(Reuters) - The Federal Reserve isn’t just afraid of financial instability, it appears to fear financial analysis too.
How else do you explain the strong relationship between the appearance of words like “equity values”, “froth”, and “lending standards” in interest-rate setting discussions and the Fed cutting interest rates?
If you made this stuff up, they wouldn’t believe you.
There is a stronger relationship, in fact, between discussions around the basics of financial analysis and financial distress and easing than the ones found between inflation and unemployment and monetary policy.
A paper co-authored by Boston Fed President Eric Rosengren makes the case that the Fed does manage the economy to a third mandate of financial stability to go along with its congressionally mandated ones on inflation and employment.
“The Federal Open Market Committee appears to be reacting after adverse shocks hit rather than proactively reacting to mitigate the buildup of financial imbalances that could cause an asset price bubble, the subsequent bursting of which could have severe adverse effects on the economy,” Rosengren and colleagues write.
That’s Fed-speak for: “we don’t pull the punch bowl when the party gets good, but we mop up after financial markets have knocked it drunkenly to the floor.”
The paper examines the use in monetary policy discussions of words that denote financial instability – what it terms, revealingly, “moaning” – and changes in monetary policy. For every 100 times the Fed, between 1987 and 2009, used “moaning” words in policy discussions we can account for a 45-basis-point drop in rates. That’s a more powerful relationship than that caused by a 1-percentage-point move in unemployment forecasts and almost double the move in rates prompted by a similar-sized move in inflation.
The study also bears out the Fed’s regrettable tendency to clean up after financial bubbles but not stop them. When credit is tight and times tough, 100 words of moaning prompt 67 basis points of interest rate cuts. But if credit is easy and a boom is on, that same 100 words only get you a hike of 36 basis points.
The subtext to much of this is the push for more macroprudential management of the economy by the Fed, meaning the use of lending standards and other regulations to try to retard the growth of bubbles through behavior modification rather than monetary policy. Rosengren favors adding financial stability as an explicit mandate, something which, if accompanied by more macroprudential policies, might take some of the burden from interest rates as the principal tool of economic management.
Inefficient markets
That the Fed is more responsive to discussions of financial instability than to its actual job of managing inflation and employment is striking. What is even more remarkable is the list of words which, when used, tend to prompt the Fed to cut rates and support markets.
Besides ones that denote turmoil, like “crash”, the study counted mostly simple terms of awareness and measurement, like “housing prices”, “liquidity issues” and “regulation”. About half the terms measured in the study are those of financial analysis or regulation, not ones which evoke distress.
It is fair to point out that the Fed is the most powerful regulator in the world, and if it needs to cut rates whenever it discusses “supervision”, something is very wrong. Many would agree, perhaps even many Fed officials, who seem both desperate for better tools and dubious of their potential utility.
Seriously though, the truly amazing thing about this list is that these “moaning” words aren’t used more frequently. How do you manage an economy using interest rates without a debate of housing and equity valuations, much less lending standards?
Much of this reflects the long-lasting impact of former Fed Chairman Alan Greenspan’s love affair with the efficient market hypothesis, which posits that markets reflect available information and thus self-correct.
As a result, market inefficiencies and manias were not part of right-thinking policymakers’ conversations, unless and until they were causing massive problems, as they did several times in the past two decades.
It may well be true that the Fed, when asked to prick bubbles, will be as bad at it as they’ve proven to be at not fomenting them. The FOMC isn’t smarter than the market and will have a tough time devising rules to make up for that.
What happens now is even worse, as investors know the market prices they create will be backstopped by the Fed.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
