Sunday, January 13, 2008

Anatomy of Fed Incompetence

I composed the following post before I saw a similar line of thinking on TG's blog.
The US Fed could have mitigated the current massive damage to the markets caused by the credit crisis. Not only that, but their ineptitude actually contributed to the market damage. Here is why.

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If the market can be viewed as a loose proxy for the US economy, then during Aug/07, the market was signalling that something was not right with the economy. The US Fed decides to ignore the message of the markets by not cutting rates when it met on Aug 7/07.
But, the market is always right. On Aug. 17/07, a mere 10 days after the Fed decides to leave the US Federal Funds rate and Discount rate unchanged, it announces that it will lower the Fed. Discount Rate by 50bps., catching everyone off guard. This action meant that the Fed had to finally acknowledge that:
a.) the Market is always right.
b.) the US Fed committed an error in judgement by leaving the discount rate unchanged during the Aug. 7/07 meeting.

The defenders of the US Fed would argue that the US Feds based its decisions in part on the economic reports, and it was the economic reports that came out between the 7th and the 17th which necessitated lowering the interest rates. Well, my response would be that that is the major contributing factor the the Fed's incompetence. The credit markets were already in trouble way before the 17th, why was it necessary to wait for more information when the situation in the credit markets were very clear long before the 17th? The US Fed should be more proactive and forward looking, instead of reactive and backwards looking.

When you are bleeding, especially if you are bleeding profusely, the first thing you naturally do is to take action to stop the bleeding, not to wait for more information about the nature of the bleeding. The credit markets were in trouble by late July, and the US Feds should have acted swiftly right there and then, instead of waiting for more economic data.

The second act of incompetence came when the Feds lowered the Fed Funds rate by 25bps on Oct 31/07. At that time, they also issued a statement which effectively said, "well, it looks like everything is alright with the credit markets. So, we will go back to worrying about inflation, which means don't expect any more interest rate cuts from us." Those presumptuous comments alone were enough to drive the markets down over 9% for most of November. The message of the markets was, "no, everything is clearly not alright with the credit markets." But once again, the Fed ignored the message of the markets.

The final act of incompetence in 2007 came on the Dec 11/07 FOMC meeting. The markets were moving up in anticipation of a 50bps cut in Fed Funds rate. The markets sold off 3% in disappointment with only a 25bps cut. Colour me an armchair economist, but if I perceived the threat of a recession to be looming, I would want to take action not only swiftly, but also early, the earlier the better. What I mean is this: Fast forward now to Jan 30/08, where if the US Fed lowers the rate by 50bps, it will be effectively admitting that the 25bps cut in Dec 11/07 was yet another error in judgement. The time to cut 50bps was on Dec 11/07, in order to stop the bleeding as early as possible.

Ben Bernanke now says that he stands ready to do what is necessary to support economic growth. However, this is something he should have said on the Dec. 11/07 meeting, thereby reinforcing the error in judgement on Dec 11/07.

In summary, the US Fed, with all their arrogant PhD's and MBA's is permanently lagging in its assessment of the econmic situation, and their dearth of proactive, decisive action contributes to the problem.


john said...

i take the side of those who say we're in this mess from the first round of rate cuts by greenspan...instead of letting the free market work itself out, they dropped a ton of liquidity...the stock market is only right in the sense that u will lose money waiting for it to come in agreement

was the market right when the nasdaq was at 5,000? of course it wasn't priced correctly...however, making money and being right are not the same thing

truthfully, a credit crunch is probably well deserved...u can't live like a drunken sailor and never get a hangover...of course its painful, but its a reminder not to indulge so much the next time

Phileo said...


I dunno, I'd agree and disagree with your point about Greespan being the true root cause.
Greenspan had no choice bu to reduce the Fed Funds rate because the economy was in recession back in 2001. But yeah, I'd agree that the Greenspan era also acted one step too late in cutting rates, and of course, cut too much, and left the fed funds rate at next to nothing for too long, allowing the housing bubble to really take form and substance.

I'm not saying that Bernanke could have prevented the 2008 recession, but I am saying that he could have exercised better judgement, and respond more quickly to the changing market conditions.

And of course you and I both know that the sailor is doomed to repeat the drunkeness/sobriety cycle because that is how he was wired up, just like how the markets will inevitably repeat the boom/bust, fear/greed, bull/bear cycle.

Such is life, eh?

john said...

agreed! sailors sure get a bad rap :-)