Global Central Bank Focus

Reflexive Disintermediation: Say What? Learning To Live With It

"Asset bubbles and their bursting have become an endemic feature of the economic and financial landscape that Mr. Bernanke will inherit from Mr. Greenspan."

I recently got a new bowling ball, drilled expertly with a fingertip grip.   It is an absolute joy to roll.   The tricky thing, however, is to actually let it roll.   For those that don’t bowl, or have only bowled with a house ball, drilled for the fingers to grip to the second knuckle, a finger-tip ball is drilled shallow, with room for only the tips of the fingers, not quite to the first knuckle.

In contrast to the house ball, configured with the objective of a straight roll into the pocket between the head pin and the one next to it, a fingertip ball is designed to hook, sweeping into the pocket with a lot of spinning action, generating an explosive conflagration amongst the pins, known as “action.” There’s nothing like it when it works!

But you have got to let the ball do the work, avoiding overpowering its natural hook proclivity.   Simply put, you gotta resist both too much speed and letting the wrist rotate in a twisting fashion.   With too much speed, the ball will roll through the break, sliding off to the right of the head pin; and with too much wrist action, the ball will over hook, missing the head pin way to the left. The right way to throw a fingertip ball is to resist accelerating the arm on the downswing, while letting it roll gently off the fingers at release. Again, when it works, there is nothing like it!

Assuming that lane conditions are predictable, that is.   For those that don’t bowl, it is important to inform that bowling lanes are regularly oiled, but not necessarily with a regular quantity.   Sometimes the lanes keeper applies it heavy and sometimes light, and sometimes both at the same time, which is the worst.   Such vagaries in oil application don’t really matter when throwing a straight ball. But when rolling a fingertip ball, lane conditions matter hugely, as they greatly influence the timing and the vigor of the ball’s natural hooking trajectory.  

So, even if you got the rhythm of rolling the ball down perfectly, you still have to make allowance for lane conditions, frequently shifting your feet a board or two to the left or right of neutral on the approach. And when you do and it works, there is nothing like it!

I don’t golf, but from conversations with friends that do, I sense a well-rolled fingertip ball is similar to a crisply-struck pitching wedge, where the club, not the golfer’s muscles, does the work, with a little fine tuning by the club operator for weather conditions. Public reports have it that Fed Chairman Greenspan is a golfer, so perhaps he could enlighten us.

Momma May Still Dance, But Daddy Don’t Roll
Apparently, however, Mr. Greenspan doesn’t bowl.   Because if he did, he would recognize that central banking is no longer a matter of brute – forcing a house ball straight, but rather rolling a fingertip ball with a hook.   This transformation of the central banking game has been evolutionary over the last twenty-five years, starting with the repeal of Regulation Q in 1980.  

Prior to that, central banking really was child’s play, as monetary policy worked its magic through a highly regulated, bank- and thrift-centric, essentially-closed domestic financial system. Regulation Q capped the interest rate that banks could pay on deposits, while capping the interest rate that thrifts could pay one-quarter percentage point higher. In return for that un-level playing field,   thrifts were required to deploy the lion’s share of their deposits into long-term, fixed rate mortgages.

It was an ideal world for banks and thrifts, as well as the Federal Reserve. It was a world of regulated competition, with the Fed having colossal power to impact the pricing, availability and terms of credit creation. The set up was particularly well suited to the Fed counter cyclically fine tuning the housing cycle (and, thus, the business cycle!).

The thrift industry played Super Man, funding long-duration assets with short-duration liabilities, running a huge duration gap, but not losing sleep about it,   snoozing soundly on book value accounting and thrifts’ 25 basis-point advantage over banks in attracting deposits.   And the Fed could pull on Super Man’s cape easily, when housing was acting bubbly, by tightening short-term rates above the deposit rate ceiling that thrifts could pay, inducing disintermediation of thrifts’ deposits into Treasury bills, creating a credit crunch – with thrifts literally having no marginal money to lend out for mortgages.   In that world, housing credit was rationed by thrifts’ availability of cash, not onerous mortgage rates.  

Twenty-five years later, only students of banking and gray beards like me remember that world, which was turned on its head by inflation that rose secularly above Regulation Q ceilings, which begat both financial entrepreneurship – initially, the advent of the money market fund and securitization of mortgages   – and the eventual repeal of Regulation Q.   Ever since, the capital markets have been in ascendancy over depositories as the marginal creator of credit and liquidity in both the domestic and global economy.  

Remembering Wojo and Henry
In the world in which we now live, credit is not rationed according to availability of depositories’ funds, as funds can be “bought” as easily as a bushel of soybeans, but rather by whatever price the market can bear.   Or, in the words of the great economists of twenty-five years ago, Al Wojnilower and Henry Kaufman, a deregulated, capital markets-driven world rations credit by bankrupting the marginal borrower.   And that takes a long, long time, when credit creation is collateralized by rising property values!

 In such a world, monetary policy tightening to lean against the wind of speculative excess in property prices and mortgage creation does not initially “work.”   Rather – per Soros’ “reflexivity” thesis, borrowed from Keynes (Chapter 12 of the General Theory) and Minsky – such tightening induces more risk-seeking borrowing and lending behavior , which generates self-validating increases in the value of property collateral. Credit does not become less available, but merely more expensive, which is hardly a deterrent to momentum-driven capital markets.

What is needed, but not available, is a tool to curtail credit creation in the capital markets without crashing them.   Regulation Q was that tool in a banking-centric financial world, but there are no counterpart tools in the present capital markets-centric world.  

Skinny Risk Premiums Are Grease, and Too Much Grease is the Word
I can think of such tools; indeed, I advocated one here over a year ago, a variable haircut for Repo’s 1. But Alan Greenspan has wanted nothing to do with any new tools that are called regulations.   In fact, he’s spent his entire 18 years at the Fed fighting regulation.   And, so, at the end of his career, he finds himself rolling the Fed’s house ball called Fed funds straight up, while capital market players hook fingertip balls all around him, generating ever-skinnier risk premiums on capital market credit creation.

One skinnier risk premium that particularly annoys Mr. Greenspan is the term risk premium, commonly known as slope of the yield curve.   He first sounded his annoyance in testimony before Congress in February, dubbing the global bond markets to be a “conundrum.” Bear with me, please, for some long quotes from him (emphasis is mine, not his):

 “…in this environment, long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. The simple mathematics of the yield curve governs the relationship between short- and long-term interest rates. Ten-year yields, for example, can be thought of as an average of ten consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on ten-year U.S. Treasury notes even if the more-distant forward rates remain unchanged. Historically, though, even these distant forward rates have tended to rise in association with monetary policy tightening.

In the current episode, however, the more-distant forward rates declined at the same time that short-term rates were rising. Indeed, the ten-year tranche, which yielded 6-1/2 percent last June, is now at about 5-1/4 percent. During the same period, comparable real forward rates derived from quotes on Treasury inflation-indexed debt fell significantly as well, suggesting that only a portion of the decline in nominal forward rates in distant tranches is attributable to a drop in long-term inflation expectations.

Some analysts have worried that the dip in forward real interest rates since last June may indicate that market participants have marked down their view of economic growth going forward, perhaps because of the rise in oil prices. But this interpretation does not mesh seamlessly with the rise in stock prices and the narrowing of credit spreads observed over the same interval. Others have emphasized the subdued overall business demand for credit in the United States and the apparent eagerness of lenders, including foreign investors, to provide financing. In particular, heavy purchases of longer-term Treasury securities by foreign central banks have often been cited as a factor boosting bond prices and pulling down longer-term yields. Thirty-year fixed-rate mortgage rates have dropped to a level only a little higher than the record lows touched in 2003 and, as a consequence, the estimated average duration of outstanding mortgage-backed securities has shortened appreciably over recent months. Attempts by mortgage investors to offset this decline in duration by purchasing longer-term securities may be yet another contributor to the recent downward pressure on longer-term yields.

 But we should be careful in endeavoring to account for the decline in long-term interest rates by adverting to technical factors in the United States alone because yields and risk spreads have narrowed globally. The German ten-year Bund rate, for example, has declined from 4-1/4 percent last June to current levels of 3-1/2 percent. And spreads of yields on bonds issued by emerging-market nations over U.S. Treasury yields have declined to very low levels.

There is little doubt that, with the breakup of the Soviet Union and the integration of China and India into the global trading market, more of the world’s productive capacity is being tapped to satisfy global demands for goods and services. Concurrently, greater integration of financial markets has meant that a larger share of the world’s pool of savings is being deployed in cross-border financing of investment. The favorable inflation performance across a broad range of countries resulting from enlarged global goods, services and financial capacity has doubtless contributed to expectations of lower inflation in the years ahead and lower inflation risk premiums. But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum . Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience.”

In July, again in testimony before Congress and with the conundrum still staring him in the face, Mr. Greenspan again bellowed off his annoyance with a low term risk premium, declaring:

According to estimates prepared by the Federal Reserve Board staff, a significant portion of the sharp decline in the ten-year forward one-year rate over the past year appears to have resulted from a fall in term premiums. Such estimates are subject to considerable uncertainty. Nevertheless, they suggest that risk takers have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons. These actions have been accompanied by significant declines in measures of expected volatility in equity and credit markets inferred from prices of stock and bond options and narrow credit risk premiums. History cautions that long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress.

Such perceptions, many observers believe, are contributing to the boom in home prices and creating some associated risks. And, certainly, the exceptionally low interest rates on ten-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of homebuilding, home turnover, and particularly in the steep climb in home prices. Whether home prices on average for the nation as a whole are overvalued relative to underlying determinants is difficult to ascertain, but there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels. Among other indicators, the significant rise in purchases of homes for investment since 2001 seems to have charged some regional markets with speculative fervor.

Shortly thereafter, I wrote 2:

“That’s about as clear as Greenspan ever speaks!   And while he would reject the proposition that he’s targeting lower ten-year bond prices (higher ten-year bond yields) as a tool to break froth and speculative fervor in property markets, that is, in fact, precisely what he is targeting .”

This became even more clear in late August, just before Katrina hit, when Mr. Greenspan declared from Jackson Hole:

“The lowered risk premiums–the apparent consequence of a long period of economic stability–coupled with greater productivity growth have propelled asset prices higher. The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions. The conversions have been markedly facilitated by the financial innovation that has greatly reduced the cost of such transactions.

Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums .”

The Greatest Irony?
And then in late September, Mr. Greenspan went a step still further in railing against skinny risk premiums, declaring in a speech before the National Association of Business Economists that:

“In perhaps what must be the greatest irony of economic policymaking, success at stabilization carries its own risks. Monetary policy–in fact, all economic policy–to the extent that it is successful over a prolonged period, will reduce economic variability and, hence, perceived credit risk and interest rate term premiums.

A decline in perceived risk is often self-reinforcing in that it encourages presumptions of prolonged stability and thus a willingness to reach over an ever-more-extended time period. But, because people are inherently risk averse, risk premiums cannot decline indefinitely. Whatever the reason for narrowing credit spreads, and they differ from episode to episode, history cautions that extended periods of low concern about credit risk have invariably been followed by reversal, with an attendant fall in the prices of risky assets. Such developments apparently reflect not only market dynamics but also the all-too-evident alternating and infectious bouts of human euphoria and distress and the instability they engender.

 Therefore, because it is difficult to suppress growing market exuberance when the economic environment is perceived as more stable, a highly flexible system needs to be in place to rebalance an economy in which psychology and asset prices could change rapidly. Indeed, as I have pointed out in the past, policies to enhance economic flexibility need to be as integral a part of economic policy as are monetary and fiscal initiatives.

Relying on policymakers to perceive when speculative asset bubbles have developed and then to implement timely policies to address successfully these misalignments in asset prices is simply not realistic. As the Federal Open Market Committee (FOMC) transcripts of the mid-1990s duly note, we at the Fed were uncomfortable with a stock market that appeared as early as 1996 to disconnect from its moorings.

Yet the significant monetary tightening of 1994 did not prevent what must by then have been the beginnings of the bubble of the 1990s. And equity prices continued to rise during the tightening of policy between mid-1999 and May 2000. Indeed, the equity market’s ability to withstand periods of tightening arguably reinforced the bull market’s momentum. The FOMC knew that tools were available to choke off the stock market boom, but those tools would only have been effective if they undermined market participants’ confidence in future stability. Market participants, however, read the resilience of the economy and stock prices in the face of monetary tightening as an indication of undiscounted market strength.

By the late 1990s, it appeared to us that very aggressive action would have been required to counteract the euphoria that developed in the wake of extraordinary gains in productivity growth spawned by technological change. In short, we would have needed to risk precipitating a significant recession, with unknown consequences. The alternative was to wait for the eventual exhaustion of the forces of boom. We concluded that the latter course was by far the safer. Whether that judgment continues to hold up through time has yet to be determined.”

Ah, “the eventual exhaustion of the forces of boom!”   Roll enough games without a fingertip ball and you don’t have to worry about overhooking it, as your arm ain’t got the strength.   But you do have to worry about underhooking it into the gutter.   For, if (1) the “greatest irony” of successful Fed-driven macroeconomic stabilization – notably achieving secular “price stability” – is excessive reduction of risk premiums, otherwise known as bubbles, and if (2) the only strategy available for addressing such bubbles is to wait for their “eventual exhaustion,” then (3) the “greatest irony” is not as Mr. Greenspan declares, but rather that he is called the Maestro.

Unexpected changes in inflation in goods and services lead to arbitrary and capricious transfers of real income and wealth between borrowers and lenders and macroeconomics instability. But so do unexpected changes in inflation in asset prices!

Endemic Is As Endemic Does
What is more, if market participants know that the central bank has a hands-off-then-mop-up strategy regarding asset price bubbles and their “eventual exhaustion,” sometimes also known as bursting, asset price bubbles become endemic to the economic environment .   That is, they are not surprises, but rather predictable outcomes.

That doesn’t, I hasten to add, make the precise size and timing of bubbles predictable. By definition, bubbles have their own idiosyncratic internal rhythm, similar to frivolity in an Irish pub on Friday night.   But conditions conducive to bubble formation are imminently predictable:  

  • A shift from a bank-centric to a capital markets-centric system of savings intermediation, 
  • In the context of price stability in goods and services, alongside
  • A central bank unwilling to use regulatory tools to temper credit creation.      

 Of these three conditions, secular price stability in goods and services is the most important, because it renders impotent the notion of “opportunistic” recessions, which takes the inflation rate to some desired lower secular level.   From a starting point of secular price stability, all recessions become “unopportunistic,” in that they immediately open up (1) the risk of “unwelcome disinflation” (to use the FOMC’s famous locution of May 2003), and (2) what is known as the “zero lower bound” for nominal policy rates.  

Consequently, market participants know that from a starting point of secular price stability, burst bubbles will elicit much more aggressive monetary ease than would be the case with inflation above secular price stability. This doctrine has been articulated by many, perhaps most elegantly by San Francisco Reserve Bank President

Yellen in August 2003 at Jackson Hole (my emphasis, not hers):
“I want to conclude by highlighting an issue relating to policy design under uncertainty where the research progress has been substantial. The issue concerns the appropriate handling of the zero bound. Here, the results from stochastic simulations are intuitive, and I suspect that they have been helpful to the Fed. First, the research shows that it is important to have a “cushion” in the inflation target to minimize the deterioration in macroeconomic performance due to the “zero bound” problem. For the United States, research suggests that a cushion of at least 1 percent (on top of measurement bias) is needed to avoid significant deterioration in macroeconomic performance, while a 2 percent cushion virtually eradicates economic problems relating to the influence of the zero bound. A larger inflation buffer becomes especially desirable if there is good reason to think that the “neutral real fed funds rate” is particularly low, as it might be in a post bubble economy, so that the odds of hitting the zero-bound are high.

The research also shows that the presence of the zero bound provides an argument for a nonlinear reaction function in which policy responds more aggressively and pre-emptively to a decline in inflation below target than to a movement above target. Here, the insurance principle that Alan Greenspan enunciated yesterday applies with a vengeance. The zero bound problem is easier to prevent than to cure. If policy is too easy and inflation rises above target, it is always possible to tighten to bring inflation down. But if inflation falls below target, the risk is that a central bank will lose its ability to stimulate the economy in the event of a prolonged downturn or further negative shocks with high costs.

Since the risks are asymmetric, the policy response should be asymmetric. A nonlinear policy would, for example, call for a central bank to lower its interest rate more rapidly toward zero and hold it at a low level for longer than the Taylor rule would suggest. It thereby reduces the odds that the zero bound will be a constraint. If understood, this policy should also flatten the yield curve, bringing long-term rates down sooner and more. The research shows that aggressive ease is justified even if the odds of outright deflation are low and a deflationary spiral remote. This logic seems quite consistent with the Fed’s aggressiveness in responding to the downturn in the economy. The federal funds rate was, for quite some time, considerably below the level predicted by the Fed’s usual reaction function.”

Ms. Yellen highlights, ironically, the “time inconsistency” problem I discussed in the September 2005 Fed Focus 2:

“The higher the Fed takes the Fed funds rate, the greater is the probability and the nearer the timing of a hard landing for property prices and the economy and, therefore, the greater the probability and the nearer the timing of a reversal to easing. Thus, the more the Fed tightens, the lower will be the “term premium,” which Mr. Greenspan says is the dominant cause (a “significant portion”) of his conundrum.”

Thus, Mr. Greenspan is very right that the full history has not been written on his judgment to follow a hands-off-then-mop- up strategy regarding asset prices.   So far, he’s looking pretty good. But no surprise on that, because as I wrote in the July 2001 Fed Focus 3:

“There is room for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed will do so, even though political correctness would demand that Mr. Greenspan would deny any such thing.”

The “full” history on Mr. Greenspan’s hands-off-then-mop-up strategy will not be written until we see the stimulative effect of policy easing on the far side of deflating (regional) house price bubbles. Remember, policy easing works by inciting animal spirits in investment and animal-spirited borrowing to fund and speculate on such investment.  

Yes, capitalism is, in real time, about the urge to gamble, the urge to take risk, particularly with borrowed money. After the stock market bubble burst, the housing market was ready, willing, and able to take its place.   But when the housing market inevitably cries speculative uncle, what asset awaits in the wings to overbuild and over lever?   We shall see.   But until then, Mr. Greenspan is right: the full historyain’t been written.

Here Comes Ben
Between now and then, I trust – and forecast! – that the post-Greenspan Fed will think anew about the nature and character of bubbles, and the wisdom of relying exclusively on the hands-off-then-mop-up strategy.   Some element of that strategy, perhaps a large element of it, must and will endure: capitalism as a going concern demands that asset markets sometimes act unruly and even irrationally, so as to lubricate the necessary process of creative destruction.

Sometimes, only the prospect of getting very rich or very broke is necessary to get economic agents to reallocate wealth and risk to its highest long-term value. The Fed should never, ever, turn itself into the DMV, regulating capitalists like the poor wretches seeking a new set of tags for their motor boats.  

That said, there is full scope, I think, for the Fed to recognize the verities about bubbles and credit creation articulated by Fed Chairman-designate Ben Bernanke in his very first speech as Fed Governor Bernanke on October 15, 2002 4.   

I consider the entirety of that speech to be must reading and re-reading for any serious student/speculator of what the Bernanke Fed might bring.   But one particular passage is especially informative:

“…to the extent that credit expansion is indicative of bubbles, I think that empirical linkage points to a better policy approach than attempts at bubble-popping by the central bank. During recent decades, unsustainable increases in asset prices have been associated on a number of occasions with botched financial liberalization, in both emerging-market and industrialized countries. The typical pattern is that lending institutions are given substantially expanded powers that are not matched by a commensurate increase in regulatory supervision (think of the savings and loans in the United States in the 1980s). A situation develops in which institutions can directly or indirectly take speculative positions using funds protected by the deposit insurance safety net – the classic “heads I win, tails you lose” situation.  When this moral hazard is present, credit flows rapidly into inelastically supplied assets, such as real estate. Rapid appreciation is the result, until the inevitable albeit belated regulatory crackdown stops the flow of credit and leads to an asset-price crash. Bubbles of this type may be identifiable to some extent after they have begun, but the right policy is to do the financial deregulation correctly – that is, in a way that does not allow speculative misuse of the safety net – in the first place. Or failing that, to intervene and fix the problem when it is recognized.”

And where is the “moral hazard” on the loose at the moment?   In exotic mortgages!   To be sure, banks that originate them don’t tend to hold them in portfolios, but rather sell them (or what is known as the “first loss” slice of them), into structured securities that are rated by the credit agencies and then sold into the global capital markets. Thus, it’s not quite the “clean” story as the botched deregulation cases referenced by Mr. Bernanke.   Rather, it is more in the nature of reflexive disintermediation of savings from banks to capital markets, blessed by credit-rating agencies driving with rear view mirrors . There ain’t nothing wrong with that on straightaways, but it is most unpleasant in turns.

Indeed, reflexive disintermediation has characteristics of VAR risk management systems, in which falling volatility leads to a mechanical increase in traders’ risk budgets, while rising volatility leads to a mechanical decrease in traders’ risk budgets.   This is the stuff of very smooth straightaways and very, very nasty turns: it works ‘til it doesn’t.   Put differently, reflexive disintermediation and VAR schemes – which are frequently paired at the hip – are by their very nature pro-cyclical, rather than counter cyclical.  

In contrast, the Fed manages its Fed funds tool counter cyclically, cutting the rate to spark credit creation and hiking the rate to curtail credit creation. Thus, reasonable people, using basic common sense, can and should rationally conclude that the Fed should recognize this pro cyclical reflexive disintermediation dynamic and endeavor (one of Greenspan’s favorite words!) to lean against it.

And indeed, the Fed has been sorta doing that since May, when it, along with other regulators, started issuing directives to banks to be careful in their underwriting of exotic mortgages. Nothing wrong with doing so, but if it is worth doing, it is worth doing with dispatch and feeling, rather than detachment and reluctance.   And there are plenty of avenues available, with regulatory teeth, not just regulatory lip service. Or, as Mr. Bernanke put it in the closing two paragraphs of that powerful inaugural speech on October 15, 2002:

“Understandably, as a society, we would like to find ways to mitigate the potential instabilities associated with asset-price booms and busts. Monetary policy is not a useful tool for achieving this objective, however. Even putting aside the great difficulty of identifying bubbles in asset prices, monetary policy cannot be directed finely enough to guide asset prices without risking severe collateral damage to the economy.

A far better approach, I believe, is to use micro-level policies to reduce the incidence of bubbles and to protect the financial system against their effects. I have already mentioned a variety of possible measures, including supervisory action to ensure capital adequacy in the banking system, stress-testing of portfolios, increased transparency in accounting and disclosure practices, improved financial literacy, greater care in the process of financial liberalization, and a willingness to play the role of lender of last resort when needed. Although eliminating volatility from the economy and the financial markets will never be possible, we should be able to moderate it without sacrificing the enormous strengths of our free-market system.”

Bottom Line
As Chairman Greenspan prepares to leave the building, the bowling bag on his shoulder will carry a straight ball, while the financial arena he leaves will be rolling fingertip balls, on lanes lubricated with the reflexive, pro cyclical grease of the capital markets. Yes, the Fed is still very powerful, as the Fed alone owns a printing press for money, a monopoly granted by we the people, through Congressional legislation.  

But the transmission of that power operates in a very different way than when the nation’s – indeed, the globe’s! – savings were intermediated primarily through Fed-regulated depository institutions.  

The Fed still pegs the Fed funds rate, but the capital markets determine the risk premiums paid and received above the Fed funds rate.   Credit is rationed primarily by price, rather than the three C’s – capital, collateral and character – of bank-centric yesterday.  

Ultimately, the Fed still has the power to significantly temper the pace of private sector credit creation, if it hikes the Fed funds rate sufficiently to overwhelm the capital market’s reflexive-driven setting of risk premiums.   But hikes in the Fed funds rate are a very, very blunt tool, at times draconian.   And the achievement of secular price stability in goods and services argues against draconian monetary policy tightening!  

Thus, asset bubbles and their bursting have become an endemic feature of the economic and financial landscape that Mr. Bernanke will inherit from Mr. Greenspan. Tempering that feature will, I believe, require that the Fed not just recognize that “our forecasts and hence policy are becoming increasingly driven by asset price changes,” as Mr. Greenspan intoned at his valedictory at Jackson Hole in August, but to also embrace a more activist regulatory approach to fine-tuning irrationally exuberant capital market-driven credit creation.

Recognizing the pro-cyclical pathologies of reflexive disintermediation, as the Fed has done, is not sufficient.   Indeed, to openly recognize those pathologies and then refuse to openly address them, except to commit to respond with outsized changes in the Fed funds rate –   if and when necessary – is, perhaps the worst possible combination – it breeds moral hazard within the capital markets, in what has become known as the Greenspan Put.

To be sure, a Bernanke Put 5 exists, too:   one against a debt-deflationary spiral, as he forcefully articulated (and led the FOMC to demonstrate!) in 2002-2003.   But that’s a different beast than the Greenspan Put, which was coupled with Mr. Greenspan’s commitment to play Mr. Magoo on the upside.  

Mr. Bernanke is not congenitally opposed to prudential regulation to check micro (as opposed to macro) excesses.   And his eyesight is a lot better than Mr. Greenspan’s 6.

Long live the Maestro. Welcome to the new world of Gentle Ben, who I hope – but do not know! – owns a fingertip ball.

Paul McCulley
Managing Director
November 23, 2005

1   ”A New Rule For Winning the Peace,” Fed Focus, June 2004
2   ”Pyrrhic Victory,” Fed Focus, September 2005    
3   ”Show A Little Passion, Baby,” Fed Focus, July 2001
4   Asset-Price “Bubbles” and Monetary Policy,
5   “Necking in the Mezzanine,” Fed Focus, December 2002
6   “Needed: Central Bankers With Far Away Eyes,” Fed Focus, August 2003


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