Apr 28, 2005

Judging Fed Policy

David Altig (in four parts - I, II, III, IV) does a fair job at taking apart Stephen Roach's most recent Fed critique. I am using the word critique pretty liberally as Roach titles the piece "Original Sin" and claims the Fed is making him into a conspiracy believer. My view is that Roach goes wrong in laying his own problems with consumer and market responses at the Fed's doorstep.
The problem with an activist central bank is that decision makers in the real economy -- consumers and businesspeople alike -- mistake the Fed's point of view for strategic advice. And so do financial market participants.
It is hard to be active in the markets during recent years and not be a bit bewildered about what participants are thinking. It often feels like the markets are only looking ahead a few weeks to a few months and are completely unconcerned about what current price levels mean over a longer horizon. I look at GM, FNM, or AIG and wonder how the prices at year end could have ignored all the negative news that came out during the fall. Throw in a housing boom and record low credit spreads and I generally feel Roach's frustration that the world is taking a much too optimistic view. He just goes a bit overboard in laying the blame on monetary policy and Fed commentary.

While Altig clearly wins the point by point debate he sets out I still have some sympathy for Roach's view that the Fed is basically trying to extract itself from past mistakes. Altig ends his piece with the following challenge for believers like me:
-- I gather the prescription favored by those who feel the same as Stephen Roach is for the Fed to be more aggressive in tightening policy. Fine, but is that what you really would have done in 1997, confronted with the circumstances at the time? In 1998? Would you have been impervious to the global financial stress I noted in the second post?
-- Would you choose to ignore the fact that employment growth in the U.S. has consistently struggled to gain traction? Would you be confident enough that bubbles exist, and that monetary policy can do something about them if they do, to tighten monetary policy if you had some concerns about the underlying strength of the real economy?
I don't really have problem with Fed policy until around Nov 1998 and I think these issues are best addressed by Paul McCulley's more constructive Fed criticism from March of 2000:

Thus, it is just not credible for Mr. Greenspan to maintain that the wealth effect is not that closely linked to the stock market, when by his own analysis of a year ago, the New Economy stocks are running on a lottery principle. If his analysis of a year ago is still correct, and I certainly think it is, and if New Economy stocks have soared versus stagnant Old Economy stocks over the last year, which is a fact, then logic compels the conclusion that the excessive boost to aggregate demand that Mr. Greenspan abhors is related to the bubble in New Economy stocks.
Which brings us to the question of whether the interest rate tool is the right exclusive instrument for dealing with the problem. I know of no economic model that postulates a high interest elasticity of demand for lotteries! Virtually every economic model incorporates, however, a high interest elasticity of demand for the goods and services of the Old Economy.
Thus, using the interest rate tool exclusively to thwart wealth creation in New Economy stocks carries grave risks for the Old Economy. It makes no sense to try to get the attention of gluttons by starving anorexics. It's bad macroeconomic policy, and it is also morally wrong.
This is particularly the case in the face of evidence that the bubble in New Economy stocks is being increasingly fueled by margin debt, as vividly displayed in the graph below. While it is a free country, and everybody has a right to foolishly overpay for lottery tickets, I do not believe that the Fed should passively endorse the purchase of lottery tickets on credit!

Under Regulation T, the Fed has the authority to set initial margin requirements for the purchase of stocks on credit, which has been at 50% since 1974. The Fed should raise that minimum, and raise it now. Mr. Greenspan says "no," of course, because (1) he cannot find evidence of a relationship between changes in margin requirements and changes in the level of the stock market, and (2) because an increase in margin requirements would discriminate against small investors, whose only source of stock market credit is their margin account. I have rejoinders to both of those objections.
I liked this passage because it draws a direct connection between Fed policy and the distortion between new and old economy assets that occurred in 1999-2000. With the collapse of the stock market the opportunity to correct that misalignment without a liquidity injection passed and the Fed has not had much choice since then but to keep rates accommodative in the face of weak employment.

Pointing out past policy mistakes might seem a bit useless but I think it is the backdrop that makes the current fiscal policies such a problem. Our economy has grown by leveraging making it more dependent on the stability provided by counter-cyclical monetary policy. While that has gone on the legislative and executive branches of government are doing their best to restrict future monetary policy by borrowing in a heavily pro-cyclical fashion (similar to Calculated Risk's conclusion).

None of this really explains willingness of the market to act as a co-conspirator preventing poor policy decisions from being reflected in asset markets. My personal guess is that executive compensation is just not very closely tied to long-term performance. That being the case anyone able to draw liquidity out of the system now can benefit from whatever future volatility may arrive. This is wandering off the subject a bit but it doesn't seem fair to ignore the obvious market flaws necessary for any monetary and fiscal mistakes to have a lasting impact.

While defending Roach's piece is a bit difficult, I am not that comfortable absolving the Fed either.

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