09-01-2007, 09:19 AM
CENTRAL BANKERS, MONETARY POLICY AND MORAL HAZARD
Dr.Harald Malmgren CEO, Malmgren Global, based in Washington, DC,
Dear DK and Colleagues
The eyes of financial centres across the world are now turning to Jackson Hole in anticipation of a speech by Federal Reserve Chairman Benjamin Bernanke. The Federal Reserve has held an end-of-summer symposium for central bankers, officials and academics for the past 31 years, 26 of which have been in Jackson Hole, Wyoming. This invitation-only weekend event not only provides the opportunity for carefully prepared written papers but also frank and off-the-record interaction among the world's most powerful central bankers.
This year's theme - housing markets and monetary policy - lies at the heart of the unfolding crisis in global markets. All of the central bankers at this gathering, including those from the Federal Reserve, the ECB, the Bank of England and the Bank of Japan, will have the opportunity to talk to each other informally about what they have learned from their own market contacts and how they now perceive the scope and depth of financial turmoil and the potential impact on the economic outlook.
At the onset of the financial crisis a few weeks ago the main central banks' responses to the subprime mortgage impact on credit markets varied widely - The ECB injected money markets with large doses of liquidity. The Bank of England refused to implement any unusual measures. The Fed tried a series of small steps to improve interbank lending, followed by a major change in discount window policy. These positions in part reflected the specific cracks that appeared in credit markets in each jurisdiction. The first evidence of potential danger to big institutions appeared, surprisingly, in Europe, where a number of European financial institutions became engaged in urgent efforts to unwind positions infected with failing mortgage debt obligations. The ECB's response was to add liquidity in large volume.
But the differences among central banks also reflected different approaches to balancing inflationary threats while revitalizing troubled credit markets. Since then the differences between the central banks may have narrowed, as serious problems spread far beyond subprime mortgage debt to critical segments of the global credit markets, including the commercial paper market and the market for CDOs, structured investment vehicles, and other securitized debt. There is also now emerging a huge question about valuation of relatively illiquid securitized debt obligations, as pressures grow for "mark to market" valuations - such valuations require buyers and sellers, but right now there are many sellers of distressed assets and virtually no buyers.
Although some central bankers had said just a few weeks ago that the subprime mortgage crisis would be "contained," it is now generally recognized that broad swathes of the credit markets have seized up. At Jackson Hole it is likely that a common diagnosis will emerge that a severe credit crunch is under way, even if the central banks continue to use different tools in response to this credit crunch.
At essentially the same time that this rapid deterioration in the market for complex debt obligations has been developing, central bankers and other regulators had been pressuring bankers to cut back the fast and loose leveraging of hedge fund investors. Now, growing margin calls have been forcing many funds to sell off good assets when confronted with the collapse of demand for their holdings of securitized debt and other risky assets. Deleveraging is certainly a contributing factor in vanishing credit market liquidity.
The formal agenda of the symposium's series of lectures was set months ago, to focus on housing and monetary policy, but it is timely for markets that are anxiously awaiting new insights from the central banks. The academic papers may prove interesting, but they are also likely to reveal how little is known about valuations of securitized debt obligations, including CDOs, and how little is known about house prices. The hard reality is that there is great uncertainty about how house prices and changes in homeowner wealth will affect national economies - and even the world economy.
For Fed Chairman Bernanke, this is "prime time." He is on stage in the midst of the biggest credit market crisis in some years - some bankers say it is the biggest crisis in decades. Fed Chairman Bernanke faces a daunting challenge in trying to explain on Friday what he believes to be happening and what he considers the appropriate responses. Virtually anything he says runs the risk of spooking markets: If he says bold action is needed, that will be interpreted as newfound pessimism about the potential for economic slump or recession. He could instead say that minor, incremental monetary measures are the right stuff, and that he does not want
to use indiscriminate interest rate cuts to ease pain for the bankers and traders who were responsible for the bursting of a bubble. If the market doesn't hear that Bernanke will cut the target rate any time soon, there would likely be a market swoon and a tide of criticism that Bernanke is out of touch with reality.
Bernanke starts from a clearly different stance than the stance taken by Chairman Greenspan in the past when confronted with credit market turmoil. Greenspan believed the Fed should simply keep credit markets from freezing up with rate cuts and rate hikes, while letting markets work out the details. It is evident that Bernanke strongly prefers a more cautious approach, using surgical tools to deal directly with identifiable "glitches" in credit markets, while valiantly trying to avoid generating increased moral hazard. This kind of response was evident in the Fed's surprise cut in the discount rate combined with a highly innovative reinterpretation of how the discount window functions. Bernanke gained some public applause for his cleverness, but much quiet criticism that the new discount window tool could only work effectively if the cut in the discount rate was much deeper than the 50 basis points cut made by the FOMC.
Fundamentally, Bernanke believes that even in times of financial turbulence, decisions on interest rates should be based on a forward-looking economic forecast and a balance of risks around that forecast. Bernanke is clearly still worried about inflation. At least until now, he has not foreseen economic slump or recession that might melt away the threat of inflation. Instead he has been worrying about such problems as rising rental costs as households turn from buying to renting - the cost of home rentals is a surprisingly large component of the rate of inflation about which the Fed worries. Bernanke and his colleagues are worried about the potential weakening of the dollar if the Fed cuts its target rate boldly, because a sharply weaker dollar would pump up the inflation rate.
Essentially, Bernanke is still relying on "incoming data" and the economic forecasts of the Fed staff, which assume continued - albeit somewhat slower - economic growth. Up to now at least, Bernanke has been far more optimistic than many investors and traders about potential damage to economic growth from credit market stresses.
Given his assignment to include comments about the housing market, Bernanke will have to express a plausible, realistic opinion on the severity and likely duration of the apparent housing slump. If he relies on data, he may be able to avoid deep pessimism, because deterioration in housing data appears well after market moves. If he acknowledges the deep pessimism, which prevails among lenders, home builders, and real estate brokers about the huge and growing inventory of unsold homes and the significant declines in prices that are now becoming evident, then his address will give a boost to the bears. If he sounds upbeat, the bulls and bears will both say he is ignorant and his prognostications will be devalued.
Ultimately, whatever Bernanke says about housing may be eclipsed by President Bush's expected Friday morning announcement of a major new homeowner protection initiative, which clearly implies that the President and Treasury Secretary Paulson believe extraordinary measures are needed
Fed officials are very aware that the pricing in of expected rate cuts by the markets has helped offset the tightening effect of the drying up of credit. Their emergency policy statement on August 17 was interpreted by bankers and traders as validation of the growing market assumption that the Fed would be easing policy. Bond markets have been especially strong as investors have piled into Treasuries while exiting many risky types of assets. Yet in recent days Bernanke seemed to send signals that rate cuts may not be the best next step, and that if it becomes necessary to make cuts, they will likely come far more slowly than troubled investors and traders might like.
Ultimately, Fed officials probably know little more than bankers and traders about the true extent of the unknown, opaque securitized debt market, including derivatives based upon it. Therefore, maintaining a degree of optimism about underlying economic growth, Fed officials themselves most likely do not yet have a clear idea about how they will deal with the rapidly unfolding credit crises. Bernanke and his colleagues seem to want to wait and see whether the credit markets will remain dysfunctional, and for how long. Unfortunately, if they wait until the evidence is absolutely clear, it may be too late. A certain amount of guessing and interaction with markets will be needed - but bankers under stress may not be willing to tell the Fed or other central bankers the whole truth, nor will they be keen to reveal fully their problems to their competitors or their shareholders. Widespread deception or obfuscation seems to be a critical part of the present credit crisis.
For investors and traders, a bigger question now is whether "lubrication" of credit markets by the Fed and other central bankers will be enough to stabilize the evident deterioration in credit markets, or whether the problems of growing distrust and loss of credibility among financial institutions, pension funds, and other investors will overwhelm whatever the central banks try to do.
Dr.Harald Malmgren CEO, Malmgren Global, based in Washington, DC,
Dear DK and Colleagues
The eyes of financial centres across the world are now turning to Jackson Hole in anticipation of a speech by Federal Reserve Chairman Benjamin Bernanke. The Federal Reserve has held an end-of-summer symposium for central bankers, officials and academics for the past 31 years, 26 of which have been in Jackson Hole, Wyoming. This invitation-only weekend event not only provides the opportunity for carefully prepared written papers but also frank and off-the-record interaction among the world's most powerful central bankers.
This year's theme - housing markets and monetary policy - lies at the heart of the unfolding crisis in global markets. All of the central bankers at this gathering, including those from the Federal Reserve, the ECB, the Bank of England and the Bank of Japan, will have the opportunity to talk to each other informally about what they have learned from their own market contacts and how they now perceive the scope and depth of financial turmoil and the potential impact on the economic outlook.
At the onset of the financial crisis a few weeks ago the main central banks' responses to the subprime mortgage impact on credit markets varied widely - The ECB injected money markets with large doses of liquidity. The Bank of England refused to implement any unusual measures. The Fed tried a series of small steps to improve interbank lending, followed by a major change in discount window policy. These positions in part reflected the specific cracks that appeared in credit markets in each jurisdiction. The first evidence of potential danger to big institutions appeared, surprisingly, in Europe, where a number of European financial institutions became engaged in urgent efforts to unwind positions infected with failing mortgage debt obligations. The ECB's response was to add liquidity in large volume.
But the differences among central banks also reflected different approaches to balancing inflationary threats while revitalizing troubled credit markets. Since then the differences between the central banks may have narrowed, as serious problems spread far beyond subprime mortgage debt to critical segments of the global credit markets, including the commercial paper market and the market for CDOs, structured investment vehicles, and other securitized debt. There is also now emerging a huge question about valuation of relatively illiquid securitized debt obligations, as pressures grow for "mark to market" valuations - such valuations require buyers and sellers, but right now there are many sellers of distressed assets and virtually no buyers.
Although some central bankers had said just a few weeks ago that the subprime mortgage crisis would be "contained," it is now generally recognized that broad swathes of the credit markets have seized up. At Jackson Hole it is likely that a common diagnosis will emerge that a severe credit crunch is under way, even if the central banks continue to use different tools in response to this credit crunch.
At essentially the same time that this rapid deterioration in the market for complex debt obligations has been developing, central bankers and other regulators had been pressuring bankers to cut back the fast and loose leveraging of hedge fund investors. Now, growing margin calls have been forcing many funds to sell off good assets when confronted with the collapse of demand for their holdings of securitized debt and other risky assets. Deleveraging is certainly a contributing factor in vanishing credit market liquidity.
The formal agenda of the symposium's series of lectures was set months ago, to focus on housing and monetary policy, but it is timely for markets that are anxiously awaiting new insights from the central banks. The academic papers may prove interesting, but they are also likely to reveal how little is known about valuations of securitized debt obligations, including CDOs, and how little is known about house prices. The hard reality is that there is great uncertainty about how house prices and changes in homeowner wealth will affect national economies - and even the world economy.
For Fed Chairman Bernanke, this is "prime time." He is on stage in the midst of the biggest credit market crisis in some years - some bankers say it is the biggest crisis in decades. Fed Chairman Bernanke faces a daunting challenge in trying to explain on Friday what he believes to be happening and what he considers the appropriate responses. Virtually anything he says runs the risk of spooking markets: If he says bold action is needed, that will be interpreted as newfound pessimism about the potential for economic slump or recession. He could instead say that minor, incremental monetary measures are the right stuff, and that he does not want
to use indiscriminate interest rate cuts to ease pain for the bankers and traders who were responsible for the bursting of a bubble. If the market doesn't hear that Bernanke will cut the target rate any time soon, there would likely be a market swoon and a tide of criticism that Bernanke is out of touch with reality.
Bernanke starts from a clearly different stance than the stance taken by Chairman Greenspan in the past when confronted with credit market turmoil. Greenspan believed the Fed should simply keep credit markets from freezing up with rate cuts and rate hikes, while letting markets work out the details. It is evident that Bernanke strongly prefers a more cautious approach, using surgical tools to deal directly with identifiable "glitches" in credit markets, while valiantly trying to avoid generating increased moral hazard. This kind of response was evident in the Fed's surprise cut in the discount rate combined with a highly innovative reinterpretation of how the discount window functions. Bernanke gained some public applause for his cleverness, but much quiet criticism that the new discount window tool could only work effectively if the cut in the discount rate was much deeper than the 50 basis points cut made by the FOMC.
Fundamentally, Bernanke believes that even in times of financial turbulence, decisions on interest rates should be based on a forward-looking economic forecast and a balance of risks around that forecast. Bernanke is clearly still worried about inflation. At least until now, he has not foreseen economic slump or recession that might melt away the threat of inflation. Instead he has been worrying about such problems as rising rental costs as households turn from buying to renting - the cost of home rentals is a surprisingly large component of the rate of inflation about which the Fed worries. Bernanke and his colleagues are worried about the potential weakening of the dollar if the Fed cuts its target rate boldly, because a sharply weaker dollar would pump up the inflation rate.
Essentially, Bernanke is still relying on "incoming data" and the economic forecasts of the Fed staff, which assume continued - albeit somewhat slower - economic growth. Up to now at least, Bernanke has been far more optimistic than many investors and traders about potential damage to economic growth from credit market stresses.
Given his assignment to include comments about the housing market, Bernanke will have to express a plausible, realistic opinion on the severity and likely duration of the apparent housing slump. If he relies on data, he may be able to avoid deep pessimism, because deterioration in housing data appears well after market moves. If he acknowledges the deep pessimism, which prevails among lenders, home builders, and real estate brokers about the huge and growing inventory of unsold homes and the significant declines in prices that are now becoming evident, then his address will give a boost to the bears. If he sounds upbeat, the bulls and bears will both say he is ignorant and his prognostications will be devalued.
Ultimately, whatever Bernanke says about housing may be eclipsed by President Bush's expected Friday morning announcement of a major new homeowner protection initiative, which clearly implies that the President and Treasury Secretary Paulson believe extraordinary measures are needed
Fed officials are very aware that the pricing in of expected rate cuts by the markets has helped offset the tightening effect of the drying up of credit. Their emergency policy statement on August 17 was interpreted by bankers and traders as validation of the growing market assumption that the Fed would be easing policy. Bond markets have been especially strong as investors have piled into Treasuries while exiting many risky types of assets. Yet in recent days Bernanke seemed to send signals that rate cuts may not be the best next step, and that if it becomes necessary to make cuts, they will likely come far more slowly than troubled investors and traders might like.
Ultimately, Fed officials probably know little more than bankers and traders about the true extent of the unknown, opaque securitized debt market, including derivatives based upon it. Therefore, maintaining a degree of optimism about underlying economic growth, Fed officials themselves most likely do not yet have a clear idea about how they will deal with the rapidly unfolding credit crises. Bernanke and his colleagues seem to want to wait and see whether the credit markets will remain dysfunctional, and for how long. Unfortunately, if they wait until the evidence is absolutely clear, it may be too late. A certain amount of guessing and interaction with markets will be needed - but bankers under stress may not be willing to tell the Fed or other central bankers the whole truth, nor will they be keen to reveal fully their problems to their competitors or their shareholders. Widespread deception or obfuscation seems to be a critical part of the present credit crisis.
For investors and traders, a bigger question now is whether "lubrication" of credit markets by the Fed and other central bankers will be enough to stabilize the evident deterioration in credit markets, or whether the problems of growing distrust and loss of credibility among financial institutions, pension funds, and other investors will overwhelm whatever the central banks try to do.