potential.

As discussed in previous posts, the fed sees the labor force participation rate shrinking for demographic reasons. So, the unemployment rate staying low with fewer new jobs are expected and part of the forecast.

This is a key fundamental supporting the forecast because gains in employment lead to gains in income, which in turn support gains in consumer spending going forward.

Looking beyond the current quarter, our baseline forecast is for growth recovering as we move through next year.

Recovery beyond the current quarter. This shouldn’t change by the meeting.

In particular, we expect that later in 2008 economic growth will move lose to its current potential, which we at the Chicago Fed see as being slightly above 2-1/2 percent per year.

Their position is that the potential non inflationary growth is relatively low.

Now this pace for potential output growth is lower than during the 1995-2003 period. But it still includes a healthy trend in productivity growth relative to longer-term historical standards. Of course, productivity growth is a key factor supporting job growth, and with it income creation and increases in household expenditures; it also underlies the profitability of business spending. Solid demand for our exports should continue to be a plus for the economy. And we do not think residential investment will make as large of a negative contribution to overall growth as it did in 2006 and 2007.

And an early turn around could derail their hopes of any ‘slack’ in the labor markets.

There is still a good deal of uncertainty about this forecast. We can’t rule out the possibility of continued market difficulties. We can’t be sure how long it will take for financial intermediaries to complete the process of re-evaluating the risks in their portfolios. And many subprime adjustable rate mortgages will see their rates climb over the next few months—a process that could feed back on to housing and financial markets. But developments could surprise us on the
upside as well.

This risk also balanced.

The real economy has proven to be resilient to a host of serious shocks over the past twenty years. Indeed, think back to the concerns we had in 1998 about a fallout on the real economy from the financial crisis associated with the Russian default and LTCM. In fact, real GDP grew 4.7 percent in 1999, a pretty strong pace by any standard. With regard to inflation, the latest numbers have been encouraging. The 12-month change in core PCE prices remained at 1-3/4 percent in September. We do not have the PCE index for September yet, but the CPI data for October showed a moderate increase in core prices. Of course, higher food and energy prices have boosted the top-line inflation numbers, and the overall PCE prices have risen nearly 2-1/2 percent over the past year. At present, my outlook is for core PCE inflation to be in the range of 1-1/2 to 2 percent in 2008-09, and for total PCE inflation to come down and be roughly in line with the core rate. Relative to our outlook six months ago, this is a favorable development.

There are both upside and downside risks to this inflation forecast. With no appreciable slack in resource markets, cost pressures from higher unit labor costs, energy, or import prices could show through to the top-line inflation numbers. However, weaker economic activity would tend to offset these factors.

Balanced risks on inflation.

But they have to say that – their job is managing expectations.

Concluding remarks

Given the uncertainties about how financial conditions might evolve and affect the real economy, policy naturally tends to emphasize risk-management approaches. That is, the Fed must adjust the stance of policy to guard against the risk of events that may have low probability but, if they did occur, would present an especially notable threat to sustainable growth or price stability. Such risk management was an important consideration in the monetary policy reactions to the current financial situation that I talked about a few minutes ago. But while the risk is still present of notably weaker-than-expected overall economic activity, given the policy insurance we have put in place I don’t see this as likely.

Isn’t forecasting activity weaker than the October 31 forecast.

As always, our focus will continue to be to foster maximum sustainable growth while maintaining price stability.

And they all believe price stability is a necessary condition for optimal long term growth and employment.

1See Gilboa, I., and D. Schmeidler, 1989, “Maxmin Expected Utility
with non-unique Priors,” Journal of Mathematical Economics, 18,
141-153; Hansen, L., and T. Sargent, 2003, “Robust Control of
Forward-looking Models,” Journal of Monetary Economics 50(3), 581-604;
Caballero, R., and A. Krishnamurthy, 2005, “Financial System Risk and
Flight to Quality,” National Bureau of Economic Research.Working Paper
No. 11834.

2For a further discussion of these examples, see Caballero, and
Krishnamurthy, op. cit.

3See Gennotte, G. and H. Leland, 1990, “Market Liquidity, Hedging, and
Crashes,” American Economic Review, 80(5), 999-1021.

*The views presented here are my own, and not necessarily those of the
Federal Open Market Committee or the Federal Reserve System.


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Second Look at Kohn Speech

Posted by WARREN MOSLER on 30th November 2007

‘People can misinterpret almost anything so that it coincides with
views they already hold. They take from art what they already
believe.’ -SKubrick

Went through Kohn’s speech again and still don’t see it the way the markets do. Am I missing something?

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 versus 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. The 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 October 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 states that in the long run the economy is supply side constrained and monetary policy is neutral for long term grown 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 government.

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 the ‘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 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 as far as to explain how the merely ‘offset operation 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 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 counter parties 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 October 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 already have 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 October 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 this 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 ‘toolbox’ 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 fed 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 fed 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 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 away 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 been carried what they see as a high premium as inflation risks have elevated substantially since October 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 send to others for their comments as well.


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