Irrational Credibility

Interpreting economic events these days is complex to say the least.

Back in the “housing bubble” days (when this blog was originally launched) the story was much simpler… housing was overvalued resulting in an economy that was far too leveraged (dangerously so) to the housing sector and to the irrational belief in the continuation of its exceptional expansion.

It only took a consensus agreement of this fact (in clear contradiction to the prevailing “contained” story promulgated by the Fed) for the wheels to finally come off the cart.

The “tech-boom” of the 90s had a similarly concise story… the enthusiasm for tech stocks got way out of hand (understandably considering the notable technological improvements of the internet and telecommunications in general) and led to price-to-earnings multiples that were clearly irrational.

But today, the irrational exuberance is not over one specific sector or asset class, it concerns a concept with much less tangible and understandable dynamics… it’s over the credibility of Fed itself.

Let’s face it, the “Greenspan Put” model of the Fed, whereby the Fed extends an “easing” hand to the markets every time there is a potentially systemic shock (i.e. Crash of 87, LTCM, post-tech wreck 1% FF rate), took a hideous turn for the worse in the wake of the housing collapse resulting in a string of unprecedented interventions that any rational observer could see would be difficult to reverse or, in the Feds parlance, “normalize”.

The belief that the Fed can, in fact, successfully “normalize” and the associated underlying anxiety that they might NOT be able to bears a strong resemblance to the physiological tug-of-war that was present during the prior housing and tech booms whereby most participants (households, firms, investors) continued to play along even though there was at least some degree, even if very diminished and subconscious, of understanding that circumstances could be out-of-line and that a reversal was possible.

So, in a sense, the ability for the Fed to successfully earn back its credibility by creating room for its traditional policy tool (the Fed Funds rate) and thereby reestablishing some semblance of normalcy is tantamount, conceptually, to housing actually “never going down” or to the tech stock boom actually ushering in the “end of the business cycle”.

That is, it is the best case scenario… the one that avoids the ugly reveal of the truly awry circumstances we all inherently know, even subconsciously, to exist.

That’s not to say that the Fed can’t succeed… but the key here is to acknowledge how high the stakes truly are… this is a pivotal moment to say the least.

If the Fed blinks in September as a result of the recent stock market turmoil and leaves the Fed Funds rate at the zero-bound, that could work (more that any other prior event) towards tipping the collective psychology one major step in the direction of loss in confidence of the Fed.

Also, recent speculation that declining stocks is equivalent to Fed tightening thereby giving the Fed some cover for inaction in the September meeting misses the point entirely.

The Feds ability to build more room in their primary “normal” policy tool has NOTHING to do with the Fed Funds rate’s text-book function and all to do with proving to the world that the Fed is credible and, more importantly, that their ability to “normalize” is truly rational.

Stuck on the Zero Bound and Dissent

So, the FOMC spoke and its statement more or less conveys the fact that we are reaching an end game of sorts for Fed policy while voting members are simultaneously beginning to break ranks.

First, the “exceptionally low levels for the federal funds rate at least through mid-2013” language is simply another way of stating that they are stuck at the zero bound.

Some are interpreting this statement as a “bold pledge” that the Fed is prepared to face the weak economic climate and ready to be accommodative for a longer period than many expected.

Nonsense, the Fed is simply stating that the economy is far weaker than they had anticipated and that they are stuck with ZIRP ala BOJ over the last score of years.

This type of sentiment hardly inspires confidence.

Voting against the change in language were three members including Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser a further indication that the Fed hardly has a collected sense of the direction of policy and the outlook for the economy.

Will Bernanke Jump the Shark Tomorrow?

As most business and finance media onlookers gear up for another dose of Fed speak tomorrow with particular interest in the Feds response to the current debt downgrade, now might be a good time to weigh the potential that Bernanke’s Fed might craft policy language that effectively conveys a sense of their ineffectiveness resulting in a loss of credibility and confidence.

Given the fact that the Fed has pulled out all the stops over the last few years implementing QE1 and QE2 as well as a vast series of extraordinary measures (principal repayment treasury purchase program, discount window lending, commercial paper lending facility, etc. etc.) , it would seem that any additional unconventional policy action geared toward propping the flagging economy or mitigating the debt downgrade may start to look desperate and futile.

Will the Fed push policy action one step too far?

Are we on the verge of a Japanese-style moment whereby the majority of participants clearly recognize that the problems we face are bigger than the Fed and its cockamamie policy tools?

The Fed Backed Mortgage Market

The latest weekly report on Factors Affecting Reserve Balances indicated that the Feds purchase of mortgage backed securities jumped to a total of $1.032 trillion, a whopping 1538% increase over the total of $63 billion seen last year.

Of course, we are all well aware of the Feds initiatives to prop the U.S. mortgage market so the above cited figures should come as no surprise.

What may be surprising though is the outcome of the Feds backing out of this mess as the TALF program ceases to exist later this month.

Will the Fed be able to successfully perform a hand-off of this critical market function back to the wounded and still reeling commercial/government-sponsored banking system?

Federal Reserve Bank of Kansas City President Thomas Hoenig thinks so but looking at the chart below its hard not to have doubts.

With a trillion dollar excursion into the commercial/government-sponsored mortgage market, the Fed served to temporarily backstop this massive function but the “organic” market is still very broken and far from clear of malinvestment.

I suppose we should not be surprised by additional initiatives that may be taken by Fannie and Freddie as the Fed exits but why would commercial banks re-enter a market with so much uncertainty and without a trumped-up government guarantee?