Wednesday, August 20, 2014

Meet Your Investment Manager

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), which was translated and republished in Chinese (2014). He is researching a book about Ben Bernanke. He writes a blog at

         There is little else left in the asset-pricing world than central bankers. The redoubtable Ben Hunt, chief risk officer at Salient investment managers ($20 billion under management), wrote on David Stockman's Contra Corner: "I've spent the past few weeks meeting Salient clients and partners across the country.... When I had conversations [with clients and partners] six months ago, I would get a fair amount of resistance to the notion that narratives dominate markets and that we're in an Emperor's New Clothes world. Today, everyone believes that market price levels are largely driven by monetary policy and that we are being played by politicians and central bankers using their words for effect rather than direct communication. No one requires convincing that markets are unsupported by real world economic activity. Everyone believes that this will all end badly, and the only real question is when."

This might be referred to as "End-of the-Cycle Mispricing, but, what a cycle! End-of-the-Cycle Mispricing discussed the derangement of prices, in all assets. Money managers as a whole have not considered protection for their funds when everyone runs for the door at once. The "catastrophic bond" paper linked to the discussion was specific, but, there are plenty of avenues to construct such protection.

What follows is a transcription of just how ignorant, moreover, willingly ignorant, and, it may be, enthusiastically ignorant, was the Bernanke Fed when it decided that holding interest rates at zero percent would be its policy. Before plunging through the looking glass, here is the conclusion: If ever there was a time to protect one's assets from further FOMC derangement, this is it. If you do not (and cannot) design a Personal Protection Plan, buy cash, gold nuggets, and silver eagles. 

Reading the transcript from the December 15-16, 2008, FOMC meeting, it is clear the Federal Open Market Committee was embarking on its zero-interest rate policy (ZIRP - which is still all we've got) as an experiment.

By way of background, the FOMC had cut the Fed funds rate cut from 5.25% on June 29, 2006 to 1.00% on October 29, 2008. Most of reduction had been over the previous few months as the pillars fell: Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs, and Morgan Stanley. The last two converted to commercial banks and received government protection as well as deposit-taking authorization.

The December meeting addressed whether the funds rate should be cut to zero (ZIRP), or, to some halfway house. As has been true throughout Bernanke's chairmanship, the 284-page debate could only have been held in the Eccles Building. The funds rate had been trading below the declared rate for a couple of months. One can only imagine the ecstasy at the Fed on December 12, 2008, when the funds rate traded at 0.00%: the "zero-bound." This had been Professor Bernanke's ad pitch since the early 1990s.

Two members of the Committee stand out as particularly itchy to get on with it, Chairman Bernanke and (then) San Francisco Federal Reserve President Janet Yellen. Bernanke broke with precedent by speaking first. Normally, the Chairman opens with a few remarks but waits until all FOMC members (plus non-voting regional presidents) have voiced their opinions before holding forth.

            In synopsis, there was no debate, not because fed funds were trading at zero already. The FOMC was discussing Fed policy. In Bernanke's words: "[W]e are at a historic juncture.... [o]f necessity, moving towards new approaches.... [T]his is a work in progress." One might wonder if the Fed chairman had created the "necessity" so that he could breathlessly declare this "historic juncture," and he could experiment with his textbook diagrams: His "work in progress."

            Through his great experiment, Bernanke seems not to have blanched at heaving new innovations from the Eccles Building without knowing what might follow. At the October 28-29, FOMC meeting, about three weeks after the Fed first paid banks interest on their reserves, Federal Reserve Governor Elizabeth Duke reported: "I asked [the banks] specifically this question about interest rates on reserves, and every single one of them said: 'We haven't had time to even focus on it. We don't even know what's going on with that.'" Bernanke responded: "Learning theory in practice. Thank you very much."

            You may remember the many borrowing windows opened by the Fed in 2008. The transcript shows there was little coherence to these conduits. At the December meeting, Bernanke said: "We have adopted a series of programs, all of which involve some type of lending or asset purchase.... [of] which even I do not know all of the acronyms anymore." Anymore? A viewer of Bernanke during Senate testimony would question whether he knew what they did to begin with.

St. Louis Federal Reserve President James Bullard lamented later in the same meeting: "I would like to see us work harder, maybe much harder, on the metrics for success of these facilities [the various borrowing windows - FJS] and perhaps rework or discontinue facilities that may not be meeting expectations.... Frankly, I am not sure in all cases what the purpose of the programs is. We have a lot of them out there. We have ideas. We should quantify that. We should be assessing, and then we should turn around and say, 'This one is working. This one is not working.' I would like to see a lot more in that direction. I understand that we haven't done it so far...." The Bernanke Fed tendency might be summed: "Assess the facilities? Why bother? Open another one."

Everyone had their say at the December meeting, During the Greenspan and Bernanke pontificates, members who disagreed with the FOMC vote were talking to a wall. In the meeting under discussion, the topic was whether to confiscate the People's interest rates (and interest earnings) or not.

The chairman opened: "I'd like to ask your indulgence. There's an awful lot here, and I'd like to go first this time and try to clear out some underbrush and to lay down some issues in the hope that it will perhaps focus our discussion a bit more." The message is unmistakable: the FOMC would vote to ZIRP the American people.

There were several members who contested ZIRP. The FOMC member chosen for exposition here is St. Louis Federal Reserve President James Bullard. This choice is two-fold. His concerns were worries a college professor might express, one who talked about - in fact, Bernanke hid behind - models, the "literature," and theory. Bullard has also been selected since he holds the bone fides Bernanke cherishes. Bullard's papers have been published in the American Economic Review, Journal of Monetary Economics, Macroeconomic Dynamics, and Journal of Money, Credit, and Banking.
The St. Louis Fed president explained his demurral: "I do not find the Reifschneider-Williams paper, which I know carries some weight around here, very compelling, so let me give the brief reasons behind that. For one thing, you are taking a model and you are extrapolating far outside the experience on which the model is based. That might be a first pass, but that is probably not a good way to make policy, and I wouldn't base policy on something like that."

What (you may not have the slightest interest in knowing), is the Reifschneider-Williams paper? David Reifschneider and John C. Williams wrote a paper in 2000, "Three Lessons for Monetary Policy in a Low-Inflation Era." The paper describes "limits to policy accommodation attributable to the lower bound on rates." The person who described the paper in that phrase will be identified later, though anyone who's been around the past few years probably has a hunch.

The second of Bullard's concerns: "There are also important nonlinearities. This whole debate is about nonlinearities as you get to the zero bound, and in my view, they are not taken into account appropriately in this analysis. You have households and businesses that are going to understand very well that there is a zero bound. It has been widely discussed for the past year. They are going to take this into account when they are making their decisions, so you have to incorporate that into the analysis. That is a tall order-there are papers around that try to do that, and many other assumptions have to go into that."

The fellow who has been widely published on macroeconomic matters went on: "The third thing I think is important is that, in other contexts, gradualism or policy inertia is actually celebrated as an important part of a successful, optimal monetary policy. Mike Woodford, in particular, has papers on optimal monetary policy inertia, and many others have worked on it. In those papers, it is all about making your actions gradual and making sure that they convey some benefit to the equilibrium that you will get.

"All of a sudden, in this particular analysis, when you are facing a zero bound, that [taking a gradual, deliberate approach towards a zero percent interest rate - FJS] goes out the window, and I don't think that it is taken into account appropriately in the analysis.

"Also, it is thrown out the window exactly at a time when you might think that the inertia and the gradualism are most important, which would be in time of crisis when you want to steer the ship in a steady way." Yes, you might think.

Bullard had plenty more to say at the December 2008 meeting. Others who zapped ZIRP were Dallas Federal Reserve President Richard Fisher, Philadelphia President Charles Plosser, and Richmond President Jeffrey Lacker. One of Plosser's many admonitions: "We still do not understand why having interest rates on reserves isn't working to keep the funds rate at its target, and there may well be unintended consequences of moving our target to zero, beyond those well articulated in the Board's staff notes." Plosser's audience had no interest in whether FOMC steps actually worked or not. Bernanke had already said, regarding Governor Duke's lack of knowledge by the banks: "Learning theory in practice. Thank you very much."

I could probably list another hundred - certainly at least fifty - other objections stated at that meeting against establishing a zero-interest rate policy. Today, at least a thousand problems created by ZIRP are throttling us.

There is not the slightest chance Chairman Yellen will lift rates. The market will do that. Yellen, then San Francisco Federal Reserve President, did not acknowledge any reason to deliberate over ZIRP: "I see few advantages to gradualism, and certainly whenever we approach the zero bound, I think the funds rate target should be quickly reduced toward zero. [Outside of the Eccles Building, it was 0.00% - FJS] As to the level of the lower bound, my default position is that we should move the target funds rate all the way to zero because that would provide the most macroeconomic stimulus."  From current speeches, it is obvious she still believes that final sentence.

            The answer to the pop quiz: Who said the Reifschneider-Williams paper describes "limits to policy accommodation attributable to the lower bound on rates?" Nobody. That is footnote number 24 to Ben S. Bernanke's speech on August 31, 2012, at Jackson Hole, Wyoming, "Monetary Policy since the Onset of the Crisis." He committed murder in his footnotes to speeches. The claim to which he attached the footnote is as improbable as he is, and Bernanke is abusing the paper (as Bullard warned the FOMC) by extrapolating its conclusions to a situation (ZIRP) which is "far outside the experience on which the model is based" to bilge his way past the crowd at Jackson Hole. That is never hard to do. Some investment manager.
            Given the FOMC's ad lib policymaking, it is difficult to believe they have any idea what to do when - yes, when - the run on the markets start, other than to close markets. This is the time to construct an avenue of personal protection.


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