Archive for November 6th, 2007

Mishkin explains the Fed Policy and rate cuts

November 6, 2007

Fed Governor Mishkin gave a speech (on Nov 5, 2007) titled Financial Instability and Monetary Policy at a New York conference. In his speech he explains the role of Fed and explains why Fed cut its policy rates (despite the criticisms).

The broad idea is Fed believed the ensuing financial instability could lead to severe slowdown the economy. He explains what is financial instability and how it effects macroeconomy.

The root cause of financial instability is worsening of information asymmetry in financial markets (explained here). This leads to two kinds of risk:

The first is what I will refer to as valuation risk:  The market, realizing the complexity of a security or the opaqueness of its underlying creditworthiness, finds it has trouble assessing the value of the security……

The second type of risk that I consider central to the understanding of financial stability is what I call macroeconomic risk–that is, an increase in the probability that a financial disruption will cause significant deterioration in the real economy.  Because economic downturns typically result in even greater uncertainty about asset values, such episodes may involve an adverse feedback loop whereby financial disruptions cause investment and consumer spending to decline, which, in turn, causes economic activity to contract.

Mishkin explains that Fed cannot do anything about the first risk but has to minimise the second risk which could disrupt the entire economy.

He explains Fed’s mandate really well:

Originally, the preamble to the Federal Reserve Act of 1913 stated that the Federal Reserve System was created “to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.” 

Later, in 1977, the Congress amended the act to introduce macroeconomic objectives explicitly.  Accordingly, it stated that “the Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”   Because long-term interest rates can remain low only in a stable macroeconomic environment, these goals are often referred to as the dual mandate–that is, the Federal Reserve seeks to promote the two coequal objectives of maximum employment and price stability.

As financial instability could increase macro risk, “Fed has a clear interest in promoting the stability of financial markets.”

He then explains how monetary policy can influence financial instability and thereby lower macrorisks:

I noted a moment ago that periods of financial instability are characterized by valuation risk and macroeconomic risk.  Monetary policy cannot have much influence on the former, but it can certainly address the latter–macroeconomic risk.  By cutting interest rates to offset the negative effects of financial turmoil on aggregate economic activity, monetary policy can reduce the likelihood that a financial disruption might set off an adverse feedback loop. 

He defends the rate cuts and says the idea was not to promote excessive risk taking (or increase moral hazard) but lower financial instability by addressing macro risks. The companies are still paying for their poor decisions (Merrill, Citi etc.) he however doesn’t name them)  by taking on higher valuation risks.

So that is the broad idea. The analysis and defending Fed’s move is pretty nicely done.

Nonetheless, I still think it is a cover-up job. By retorting to jargons, Mishkin has explained and justified but it doesn’t really help. Valuation risk and macro risk are related concepts and according to me both go in tandem. By addressing macro risks, Fed also helps lower valuation risks. As rates decline, lenders and borrowers gain confidence and activity increases in financial markets. The distressed borrowers renegotiate their loans and this helps lenders free more of their capital leading to more loans and so on.

The thing is rate cuts have helped wall street (Mishkin denies it though) lower their losses. They would have made much bigger losses if Fed did not cut rates and may be we would have seen some complete collapse of some reputed financial firm.

The central message from this crisis is that Central Banks might just have to rethink their roles. They just can’t hang on to the inflation/price stability role most have been advocating.

Assorted Links

November 6, 2007

1. WSJ Blog points that there are only 6 non-financial AAA rated companies in US. It also pointsto an interesting paper on Canseco effect.

2. Mankiw points to some interesting articles (as he mostly does). One on behavior, two on Warren Buffet . 

The Buffet one is actually a speech from Mark Sellers (a hedge fund guy) who says Buffet is an excellent writer and his writing shows he thinks quite clearly helping him in his investment decisions. I think this is an excellent point to make. Buffet’s annual letter to shareholders is a treatise. Knowing finance and its concepts alone don’t make you rich, other skills matter as well.

3. Ruchir Sharma has written a nice article in ET explaining current developments in Indian stock market.

Most analysts are trained to assume that valuations are all-important in determining the price of any asset and that there is a strong tendency for mean-reversion in financial variables. But the trend, of late, has been about the so-called expensive stocks and markets getting even more richly valued with few takers for the cheap stuff. Valuations are almost irrelevant and it’s all about growth and price momentum.

I have always been wondering and looking for reasons for this current market rally. Why do stocks like Reliance Petro (which have zilch revenues till date) continue to move up? I understand the expectations bit but that much?

Similarly other companies have been rising….the analysts say it is rising tracking earnings of companies and  they believe it would rise in future… I agree but let us not forget companies need basic infra to produce and sell their goods and services….Are we seeing anything on that front except for arguing endlessly how much money do we need to finance infrastructure?

Financial Markets trade assets and liabilities on the basis of activity in real economy. Real economy is also moving spectacularly for the past 4-5 years but financial markets have been moving ahead much faster.

4. ET raise concerns over food security and in BS Surinder Sud writes about National Food Security Mission.

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