Wednesday, February 26, 2014

Those FOMC Transcripts: Watch Out Below

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

                    The Federal Reserve releases transcripts of FOMC (Federal Open Market Committee) meetings after a five-year wait. The 2008 transcripts were made public late, last week. The FOMC is the monetary policymaking body within the Federal Reserve System. Having read at least 10 years of transcripts when writing about Greenspan and his Fed, there is a lingering question of what might have been redacted before the public release as well as what might be said outside the boardroom so as to escape transcription. Every once in awhile some forward-thinking FOMC attendee (a rarity, to be sure) will remind the mob: "Remember, that comment will be public in five years."

The FOMC transcripts also do not include "other meetings at which smaller groups of Fed officials, working with the Treasury Department, arranged the bailouts of bankrupt Bear Stearns, the American International Group (NYSE: AIG), and housing service entities Fannie Mae and Freddie Mac. Nor do the transcripts include notes from the meetings at which policy makers decided to let Lehman fail." (FOXBusiness, "Fed Releases Transcripts from 2008 Meetings")

Nevertheless, the initial stories across news channels were full of ridicule and indignation at the FOMC's real-time ignorance as banks and markets collapsed. We are fortunate that two of the scheduled FOMC gatherings happened to be on March 18, 2008, and September, 16, 2008, immediately after the collapse of Bear Stearns and Lehman Brother, respectively. The FOMC also held a conference call on March 10, 2008, days before the Bear Stearns failure. The conversations from each show a body more incapable of making connections, translating their macro models to the real world, than a five-year-old. (I remember clearly: a five-year-old walking into the kitchen, looking at the September 16, 2008, New York Times, seeing a large picture of an ex-Lehman employee carrying her belongings out of the building, and asking: "Daddy, are we in a Depression?")

The story of the 2008 transcripts will fade. It must: to preserve faith in the Fed and the stock market. If the Fed was thought unable to "make connections," as it so clearly failed to do in 2008, this might cause a reduction in market exposure (from 99% to 98% leverage). Market authorities remind investors of "considerations which must nowadays modify ideas about the future. One is the power and protective resources of the Federal Reserve." (New York Times, September 9, 1929).

The Fed has been awarded greater power and resources than ever before (to put it mildly) since 2008, yet, the results of its "learning by doing" experiments show the FOMC is no wiser than when Chairman Ben S. Bernanke, Great Depression scholar and legend in his own mind, gathered his flock on September 16, 2008. In the same monologue, the professor claimed: "I think that our policy is looking actually pretty good" and "I am decidedly confused and very muddled about this." He might seem to possess the wiring of a schizophrenic, but there actually is no contradiction in the professor's mind. It is we who wander without full knowledge.

The Fed, ECB, IMF, and fellow travelers operate under the presumption any disturbance can be corrected by central bankers. Their model says so. The Dynamic Stochastic General Equilibrium (DSGE) model made it certain the Fed would not take action before the 2007 financial implosion. The economist Bernard Connolly wrote to his clients in 2006 (when at AIG) the Federal Reserve would not - could not - act beforehand. The holy DSGE model was the reason Bernanke could feel kinda' good when he was confused and muddled. The model provides a central-banking solution for all human errors. Connolly wrote on February 4, 2008, the "DSGE contention that negative demand disturbances (although perhaps exhibiting some serial correlation) rather soon revert to an expected value of zero, is, in conditions of intertemporal disequilibria, nothing more than a fairy tale..." This is difficult to absorb, especially in such an abbreviated form, but it is way the world works (currently). All of Connolly's work from that period can be read at his firm's website, "Hamiltonian Associates," under the "AIG" tab.

The vote was unanimous at that September 16, 2008, meeting: to do nothing, leave the funds rate at 2.0%. Within days, Bernanke and Hank Paulson were terrorizing congressmen and Americans: the end was nigh. In case you have forgotten the general panic, an example was at a Whole Foods outlet where a woman of means turned and asked "I'm worried. Do you think we're in a Depression?" The customer so queried told the worrywart: "You'll have to ask my daughter." Which she did. This customer's five-year-old daughter, having given some thought to her confusion on the morning after Lehman's failure, replied: "Some parts of the country are in a depression, but we are not, at least, yet." This response relieved the anxiety of the woman of means.

The point is not whether the five-year-old was correct or not, but that she had given more thought to current events than the entire FOMC bureaucracy. Chairman Bernanke spoke for those who worshiped the DSGE model at the October 7, 2008 meeting: "It's more than obvious that we have an extraordinary situation.... I should say that this comes as a surprise to me." This is to be expected. Financial markets are not part of the model.

Since 2008, central bankers have been "learning by doing," as Simple Ben told a Jackson Hole, Wyoming audience on August 31, 2012. His speech carried the title of "Monetary Policy Since the Onset of the Crisis." The speech made clear the model was holier than ever. ("It is likely that the crisis and the recession have attenuated some of the normal transmission channels of monetary policy relative to what is assumed in the models...") Reliable sources report the DSGE model is still sacred at the Yellen Fed. In fact, the younger generation of economic Ph.D's who now tweak the input have often learned nothing else in their post-graduate work.

            It is important for the rest of humanity to comprehend the consequences. No action will be taken to prevent what cannot happen. The media sometimes veers towards the fatal FOMC flaw but lacks a full understanding. Thus, Binyamin Appelbaum, writing about the 2008 transcripts in the February 21, 2014, New York Times, explained: "The Fed's understanding of the crisis, however, was clouded by its reliance on indicators that tend to miss sharp changes in conditions. The government initially estimated, for example, that the economy expanded in the first half of 2008 because it basically assumed that some economic trends, like the pace of business creation, had continued apace. The Fed also relied on economic models that assumed the existence of smoothly functioning financial markets, limiting its ability to project the consequences of a breakdown."

            Appelbaum does not quite understand the assumption "of smoothly functioning financial markets" is imbedded in FOMC policy. Financial markets are not part of the DSGE model since "negative demand disturbances" of financial markets "rather soon revert to an expected value of zero." Therefore, they do not exist and FOMC transcripts from 2009 through 2014 will show discussions by the hallowed professors made no allowance for reality and were "nothing more than a fairy tale."

An unrelated note. From the February 26, 2014 Wall Street Journal: "LONDON - Last summer, Adrian Eady, a banker with Royal Bank of Scotland, was nearly crushed hauling a crate of feta cheese off a forklift truck in a North London warehouse."

Does anyone understand what's going on?