The Great Debate: Inflation vs. Deflation

A populist revolt has been brewing on the web for years now. Taking on financial regulators, and second guessing Bernanke, is nearly as popular as fantasy baseball, and nearly everyone is in on it in 2008. I am not above lobbying a few hand grenades in Hank Paulson's direction; he has been a disappointment in my book, slow to act, and too dismissive of the shenanigans in the energy pits, stating in late May: “If you look at the facts, they show that the price of oil is about supply and demand,” I did not buy it then, and certainly do not buy it now, Hank. Why did we run up in July in the face of demand destruction?

Ben Bernanke has been a frequent target of online tirades; perhaps someday these bloggers will look back with embarrassment...although I kind of doubt it. But some people are politely asking....what's the point?

-Most of the big-time Street critics of the Fed (including plenty of those who are really smart, great traders, and offer timely advice) are overplaying their hand with Fed criticism.

- Wall Street guys need to learn that intelligent people can look at the same data and reach different conclusions. The fact that one has a lot of money to manage or gets a big paycheck does not imply omniscience.

- People confuse what they believe the Fed should do with what they expect the Fed to do. There is more money to be made by predicting the Fed, than by pontificating about their errors. A Dash of Insight

Pontificating over the Fed’s missteps draws bigger rating than admitting mistakes when you run a blog; many of the folks who have turned their Fed bashing into a cottage industry just missed a huge rally in the Russell 2000, dead cat bounce or not. Will they exhibit the flexibility to turn constructive on equities when the time is right?  Or will they continue to second guess the Fed?

Perhaps someday they will realize their sites are glass houses....

Others criticize the Fed in terms that are basically ad hominem.  They see the FOMC and the hundreds of professional economists on staff as stupid, stooges, or whatever.

But as the Old Prof notes, a blogger from the Atlanta Fed has ended his radio silence after a year, and is attempting to explain some of the extraordinary moves the Fed has made over the past year, and recaps the moves in case you have forgotten:

August 17, 2007: The Board of Governors cuts the primary credit rate (or discount rate), the interest rate Federal Reserve Banks charge on direct loans made to banks.

September 18, 2007: The FOMC cuts its target for the federal funds rate, the first in a string of seven consecutive rate reductions.

December 12, 2007: The Board of Governors introduces the Term Auction Facility (or TAF), initially a mechanism for providing loans to banks for a period of 28 days (as opposed to the typical overnight maturity associated with standard primary credit loans). Last week, the Board announced the program would be extended to make loans available for a term of 84 days.

March 7, 2007: The FOMC authorizes the New York Fed to conduct open market operations using Term Repurchase Agreements. Like the TAF, the term repo program allowed the Fed the flexibility to conduct operations over periods of about a month rather than the overnight basis that is typical in more normal environments.

March 11, 2008: The FOMC approves the creation of the Term Security Lending Facility (TSLF), which authorized swapping Treasury Securities (over a period of 28 days) for “other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS.”

March 16: The Board of Governors creates the Primary Dealer Credit Facility (PDCF), authorizing direct loans to broker dealers who are authorized to engage in securities transactions with the Federal Reserve. Atlanta Fed Macroblog

Fair enough..but we really appreciate the color they give

As I noted above, I see a progression of logically consistent steps that neither lurched to extreme solutions nor ignored the imperatives of the problem at hand:

* The first step was to invoke the usual tools of monetary policy (in the form of discount window lending and federal funds rate adjustments).

* Then it became obvious that injecting liquidity into overnight markets alone was not solving the problem of funding being unavailable for periods of time even as short as one to three months. The next step, then, was to lengthen the maturity of loans and asset exchanges in policy operations (in the form of the TAF and Term Repurchase Agreements). (An additional salutary effect of the TAF was apparently the lack of “stigma” that is thought to be attached to borrowing from the discount window.)

* From there, it became clear that Treasury securities were rapidly emerging as the only widely accepted form of collateral to support short-term borrowing and lending, a function that securities backed by real estate assets were simply unable to perform. Some relief to this problem was already inherent in the form of the broader-than-Treasuries collateral options in the TAF. Further relief was provided by the TSLF, which in effect implemented a swap of in-demand Treasury securities from the Federal Reserve’s balance sheet for less liquid mortgage-backed assets.

* Finally, the potential systemic consequences of acute stress in the primary dealer network led us to the PDCF, in effect broadening the class of institutions to which the central bank would stand ready to infuse short-term liquidity.

Once again, in my view there is a methodical progression to the whole process that is too commonly overlooked: Start with the standard tools (the discount rate and federal funds rate), move on to a lengthening of the maturity in the term of those standard tools (TAF and Term Repurchase Agreements), on to a broadening of the collateral used to support monetary policy operations (TSLF), and finally expanding the class of institutions to which the Federal Reserve will lend (PDCF).

It is not entirely obvious that the new long-run level of the OIS-Libor spreads pictured above will once again converge to the values that prevailed prior to August 2007, but I would argue that the still-elevated levels of these spreads implies we have a ways to go before financial markets are again fully functional. Though the lending programs put in place in the past year have not been, and could not be, a magic elixir for solving all financial market woes, I would take the bet that they are least providing enough stability for the market to continue the painful process of healing itself. Getting to this point has not always been pretty in real time, and there is plenty of room for debate about the long-run costs and benefits of each step along the way. But given a little time for perspective I believe we will find a certain beauty to it all.

While not everyone is buying into Dr. Altig’s return as one comment notes:

If you keep insisting to the crowd, that nothing bad is happening, or going to happen, then turn around and implement a series of emergency facilities you lose credibility.

PS:I’m not sure restarting your blog is a good idea. There is a lot of anger out here, and if you are seen as a mouth piece for the fed, you will receive a large helping of it.

On the institutional side of the Street slightly more erudite discussions are taking place....one of my favorite strategists, who,in his prior life was responsible for macro strategy at one of the oldest, and best known hedge funds, said in early June:

1. Sustained but untenable Ponzi finance games between U.S. lenders and borrowers have created the appearance of economic resiliency. The now ongoing intense but transitory fiscal stimulus package is reinforcing the appearance of such resilience.

2. The Ponzi finance process is not sustainable. The markets for the assets of households that matter most – homes and equities – are in some stage of decline. The end of these asset bubbles should spell the end of the Ponzi finance process in this cycle, since the capitalization of interest through new lending – the essence of Ponzi finance – cannot continue if collateral values fall. There will be a second wave to the financial crisis.

3. The markets are irrationally complacent. They see transitory economic resilience and rising headline inflation emanating from a commodity bubble. They are making a mistake in bidding up Fed funds futures and bidding down bond prices.

4. This mistake will persist until the transitory fiscal stimulus fades, the commodity bubble bursts, and/or a second wave of financial crisis begins. This interlude should last well into the summer.

5. The spike in the oil price, though a transitory bubble event, is a powerful depressant on aggregate demand as long as it persists. Bernanke is right in seeing the oil price spike as more of a deflationary danger than an inflationary threat.

6. Bernanke, correctly cognizant of the risk posed by the “financial accelerator”, will not raise rates in response to headline inflation. When the second wave of financial crisis sets into motion the financial accelerator, the Bernanke Fed will cut rates instead.

7. Then the Great Fake Out will end and the fixed income markets will fly.

We shall see if rate cuts are in the cards; but Frank Veneroso’s crystal ball was working just fine. Bernanke stood his ground, and every month we inch toward improvement in the housing market, which is probably a prerequisite for improvement in credit and then the equities market.

However, while the Wall Street Journal is scratching its head trying to figure out why small-caps outperformed large cap over the past month, the debate over inflation vs. deflation and the Fed’s future policy responses are moving to the front burner. There is no middle ground in this debate, and the side you choose could define your performance in the years ahead. Position yourself accordingly, and if you get it wrong, be sure to cut your losses quickly.

Get your rest while you can...the next two weeks might be slow but the homestretch of 2008 is likely to be anything but.

Although I don’t think we get another Saturday Night Massacre in October.
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Evaluating the Fed: Pick Your Sources!
A Dash of Insight

What the Fed did during macroblog’s vacation
Altanta Fed Macroblog
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The content contained in this blog represents the opinions of 1440 Wall Street. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author. No Positions

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