At First Blush

Author: Bob Eisenbeis, Post Date: December 17, 2008
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Markets responded overwhelmingly positively to the Fed’s policy announcement yesterday.  At first blush, the Fed appeared to pull out all the big guns.  The Wall Street Journal characterized the move as Bernanke having gone all in, to draw upon a poker analogy. 

The FOMC cut its policy target rate to a new low and also expressed it as a range instead of a single rate.  The Committee stated that its new target for the Federal Funds Rate was a range of between 0 and 25 basis points. Furthermore, it indicated that it will employ “all available tools” to ensure a resumption of trend growth of the real economy.  These tools would include, but were not limited to, enlarging the Fed’s balance sheet by purchasing agency debt and mortgage-backed securities, and wide use of its Term Asset-Backed Securities Loan Facility to support the extension of consumer and small business credits, as well as possible purchase of long-term Treasury debt.  The Board of Governors, in addition to lowering the discount rate to 50 basis points, lowered the rate it would pay on reserves to 25 basis points. 

What has been overlooked in the market’s euphoric reaction is how little was actually new in the FOMC’s announced policies.  In reality, what the Fed actually did was to make public what it had been doing de facto for the past two weeks.  For example, the Federal Funds effective rate has not exceeded 20 basis points since December 4.  The asset purchase programs were previously announced or were minor extensions of existing programs to accept agency and mortgage-backed securities as eligible collateral for many of its new liquidity programs.  And the intention to provide direct funding to consumer loans and small business-related paper was a restatement of existing policy. 

What the FOMC’s actions really have done is make explicit that it had changed its policy implementation regime.  The Fed Funds Rate is no longer a target, but rather it will fluctuate within a range – which it has been doing for some time now, anyway.  Interestingly, the Fed has set the rate that it will pay on reserves at 25 basis points, setting up a risk-free arbitrage for those banks able to buy funds at the effective funds rate, to increase their reserve balances at the Fed.  The policy focus is now not on interest rates but on the size of the Fed’s balance sheet or, equivalently, the money supply.  And we can count on this for “some time.”  The rationale for this regime shift is to provide whatever funds are necessary to ensure well-functioning financial markets.  Call it quantitative easing, if you wish. 

However, there are some interesting side issues.  The first is how and by whom policy will be decided during this period.  The size of the Fed’s balance sheet is largely dependent upon the Board of Governors and its lending programs and is not the province of the FOMC.  Day-to-day decisions will be determined by the Open Market Desk and, presumably, Chairman Bernanke.  Will the guidance to the Open Market Desk be to keep the Fed’s balance sheet at a target level, or will that target change on a day-to-day basis?  From the current statement, all we know is that the balance sheet will remain at a “high level.”  If the balance sheet target changes daily, then those changes will affect the supply of reserves and impact rates, and consequently will affect the players in those markets in which the Fed operates. This looks an awful lot like the policy regime in the ’50s and ’60s, when then Fed Chairman William Machesney Martin, and the manager of the desk, set monetary policy daily, which they characterized as “responding to the tone and feel of the market.” 

This new regime also raises an important issue of transparency to the market, for several reasons. 

First, when Chairman Martin ran policy, markets were completely in the dark as to whether the Fed was pursuing tighter or easier policies and could only infer shifts in policy by carefully watching after-the-fact what had happened daily to interest rates.  Fed watching was a boon to economists who understood the tone and pulse of markets.  Since today’s Fed will be operating by increasing or decreasing the size of its balance sheet, information on changes in size and composition will be critical to market participants.  Right now the Fed only publishes a weekly balance sheet, ex post.  Will it announce a daily target for its balance sheet?  Will it publish a daily balance sheet, and if so, how detailed will it be?  The more transparent the Fed is as to what it is doing on a daily basis, the better market participants will be able to infer when policy has, de facto, been tightened or loosened. 

Second, we need to keep in mind that in the new regime, if the Fed relies upon the 17 primary dealers as sources of the non-traditional assets it will be purchasing, these institutions will have a real informational advantage relative to market participants without access to daily information on the Fed’s activities.  In addition, over half of these are foreign institutions or their affiliates. 

Third, because the Fed indicates that it will be operating in the markets for different types of assets, and perhaps not Treasuries initially, information on exactly what the Fed is doing on a daily basis will be critical to assessing changes in market rates in those markets.  Otherwise, by looking only at rate changes, one will not know whether they changed because of actions by the Fed to increase or decrease the supply of funds in those markets or because of changes in market perceptions of risk premiums.

Finally, there is the issue of what the role of the FOMC will be in policy formulation.  This new regime is not one in which the FOMC can meet and consult eight times a year, set the operating directions for the desk, and go home.  This is a regime that requires daily decisions.  It is neither feasible nor practical for the Reserve Bank Presidents to move to Washington and meet daily.  So it is likely that the FOMC will be de facto mothballed, until and if there is ever a return to “normalcy” in the policy formulation process

All of these issues seem to swamp the initial reaction to the Fed’s supposed rate reduction yesterday.

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