Bernanke’s Financial Accelerator Principle Suggests For More Rate Cuts

``A weak banking system grappling with non-performing loans and insufficient capital or firms whose creditworthiness has eroded because of high leverage or declining asset values are examples of financial conditions that could undermine growth.”- Ben S. Bernanke, The Financial Accelerator and the Credit Channel

So with financial markets and some economic indicators pointing towards emergent signs of deflation, this ultimately leads us to the probable responses of US monetary authorities from which the direction of global markets will be anchored.

The question remains: Will Mr. Bernanke & Co face the music and save the US dollar by allowing deflationary trends to permeate and segue into a full blown recession or will they undertake measures to prevent the economy from falling off the cliff by utilizing its monetary tools?

We have long argued that the US Federal Reserve is sensitive to financial markets more than the economy [see sensitive August 13 to 17 edition, US FEDERAL RESERVE Is Financial Markets Sensitive!].

Our thoughts has been that given the Paper Money US Dollar standard from which the world operates on, the US Federal Reserve will do everything it can to sustain the present monetary system, which has given Americans an undue advantage over the rest of the world by simply issuing promises to pay (dollar notes) in exchange for goods or services. Hence for us, the Fed’s unstated mandate is to forefend its main constituents (banking system) from a collapse. Forget moral hazard, it’s all about perpetuation of the system.

We have also shown in the past that since Central Banking has been introduced in the US in 1913, the Purchasing power of the US dollar continues to approach ZERO, a natural predisposition of all paper currencies, see August 20 to 24 edition [see In Defense of the Philippine Stock Exchange From Political Correctness].

The plight of the purchasing power of the US dollar not only reflects on the impact of the cumulative inflationary policies but also of the historical responses by the US Federal Reserve when confronted with a financial or economic crisis, where the tendency has been to sacrifice the US dollar at the altar of the Paper Money-US dollar Standard.

So aside from the need to rescue its major conduits to sustain the system, the Fed likewise recognizes the overwhelming dependence of US households on financial assets to sustain their consumption patterns, which further buttresses the case for more intervention.

We are here to discuss not on the merits but on the proposed action and potential effects to the markets. As we always say, markets reflect on policies imposed.

And this bailout would come in the form of various monetary tools that the FED possesses such as injecting liquidity or manipulating interest rates to possibly even intervening directly in the financial markets. And such is the reason why a contingent executive committee, commissioned by EO 12631 in March 18, 1988, called as the Working Group on Financial Markets exists, or otherwise known as the Plunge Protection Team.

“Helicopter Ben” was the moniker Mr. Bernanke garnered following his November 21, 2002 speech Deflation: Making Sure "It" Doesn't Happen Here advocating the use of unconventional tools to fight deflation at all costs.

In a recent speech (June 15, 2007) entitled “The Financial Accelerator and the Credit Channel” by Fed Chairman Ben Bernanke, it appears that our thesis has gotten even more validation.

From Mr. Bernanke (highlight ours), ``…financial conditions may affect shorter-term economic conditions as well as the longer-term health of the economy. Notably, some evidence supports the view that changes in financial and credit conditions are important in the propagation of the business cycle, a mechanism that has been dubbed the "financial accelerator." Moreover, a fairly large literature has argued that changes in financial conditions may amplify the effects of monetary policy on the economy, the so-called credit channel of monetary-policy transmission.”

Figure 4: St. Louis Federal Reserve: FED Funds Futures

In figure 4, from the Saint Louis Federal Reserve Fed futures have placed a rate cut of about 25 basis points this coming December.

So what this means?

Despite the hawkish tone of “no further cuts” from Fed Governor Randall Kroszner and St. Louis Fed President William Poole, the continuing stress in the financial markets will most likely spur the FED to cut in the next meeting (December 11) otherwise risk a meltdown in almost all asset classes.

Mr. Bernanke’s Financial Accelerator principle reveals of the incentives by the FED to support the financial markets. Hence, we are likely to see them slash another 50 basis points, especially if the US equity markets regresses back to its August lows or even activate emergency cuts prior to the meeting if the slump deepens or a crisis turns into full blown turmoil. Goldman Sachs’ Jan Hatzuis warning serves as an implicit signal to the Fed and to Treasury Secretary Henry Paulson (ex-Goldman Sachs CEO) of the need to insure their position. We do not believe this warning will be ignored.

Besides many of these FED officials had been talking incessantly about “inflation” even prior to the first rate cuts but suddenly voted in favor of cuts during the past FOMC meetings which goes to show how these officials lack the credibility by saying one thing and doing another.

Like any politicians or bureaucrats, the FED will protect its interests.