Wednesday, November 28, 2007

Losses = Lessons Learned?

In Oct. I was concerned that a rate cut could lead to an erosion in Fed credibility. The way I saw it the Fed had to options: hold firm and signal more easing or cut and signal that the easing cycle was over. I prefered the former, the Fed chose the later.

Now, it seems that their decision may be coming back to haunt them. As many have pointed out the situation has detoriated and there is strong reason to ease again in December. I tend to support antoher quarter point cut at this point.

However, what does it say about Fed credibility and foresight that just weeks ago they signaled that the cycle was ending and now it may be begining anew?

On the positive side, though, massive losses by the banks and brokers have loosened some of the concern about moral hazard. With record right downs it is hard to argue that the financial markets have not been forced to account for the excess of the past five years. This is good news for those hoping for more cuts.

26 comments:

Mike said...

"However, what does it say about Fed credibility and foresight that just weeks ago they signaled that the cycle was ending and now it may be begining anew?"

credibility - almost nil
foresight - not very far

You have to wonder what they were looking at earlier in the year when the Fed said the "subprime" issue was contained.

Mike said...

What can we make from the following comments from the Fed?

http://tinyurl.com/2bgjd8

Yesterday Plosser and Evans - rate cuts > increased risk of inflation

Today Kohn - " losses ... greater than people expected ... more turbulence ... have to be nimble"

Seems they don't talk to each other that much and present conflicting views. Which makes them seem like idiots.

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knzn said...

The Fed has always said that they respond to incoming data. And why should one expect the Fed to have significantly better foresight than the private sector? The Fed cut in October and said that the risks were balanced, which was a reasonable assessment of the situation as it appeared at the time. That should be interpreted to mean that, barring unexpected news bearing on the balance of risks, the Fed would stop cutting. But there has been unexpected news, and the risks are no longer balanced. I don't see why that should be a problem for the Fed's credibility, unless the market thinks the Fed has a crystal ball. The Fed remains more hawkish than the Street, but the whole distribution has now shifted to the point where both want a cut.

Mike said...

What unexpected news?

Mike said...

You mean the Fed didn't know about all the bad debt?

Karl Smith said...

I don't see why that should be a problem for the Fed's credibility, unless the market thinks the Fed has a crystal ball.

While the Fed doesn't have a crystal ball it shouldn't appear to be behind the ball either. Perhaps, I am a bit old school in this, but I think investor confidence in the Fed is an asset.

The Fed should not appear to be playing catch-up. One of the vulnerabilities of too much transparency too fast may be that the Fed at times appears less unsophisticated.

I do tend think of this as a danger because we would like to be in a position where the Chairman could calm markets simply by saying "The Fed stands by to supply liquidity as needed" and have market participants believe that this is sufficent.

knzn said...

There is no way to avoid having the Fed play catch up, except to jump too far ahead and then expect to play catch up in the other direction. When the economy is weakening, the news comes gradually and is subject to reversal.

mike, the Fed was unaware of the breadth of the problem, as was the market. You will notice how credit spreads have widened and the stock market has dropped over the past month.

Karl said...

Well one way of satisfying all the constraints would have been to

1) Pause in Oct.

2) Note that the predominate concern is growth and that data will be monitored very closely.

3) Cut 50 bps in Dec in response to credit conditions.

That way you are saying "We see whats going on. We are concerned. We are a conservative by nature but when it becomes clear that there is a problem we are willing to act rapidly."

Mike said...

So right now the Fed isn't concerned with the value of the dollar even though we hear that they want a strong dollar? Or is it more about trying to reduce the trade deficit?

And how would a rate drop really help the average person?

http://blogs.ft.com/maverecon/2007/11/should-the-fed.html

Mike said...

Try the link again:

http://tinyurl.com/2ncsvl

knzn said...

Karl, Are you making a general argument for taking larger and less frequent steps?

Mike, I don't think the Fed said it wants a strong dollar. Treasury Sec'y Paulson may have said so, but my guess is he was lying, just trying to make sure it doesn't fall too quickly.

Karl Smith said...

Karl, Are you making a general argument for taking larger and less frequent steps?

I wouldn't go quite as far as saying "generally" large and infrequent steps are preferable.

I would say that when uncertainty is high and the potential downside risks are high that such a policy can be useful.

In August for example, it was clear that the credit channel was tightening dramatically, at that point 50 bps was completely justified.

In Oct, things were murky again. So there I was inclined to pause.

Now, I think we are becoming very confident that credit is tightening again so I am inclined to move big again.

I would go so far as saying that the Fed should always move to the "ideal" rate in one or two steps, however.

Karl Smith said...

Note by move big I mean certainly 50 if we had paused in Oct and 25 to 50 now.

I am not saying that we should be start a cutting cycle with a goal of 3% as some people have suggested. Lets see what we get from the cut now and if credit conditions improve.

Mike said...

Does the high ADP jobs report reduce the chance of a rate cut?

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