The Fed Wanted a Credit & Debt Recovery, Got Nothing

Story Stream
recent articles

In the early months of 2008, the Overnight Index Swap (OIS) rate had dragged the 3-month LIBOR rate below even the effective federal funds. This happened on two separate occasions, the first coming in January. To policymakers, this was very significant, as it seemed to indicate that their efforts were paying off. A settling of LIBOR appeared to show, as under any doctrinaire interpretation, that money markets and liquidity were responding very positively to a more pro-active, if traditional, FOMC standing.

The reason for that is what the LIBOR-OIS spread is believed to measure. LIBOR is, of course, a rate for unsecured term lending in eurodollars, while OIS is a fixed rate leg of a swap into a floating payment based on the federal funds rate. Thus, the spread between those rates gives us some insight into how money markets view not just what the FOMC might do as far as policy but also how the markets are taking those policy projections into actual funding positions. The problem relates to just how much insight can be obtained from the figures, and the FOMC in 2008 was completely convinced, and fooled, of them.

The head of the St. Louis branch of the Federal Reserve, William Poole, mentioned exactly this point on the January 28, 2008 intermeeting conference call (where the Fed was worried its "emergency" rate cut would be interpreted as, foreshadowing monetary impotence, bowing to the S&P 500).

"Second, this action will not be viewed in the marketplace as anything other than a direct response to the stock market. I understand the comments about the other strains in the financial markets. Although the thing that we have most commonly pointed to, and it has occasioned the most market discussion, has to do with the behavior of the LIBOR rate, LIBOR seems to have settled down. It is trading below fed funds, and the further out you go in the future, the lower is LIBOR. So it seems to me that that situation has largely returned to normal."

As I mentioned, this depression of LIBOR with respect to federal funds occurred twice, with Poole's comments above taken from the first. The second time arose starting the week of February 29, 2008, until the week of March 21. If you have even minimal awareness of the history of the 2008 panic that particular period of time contains one of the most significant events of the entire crisis period - the failure of Bear Stearns in a chain of smaller failures.

OIS by itself is not simply a measure of the FOMC's intention or the money market's acceptance of it: it is a "working" interest rate which also contains bank balance sheet mechanics. One of those is to cross secured funding arrangements and liquidity with unsecured: repo. The repo market grew simply as a means of efficiency, where banks could obtain the most cheapened source of liquidity but that didn't mean there weren't pockets of inefficiency. Term repo often occurs with a liquidity premium, which means that the ease and low cost of repo was/is highly exposed to rollover risk.

One way to work around the liquidity cost to try to "term out" repo funding was to pair it with a swap tied to OIS. I won't get into the exact nature of the transaction here, but suffice to say that demand for OIS was not strictly related to federal funds and policy activities. That is particularly relevant for the time periods in question, as the repo markets were under immense strain starting at the end of 2007.

The fact that LIBOR was tied to the OIS takes place via arbitrage and those dealers that have benchmark arrangements with the OIS curve; in short, the OIS rate appears to have, again, pulled LIBOR down and thus confused the FOMC into believing its monetary transmission intentions were transmitting. What Governor Poole was talking about as "returned to normal" was just as likely balance sheet restriction in a most esoteric manner causing abnormal relations. These two time periods where 3-month LIBOR fell below effective federal funds also saw some of the largest spikes in repo fails in history ("bested" only by the Lehman moment). Thus we can ascertain that money markets in the first three months of 2008 were not conveying even minimal success for the FOMC, but rather an overburdened repo market screaming for help and aid from a policy apparatus still clinging, somehow, to a 1950's view of the universe with its already anachronistic interest rate target through a federal funds rate that had been long surpassed in every meaningful way.

For that, the FOMC has received generally high marks from the mainstream, media as well as politics, in how it handled the 2008 event. The standard for that seems to be that Western civilization did not completely collapse, therefore there must have been some good measure of monetary success. The incongruity astounds, and it has not relented.

Even the Wall Street Journal applauded Ben Bernanke and his efforts in 2008, even though it has persisted in being very critical ever since. For a mainstream outlet, the Journal's editorials have been quite biting going back some time. In January 2010, they opposed Bernanke's re-appointment as Chairman, proclaiming that he had become far too political. In doing so, they failed to link the problems of 2010 (or today) with those of 2008.

"We agree that the Fed needed to ease money precipitously when the financial markets suffered their heart attack in late 2008, and we praised Mr. Bernanke for that at the time and since. But the issue for the next four years is whether the Fed can extricate itself from its historic interventions before it creates a new round of boom and bust. We already see signs that it has waited too long to move."

"Ease money" is an easy term to use, uncritically generic that discounts the utterly inane complexities of actual systemic functioning. The Fed wanted to "ease" all through 2008, they just couldn't figure out how. It was the first full-blown panic in history that featured no public component, just of banks, by banks, yet there is great deference to orthodox monetary policy when it insists on maintaining this wholesale system, the only part that failed, above all else.

The "ease" argument has persevered through the years now even though the Journal's worst fears over runaway (consumer) inflation have never materialized. Just yesterday, the Journal was again pounding Mr. Bernanke's record as Chair, under an editorial titled, The Slow-Growth Fed. At issue this time is, of course, the fact that the economy cannot gain more than temporary traction. At even greater issue is the fact that we are still debating a recovery some eight years after the first appearance of so many regular "aberrations" (like OIS).

GDP itself is a measure constructed most favorable and charitable toward framing economic growth; it, after all, takes government spending as if it were a pure source of economic expansion. For even GDP to fall apart so quickly and dramatically, from -2% to +5% and back again in the space of just five quarters, is another in a long line of indications that there is "something" sorely amiss in the US economic formulation.

The Journal's impressions and examination of that hit far too close to home for Mr. Bernanke, who immediately took to his blog at the Brookings Institute to fire back:

"However, the WSJ editorialists draw some incorrect inferences from the FOMC's recent over-predictions of growth. Importantly, they fail to note that, while the FOMC (and virtually all private-sector economists) have been too optimistic about growth, they have also been consistently too pessimistic about unemployment, which has fallen more quickly than anticipated. The unemployment rate is a better indicator of cyclical conditions than the economic growth rate, and the relatively rapid decline in unemployment in recent years shows that the critical objective of putting people back to work is being met."

This is disingenuous to the point of almost childishness. It was Bernanke himself during QE's taper drama in 2013 who declared the unemployment rate was being overly optimistic, keenly aware then that the drop in absolute level was far more the denominator. In other words, to "clear his name" from the Journal's devastatingly effective critique he reached for the one measure that would best frame his tenure; that he can only find one of the most flawed, that even his past, professional self downplayed, confirms that there isn't anything else to vindicate the QE years.

He made sure to get in his own counterpunch, though unrelated to the topic at hand. Bernanke rightly accused the Journal of being Chicken Little with regard to inflation, but that too is suggestive of his weakness in argument, almost desperately wielding such a logical fallacy (the Journal's editors may have been consistently wrong about runaway inflation, or any inflation for that matter, but it does mean they are wrong about slow growth or even no growth). But his misdirection is actually relevant if only in describing the current trap and the detritus of monetary policy in 2015 - everyone is looking for inflation and growth and are so confounded to find neither.

Into that chasm has poured Keynes once more, this time in the form of Paul Krugman. For years now, Krugman has been staking out his "deflationary vortex" as to why and how there is no growth and no inflation. For that he is being rewarded of sorts in making all manner of consultative journeys to economically-afflicted geographies. From Japan to Greece, you can bet Krugman has been there preaching the "deflationary vortex" as a means to explain what neither Bernanke nor the Journal can of their orthodox tendencies.

Doubly ironic, Krugman used his deflationary theories to support Ben Bernanke, going back to a column from September 2014.

"On Thursday, the European Central Bank announced a series of new steps it was taking in an effort to boost Europe's economy. There was a whiff of desperation about the announcement, which was reassuring. Europe, which is doing worse than it did in the 1930s, is clearly in the grip of a deflationary vortex, and it's good to know that the central bank understands that. But its epiphany may have come too late. It's far from clear that the measures now on the table will be strong enough to reverse the downward spiral.

"And there but for the grace of Bernanke go we. Things in the United States are far from O.K., but we seem (at least for now) to have steered clear of the kind of trap facing Europe. Why? One answer is that the Federal Reserve started doing the right thing years ago, buying trillions of dollars' worth of bonds in order to avoid the situation its European counterpart now faces."

This was back when the US economy was assured of its long-sought, at last recovery; when GDP was up near 4-5% and it was safe and easy to ignore the "rising dollar" and collapse in oil prices. At the time, there was enormous crowing about how monetary policy was the entire difference between the US and Europe, that the Fed got it right where the ECB dithered (curiously, nothing is ever said about the Bank of Japan, who got it far more "right" than the Fed did). With growing recognition of even a US economic "slump" underway (nondurable goods spending in Q1 was the second worst quarterly decline in the entire series dating back to 1947, worse than even Q1 2009!) and crashing oil prices playing havoc with any sense of "inflation" Krugman is both right and wrong.

We can argue about the semantics of his description, including the "vortex" part, but the essential idea carries forward very easily in these more unsettled months. The tendency of even the US economy, but especially the global economy, is clearly not toward growth, and for "some" reason continues to "want" to decline. What kind of condition can there be where the "natural" course of economic function is negative?

For these Keynesians and monetarists there are no answers to the question; in fact they largely side-step it in the first place. The deflationary vortex just is. That is the genesis of "secular stagnation" and the conjecture over a negative natural interest rate, which are really just admissions that they have no explanation for any of this. Sure, they recognized some manner of "oversupply", but almost always couched in their more comfortable alignment of a "shortage of demand." That is what their remedies always apply, an appeal, an endless and enlarging stream of appeals for more and more demand. And it never comes.

The basis for "aggregate demand" is that all demand is demand and therefore can be substituted by command, just like their views on money rates and spreads. Whether government, via borrowing, or private, via borrowing, the monetarists and Keynesians seem to believe that any increase in economic activity must spring from nothing but a centralized source. They have socialized all monetary and economic function in this way, regardless of how they want to view the role of "markets" under these assumptions.

Thus, if rapidly rising stock prices (perhaps missing inflation?) spark a "wealth effect" then that is taken as successful monetary application. If that so happens to start with the most wealthy, as pure mathematics would suggest, then so be it. The problem from an economic standpoint is that the US and global economies are drowning in wealth effects. If monetary policy has succeeded at anything, it is clearly how well purely financial agents have been relative to anyone else. Luxury goods, especially luxury autos, have been flying off the shelves almost since 2009. In Japan, luxury goods since the start of QQE are up 20% while total retail sales have increased just 2.6%.

That was supposed to lead to further positive effects further down the economic trough, as the idea of richer rich people is thought to lead to more spending and hiring and so on. But clearly, after years and years of such "inequality" there has been nothing much further at all. What this really consists of is redistribution through purely financial means as a first step in Keynes' definition of "pump priming."

But in this manner, the idea of paper wealth, gained on the surge in monetary assumptions (including how monetary policy actually works, and the further assumptions that monetary policymakers actually know how monetary policy actually works), is that the central bank can simply take a short cut. No need to wait for a wealthy industrialist to build a factory or start a new business, instead we can skip right to the part where the stock market "rewards" him for doing it before it ever happens. And so we get enormous waves of such rewards without the efforts needed to bring them to existence; the capitalist horse has been banished so far behind the societal cart as to be no longer visible.

Monetary policy entirely discounts the process that creates wealth in the first place so that the possibility of economic socialization can "make sense"; most especially from its fanatical adherence to far-too conceptually simple mathematics. In skipping to the consumption end point, the monetary practitioner is taking a rather dim view of the forces and shaping of actual productive processes and the attainment of true wealth in the first place, as if there is nothing to gain by "building it" (as a euphemism for all business and businesses functions, including service businesses). Financial "wealth" and gains based solely on asset prices take no discipline or productive effort to attain it.

This gets back to "inequality" as there is absolutely nothing wrong with it in its most undisturbed format. When inequality arises, however, from nothing but artificial redistribution through purely financial channels, bubbles mostly, there are not just serious economic problems but those that spill over into social and societal bonds. The means for that is just as clear, as redistribution forces some to "pay for" the artificial increases; in the case of asset bubbles, who "won" and who "lost" in the FOMC's "magnificent" work in 2008? There is still a vast swath of homeownership underwater, and the homeownership rate itself in the US has just now sunk to the lowest point since 1993.

There are fewer full-time jobs today than there were in late 2007, and only barely more jobs in total than that prior peak despite the turn of almost eight calendar years since. It isn't much of a mainstream subject anymore largely because last year economists were adamant about the final turn toward recovery, and that the languishing state of labor in the US will finally correct, and economists somehow still hold a monopoly on economic opinion. Labor specialization is the true measure of economic gains in a non-barter economy, not the dollar value of goods and services somehow traded and transacted. Actual labor gains are the real means of productive redistribution, through income not stock prices, in a true capitalist system. Might there not be a point of that in the racial unrest that has suddenly turned so hot in the past year or so?

The fires in Baltimore right now are certainly caused by decades of progressive policies being carried out, that the "investments" of government are the only ones to be made. But what Baltimore has become on a smaller scale, like that of Detroit, has been leaking into the wider system for some time too. The results are exactly the same - if you analyze the major problems of these large inner cities where disturbance is so sharply turning up the common feature is stability; in other words, these places don't ever change despite the untold promises and unimaginable millions (maybe billions) spent on that direction.

If you are to describe the US (and global economy) right now, stability is exactly the problem. The socialization of money has taken place for exactly that reason, discounting the role of variability in fostering actual economic growth and sustainable advance. Monetary policy is dedicated to a "smooth" existence, one without too much peaks and valleys - and we have certainly attained that if only after an impossibly deep valley. That is the "deflationary vortex." The economy itself wants to find its more natural rhythms and existence, and it will break toward that view one way or another along the path of least resistance. Right now that is decidedly down. The free markets wish to self-correct and all the governments and monetary agents around the world (save perhaps one) are striving to deny that.

In my view, the outbreak of violence is a parallel trend to the outbreak of neo-fascination with Marxism that has been fairly consistent since Occupy Wall Street. That shouldn't be surprising since there are many indications the string of riots has been nurtured by cultural Marxists if apart from the efforts of their economic sympathizers. The economic failure of Ben Bernanke, QE and ZIRP, even tracing back to the smaller things done so "successfully" in 2008, has been carried out by this overarching desire and need to prevent dynamic rebuttal to the socialized structure imposed these past few decades, something that the rioters themselves are fighting both for and against even if they don't seem to appreciate it. The command structure has proclaimed that there are not to be any choices about how to resolve these imbalances, inner city and global economy alike. Bernanke argues against the Journal, and Krugman is associated in both and against both, but in reality their disagreements are truly superficial amounting only in the degree to which the same thing has or hasn't happened; there is no difference between any of them in the formal processes they wish to see.

The Fed has been saying, all along, that the recovery must either be financial in character or nothing at all. If it isn't driven by credit and debt then they don't want it. And so they haven't got it.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

Show commentsHide Comments

Related Articles