Supply-Side Forum

This is a forum to discuss Supply Side Economics and related issues.

Monday, August 14, 2006

Good articles.

An excellent article on why oil prices are so high, from the weekend Wall Street Journal.

Last week Alan Reynolds second-guessed Fed policy, while at NRO, Tom Nugent defended the central bank.

And today, the Wall Street Journal had an op-ed criticizing the Fed:

How the Fed Lost Its Groove
By Henry Kaufman

In its most recent directive, the Federal Open Market Committee restated the Fed's long-standing and laudable goals: to seek "monetary and financial conditions that will foster price stability and promote sustainable growth in output." But the Fed's monetary tactics are flawed, and work against these objectives.

Fed strategy of the last few years stands on three tactical legs. First, its responses to economic and financial developments have been measured; second, its intentions and actions have been transparent; and third, it has relied on an econometric model for projecting future developments. These approaches would be reasonable, rational and effective -- if not for the uncomfortable fact that markets have learned how to circumvent them.

Consider the steady ratcheting up of the Federal funds rate -- from 1% to 5.25% over the last several years. Has this reined in debt expansion and credit availability? Non-financial debt in the U.S. expanded at a rate of 6% in 2001, grew by 10% in 2005, and has been swelling at an even faster rate this year. At this pace, debt is growing an astounding 50% faster than GDP.

Meanwhile, outstanding credit derivative contracts increased from about $4 trillion at the end of 2003 to more than $17 trillion at the end of 2005; and the large volume of financial market activity so far this year suggests that outstanding derivative contracts are even higher now. The recent surge of these instruments is not just about reducing risk; it is fueling speculation.

What about the flattening of the yield curve? By historical standards, yield spreads (between high-grade and low-credit-quality debt) are very narrow. It costs somewhat more to borrow today than it did two or three years ago, but credit remains readily available.

While the yield curve has flattened, moreover, there has been a substantial increase in the profitability of major financial institutions. This is extraordinary: Historically, the profitability of financial intermediation gets squeezed as the differential between yields on short and long obligations disappeared.

Major financial intermediaries have found ways to overcome the retarding impact from Fed fund rate increases. They have actually increased their volume of outstanding assets, liabilities, off-balance sheet commitments, and profits.

How can this be? The Fed policies of measured response and transparency have improved the capacity of financial intermediaries to gauge the market impact of central bank actions. In this kind of environment, financial intermediaries employ a variety of "value at risk" analytical techniques, along with a wide range of credit instruments, to quantify risks within narrow bounds.

Ironically, the predictability born of the Fed's measured response and transparency encourages risk taking and speculative trading. As the Fed lowers uncertainty about the near term, investors grow bolder.

Today's large financial institutions set profit objectives that motivate lending officers, investment managers and traders to increase loans, investments and trading opportunities. Is there a large conglomerate financial institution around today that does not set revenue and profit targets for each of its subsidiaries above those of the previous year? I think not. This is another way that the Fed's measured response and transparency policies spur credit creation -- and as debt balloons beyond reason, inflation and volatility will follow.

The third leg of the Fed's policy stool -- heavy reliance on an econometric model -- is also wobbly. Such models are formulated on the basis of past economic and financial variables that do not adequately incorporate structural changes in business and financial behavior. Their underlying economic equations and statistical projections offer, for the most part, false comfort. The econometricians trained in this kind of model building, some of whom shape economic policy, should understand the limitations. Instead, they seem to have become entranced by their own magic.

The historical record offers a litany of monetary foibles and follies akin to the Federal Reserve's current off-kilter approach. In the 1920s, it tolerated over-speculation for too long, then helped usher in a depression by overreacting. In the 1970s, the Fed failed to discern that lifting interest rate ceilings gave banks the freedom to pass on the cost of money to borrowers. Borrowers' costs rose sharply, their profits declined, and their credit quality deteriorated. The Fed also miscalculated during this period when -- in tracking inflation -- it focused on indices that excluded the cost of energy and food.

Yet another tactical error, which extended through much the 1970s and 1980s, was the Fed's policy of targeting the growth of the money supply. This eventually was jettisoned as it became more and more difficult to differentiate between money and credit.

Last week, during his Congressional testimony, Fed Chairman Ben Bernanke reaffirmed that he will be using the Fed tactics that are so problematic. Measured response was very much in the tenor of his presentation; so too was his adherence to an economic model that is basic to the Fed's business forecast and monetary policy -- although Mr. Bernanke included the typical caveat that economic forecasting is far from a science. He made some nuanced comments that suggest a pause down the road for the rise of the federal funds rate. He did not comment on the extent to which the structural changes in the financial markets are modifying economic and financial behavior.

The market's response to Mr. Bernanke's testimony was decisive: Bonds and stocks rallied sharply. To market participants, the downside to risk taking was sharply reduced for the near term -- a factor which, regardless of fed fund rate changes, will only encourage substantial growth of debt.

Mr. Kaufman is President of Henry Kaufman & Company, Inc., an economic and financial consulting firm, and author of "On Money and Markets: A Wall Street Memoir."


Anonymous Terje said...

The first of the articles that you reference (by Bret Swanson) was excellant.

4:29 PM  
Blogger ed hanson said...

Who let this Kaufman guy print such jibberish in WSJ.

4:47 AM  

Post a Comment

<< Home