Page 2 of
2 Playing 'chicken' with the
markets By Julian Delasantellis
harbinger of future economic
distress; they were, in effect, the actual
economic distress that had to be countered with
rate cuts. It began to be said that one of the
factors that was underpinning the strong rally in
stock prices that began late in 2002 was the
existence of what was called the “Greenspan put”,
a put being a stock option instrument that an
investor uses to put a floor under any potential
losses in an equity he owns. In effect, by seeming
to
always come to the rescue of a stock market in
trouble, the stock market acquired the impression
that the US Federal Reserve would always be there
to bail them out.
Bernanke, who appeared
to be following this pattern with his rate cuts of
August and September, now seems to want to
disabuse the markets of this notion. In my
November 2 ATol article, Bernanke: Don't take me for granted,
boys, I noted that there were leaks
emanating from the Federal Reserve regarding a
desire to change the market’s expectation that
stock selloffs would always be met with rate cuts.
In his Cato speech, Bernanke further expanded on
these ideas.
Bernanke seems to desire
moving Fed policy away from Fed cuts to be
expected upon market hiccups towards a policy
called “inflation targeting”, common with other
central banks such as the Bank of England.
Very much as the name implies, inflation
targeting means setting a formal inflation goal,
and altering policy in order to zero in on the
desired goal, for instance, raising rates to
tighten monetary policy should inflation be coming
in above the target goal.
Bernanke
informed Cato of his views on inflation targeting.
“As you may know, I have been an advocate of the
monetary policy strategy known as inflation
targeting, used in many countries around the
world. Inflation targeting is characterized by two
features: an explicit numerical target or target
range for inflation and a high degree of
transparency about forecasts and policy plans.”
Bernanke’s new policy states that the
Federal Reserve will double, from two to four, the
number of annual forecasts it gives regarding how
it sees future prospects for inflation. The
“transparent” aspect of the policy is that the
goals will be public, there for all to see.
But besides fighting inflation, the
Federal Reserve has also been ordered by Congress
to promote economic growth in order to move
towards full employment. “As I have emphasized
today, the Federal Reserve is legally accountable
to the Congress for two objectives, maximum
employment and price stability, on an equal
footing. My colleagues and I strongly support the
dual mandate and the equal weighting of objectives
that it implies.“
But there is nothing in
the new Bernanke approach that implies that one of
the new goals will be enhancing “market
stability”, the catchphrase codewords employed by
Greenspan to ride to the rescue of the markets.
Almost like a parent who deflects a child’s wish
for a higher allowance by producing and displaying
an overdrawn bank statement, the new policy seems
to have the Fed someday telling the markets, “We’d
like to cut rates, but, sorry, our rules say that
we just can’t.”
It is highly questionable
whether under the new policy guidelines the Fed
would have cut rates the three times it has since
August 17, for, by the Fed’s own admission, the
overwhelming rationale for at least the first and
second cuts, and a major factor in the third, was
alleviating financial market turmoil.
The
question now becomes, will the new policy preclude
another cut at the Fed’s next meeting, on December
11? If the Cato speech represents new policy
guidance then the answer is probably yes.
Inflation fears are, if anything, growing;
the US dollar is plunging, and two of the bond
market’s prime gauges for judging future
inflationary expectations are flashing red. The
spread in yield (called the “yield curve” in the
markets) between what is being offered in yield by
two-year and 10-year US Treasury securities is at
a two and a half-year high, as is another closely
watched inflation warning indicator, the “TIPS”
spread between conventional fixed rate and
inflation protected 10-year Treasury securities.
It also does not appear that another cut
can be justified with an argument that economic
growth is slowing. Third quarter US GDP growth, at
3.9%, is surprising strong; the subprime/credit
crisis spooking the markets more and more with
each passing day implies an economic slowdown that
has not really commenced, at least not yet.
But the markets are acting as if nothing
has changed with the Fed. Federal Funds futures,
reacting to the continuing equity market selloffs,
are still giving 94% odds of a cut at or before
December 11.
On November 12, BCA Research,
a prominent Montreal research organization,
expressed the standard "equity market weakness
equals Fed rate cuts" paradigm in this way.
“Increasing stress in the financial system and
signs of reduced credit availability mean that the
Fed has a lot more easing ahead. The shift to a
neutral bias by the FOMC was misplaced given the
renewed rioting in the financial markets.”
This is thinking that the stock markets
can understand, that selloffs will always be met
by cuts. Unless there is an unbelievably rapid
improvement in the subprime/credit picture in the
four weeks before the next meeting, it will be the
picture that will greet the Fed governors on
December 11. If they do cut, finding a way to
produce some sort of justifying blather in the
accompanying post-meeting statement, right in the
face of the current Fed independence bravado
represented by the Cato speech, will be difficult
if Bernanke is to have any credibility attached to
any of his public statements for the remaining 6
years of his term.
If they disappoint the
markets and fail to cut, listen for the screams of
anything but joy as the stock market roller
coaster takes a long, hard plunge.
Notwithstanding Cato, I think they’ll cut.
American society is currently at a place where, if
a child falls and skins a knee on an unfilled
crack in a school playground, the local TV
stations will send video crews to hound the poor
school janitor, or better yet, the feckless school
bureaucrat in charge, until the poor sod ends his
misery and sticks his head in a gas oven. At which
point, the media would be very satisfied.
“Justice for little Timmy. Story at 10.”
Imagine the media coverage of the huge
losses that would follow upon the markets being
disappointed by the lack of a cut. In the 24/7
vigilante pundit saturnalia that has taken the
place of what Americans once received as news, a
hunt would be initiated for the responsible
scalps, and, for this, Bernanke’s hirsute
challenged pate will do very nicely.
But
perhaps they won’t, maybe Bernanke’s pride will
come before a very big fall. Bernanke and the
markets are like two teenage boys playing
“chicken” with very fast cars. Both are waiting
for the other to pull away, to blink.
For
all our sakes, I hope somebody takes their car
keys away before the entire world’s economy
crashes.
Julian Delasantellis is
a management consultant, private investor and
educator in international business in the US state
of Washington. He can be reached at
juliandelasantellis@yahoo.com.
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