Wednesday, December 12, 2007

Fed extends a lending hand

Over a year ago Guambat made the crass characterisation of Central Bank activity as that of a magician, transfixing us with quarter-point moves in interest rates whilst keeping the other hand to other ropes, at that point, money supply, to try to work the economy. Guambat, in a rush to the head that gave him the feeling of eureka, offered as how,
the Fed should make some heavy and very public use of its regulatory powers and begin to put the easy credit genie back in the bottle.

As long as credit is as easy as it obviously is, and as long as new "instruments" and "structures" can be concocted to further increase the "leverage" in the system, money will have no real store of value and inflation is bound to pop out of the hat instead of the rabbit and dove.

Now, it appears, the Fed is going to do just that: use its regulatory powers in preference to interest rate moves. This is what Greg Ip in the WSJ had to say:
Fed officials, however, continue to consider ways of using various tools -- including the discount rate -- to combat banks' unwillingness to lend even to each other, which they view as a threat to economic growth.

The Financial Times ads to the Fed's toybox:
The Federal Reserve is set to overhaul the way it provides liquidity support to financial markets, following a negative reaction to Tuesday’s interest rate cut.

The overhaul, which could be announced as early as Wednesday, is likely to take the shape of a new liquidity facility that will auction loans to banks. This would allow the Fed to provide liquidity directly to a large number of financial institutions against a wide range of collateral without the stigma of its existing discount window loans.

The idea is that this would ease severe strains in the market for interbank loans, and help restore more normal conditions in credit markets generally.

However, it is unclear whether the new initiative will win over investors disappointed by Tuesday’s announcement. Many had hoped for a 50bp cut in the main interest rate, or at least a 50bp reduction in the discount rate, and a stronger indication of further cuts in the pipeline.

The markets seem to have become addicted to that old black magic called interest rates.

LATER: Continuing the train of thought, Guambat noted that the post cited above was in response to/in the context of the surge/glut/abundance of liquidity brought about by the over-leveraging of deals and derivatives. The liquidity may likely have had some root in Greenspan's too low too long rate policies, but the hyperbolic rate of growth was more about the leverage in the broad banking and financial system. Whatever Bernanke did to raise rates would have no immediate nor, evidently, proximate effect on containing the liquidity.

So now, with the busting of the leveraged liquidity flows, the stock and financial markets are baying for Bernanke to cut rates and restore their former glories. But the reason behind the bust is the risk realities that were ignored in the great leveraging and the consequent de-leveraging involved in accounting (marking to market) for that risk. It had little to do with Bernanke's interest rate policies then, and the fall-out has little to do with it now. It is all about the lending, being either too little (Bernanke's problem now) or too much (Bernanke's problem then).

Guambat is not sure that Bernanke is doing the right thing now. Guambat is just too thick and slow to know. But Guambat has no confidence that the folks now castigating Bernanke as a clown and otherwise demanding Fed action to lower rates, who Guambat reckons were the very same ones who bid up that leveraged bubble in the first place (with all its alphabet soup derivatives and structures and private equity tax deals and subprime scams), and Guambat would rather give Ben the benefit of the doubt than fall into their camp. Guambat reckons that the issue in both time-frames has not been so much about the price of credit as of the credit-worthiness of the credits, and changing rates does little to nothing to restore the former, as Japan found out over a decade ago.

See today's WSJ Morning Brief:
But if there's a sense on Wall Street that, as Morgan Stanley economist David Greenlaw argues to The Wall Street Journal, "the Fed doesn't get it," Fed policy makers themselves might consider such ignorance the healthiest point of view.

And while the last rate cut was deemed pre-emptive insurance against "adverse" economic problems to come, yesterday's was described as the fuel for greater borrowing the economy needs now.

But whatever the Fed said, inflation isn't the bigger worry; a lack of available credit for businesses to spend and build and hire is.
And again Later, Guambat found this:
Calculated Risk reminds us of what Bank of England's Mervyn King said a couple of months ago:
Injections of liquidity in normal money market operations against high quality collateral are unlikely by themselves to bring down the LIBOR spreads that reflect a need for banks collectively to finance the expansion of their balance sheets. To do that, general injections of liquidity against a wider range of collateral would be necessary. But unless they were made available at an appropriate penalty rate, they would encourage in future the very risk-taking that has led us to where we are.

If risk continues to be under-priced, the next period of turmoil will be on an even bigger scale. The current turmoil, which has at its heart the earlier under-pricing of risk, has disturbed the unusual serenity of recent years, but, managed properly, it should not threaten our long-run economic stability.


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