Making A Bad Policy Even Worse

By: Michael Ashton | Tue, Nov 23, 2010
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The markets continue to respond relatively calmly to the news floating about, almost all of which is bad. Although I have not written about it before, because it seemed to involve only one or two bad actors who had previously worked at SAC Capital (one of the 'blue chip' hedge fund names), the SEC has been widening its probe into insider trading. Today, document requests were sent to SAC Capital, Wellington Management Company, and Janus Capital. This is a bit of an escalation in significance from the raids yesterday of Level Global Investors LP, Loch Capital Management, and Diamondback Capital Management LP - the funds that were founded by the former SAC traders. The SEC is casting a wide net, and it hardly needs to be said post-Madoff that they need some wins, badly.

Meanwhile, looking to Asia, North Korea shelled an island populated by South Korea. Now, lobbing shells at South Korea isn't completely unusual activity for North Korea, and had happened several times over the past decade - it was only this past March when the North Koreans sunk a South Korean warship. There are three differences this time which make this instance slightly more dangerous. One is that North Korea this time has targeted civilians; the second is that North Korean dictator Kim Jong Il is ill; the third is that the North Koreans just revealed the existence of a uranium enrichment plant that a U.S. scientist toured and called "stunning" (presumably, not merely for its beauty alone).

And, lest we forget, Ireland is in the throes of collapse with some observers wondering who the EU will negotiate a bailout package with if there is no government in power. Irish 10y rates rose 37bps; Portuguese rates jumped 21bps and Spanish yields rose 16bps among the periphery countries.

With all of this geopolitical unrest, it wasn't surprising to see the dollar rally to its highest level since September, which triggered some mild weakness in commodities. It wasn't a shock to see bonds rally, with the 10y yield falling to 2.76%. It can't be considered unusual that the VIX rose from 18.4 to 20.7. And a 1.4% drop in equities isn't anything to write home about. The only thing surprising was how pedestrian the moves were and how lethargic the intra-day action. I wonder if this isn't going to be one of those times when we all are looking around wondering why the market isn't reacting very significantly to significant news...and then it suddenly wakes up.


Today the FOMC released the minutes from its early November meeting. They were almost comical, as I suppose we should have expected them to be when the actual decision about QE2 had clearly been already made prior to the meeting. The discussion seemed to accurately assess conditions, but those conditions didn't match with the decision about what to do with monetary policy. Here are a few excerpts:

The Desk judged that if it continued reinvesting principal payments from the Federal Reserve System's holdings of agency debt and agency MBS in longer-term Treasury securities, then it could purchase additional longer-term Treasury securities at a pace of about $75 billion per month while avoiding disruptions in market functioning.

I have mentioned this before - whether you think the Fed wants to add $1 trillion or $2 trillion or "only" $600bln to the money base, the decision to add $600bln by June was essentially a pedal-to-the-metal decision. The manager of SOMA (the "System Open Market Account", aka "The Desk" at the NY Fed where they buy and sell securities for the account of the Fed) told them he could only handle $75bln per month, and that's what they got.

Participants again discussed the extent to which employment was being held down, and the unemployment rate boosted, by structural factors such as mismatches between the skills of the workers who had lost their jobs and the skills needed in the sectors of the economy with vacancies, the inability of the unemployed to relocate because their homes were worth less than the principal they owed on their mortgages, and the effects of extended unemployment benefits on the duration of unemployed workers' search for a new job. Participants agreed that such factors were contributing to continued high unemployment but differed in their assessments of the magnitude of such effects.

In other words, we don't really know exactly what is driving the Unemployment Rate. Doesn't this suggest we ought to be careful with monetary policy?

While underlying inflation remained subdued, meeting participants generally saw only small odds of deflation, given the stability of longer-term inflation expectations and the anticipated recovery in economic activity.

Hmmm, and there's also no real risk of deflation. Doesn't that suggest we can be more careful with monetary policy?

Participants generally agreed that the most likely economic outcome would be a gradual pickup in growth with slow progress toward maximum employment. They also generally expected that inflation would remain, for some time, below levels the Committee considers most consistent, over the longer run, with maximum employment and price stability. However, participants held a range of views about the risks to that outlook. Most saw the risks to growth as broadly balanced, but many saw the risks as tilted to the downside. Similarly, a majority saw the risks to inflation as balanced; some, however, saw downside risks predominating while a couple saw inflation risks as tilted to the upside.

There seems to be a fair amount of disagreement, and fairly balanced risks in the eyes of the average Committee member. Is this a prescription for a pedal-to-the-metal easing? Moreover, the thing that the Committee is most worried about, Unemployment, is also the thing that monetary policy is less efficacious in dealing with. So the Fed is going to gun for small gains while taking big risks?

Some participants, however, anticipated that additional purchases of longer-term securities would have only a limited effect on the pace of the recovery; they judged that the economy's slow growth largely reflected the effects of factors that were not likely to respond to additional monetary policy stimulus and thought that additional action would be warranted only if the outlook worsened and the odds of deflation increased materially. Some participants noted concerns that additional expansion of the Federal Reserve's balance sheet could put unwanted downward pressure on the dollar's value in foreign exchange markets. Several participants saw a risk that a further increase in the size of the Federal Reserve's asset portfolio, with an accompanying increase in the supply of excess reserves and in the monetary base, could cause an undesirably large increase in inflation. However, it was noted that the Committee had in place tools that would enable it to remove policy accommodation quickly if necessary to avoid an undesirable increase in inflation.

So "some participants," not just Hoenig, were pretty worried - and the Minutes spends a surprising amount of space cataloguing a very reasonable set of views. Were they really swayed away from these legitimate concerns by the perception that the Fed can "remove policy accommodation quickly if necessary?"

What policy tools are these, anyway? It is generally believed that actions by the central bank take about 6-18 months (depending on who you talk to) to affect the economy. Direct injections and/or drainings of liquidity are probably quicker, but presumably the Desk can't sell bonds any faster than they can buy them so how quickly can they really remove policy accommodation? Increasing IOER may be what they have in mind, but IOER is an uncalibrated instrument that we have almost no experience in using.

So, with all of this discussion, the Committee decides almost unanimously "in for a penny, in for a pound" and starts flushing liquidity into the system as quickly as they can.

But that's not the worsening of policy that the title of this column refers to. In the FOMC minutes was also a notation about a videoconference meeting that occurred on October 15th. Among the topics considered at this meeting:

Participants discussed whether it might be useful for the Chairman to hold occasional press briefings to provide more detailed information to the public regarding the Committee's assessment of the outlook and its policy decisionmaking than is included in Committee's short post-meeting statements.

Seriously? The single biggest failure of Federal Reserve policy over the last two decades, in my view, is that over-communicating their goals and expectations creates a false sense of safety for investors (false, because the Fed has nowhere near the control that investors think they do, as they have proven repeatedly) while creating the conditions for a sudden loss in confidence in the central bank. If no one knows what you were trying to do, (a) they need to be careful in case you're not doing what they thought you were doing, and (b) they can't as easily lose confidence in you for making a big mistake - because they don't know what you were expecting. So, really? The Greenspan Cult of Personality wasn't enough? We need Bernanke Briefings? This ain't Princeton, and this ain't a classroom. We don't need a lecture; we need you to figure out what to do with monetary policy. And if the right answer depends on what the press-conference-viewer thinks about what you have to say, then you've already lost.


On Wednesday, a flood of economic data sends us into the Thanksgiving holiday with an exclamation point. Durable Goods (Consensus: +0.1%, +0.6% ex-Transportation) is expected to bounce back smartly from last month's decline. Personal Income (Consensus: +0.4%) and Personal Spending (Consensus: +0.5%), the Core PCE Deflator (Consensus: +0.0% month/month; +1.0% year/year), and Initial Claims (Consensus: 435k) are all released at 8:30ET. Good luck making lunch out of that soup. The revision of the Michigan Confidence figure, the September Home Price Index (Consensus: 0.0%), and New Home Sales (Consensus: 312k from 307k) are all out on or around 10:00ET.

So, while you're enjoying your Thanksgiving feast, remember all of the poor economists, who will probably still be writing up their analyses.

None of this is, however, as important as the geopolitical developments. And, it being the Wednesday before Thanksgiving, none of it is probably likely to excite the market very much. But you never know when investors will wake up and realize that the biggest issue they have to confront is not the question of Black Friday sales at the mall. I suspect that day is coming.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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