Moral Hazard on Main and Wall Street

The Federal Reserve has taken several steps up a policy escalation ladder to address the turmoil in the capital markets. It has allowed the Fed funds rate to deviate sharply from its target, and has created conditions that have allowed an approximate five-fold increase in excess reserves of the banking system.

The Federal Reserve took additional steps earlier today. First, it liberalized the so-called discount window borrowings, which are neither at a discount nor take place at a window. The Fed cut the punitive rate from 100 bps more than the Fed funds target to only 50 bps and lengthened the period that the funds can be borrowed. Yet, discount window borrowings are minor ($265 mln total in the week ending August 15), and the discount rate is still above the Fed funds target and well above the recent average effective Fed funds rate (weighted by size). As such, these moves are largely symbolic.

Second and arguably more importantly, the Fed changed its bias by saying “Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have potential to restrain economic growth going forward.” This was the first sentence of their statement with the announcement of the changes in the discount facility. This is important because it represents a stronger recognition of the potential for the macro-economy to suffer from the capital market turmoil than was expressed in the Fed’s statement after the August 7 FOMC meeting. Over the last couple of weeks, we have argued that the bar for a Fed cut was high and that a material impact on the real economy would be necessary. With today’s statement, the Fed in effect indicates that it is a bit closer to the bar than it was previously.

This means that the odds of a September rate cut have increased. However, it is not a done deal. First, the Fed explicitly stated that the discount moves were temporary and indicated that “these changes will remain in place until the Federal Reserve determines that market has improved materially.” Second, the Federal Reserve seems reluctant to cut its Fed funds target, even though some pundits have suggested that the Fed under Alan Greenspan would have.

At the heart of this debate is the status of what has euphemistically been called the Greenspan put. This refers to the concept articulated by the then chairman of the Federal Reserve in late 2002. There were three components to what he said. First, Greenspan said that asset bubbles cannot be detected with a high degree of certainty. Second, he said that monetary policy should not try to offset asset bubbles. Third, he said that the collapse of the asset bubbles can be detected and that the economic fall-out can be mitigated by timely use of monetary policy.

In effect, policy should not be used to curb “irrational exuberance” but should be used to clean up the mess created when the asset bubbles pop. This asymmetrical role of policy should therefore not deter excessive price appreciation of asset markets, but should limit the knock-on effects of asset price depreciation. In early 2003, current Fed chief Bernanke seemed to concur.

This asymmetry creates a moral hazard as surely as any social welfare program does. The pendulum of market sentiment swings, and sometimes violently so, on its own between fear and greed, but the asymmetry of the Greenspan-Bernanke doctrine encourages unhealthy greed by socializing the costs of the shift toward fear. It rewards imprudent economic actors and punishes the prudence of others.

Part of the confusion in the markets presently which may be adding to the market turmoil is that the market is not sure that Bernanke still adheres to what Greenspan and he previously articulated. We suspect Bernanke does in fact want to distance himself from it, but that the turmoil in the markets is making it difficult to jettison it completely at this juncture.

Officials have intimated that the market was mis-pricing risk for some time. As credit spreads widened, the Fed was more than willing to stay on the sidelines. When the stress moved to the short-end of the curve and morphed into a liquidity issue, the Fed, like the ECB, the Bank of Japan, Bank of Canada, and the Reserve Bank of Australia, provided extra liquidity into their respective banking systems.

However, it was clear from the continued turmoil in the markets that the liquidity provisions, while sufficient to keep overnight rates low, failed to arrest the fear that seemed to be paralyzing the two main channels of capital distribution: the banks and the markets. It is too early to tell whether the Fed’s moves will be sufficient to stabilize the situation. On one hand, if these moves are successful, there seems to be little reason for the Fed to take additional policy steps. On the other hand, if it fails, then it is also less clear that a 25 bps or even a 50 bps rate cut would rekindle the animal spirits. And, it is not clear that that is truly desirable from a policy making point of view.

In the process of ameliorating the fallout from the end of the equity and technology bubble, the Federal Reserve, so the argument goes, helped foster the real estate bubble. A rate cut now would potentially risk a new bubble and thereby keep the Fed and the markets in this perverse cycle.

Unlike in 1998 and 2000, the US and the world economy appear strong enough to absorb the current dislocations. What happens on Wall Street does not always impact Main Street. US growth in Q2 is likely to be revised sharply higher to a 4% handle, and the early signs suggest the economy enjoyed reasonably good momentum as the financial crisis deepened. Growth in Q3 is likely to be slower than Q2, but not nearly as weak as Q1.

If the situation does get worse in the coming days, the Federal Reserve and Treasury still have a number of policy tools in their arsenal before climbing the escalation ladder to an inter-meeting cut. Bernanke is likely to resist a rate cut as long as possible. The real economy does not merit such a move, and core inflation readings have begun creeping up. Nor does he appear anxious to soften or socialize the discipline of the market place.