Friday, August 17, 2007

Should Ben Bernanke Resign? Who Should Be the New Federal Reserve Chair?

Bernanke’s Bailout Destroys His Credibility
in wrong response to banks incresing effective Fed funds rate toward 6%

Federal Reserve Chairman Ben Bernanke replaced Alan Greenspan and, like all new central bankers and substitute teachers, sought to establish authority and credibility immediately. However, Bernanke has been like a deer frozen in the headlights by freezing the official target Fed funds interest rate at 5.25% (the Fed declares a target and works to maintain it but the “effective rate” is what the market actually does).

The problem with 5.25% is that credit is still too cheap and risk is still too underpriced (the cost margin between low and high risk is too small). Worse, many special interests are lobbying to cut the rates back to the dangerous levels of easy (but depreciated) money that caused the bubble recklessness and put us in the current predicament in the first place.

Greenspan loosened monetary policy in the 1990s, organized the 1998 bailout of Long-Term Capital Management (LTCM) hedge fund, and began slashing the Fed funds target interest rate on January 3, 2001 (during the Clinton administration before 9/11, contrary to frequent punditry) through June 25, 2003's 1% rate and kept 1% for over a year until June 30, 2004, never since returning to the May 16, 2000 6.5% rate despite all the talk of a "Goldilocks ecocomy" prosperity, and meanwhile igniting the housing bubble and feeding the subprime beast a steady diet of loose credit. Greenspan was known to the markets as a soft touch because they felt that the infamous “Greenspan put” (his willingness to bailout the markets by pumping more cheap money into the system) always would postpone the day of reckoning yet again.

Fed Needed New Spine, Got New Face Instead

Bernanke has destroyed any potential authority he might have had by caving in to the first signs of volatility and pumping tens of billions of dollars into the markets in the last 2 weeks. One commentator argued that people are overreacting to the Fed’s actions because the liquidity is “temporary.” However, it does not matter that much of those injections have been returned to the Fed when (1) the Fed issued a “blank check” by stating that it was ready at all times to bailout whenever “necessary” and (2) the typical 14-day limit to each liquidity injection does not matter if the Fed is willing to refinance perpetually with fresh injections.

The markets “got” the message that “Helicopter Ben” Bernanke will come to the rescue and the party can continue: The effective Fed funds rate sank below the Fed’s target of 5.25% and some deals hit the basement of 0% interest. Further, the Fed-funds futures market responded by expecting a rate cut at the next Federal Open Market Committee (FOMC) meeting.

Fed Failure

  • Bernanke’s Fed claimed that it intervened last week because the always-fluctuating effective Fed funds rate was not at the target rate. However, the Fed’s overreaction to understandable market volatility, and to the desirable market correction in pricing (banks raising the effective rate to price risk better), left the effective rate still off target (not higher anymore but lower than the target rate, which is worse than the initial “problem”).
  • The Fed’s action also interfered with the market healing itself just as participants finally were trying to grapple with more-realistic prices.
  • Actions speak louder than words and Fed protestations that it will not bailout investors pale against its panicky interventions to stop panic. Traders can see who is panicky and they know an easy mark when they see one.
The Fed has increased moral hazard. The markets will expect more bailouts in the future. Each Fed bailout increases the pressure for the next bailout.

Meanwhile, each bailout placates only temporarily but at the cost of repeating the over-liquidity mistake that caused the mis-pricing problem in the first place.

The market initiated the solution and the Fed stepped in to sabotage the solution.


Marinite said...

We need another Paul Volcker, not another Greenspan. What will it take to get rid of Bernanke?

J at IHB and HFF said...

Since Greenspan got a medal for bad policy, maybe Bernanke will have to do something intelligent to get fired.

Anonymous said...

Bernanke out. Lawrence Cudlow in. We need a free market capitalist now!