Wednesday, December 12, 2007

What We Have Here is a Failure to Communicate

The markets were very disappointed with the Fed's decision. Immediately after the announcement, the markets sold-ff hard. Looking back at the most recent Fed speeches, it's easy to see why the markets were so unhappy.

Notice these statements from Janet Yellen:

For example, there continues to be a strong demand to hold U.S. Treasury securities—which are the safest and most liquid in the world—leading to Treasury yields that are much lower than they were before the shock hit in mid-July. Of course, one reason for the decline in Treasury yields is that the Fed has cut the federal funds rate and the market expects substantial additional cuts in the future, reflecting the view that policy will ease further to offset the contractionary effects on economic activity of the financial turmoil. But another important reason is that there has been a worldwide “flight to safety.” Stated differently, the spreads of most risky assets above Treasuries have risen.


Likewise, the cost of insuring investors against default on securities they hold, through derivatives known as credit default swaps, has jumped again in recent weeks and is far higher than normal.


The mortgage market has been the epicenter of the financial shock, and, not surprisingly, greater aversion to risk has been particularly apparent there, with spreads above Treasuries increasing for mortgages of all types.


Moreover, many markets for securitized assets, especially private-label mortgage-backed securities, continue to experience outright illiquidity; in other words, the markets are not functioning efficiently, or may not be functioning much at all. This illiquidity remains an enormous problem not only for companies that specialize in originating mortgages and then bundling them to sell as securities, but also for financial institutions holding such securities and for sponsors, including banks, of structured investment vehicles—these are entities that relied heavily on asset-backed commercial paper to fund portfolios of securitized assets.


Depository institutions are increasingly facing challenges.

None of these developments is good. More importantly, these statements added to the belief that the Fed would address the problems in the market.

Fed President Kohn's statements added to the markets expectations:

At the same time, the term interbank funding markets have remained unsettled. This is evident in the much wider spread between term funding rates--like libor--and the expected path of the federal funds rate. This is not solely a dollar-funding phenomenon--it is being experienced in euro and sterling markets to different degrees. Many loans are priced off of these term funding rates, and the wider spreads are one development we have factored into our easing actions. Moreover, the behavior of these rates is symptomatic of caution among key marketmakers about taking and funding positions, and this is probably impeding the reestablishment of broader market trading liquidity. Conditions in term markets have deteriorated some in recent weeks. The deterioration partly reflects portfolio adjustments for the publication of year-end balance sheets. Our announcement on Monday of term open market operations was designed to alleviate some of the concerns about year-end pressures.

And then there are Bernanke's statements:

With respect to household spending, the data received over the past month have been on the soft side. The Committee will have considerable additional information on consumer purchases and sentiment to digest before its next meeting. I expect household income and spending to continue to grow, but the combination of higher gas prices, the weak housing market, tighter credit conditions, and declines in stock prices seem likely to create some headwinds for the consumer in the months ahead.

Core inflation--that is, inflation excluding the relatively more volatile prices of food and energy--has remained moderate. However, the price of crude oil has continued its rise over the past month, a rise that will be reflected in gasoline and heating oil prices and, of course, in the overall inflation rate in the near term. Moreover, increases in food prices and in the prices of some imported goods have the potential to put additional pressures on inflation and inflation expectations. The effectiveness of monetary policy depends critically on maintaining the public’s confidence that inflation will be well controlled. We are accordingly monitoring inflation developments closely.

The incoming data on economic activity and prices will help to shape the Committee’s outlook for the economy; however, the outlook has also been importantly affected over the past month by renewed turbulence in financial markets, which has partially reversed the improvement that occurred in September and October. Investors have focused on continued credit losses and write-downs across a number of financial institutions, prompted in many cases by credit-rating agencies’ downgrades of securities backed by residential mortgages. The fresh wave of investor concern has contributed in recent weeks to a decline in equity values, a widening of risk spreads for many credit products (not only those related to housing), and increased short-term funding pressures. These developments have resulted in a further tightening in financial conditions, which has the potential to impose additional restraint on activity in housing markets and in other credit-sensitive sectors. Needless to say, the Federal Reserve is following the evolution of financial conditions carefully, with particular attention to the question of how strains in financial markets might affect the broader economy.

The Federal Reserve's speeches were (and still are) very clear. They see a deteriorating situation in the economy and a worsening picture in the credit markets. Yet -- they did very little to alleviate either problem. The cut in the discount rate merely maintained the current Fed funds/discount rate spread. This implies the Fed really doesn't see the current credit market situation as a problem. And the 25 basis point cut seems too little in light of the Fed's last three public statements.

Now, in the Fed's defense there are two issues to consider. One is the dollar, which has been dropping hard since the Fed's last two cuts. A 50 BP Fed funds cut may have seriously damaged the dollar, sending it lower still. The second is inflation from food and energy prices, which the Fed specifically mentioned in their statement yesterday. Yet both of these issues were near absent from the Fed's pre-meeting public discussions. The dollar was completely absent and inflation was by far a secondary topic in relation to the credit market issues which took clear center stage.

The bottom line is the Fed screwed this one up big time. They told the markets the Fed was really worried about the credit markets but then didn't do much to alleviate those problems. Then the Fed said the economy is in trouble yet only cut rates by 25 basis points. This is why the markets tanked hard after the announcement. The Fed set the markets up and then dropped the ball in a big way.