Fed Alert: FRBNY Studies "Educational Intervention"

In a climate where the word "czar" can be casually bandied about without raising an eyebrow, the New York Fed isn't the least bit shy about studying "intervention" in each and every form.

And this relates to monetary policy how?:

Program Design, Incentives, and Response: Evidence from Educational Interventions

Forthcoming

JEL classification: H40, I21, I28

Rajashri Chakrabarti In an effort to reform K-12 education, policymakers have introduced school vouchers—scholarships that make students eligible to transfer from public to private schools—in some U.S. school districts. This article analyzes two such educational interventions in the United States: the Milwaukee and Florida voucher programs. Under the Milwaukee program, vouchers were imposed from the outset, so that all low-income public school students became eligible for vouchers to transfer to private schools. In contrast, schools in the Florida program were only threatened with vouchers, with students of a particular school becoming eligible for vouchers only if the school received two “F” grades in a period of four years. Unlike the Milwaukee schools, Florida schools therefore had an incentive to avoid vouchers. Using school-level data from Florida and Wisconsin, this study shows that the performance effects of the threatened public schools under the Florida program have exceeded those of corresponding schools in Milwaukee. The lessons of the study are broadly applicable to New York City's educational reform efforts.

HTML executive summary PDF full article22 pages / 302 kb Press release

Given that the new Bureau of Consumer Financial Protection is being sequestered (off balance sheet) under the Fed's umbrella, is it paranoid to wonder if we'll see similar shifts with respect to educational concerns? Or, is the New York Fed simply targeting the victims of its next PR campaign?

Geithner Outlines Basel's All New Boom-Bust Detonator

Your central planners have been toiling ceaselessly to reshape the global financial ponzi landscape for the benefit of all. Now that round one of the so-called Basel III talks has wound down, Geithner graced the House Financial Services Committee with a missive outlining how two half measures equal a whole, describing in broad terms how the ruling class will banish the pesky business cycle once and for all. We thought we'd extract a few choice quotes upon which to expand:

It is also essential that the Basel agreements are implemented by national authorities in a way that generates a `level playing field' in our increasingly integrated global financial system. We will engage our foreign counterparts to look for ways to ensure that that these agreements are implemented in a transparent and consistent way by supervisors in different countries.

We will also continue to explore innovative ways, such as the use of counter-cyclical buffers and contingent capital, to expand the capacity for the system to absorb unexpected losses without amplifying shocks to the system.

Note the use of scare quotes around "level playing field." One wonders which staffer had to strike "LOL" from Geithner's Kool-Ade-stained draft. And, while the term "innovative" out of the mouth of a regulator is enough to make the hairs on our neck stand on end, we'll move on and explore just what are those counter-cyclical buffers. Felix Salmon writes:

When credit in an economy is growing faster than the economy itself, a countercyclical capital buffer kicks in, which essentially says that banks need to have more capital in good times. That countercyclical buffer won’t be set by the BIS in Basel; it’ll be left up to national regulators. But you can probably expect the UK, US, and Switzerland to enforce it up to the maximum of 2.5%.

So when the economy’s booming, banks are going to need 9.5% common equity, 11% Tier 1 capital, and 13% Tier 2 capital.

To which, Robert Wenzel, at EPJ Central adds:

Got that? Central banks create the boom bust cycle by printing money, which enters the economy through the banking system. If the economy "heats up" a "countercyclical buffer" will kick in to slow bank lending, as part of Basel III. But this "countercyclical buffer" could be done without all this Basel III mumbo jumbo by central banks simply slowing money printing. Since central banks target either interest rates or money supply growth, if the countercyclical buffer kicks in, it simply means that central banks will have to be more aggressive adding reserves to maintain a particular interest rate level or money growth level. Bizarre.

As for protecting banks against a future crisis by these new capital levels, not a chance. Following the 1929 stock market crash margin requirements were boosted to 50% to eliminate stock market crashes, a lot of good that did.

As long as central banks pump money into the system, the economy will be vulnerable at the points where that money goes first and since banks are the ones who put that money into the system, they will continue to be vulnerable to slowdowns in money growth. 10%, 12% and 13% capital levels will never be enough to protect them (especially when some of the assets are held in the form of Freddie and Fannie paper, not to mention sovereign debt of the PIIGS).

Not to be accused of passing judgement rashly, we thought we'd consult the source--the BIS' own Countercyclical capital buffer proposal, where on page 21, we find the magical formulas that will save mankind from future financial Armageddon. Namely, the "aggregate private sector credit/GDP gap," which is subsequently transformed into the crisis-averting capital buffer:

RATIO_t=CREDIT_t / GDP_t Х 100%

where

GAP_t=RATIO_t – TREND_t.

where

TREND is a simple way of approximating something that can be seen as a sustainable average of ratio of credit-to-GDP based on the historical experience of the given economy. While a simple moving average or a linear time trend could be used to establish the trend, the Hodrick-Prescott filter is used in this proposal as it has the advantage that it tends to give higher weights to more recent observations. This is useful as such a feature is likely to be able to deal more effectively with structural breaks...

We could continue into the buffer transformation, but it's a bit nauseating. Despite the fancy Hodrick-Prescott filter--the functional equivalent of an exponential moving average--the immodest model builders are trend followers, never catching the highs or lows--just the juicy middle, seemingly oblivious that they are the lead foot on the pedals of the very monetary and credit trends that mystify them so.

Did the Fed Simply Pass the Printing Baton to the Bank of Japan?

Yesterday, rumors fueled an early equities rally on speculation that the FOMC would announce next Tuesday a new round of Treasury purchases--the long awaited QE 2.0--in no small part to the statement we quoted from Morgan Stanley in our discussion of the same subject. The theory being: this would be the Fed's last chance to accommodate during the historically perilous September/October time frame for the stock market, and also not wanting to be seen as influencing the November mid-term election (the next announcement would actually occur the day after the election on November 3). Regardless, MS has relegated its stock-goosing hypothesis to a low probability event. Yet overnight, the Bank of Japan, as agent for the Minister of Finance, took printing matters into its own hands. From Goldman Sack's Fiona Lake:

In the last phase of Japanese intervention running from early 2003 to March 16th 2004, the Japanese intervened on 129 of those days, accumulating Yen36.3trn-worth of reserves in the process. The most persistent phase of intervention was in late 2003, beginning of 2004 and the largest one day Yen selling January 9th 2004 of JPY1.6trn. Over that period, the Japanese initially defended the 116 area, before stepping away in late September, in the run-up to the Dubai G7 meeting and ‘smoothing’ the cross down to 105-106. This level was subsequently defended heavily. The BoJ/MoF will provide aggregate data on the size of today’s intervention and any subsequent intervention on the last business day on the month. Detailed daily intervention data typically becomes available on a quarterly basis.

On the assumption that the volatility around the DPJ election result yesterday was a key trigger for intervention today, it is quite possible that the Japanese authorities will intervene again in response to similar circumstances and it is indeed possible that we see more intervention in the next few days. Broadly speaking, the administration likely want to introduce more two-way risk in USD/JPY in order to stem further speculatively Yen appreciation vs the USD or on a TWI basis. Despite intervention today, we would not rule out notable new lows in $/JPY at this stage. Importantly, the political environment is unlikely to tolerate persistent Japanese intervention given the broader political pressures to allow Asian FX appreciation.

BoJ Governor Shirakawa commented that he hopes MoF action will stabilise FX rates and that the BoJ will continue to supply ample liquidity to the markets and pursue strong monetary easing. This suggests that the BoJ are not in a rush to mop up the liquidity provided by today’s intervention. As a reminder, in an emergency meeting on August 30th the BoJ announced it would start providing 6-month term funding of approximately JPY10trn.

If this is, in fact, only the beginning of a sustained intervention with no attempt at sterilization, the Bank of Japan may simply be picking up the global liquidity slack now that its own election is over while the Fed awaits the end of mid-terms to tag back into the printing ring. Though it's true the BoJ removed US Dollars in an amount equal to the Yen it sold at the prevailing exchange rate, there is nothing that constrains it from sheltering those Dollars. It could lend them to its banks (Nomura's also a primary dealer), purchase US Treasurys or use them to buy any other number of Dollar denominated assets. The BoJ has even been known to buy equities held on its member banks' books (its most recent stock buying program ended in April, 2010, which coincidentally top ticked the US equities rally).

Accordingly, it's instructive to review the prior BoJ intervention period from 2003 through March, 2004, which was also concurrent with extreme Federal Reserve accommodation.

Click for larger image.

While there are, of course, many other variables at play, the image is startling. (Incidentally, this too was a period when the BoJ purchased equities.) Given the apparent failure of the prior intervention (the Yen actually strengthened 10.8%), one wonders if the goal was as much to make Japanese exports cheaper as it was to salvage a principal market for its exports--that is to save the US economy by conspiring with the Fed to kick off the next bubble.

As RW at EPJ Central noted earlier, there were big currency movements underway even before the intervention, with the US Dollar sliding big against the Euro and actually reaching parity with the Swiss Franc. With Yen strength so prevalent as of late, it could simply be a last ditch attempt to preserve the carry trade. Regardless, we'll look with keen interest in the days and weeks ahead as this potential source of back-door QE develops.

Why the Federal Reserve MUST Print, Print, Print...

The law of unintended consequences continues to wreak havoc with the Fed's ad-hoc dart throwing exercises plans, as only yesterday, the New York Fed confirmed our expectations that it will have to ramp up its Treasury purchases by 50% over the next month to the tune of $27 billion (our estimate: $25.5 billion)--all, to keep up with the Jones' refis, defaults and loan mods. It's easy to lose sight of just how this latest round of so-called QE Lite came to be. And, as this is but a hint of future printing, upon which a hand-bound Fed will find itself with no choice but to embark, a brief recap is appropriate.

During and after the carnage of Fall, 2008, the Fed engaged in a multi-trillion dollar large scale asset purchase program, otherwise known as quantitative easing, or QE. It complemented the myriad temporary lending facilities it also had conjured, some as early as August, 2007. QE was essentially a series of permanent cash subsidies to those holding certain financial instruments--select primary dealers that transact directly with the Fed, in particular. But, anyone holding a similar class of security benefited from the price floor that the Fed established. This influx of cash had a side effect of funding a global risk rally that hit its stride in the second and third quarters of 2009 (which was also aided in no small part by 10 to 100 times levered bets from US Dollar borrowings at record low interest rates--also abetted by the Fed).

$300 billion in long term Treasury purchases and a near-zero interest rate policy kept yields suppressed across the curve. $1.25 trillion in mortgage backed securities and $200 billion in agency debt purchases single handedly propped up the financial side of the housing industry, and in turn, the housing industry itself, and in turn the global Ponzi scheme built upon housing and its related securitization. Other central banks joined the fray, and their actions sucked volatility and risk premium out of the entire global financial system, taking corporate risk onto their own balance sheets. The purchased instruments, in private hands, would ordinarily be hedged as interest rates fluctuated, but not so when bathed in the SOMA's warm amniotic Sack.

Thus, nearly every signal available to investors--from interest rates to liquidity to volatility--had been distorted by the Fed's actions to induce the Pax Reserva--that fleeting window in time when some semblance of normal emerged from financial Armageddon. Fleeting and semblance are the operative words, because when one scratched the surface of the statistical recovery, there seemed little beyond a junk-off-the-bottom risk rally (including stocks) aided by a fiscally imprudent (read Keynesian) administration. The Pax Reserva would not last.

Fourteen months and one flash crash later, amidst daily rumors of an imminent Eurozone breakup, the world couldn't get enough Dollars and govvies in the summer of 2010. May 6 was not only a day in which the Dow dropped 1,000 points, but one in which months of pent up volatility was unleashed in a matter of minutes. To be sure, dubious trading practices, such as high frequency trading, exacerbated the situation, but the unprecedented central bank intervention provided the framework.

With the Treasury on the hook for Fannie and Freddie paper, an up-trending mortgage default rate mattered naught, and what was sauce for the goose was sauce for the gander. With fundamentals out of the way and Bernanke willing to buy paper that would make Angelo Mozillo blush a shade less tan, anyone chasing incremental yield was happy to scoop up MBS paper guaranteed against default, yielding a few whole percentage points over Treasurys.

The result: 30 year mortgage rates tumbled 70 bps over the summer of 2010 to 4.35%, which lead to a second refinancing boom. While MBS securities are designed to payout in line with the terms of the underlying loans (15 to 30 years in the case of fixed rate loans), changes in interest rates to the downside will accelerate the MBS principal payments (prepayments) as the proceeds from refinanced loans are funneled to the holders of the MBS securities (a phenomenon known as negative convexity). In addition, MBS principal payments will increase as a result of loan modifications or defaults (which, as of March, 2010, Freddie has pledged to pay on any loan 120 days in arrears).

The Fed's share of these prepayments led to an accelerated decline in the asset side of its balance sheet--effectively giving a tightening bias to Fed monetary policy as it accepted principal payments on its MBS assets. In addition, the Agency (Fannie/Freddie) debt that the Fed bought has been maturing and rolling off its balance sheet at the rate of a few billion per month. To recycle this money into the economy, it began mid-August purchasing Treasury securities at auction from its primary dealers in amounts equaling the expected influx of payments and maturations. Of course, there's no guarantee as to where this money will be deployed, so while this is declared to be reserve-neutral, it is most certainly not effect-neutral.

So what's it going to be then, eh...deflation or inflation?

We've avoided this discussion in the past because rarely does inflation or deflation alone persist across an economy. Most times, there is a mix, with one more visible than the other. From the Fed's perspective, debt deflation is currently most critical, yet its advisors and peers also see hints of inflation, notably in the food sector. Overall, this is a marked reversal from the beginning of 2010, when the Fed was crowing at every opportunity about the tools it would need to fight future inflation. Indeed, as Congress was making up its collective rassoodocks whether or not to reappoint Bernanke in January, 2010-- a time when "green shoots" was still uttered by a few without a smirk--we were discounting the Fed's inflation warnings:

Since October, 2009, the Federal Reserve has increasingly hyped the inflation meme by publicly touting the more than $1 trillion in excess reserves (held by banks with the Fed) which, as the theory goes, could come flying out into the economy in an HFT-New York second, in one hyperinflationary swoop. If all the world’s a stage, then Bernanke will be winning an Oscar for this performance, because the futures and currency markets are pricing in a Fed rate hike in the second half of 2010 and a robust US economy. Rather, we have postulated that this tightening theatre is mere preparation for QE 2.0, which has been confirmed today (at least with respect to more Agency MBS purchases by the Fed). We suspect the Fed will wait until the US Dollar index rallies to at least 81 or 82 before announcing the next round of long term Treasury purchases. Make no mistake, however, those pesky excess reserve dollars will eventually get itchy to rejoin their friends in the economy (perhaps when they amount to $3 trillion sometime in 2011), and the Fed will need all the tools it can strap around its bloated waist to reign them in.

Expectations of a rate hike have been pushed out to Q3 2011 and, with serious talk of the next round of easing, it's time to start thinking about those excess reserves again and how they might find their way into the economy against the best wishes of the Fed.

The Fed is perceiving its greatest enemy--deflation--at work, as evidenced by Bernanke's post-Jackson Hole speeches. Recent data from the real time consumption-side GDP measurements of the Consumer Metrics Institute demonstrate that current consumer retrenchment is approaching the extreme levels seen in the last election cycle that preceded the panic of 2008.

Consumption is unlikely to rebound until the uncertainty of the election is over, and the Fed is acutely aware of this. Accordingly, we're fast approaching the window of time in which the Fed would attempt to reclaim the Pax Reserva with a second great reflation attempt. On that note, Morgan Stanley recently hypothesized that the Fed may open the door to QE 2.0 as early as the September 21 FOMC meeting so as not to be perceived as attempting to influence the upcoming election at its early November meeting. [Update: this hypothesis has since been withdrawn] If this is the case, it would be characteristic for hints to be dropped in Fed speeches over the next week.

The effects the next reflation will have on the markets and economy depend on its magnitude and timing, as well as concurrent fiscal initiatives, including the 2011 tax cut expirations. With all the variables and skeins of potentiality, we are indeed living in kaleidic times. What we can say is that if the Fed undershoots or simply maintains present policy, deflationary forces, especially with respect to interest rates, could certainly persist. This appears to be the case with the current Treasury buybacks--just enough buying pressure to keep yields low, while having little stimulative effect on the money supply (when measured year over year, non-seasonally adjusted).

If, on the other hand, the Fed overshoots, inflation expectations could immediately reverse. It's instructive to remember that on the original Treasury QE announcement of March 18, 2009, the 10 year yield dropped an eye watering 55 basis points that day to 2.47%. However, it dramatically reversed to the upside over the next three months to reach a high of 4.01% and, to this day, has not reclaimed the prior low. Notwithstanding the current intermediate down trend in yields, they are susceptible to an upwards reversal on a change in inflation expectations. The most likely candidate is the Fed's next reflation announcement, but any number of other events could be catalysts as well.

While it is assumed that future Fed accommodation will come from asset purchases, it is also possible it would lower the interest rate on excess reserves (IOER) it pays to banks to keep their money tied up at the Fed, currently 0.25%. While this route is much less likely, it is instructive to understand the dynamics of the IOER and how it relates to other rates because it will have implications for recognizing when the Fed has truly lost all appearances of control. We wrote about these relationships here in August:

What is relevant is the spread of IOER to other short term rates on the lower end of the yield curve--namely, (1) the Federal Funds rate paid on uncollateralized overnight loans between banks and other large financial institutions and (2) short term Treasury Bill rates. As of Friday, August 5, the Fed Funds rate was 0.19%, and the 1, 3 and 6 month T-Bills were yielding between 0.15% and 0.19%. Even 1 to 2 month investment grade commercial paper has been yielding less than the IOER.

This means that banks can leave their excess money at the Fed and get paid 0.25% every night, as opposed to lending to another bank at the lower rate of 0.19% or locking the money up in Bills or commercial paper for a month or more. [It's also important to know that the reason the Fed Funds rate, which is uncollateralized, is less than the IOER is largely because the biggest lenders are Fannie and Freddie, both ineligible to park their money at the Fed because they are not banks.]

Accordingly, were the Fed to lower the IOER to say 0.10%, several investment options would immediately become more attractive to banks and a material amount would likely leave the custody of the Fed. How much and in which directions cannot be known, but the implications should not be ignored simply because the spread is seemingly small. We're talking over $1 trillion of leveragable cash held by banks.

One of the worst case scenarios for the Fed would be to engage in a new large scale asset purchase scheme, only to see the Fed Funds rate creep (much less jump) above the IOER threshold of 0.25%. This came close to occurring in mid-June, 2009, but was averted by fears that the nascent equities rally had come to an end. If the Fed Funds rate were to trade up to say, 0.30% or 0.40%, the effect would be similar to that if the Fed had lowered the IOER--banks would start looking for places other than the Fed to put their money, and money multipliers would start taking over. The Fed could either allow the consequences of serious inflation to take hold, or it could raise the IOER. Neither would be attractive, as it would look either negligent or pusillanimous.

The bottom line? The "recovery" is ubiquitously recognized as a statistically-manipulated sham (at least, in a universe that excludes CNBC hosts). The Fed, when faced with signs of both deflation and inflation, will always resolve such dilemma in the direction that the printosine bases embedded in their phosphate-deoxyribose backbones direct. Ad hoc interventionist measures beget only more of the same, and thus, what seemed a binary central banking world a mere two years ago--to print, or not to print--is a unary one. The "decision" is only the magnitude, with the margin for error exceedingly small.

Update Sep 15 2010: Date of next FOMC meeting was corrected.

Estimates for Sep-Oct 2010 Fed Treasury Purchases

Due to material increases in MBS factors for the 4.5% and 5.0% coupons in the Fed's MBS portfolio (indicating not only increased refinancing but mortgage default payouts by the GSEs), along with an increase in agency debt maturing over the four week period, Treasury purchases are expected to jump nearly $7.5 billion from the $18 billion bought in the first four week purchase period. Next Monday, Sep 13 at 2:00 pm, Brian Sack tells us just how close we are.

Agency MBS Principal Payments* $21,066,000,000

Agency Principal Payments 494,657,000

Agency Maturing** 3,946,000,000

Est. Treas. POMO mid-Sep to mid-Oct $25,506,657,000

* Includes purchase of 120 day delinquent mortgages by Freddie Mac. See page 37.

** Per FOMC Minutes released Aug 31, 2010, Fed will replace maturing Agency debt with Treasury securities. This accounted for our shortfall in the Aug-Sep estimate wherein it was believed the Fed would replace maturing Agency debt with like securities. Apparently, the Fed cannot miss the opportunity to gift a commission to the PDs and float the Treasury market.

How Congress Literally Turned Back the Hands of Time to Ram Through the Federal Reserve Act

Prior to television, it was the duty of newspaper reporters to inform the public of the important facts surrounding the signing of a major bill--the names of those present, the color of the president's suit, who remarked which witty remarks, etc. The signing of the Federal Reserve Act by President Wilson on December 23, 1913, was no less an occasion for the NY Times to practice an introduction worthy of what would later regularly appear on page 6 of the New York Post. How appropriate that the headline, "[President] Affixes His Signature at 6:02 P.M., Using Four Gold Pens" would foreshadow Wilson's own remarks on gold which, themselves, would foreshadow a century-long love-hate (okay, mostly hate) relationship between the progressive central planners and the yellow metal:

With the second of the plain gold pens he wrote the first syllable of his last name, and finished his Signature with the other pen. "I'm using a series of pens," explained the President to the gathering. In response came the deep voice of Senator James Hamilton Lewis 0f Illinois: "the bill came forth in installments."

Everybody laughed at this, of course, and there was another laugh when the President, as he reached for the fourth pen, remarked: "I'm drawing on the gold reserve."

And with that precedent set, whereby future presidents would assume the authority of Gold Steward/Leaser in Chief--incrementally, then completely abdicating the gold standard--the [young] gray lady then treats us to a procedural blow by blow of how the Grinch was enabled to steal every single future Christmas Federal Reserve Act came to be. All we can do is reproduce the text and wonder what shenanigans went on behind closed doors and off the record.

After debate that began at 10 o'clock and lasted until 2:30 the Senate adopted the conference report by a vote of 43 to 25. All Democrats present. Three Republicans and the only Progressive in the Senate voted for the report.

...

The vote was taken at 2:30 when Mr. Owen ended [sic], and the engrossed bill was rushed to the House for the Speaker's signature. Before it returned the Senate had agreed to the House resolution providing a recess until noon of Jan. 12, and had gone into executive session.

The bill was received in secret session and the Vice President signed it before the doors were open. Adjournment was taken with the doors still closed and when they were thrown open it was found that only four Senators remained on the floor. Most of them had already caught trains for home. Speaker Clark placed his signature to the enrolled parchment copy of the currency bill at 13 minutes to 3 o'clock, in the presence of the House.

After its late session of last night the House had taken an adjournment until 2:30 o'clock this afternoon to await the acceptance of the conference report by the Senate. When it met the action of the Senate had not been "messaged" over to the House and a recess was taken until 3 o'clock. While the House was in recess the bill, in its final enrolled form, bearing the signature of Vice President Marshall, was received at 13 minutes to 3 o'clock. As the House had recessed until 3 o'clock orders were given to employes to turn the hands of the clock over the Speaker's desk forward twelve minutes, to make the time 3 o'clock, and the enrolled copy of the bill was then signed.

The article closes with some words by the remarkably self-assured Speaker Clark:

Clark Congratulates Coutry.

Speaker Clark, after signing the bill issued a statement as tollows:

"Most assuredly the country is to be congratulated on the fact that, at last, the Currency bill is upon the statute books; for in such matters of great pith and moment, it is the uncertainty that hurts--even where a bill might be the sum total of human wisdom on any particular subject. Now, all men of intelligence will know very soon what the Currency bill contains and what it means, and can conduct their affairs accordingly.

"My own judgment is that it will be satisfactory to the country in a high degree--at least I hope so. The fact that a large number of Republicans and Progressives voted for our bill is proof positive that the country is well pleased with the bill. [Notwithstanding the time-bending convolutions exercised to get it passed two days before Christmas.]

"So many of them so voted that it may not improperly be denominated non-partisan law. We certainly have ample cause for self-congratulation that in nine months we have passed a bill revising all the tariff schedules and a bill thoroughly revising and overhauling our currency system-presenting bills so fair and so wise that even political partisanship gave way to such an extent that many Republicans and Progressives voted with us.

"Our two bills are excellent samples of constructive legislation. The tariff bill is working well and now that the uncertainty as to the Currency bill is removed. I hope and believe that the country is entering upon a long period of prosperity.

"Everybody in any way responsible for these two bills is to be congratulated on the results."

Most striking is that, a century ago, it was not necessary for legislators to hide airs of omniscience and the pretense of being conduits of infinite wisdom. The participation of a few members across the aisle was enough to suggest that words scribbled on legislative parchment in the hallowed halls of the Rotunda state temple had been revealed by a divine creator. While such speech would be derided today, the content of the voluminous bills passing across the current president's desk suggests the public is, if anything, more deferential. Hopefully, historians a century from now will look back and see our present time as one in which the veil of fog was lifted and the naked emperors were seen for the dim-witted, banal thieves they are.

The full article is below.
NYT Federal Reserve Act 100414417

Bernanke, Bubble Denier: The Greatest Fed Tool of All

Over the past two days, the assorted regulatory freaks have been patting themselves on the back in front of your appointed financial elite, better known as the Financial Crisis Inquiry Commission. Our intrepid printer-in-chief himself made the rounds yesterday morning in the second appearance of his Whip Deflation Now^TM tour. A translation of his first appearance has been kindly provided by Gary North (part 1, part 2).

We focus on Bernanke's remarks regarding monetary policy, wherein he dodges all responsibility for the Fed creating, then failing to identify, the housing bubble. Naturally, he concludes with allusions that the unprecedented interventionist structure being built will once and for all do away with that pesky business cycle. However, we'll let him tell his story:

Monetary Policy and Related Factors

Some have argued that monetary policy contributed significantly to the bubble in housing prices, which in turn was a trigger of the crisis. The question is a complex one [sic: beyond the limits of our Keynesian models], with ramifications for future policy that are still under debate; I will comment on the issue only briefly.

The Federal Open Market Committee brought short-term interest rates to a very low level during and following the 2001 recession, in response to persistent sluggishness in the labor market and what at the time was perceived as a potential risk of deflation. Those actions were in accord with the FOMC's mandate from the Congress to promote maximum employment and price stability; indeed, the labor market recovered from that episode and price stability [sic: inflation in perpetuum] was maintained.

Did the low level of short-term interest rates undertaken for the purposes of macroeconomic stabilization inadvertently make a significant contribution to the housing bubble? It is frankly quite difficult to determine the causes of booms and busts in asset prices; psychological phenomena are no doubt important, as argued by Robert Shiller, for example.8

Note: when your head is lodged within the box's colon, it's going to be a bit difficult to think outside of it and beyond your equation-scribbling peers--but yes, chalk it off to psychology and be done with it.

However, studies of the empirical linkage between monetary policy and house prices have generally found that that that linkage is much weaker than would be needed to explain the behavior of house prices in terms of FOMC policies during this period.9 [And just how many of these studies were written by those currently or formerly on the Fed's dole? Answer: all.] Cross-national evidence also does not favor this hypothesis. For example, as documented by the International Monetary Fund, even though some countries other than the United States had substantial booms in house prices, there was little correlation across industrial countries between measures of monetary tightness or ease and changes in house prices.10 For example, the United Kingdom also experienced a major boom and bust in house prices during the 2000s, but the Bank of England's policy rate went below 4 percent for only a few months in 2003.

Well, everything's relative, isn't it:

Not that there weren't unique factors within the UK that facilitated a bubble relating to housing in particular, but it takes massive doses only of the world's reserve currency to achieve what Jeremey Grantham called in 2008 (as recently quoted by Paul Farrell), "The First Truly Global Bubble:"

From Indian antiquities to modern Chinese art; from land in Panama to Mayfair; from forestry, infrastructure, and the junkiest bonds to mundane blue chips; it's bubble time. ... The bursting of the bubble will be across all countries and all assets ... no similar global event has occurred before.

Congratulations, Fed--you own it all. With respect to the UK, it was especially vulnerable as it was a substantial profit reaper of US securitization efforts. Just what were those London bankers doing with their fees? Buying homes maybe?

The evidence is more consistent with a view that the run-up in house prices primarily represented a feedback loop between optimism [sic: increased inflation expectations as a result of Easy Al's print shop] regarding house prices and developments in the mortgage market. In mortgage markets, a combination of financial innovations and the vulnerabilities I mentioned earlier led to the extension of mortgages on increasingly easy terms to less-qualified borrowers, driving up the effective demand for housing and raising prices. Rising prices in turn further fueled optimism about the housing market and further increased the willingness of lenders to further weaken mortgage terms. Importantly, innovations in mortgage lending and the easing of standards had far greater effects on borrowers' monthly payments and housing affordability than did changes in monetary policy.11

While it's true that politicians lusting after votes created a legal framework over decades that allowed for the relaxation of lending standards to criminally low levels, and it's true that securitization efficiencies facilitated the rapid creation and transfer of credit, another truth is that rocket ships don't leave the ground without fuel. And, the fractional reserve rocket ship required the Maestro and his apprentice to conjure the digital zeros that would be sent out to be fruitful and multiply, thus doing Goldman's work. To be sure, this ship went parabolic in the 80's, but it was that final dose of nitrous in 2003-2004 that kicked off the asset backed securities binge, where everything from student loans to second mortgages to bookie receipts were sliced, diced, rated and sold as quickly as everyone's faith in perpetual asset price inflation would allow.

Source: Robert Prechter

Bernanke continues:

The high rate of foreign investment in the United States also likely played a role in the housing boom. For many years, the United States has run large trade deficits while some emerging-market economies, notably some Asian nations and some oil producers, have run large trade surpluses. [Can anyone say Chinese/Saudi Dollar peg or BOJ intervention ad infinitum?] Such a trade pattern is necessarily coupled with [state enforced and manipulated] financial flows from the surplus to the deficit countries. International investment position statistics show that the excess savings of Asian nations [ah, the bane of Keynesians everywhere and always] have predominantly been put into U.S. government and agency debt and mortgage-backed securities [good dog], which would tend to lower real long-term interest rates, including mortgage rates. In international comparisons, there appears to be a strong connection between house price booms and significant capital inflows, in contrast to the aforementioned weak relationship found between monetary policy and house prices.12

Though, debunked prior, if there are any more doubts:

Bernanke continues:

International investment position statistics show that the United States also received significant capital inflows from Europe in the years before the crisis. Europe's trade has been about balanced over the past decade or so, implying no large net capital flows on average. However, substantial gross flows occurred in the years running up to the crisis. Notably, European institutions issued large amounts of debt in the United States [and why wouldn't they with low rates and the continued promise thereof?], using the proceeds to buy private-sector debt, including securitized products. [Borrow low from Fed, lock in higher rates with Fannie/Freddie wink-and-a-nod-guaranteed debt and other "AAA" rated products. Seems like a no brainer.] On balance, the effect of these sales and purchases on Europe's capital account balance approximately netted out, but the combination led to growing European exposures to the kind of distress in U.S. private-sector debt markets that occurred during the crisis. The strength of the demand for U.S. private structured debt products [as a result of Al's predilection for bank philanthropy] by European and other foreign investors likely helped to maintain downward pressure on U.S. credit spreads, thereby reducing the costs that risky borrowers paid and thus, all else being equal, increasing their demand for loans.

Even if monetary policy was not a principal cause of the housing bubble, some have argued that the Fed could have stopped the bubble at an earlier stage by more-aggressive interest rate increases. [or perhaps not lowering them thirteen times in a row the first place?] For several reasons, this was not a practical policy option. First, in 2003 or so, when the policy rate was at its lowest level, there was little agreement about whether the increase in housing prices was a bubble or not (or, a popular hypothesis, that there was a bubble but that it was restricted to certain parts of the country).

First, even before "2003 or so"--at the September 24, 2002 FOMC meeting to be exact--there was already discussion of the emerging "bubble" in housing, with the term used several times, including this curious exchange amongst the Committee recorded in the transcript (yes, the very type of transcripts that were once denied by Greenspan to exist):

[MS. BIES:] ...Rising house prices have sustained the consumer’s wealth position against falling equity markets, and any decline in house prices could have significant impacts on consumer spending. However, since I still have a house in Memphis for sale, I’m less inclined to believe that there’s a widespread bubble. [Laughter]

MR. GRAMLICH. Is that house for sale?

MS. BIES. Oh yes.

VICE CHAIRMAN MCDONOUGH. Still.

CHAIRMAN GREENSPAN. Are you bidding?

MR. GRAMLICH. No, I’m just pointing out that there’s a bubble.

At the same meeting, FRB Atlanta bank president, Jack Guynn, said:

Although I would not yet characterize price developments in housing as a general housing bubble, I’m hearing more and more reports of what might be characterized as purely speculative housing and property deals, mostly in Florida. These deals are all driven by claims that sound as if the property can be resold in a few months or a few years at a nice profit so at current interest rates how can one pass up such an opportunity. Of course, there’s a bit of a Catch-22 in that these slow adjustments induced by low interest rates have served to sustain some measure of stability as the economy works through other adjustments. While I’m certainly not suggesting that we consider any policy tightening at this meeting, I do think we may already be in a bit of a policy trap. I recognize that some downside risks remain, including some potentially large and negative shocks, but I do not think we should exacerbate our long-term problem with still lower interest rates unless the downside risks loom larger or the negative shocks are realized. Thank you, Mr. Chairman.

The FOMC would go on to lower rates twice more, eventually to 1%, then keep them there for a year. Later, at the June 29-30, 2004 meeting, Mr. Guynn would say:

If I am correct, then we run the risk of pursuing a more accommodative monetary policy than we intend, with the likely outcome being a higher rate of inflation than expected. There’s a temptation to downplay the risk I’m raising. After all, the U.S. economy has functioned quite well with low inflation rates and with a negative real short-term rate, and some see continued resource slack as taking pressure off prices. But I suggest, given the recent combination of expansive fiscal and monetary policies, that our low inflation rate is most likely the consequence of heavy support for the dollar provided from abroad and a willingness on the part of foreigners to invest in this country, compensating for the low U.S. saving rate.

Accordingly, the connection between monetary policy and foreign investment, discussed previously, was expressed by at least one member of the FOMC. But, back to Bernanke, now:

Second, and more important, monetary policy is a blunt tool; raising the general level of interest rates to manage a single asset price would undoubtedly have had large side effects on other assets and sectors of the economy. In this case, to significantly affect monthly payments and other measures of housing affordability, the FOMC likely would have had to increase interest rates quite sharply, at a time when the recovery was viewed as "jobless" and deflation was perceived as a threat.

Here we see the central banker's innate twin fears of the falsely perceived "liquidity trap" and the CB's mortal enemy: deflation. For the record, Ben, the recovery was "viewed as jobless" precisely because the Fed serially over-accommodated through printing, and never let the bust part of the business cycle assume its proper role of adjusting for prior artificial accommodation. That is, Fed money printing so grossly exaggerated capital structures that securitization itself became an end, with the production of collateral secondary. (Indeed, toward the end, even collateral became unnecessary with such financial innovations as CDO squared).

A different line of argument holds that, by contributing to the long period of relatively placid economic and financial conditions sometimes known as the Great Moderation, monetary policy helped induce excessive complacency and insufficient attention to risk. Even though the two decades before the recent crisis included two recessions and several financial crises, including the bursting of the dot-com bubble, there may be some truth to this claim. [No, it is one of the truths.] However, it hardly follows that, in order to reduce risk-taking in financial markets, the Federal Reserve should impose the costs of instability on the entire economy.

Replace "reduce" with "induce", and one wonders what good purpose at all the Fed serves:

However, it hardly follows that, in order to reduce induce risk-taking in financial markets, the Federal Reserve should impose the costs of instability on the entire economy.

Bernanke concludes:

Generally, financial regulation and supervision, rather than monetary policy, provide more-targeted tools for addressing credit-related problems. Enhancing financial stability through regulation and supervision leaves monetary policy free to focus on stability in growth and inflation, for which it is better suited. We should not categorically rule out using monetary policy to address financial imbalances, given the damage that they can cause; the FOMC is closely monitoring financial conditions for signs of such imbalances and will continue to do so. However, whenever possible, supervision and regulation should be the first line of defense against potential threats to financial stability.

In other words, the Fr-oddulently created Financial Stability Oversight Council and the Office of Financial Research will now paper over insolvency on an institution by institution basis, while the Fed will retain macro control over papering over system-wide insolvency.

While economists can call for the targeting of this-or-that inflation rate or this-or-that interest rate--credit aggregates, monetary aggregates, employment rates, etc.--

the fact is, until business owners, especially small business owners, are unshackled from the

institutionalized

competitive advantages bestowed by the government upon their less efficient and better-connected rivals, prosperity for all will continue to decline. We could, as some suggest, force banks to lend by imposing a penalty on the $1 trillion in excess reserves held by banks at the Federal Reserve (as opposed to paying them 0.25% interest on such), which by the way, would lower interest rates further, not raise them--no matter how hard you wish.

Just how much of this money would chase loans versus how much would be redirected into other investments is unknown.

With the new myriad statutes, we're probably just a few short steps away from regulators forcing banks to make loans en masse to privileged groups that own small businesses. H

owever,

didn't we try this already with sub-prime? Sending unlimited good money after bad, cloaked in the "security" and moral hazard of government guarantees is what got us here.

We don't need to "get money in the hands of consumers" or "make banks loan to small businesses", or advocate anymore madcap schemes for the Fed to implement. We need to let businesses figure out for themselves how to satisfy consumer demands on a fair playing field, and let consumers decide when they want to consume versus save. This does not require the gentle coaxing of the central planners. It precludes it.