Fed Is a Manager, Not a Leader

 | Jan 08, 2013 | 3:30 PM EST
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Last week, the minutes of the Federal Open Market Committee meeting of three weeks earlier on Dec. 11 and 12 were released. Traders were caught unprepared for the hawkish inflation sentiment concerning the continuation of quantitative easing expressed by many members. They responded immediately by selling all asset classes and going to cash, with gold, bonds, and equities all falling simultaneously.

The dominant issues being discussed in the media now concerning the minutes is how fast yields and/or rates will rise, and whether or not it will it kill equities, gold and housing.

Given the discontinuity expressed in the minutes of the December minutes vs. the decisions announced concerning the new purchases of Mortgages (QE3) announced in September, and the decision to continue Operation Twist duration extension programs but without sterilization (QE4) at the December meeting, the markets initial response is understandable and warranted.

It was most probably overdone though and indicative of a flash back to 1994. For anyone currently involved in the financial markets who was also involved in 1994, that year remains as an ominous event, and is now a noun in the financial markets

On Feb. 4, 1994 the FOMC unexpectedly raised the fed funds rate, which was the first step in a march toward higher rates, with the Fed raising rates 7x over the next year, the most aggressive tightening in Fed history, moving the fed funds rate from 3.25% to 6%.

The 10-year Treasury yield moved from 5.81% on Feb. 3 1994 to 8.05% on Nov. 5 1994, just nine months later.

The increase in Treasury yields was exceeded by the increase in loan rates, especially for residential and commercial mortgages as lenders and the still developing mortgage backed securities market reflected a sense of panic about rising rates.

The principal result of that tightening process was that lending came to a crushing halt as banks and borrowers simply stopped doing anything because loan rates were rising faster than the markets could underwrite loans.

Although GDP in 1994 did increase to about 5% from about 2.5% in 1993, it also crashed down to about 1% during the middle of 1995 with the U.S. coming very close to recession again; and did not recover to the long-trend average until the latter half of 1996.

This episode is considered by many who were involved in the financial markets at the time as one of Greenspan's biggest mistakes.

There is a difference between leading and managing. Leading is done publicly, managing is done privately. Leading is a proactive event and managing is a concurrent and reactive event.

The FOMC members, including Bernanke, have struggled with this difference ever since Lehman Brothers failed. Since the Federal Reserve was created in 1913 part of its unwritten but universally accepted mandate is that it be reactive with policy decisions; that it manage Fed policy in response to empirical data on economic activity.

Since autumn 2008, however, it has had to move its operations into a leading position, ahead of economic data, in an attempt to calm markets and assure private capital that it was prepared to do whatever it takes to restore confidence.

Confidence in the markets and economy by consumers, lenders and business in general requires leadership, salesmanship, and conviction in doing so. It is an absolute position and there is no room for leaders to publicly question their decisions at the same time they are providing them.

That is not the way the Fed is set up to operate though. The discussion and hesitation about continuing and expanding QE at the same time they are doing so is what they should do.

The bottom line is that in order to stimulate activity, the Fed is committed to holding down long-end Treasury yields and driving down loan rates in the process.

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