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3 Vox populi: Why the Fed
did a U-turn By Julian
Delasantellis
solid growth in
employment and incomes and by robust economic
growth abroad."
Even among the dark clouds
of the subprime crisis, the Fed found the silver
lining. Credit quality fears had caused a flight
to safety into US Treasury securities, lowering
their yield, so the long-term mortgage rates tied
to Treasury rates had also declined.
"Participants also observed that mortgage
loans remained readily
available to most potential
borrowers, and that interest rates on conforming,
conventional mortgage loans had declined in recent
weeks, providing some support to the housing
sector."
Stock market selling resumed
immediately after the Fed’s views hit the markets,
and by late in the afternoon of August 9, two days
later, it was time for the great policy reversal
to commence. At an emergency conference call, the
Fed decided that there had been a remarkable
deterioration in the economic outlook in just the
2 ½ days since the last statement.
"Financial market conditions have
deteriorated, and tighter credit conditions and
increased uncertainty have the potential to
restrain economic growth going forward. In these
circumstances, although recent data suggest that
the economy has continued to expand at a moderate
pace, the Federal Open Market Committee judges
that the downside risks to growth have increased
appreciably."
The policy actions to be
implemented following the conference call would be
increased "interventions" (reported at the time to
be in the neighborhood of US$130 billion) in the
short-term money markets, to defuse the now
obvious liquidity crisis that was driving
short-term interbank rates above the Fed’s 5.25%
target zone. (I discussed the August 10 events in
my August 14 ATol article, Central banks' easy virtue, easy
money.)
But still the situation
looked threatening. On August 16, the Dow Jones
Industrial Average went into an early morning
freefall, losing 400 points to bottom out at
12,500, making it a 1,500 point drop from the
previous month's highs; it rallied into the close
to finish off just 16 points for the day. The VIX
option volatility/market fear index reached its
highest point since the index was recalibrated in
2004.
This led to another Fed emergency
conference call. At its conclusion, the Fed
announced its first interest rate cut in over 4
years, a 50 point cut in the discount rate that
the Fed charges its member banks for emergency
borrowing (see When the big guns fail, call in
China).
In marked contrast to
the rosy picture of just the previous week, the
Fed now reported that "Financial market conditions
have deteriorated, and tighter credit conditions
and increased uncertainty have the potential to
restrain economic growth going forward. In these
circumstances, although recent data suggest that
the economy has continued to expand at a moderate
pace, the Federal Open Market Committee judges
that the downside risks to growth have increased
appreciably. The committee is monitoring the
situation and is prepared to act as needed to
mitigate the adverse effects on the economy
arising from the disruptions in financial
markets."
August 16 marked the lows (so
far) in US equity markets, but the Fed's interest
rate reversal still had one more act to play. On
September 18, at the its next regularly scheduled
meeting, the Fed surprised the markets with 50
basis point cuts of both the discount and the
Federal funds target rates, the most aggressive
Fed easing move since late 2002.
According
to the Fed’s statement and meeting minutes, things
sure had changed since those blissful, prosperous
days of early August. "Weakness in employment was
spread fairly widely across industries.
Residential construction and manufacturing posted
noticeable declines in jobs, employment in
wholesale trade and transportation was little
changed, and hiring at business services was well
below recent trends … trend growth in jobs had
fallen off even prior to the recent financial
market strains, and participants judged that some
further slowing of employment growth was likely …
some recent data and anecdotal information pointed
to a possible nascent slowdown in the pace of
expansion. Given the unusual nature of the current
financial shock, participants regarded the outlook
for economic activity as characterized by
particularly high uncertainty, with the risks to
growth skewed to the downside."
What about
all that concern about inflation expressed during
the August meeting? As they might say in Brooklyn,
"Fuhgeddaboudit!"
The board "recognized
that incoming data on core inflation continued to
be favorable, and they generally were a little
more confident that the decline in inflation
earlier this year would be sustained. Inflation
expectations seemed to be contained, and the less
robust economic outlook implied somewhat less
pressure on resources going forward."
The
key period here is those couple of days after the
August 7 meeting but before the first market
interventions of August 10. What were the factors
that caused the great ship Bernanke to start the
process of an emergency 180 degree turn of the
policy rudder?
We all can wonder and
speculate as to what was happening up there at
those most august levels of economic policymaking,
but it was Wharton School of Finance lecturer Dr
Ken Thomas who actually went out and tried to find
some answers. In doing so, if they give an annual
award to the cheekiest bastard in the news, Dr
Thomas will certainly get my vote in 2007.
Through employment of the US government’s
Freedom of Information Act, the 1966 legislation
that allows American citizens relatively
unrestricted access to government documents not
protected by a national security or criminal
justice privilege, Thomas requested and received
Bernanke’s appointment and phone logs for that
critical August 7-9 period.
Who had
Bernanke's ear and attention during this period?
Here's a hint: if your net worth was under $100
million or so, or you were
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