Thinking About Monetary Policy: A Counterfactual

Thinking About Monetary Policy: A Counterfactual
After 9 years the Fed finally raised interest rates. Fed Chair Yellen took the historic step after her predecessor, Ben Bernanke, lowered rates to 0% during the depths of the 2008 global financial crisis.

I received an email from a longtime reader:

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David, here is a (possibly useless) thought experiment.

In 2005, PIMCO’s Paul McCulley was begging Ben Bernanke to halt the on- going quarter-point raises in the Fed Funds rate at 3.5 percent. I forget his exact reasoning, but he clearly thought that the financial markets couldnot accommodate short-term rates above 3.5 percent without substantial disruptions.

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Suppose that Bernanke had listened to McCulley and capped the Fed Funds rate at 3.5 percent until it was clear how the markets would fare at that level. Would that alone have been sufficient to postpone or even avert the housing crisis? Or would it have made the crash even worse?


According to FRED, the Funds rate reached 3.5 percent in August 2005, and as we know housing prices nationally peaked about one year later, just as the Funds rate was topping out at 5.25 percent. Question is, did the additional 1.75 percent of increases serve to tip the housing market into decline, or was the collapse inevitable with or without the last seven quarter-point raises?

Any thoughts?

Here was my response:

I proposed the same thing at RealMoney, except I think I said 4%.  My idea was to stop at a yield curve with a modestly positive slope.  It might have postponed the crisis, and maaaaybe allowed banks and GSEs to slowly eat up all of the bad loan underwriting.

I had Googlebots tracking housing activity daily, and August 2015 was when sales activity peaked.  I announced it tentatively at RealMoney, and confirmed it two months later.  From data I was tracking, housing prices flatlined and started heading down in 2006.  The damage was probably done by 2005 — maybe the right level for Fed funds would have been 3%.

The trouble is, hedge funds and other entities were taking risk every which way, and a mindset had overwhelmed the markets such that we had the correlation crisis in May 2005, and other bits of bizarre behavior.  Things would have blown up eventually.  Speculative frenzy rarely cools down without the bear phase of the credit cycle showing up.

So, much as it would have been worth a try, it probably wouldn’t have worked.  The housing stock was already overvalued and overleveraged.  But it might have taken longer to pop, and it might not have been as severe.

But now for the fun question.  Is the Fed trying to do something like that now?  Are they so afraid of popping any sort of asset bubble that they have to be extra ginger in raising rates?  It seems any market “burp” takes rate rises off the table for a few months.

I don’t know.  I do know that the FOMC has only 1% of tightening to play with before the yield curve gets flat.  Also, obvious speculation is limited right now.  There is a lot that is overvalued, but there is no frenzy… unless you want to call nonfinancial corporation and government borrowing a frenzy.

Thanks for writing.


The FOMC is Afraid of its own Shadow

If I were the Fed, I would end the useless jabbering that they do.  I would also end the quarterly forecasts and press conference. I would also end publishing the statement and the minutes, and let people read the transcripts five years later. We would go back to the pre-Greenspan years, when monetary policy was managed better.   Before I did that I would say:

The Fed has three responsibilities: controlling inflation, promoting full employment, and regulating the solvency of the banking system.  We are not responsible for the health and well-being of financial markets.  The ‘Greenspan Put’ is ended.

We will act to limit speculation within the banks, such that market volatility will have minimal impact on them.  We want our pursuit of limited inflation and full employment to not be hindered by looking over our shoulder at the boogeyman that could affect the banking system.  To that end, please realize that we will not care if significant entities lose money, including countries that may get whipped around by our pursuit of monetary policy in a way that benefits the American people.

We are not here as guarantors of prosperity for speculators.  Really, we’re not here to guarantee anything except pursue a stable-ish price level, and to the weak extent that monetary policy can do so, aid full employment.

We hope you understand this.  We do not intend to use our “lender of last resort” authority again, and will manage bank solvency in a way to avoid this.  We may get called ‘spoilsports’ by the banks that we regulate, but in the end we are best served as a nation if solvency concerns dominate over the profitability of the banking industry.

As it is, the present FOMC fears acting because it might derail the recovery or spark a bear market in risky assets.  Going beyond the mandate of the Fed has led to bad results in the past.  It will continue to do so in the future.

The best way for the Fed to maintain its independence is to act independently and responsibly.  Don’t listen to outside influences, particularly when hard things need to be done.  Be the adult in the room, and tell the children that the medicine that you give them is for their good.  Recessions are good, because they clear away bad uses of capital from the ecosystem, and make room for new more productive ideas to use the capital instead.

As it is, the Fed is afraid of its own shadow, and will not take any hard actions.  That will either end with inflation, or an asset bubble that eventually affects the banks.  A central bank like that does not follow its mandate does not deserve its independence.  So Fed, if you won’t act for our long-term good, will you act to preserve your existence in your present form?


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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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