``Certainly not without justification, the markets came to the recognition that yesterday’s increase in the discount rate did not signal any imminent tightening of financial conditions. It will be interesting to see if the markets eventually end up calling a bluff on Fed “exit” policies more generally.”-Doug Noland, The Beginning of Tightening?
The US Federal Reserve surprisingly raised its discount rate or its overnight lending rates to banks!
However, it maintained the Fed Fund rates, or the interest rates banks charge to each other, while it also shortened the maturity for primary credit on the discount window.
The widening of the spread of the Discount rate and the Fed Fund rate, according to the Federal Reserve Board, ``will encourage depository institutions to rely on private funding markets for short-term credit and to use the Federal Reserve's primary credit facility only as a backup source of funds.”
Figure 1: FT Advisors and Northern Trust: Spread of Discount and Fed Rates and Reserve Bank Credit
The fact of the matter is that the Federal Reserve has been reacting to the meaningful current improvements of market conditions, where access to the emergency credit window of the Federal Reserve has apparently been on a decline (see figure 1 right window).
The Federal Reserve has also been in the process of withdrawing other emergency programs prior to this week’s surprise. According to the Businessweek, the central bank has ``closed its emergency aid programs to money markets, bond dealers and foreign central banks.”
Since the cost of borrowing from using the Federal Reserve’s discount window would be higher than the interest rates of banks charge to each other, then the present policy adjustments incentivizes the banking system to wean from dependence on the central bank funding.
Nonetheless, the Fed’s action could be read as ex-post reaction of the little used programs which Asha Banglore of Northern Trust aptly labels as programs “dying a natural death”.
Markets Reaction To The Federal Reserve Policy Changes
We said that the Fed’s action had been a surprise, that’s because while everyone knew it was coming, no one exactly knew of the timing.
Nevertheless, Fed officials immediately rushed into “calming” of the markets such as Federal Reserve Bank of Atlanta President Dennis Lockhart who was quoted by Bloomberg, “I would not interpret this action as a tightening of monetary policy or even a sign that a tightening is imminent,” Lockhart said. “Rather, this action should be viewed as a normalization step.” (italics mine)
It’s the same with Federal Reserve Bank of New York President William Dudley who called the adjustment “technical” in nature. The Wall Street Journal blog quotes Mr. Dudley, “We made a very small technical change” by raising the discount rate, Dudley said. “The action yesterday was really an action about the improvement in banks,” and reflected the fact these institutions no longer need this emergency source of cheap funding the way they did during the depths of the financial crisis, the official said.
``The discount rate increase “is not at all a signal of any imminent tightening” in monetary policy, and the Fed’s commitment to keep rates very low for an extended period “is still very much in place,” Dudley said.” (italics mine)
First Trust’s Brian Wesbury and Robert Stein noted that Ben Bernanke appeared to have telegraphed this action during his congressional testimony last week.
Mr. Wesbury and Mr. Stein quotes Mr. Bernanke: ``(B)efore long, we expect to consider a modest increase in the spread between the discount rate and the target federal funds rate. These changes…should be viewed as further normalization of the Federal Reserve's lending facilities, in light of the improving conditions in financial markets; they…should not be interpreted as signaling any change in the outlook for monetary policy, which remains about as it was at the time of the January meeting of the FOMC.” (italics mine)
But of course not everyone is pleased.
David Kotok of Cumber Advisors thinks that the “surprise” factor more than the policy action itself constituted as uncertainty.
He sardonically writes, ``By using this surprise the Fed has introduced some confusion into markets. It doesn’t mean rates are going up tomorrow or next month or by mid-summer. But it does mean that an additional uncertainty has been introduced into market pricing. Interest rates will now reflect this uncertainty. The dollar strengthened immediately as one would expect it to do. Currency exchange rates are now the first thing to react to changes in policy. And this was a change in policy event though the Fed says it is not so…
``But the Fed has now added an uncertainty premium and markets are adjusting to it. That means somewhere, some mortgage will not get refinanced. And somewhere, some bond financing will cost more to accomplish. And somewhere, some US manufacturer who exports will face a headwind because the dollar is stronger and his foreign competitor can sell more cheaply than yesterday. And somewhere, some person is not going to get hired because this uncertainty has raised the risk of hiring to the employer. That, friends, is a tightening.”
In my view, the market’s reaction to unexpected information matters most. It’s simply people reacting by voting with their wallets!
Figure 2: stockcharts.com: Financial Markets Shrugs Off Discount Rate Hike
While the US dollar had an intraday spike following the “surprise” announcement, which subsequently faltered, the rising US dollar or the new policy action failed to contain the gains of the US broad based equity index the S & P 500, which incidentally rose 3% over the week! (I heard somebody uttered the US dollar carry trade?? Where???)
Importantly, major commodities as gold (+3.8%), silver (+4.96%), copper (+8.9%), oil (WTIC-7.5%) and the CRB (3.7%) index soared!
The advances of gold prices had even been subdued due to the IMF announcement of its second batch of on-market phase gold sales program, which amounted to 191.3 metric tons out of the original 403.3 metric tons, a day ahead of the Fed action.
What the markets appear to be saying is that the newly adapted policies by the Fed could likely be even more inflationary!
Are the markets suggesting that US interbank lending is likely to improve thereby venting its effect currently on the markets which would extrapolate to a spillover effect into the real economy?
In other words, markets appear to have reacted in stark defiance to mainstream expectations.
Yet despite the Fed’s purported efforts to rollback its influences, in my opinion, they still contribute immensely to the direction of the marketplace.
Figure 3: Federal Reserve Bank of Atlanta: Federal Reserve Assets
The Fed continues to balloon its balance sheet with purchases of agency debt and agency backed mortgaged back securities (MBS) which according to the Federal Reserve of Atlanta has reached 96% and 95% of respective Quantitative Easing (QE) quotas (see figure 3).
So while some mischievous minds could be entertaining the thought of the Fed or the US government could have been tweaking the markets, a generalized manipulation of sundry markets seems improbable.
Of course a day or a week doesn’t a trend make, which means we are likely to ascertain the sustainability of the market’s reaction over the coming sessions.
Although if the present momentum continues at its present pace then deflation advocates are likely in for a big a surprise!
The Philosopher’s Stone As The Dominant Policy
Notice further that the Fed’s campaign to pacify the markets had been directed at the assurance that the said adjustments in policies had not been aimed at tightening. Said differently, the promise is that the environment of cheap funding will remain intact.
In addition, the gingerly approach by Fed officials simply reveals what we’ve been saying all along…policymakers are so highly sensitive to the direction of asset prices as to concentrate their verbal signaling on maintaining current monetary conditions.
From these premises, should we believe that the Federal Reserve will meaningfully withdraw, even factoring in its present actuations?
My answer is NO.
Why?
Because aside from the entrenched economic ideology that has been institutionalized in the technocratic bureaucracy [as discussed in Getting Ahead Of The Curve], the path of the Fed’s policies are seemingly being telegraphed in terms of ‘political pressure’ from what is projected as ‘political consensus’.
The vast tentacles of the US Federal Reserve in the academia, Wall Street and related political institutions could be working to paint the impression that there is a popular clamor to use inflation as the most effective tool to resolve the current economic predicaments.
Proof?
In a morbid fear of deflation, these networks of experts have been pushing hard for policies that would inflate away the debt in the system which they believe could simultaneously buoy nominal economic growth rates.
For instance, IMF’s chief economist Oliver Blanchard recently asked central banks to consider a higher rate of inflation. Basing his recommendations from a study by his IMF economist underlings, Mr. Blanchard recommends an annualized target of 4% to deal with the present predicament.
According to the Wall Street Journal, ``In a new paper with two other IMF economists, Giovanni Dell'Ariccia and Paolo Mauro, Mr. Blanchard says policy makers need to consider radically different approaches to deal with major banking crises, pandemics or terrorist attacks. In particular, the IMF paper suggests shooting for a higher-level inflation in "normal time in order to increase the room for monetary policy to react to such shocks." Central banks may want to target 4% inflation, rather than the 2% target that most central banks now try to achieve, the IMF paper says.
``At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.”
Morgan Stanley’s Spyros Andreopoulos sees an average inflation rate of 4-6% to stabilize public debt.
Bloomberg’s Caroline Baum cites Harvard luminaries asking for nearly the same levels of inflation, ``Last May Harvard University economists Ken Rogoff and Greg Mankiw joined a chorus advocating higher inflation. Rogoff lobbied “for at least 6 percent for a couple of years” to help the deleveraging process while Mankiw saw inflation as a better alternative to more stimulus packages and higher national debt.”
One must be reminded that Ken Rogoff was the chief economist for the IMF (2001-2004) and Greg Mankiw was chairman of the Council of Economic Advisers for ex-President George Bush.
But why stop at 4-6%?
Ms. Baum mockingly remarks, ``if 4 percent is good, 8 percent should be better and 10 percent better yet!”
As Ludwig von Mises had warned, `` In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.” All these are simply manifestations of the political elite chronic addiction to inflationism.
Yet for the mainstream what matters is a band-aid approach in dealing with structural problems, with little concerns on the long term repercussions. As Cato’s Jerry O'Driscoll comments on an article, ``A little bit of inflation is like being a little bit pregnant. Once the process has begun, it is ended at only great cost.”
To consider, with the Fed’s quantitative easing program nearing completion and considering that the US mortgage market has been dependent on [where 9 out of 10 mortgages have been estimated to have been owned or guaranteed by], the US government, an abrupt retreat from the markets is a scenario that would likely be unacceptable to politicians and the bureaucrats. Besides, whatever short term political gains accrued today could be perceived as being negated by a sudden withdrawal.
Hence, the support for the housing market via the mortgage markets will likely be sustained, although the difference would be in the manner of how funding will be obtained. Most possibly this will be through the extension of quantitative easing by the Federal Reserve or through the US treasury by issuing sovereign liabilities (the latter could also be tacitly financed by the Fed) to cover the deficits or losses.
At the end of the day, mortgage investors are likely to be subsidized by the US government at the cost of the US taxpayers [Dr. John Hussman calls this “How to spend (up to) $1.5 trillion without Congressional approval”]. These are the kind of redistributive policies that will eventually erode the comparative advantages of the US relative to the world.
To add, as mentioned in Poker Bluffing Booby Traps: PIMCO And The PIIGS, there are many prominent personalities who superficially use “economic” analysis to masquerade as political propaganda.
The typical or identifiable approach by political propagandists would be for them to issue “analysis” that limns on a dire environment, where the helplessness of the situation would necessitate for more government intervention, via inflationism, as the only feasible solution.
As Professor Bryan Caplan aptly conveys, ``This pessimistic bias is a general-interest prop to political demagoguery of all kinds. It creates a presumption that matters, left uncontrolled, are spiraling to destruction, and that something has to be done, no matter how costly or ultimately counterproductive to wealth or freedom. This mind-set plays a role in almost every modern political controversy, from downsizing to immigration to global warming.” (bold highlight mine)
So I’d be leery of heeding ‘doomsday’ analysis from the progressive camp. They signify no less than self fulfilling propaganda predicated on the addiction to inflationism.
The bizarre part is that even if these experts know how baneful the after effects of inflation can be, they refuse to acknowledge that the path of any form of addiction is self-destruction.
They are inclined to believe in the alchemy of the philosopher’s stone where they can turn lead into gold or attain the elixir of life by the miracle of converting stones into bread.
Meanwhile, markets are likely to continue manifesting incremental signs of inflation, which will persist to seep through markets, consumer prices and into the economic system, both in the US and around the world.
This is not only because of the impact of past policies but also of the direction of prospective political policies.
As we said at the start of the year, Poker Bluff: The Exit Strategy Theme For 2010, we are likely to be faced with policy bluffs until authorities are faced with the true menace.
