Essay | Federal Reserve innovation…not
Ronald Reagan once said, “The nine most terrifying words in the English language are ‘I’m from the government and I’m here to help.’” Not to be outdone, Federal Reserve Chairman Ben Bernanke has brought terror in five words: “The Federal Reserve has innovated.” He followed up with the insight that “the Fed does not know the costs of these innovations.” An assessment of both the innovations and the costs are in order.
Capitalism, in a “free market” economy, is self-correcting. Recessions, periods of economic weakness, are necessary to cleanse the excesses of misguided investment and excess consumption. A recession is the body economy’s way to right itself and provide a more stable base from which to go forward.
We have historically had a recession once every four to five years. During the long tenure of Fed Chairman Alan Greenspan, we were in recession less than 6 percent of the time. It appeared as though the Central Bank, by tinkering with interest rates, had tamed the economic cycle. Bob Woodward labeled Greenspan “the maestro” and wrote a book about him.
Moreover, during the Greenspan years, Wall Street had “innovated” greatly. Products like collateralized debt obligations (CDO’s), credit default swaps (CDS’s), and an alphabet soup of other derivative products were lauded by Greenspan as “disseminating risk to the institutions most able to bear it.” More rational minds saw these products as part of the speculation; Wall Street could underwrite garbage and hedge itself (lay off the risk to “sophisticated investors”). Greenspan was so in awe of these products that he resisted efforts by the Commodity Futures Trading Commission to regulate and create a central clearing house for them. This failure made the Crisis of 2008 more intense.
We now know that there was no maestro after all; that Greenspan’s efforts to tame the economic cycle led to an accumulation of risk and that the cost for not allowing corrections was an accumulation of excesses that when they finally brought the economy down, would do so in a Depression-like fashion.
The Crisis of 2008 was a message to unwind the excesses but under Chairman Bernanke, the Fed is resisting. Financial innovation has led to complexity that needs to be simplified. In Bob Woodward’s new book “The Price of Politics”, Woodward quotes President Obama saying that there would not be a housing fix in the 2009 stimulus plan because the President’s men knew not how to fix it. Message to President Obama: the fix is to unwind the contorted products holding residential mortgages on Wall Street and return mortgage finance to plain vanilla banking.
In its role as regulator, the Fed should be assisting in that simplification but is instead dealing with the problem through interest rates. The Fed has refused to sit in judgment of these products and the elaborate financial structures presumably because it does not want to interfere with the free market. These products might not exist at all in a maestro-less world but the Fed now tolerates an inefficient pass-through of its interest rate reductions in order to preserve them.
What are the new tools to which Chairman Bernanke refers? The Fed’s mandate allows it to conduct monetary policy through open market operations; the buying and selling of treasury bills to directly influence the amount of bank lending. The new tools: large scale asset purchases (LSAP) and quantitative easing (QE), the maturity extension program (MEP, also known as operation twist), and communication that short-term interest rates will remain at zero through 2015, bring new power.
It is not important that the reader know about these programs in depth but what is important is that we recognize that the Fed has undergone a huge morphing of its mandate and has a mission creep problem. It distorted the economy greatly by controlling bank lending through its short-term interest rate decisions; it now controls the level of long-term interest rates by using its balance sheet to buy mortgage-backed securities and long-term treasury bonds.
The yield curve is the market’s judgment of the level of interest rates extending out 30 years. The Federal Reserve has overridden that judgment. It believes that by doing so it has lowered mortgage rates by between 0.8 percent percent and 1.2% percent and housing has been the beneficiary. What are the costs? We turn on our favorite business news channel in the morning and we hear phrases like “risk on” and “risk off”. Every fixed income security in the world is priced off the risk free rate structure of the United States Treasury yield curve. Not knowing where the “real market” is, traders follow the dogs with the biggest balance sheets. Investment time horizons have been shortened. The same can be said for the currency markets that are linked to interest rate levels.
What should Ben Bernanke do? He should return to his original mandate; to control the level of overnight interest rates and appropriate regulation of the banking system; doing that which his predecessor would not do.
Readers will remember that Ronald Reagan followed his terrifying nine words with the comment, “The government is the problem.” Today that can be said of the Federal Reserve.