naked capitalism

Submitted by Richard Alford, a former economist at the New York Fed. Since them, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

TARGET FIXATION AND THE FED AS THE SYSTEMIC REGULATOR

Target fixation is a process by which the brain is focused so intently on an observed object that awareness of other obstacles or hazards can diminish…The term “target fixation” may have been borrowed from World War II fighter pilots, who spoke of a tendency to want to fly into targets during a strafing run….(From Wikipedia, the free encyclopedia)

Despite the complexity of the world-wide financial and economic crises that began in 2007, US-based analysts have gravitated toward a single explanation for the crisis: weakened financial regulation in the US. This post suggests that this view should be tempered. An inflation “target fixation” on the part of the Fed led it to ignore or dismiss numerous signs of non-sustainable real and financial imbalances. This policy target “fixation” allowed for the relatively accommodative stance of monetary policy post-1996, which contributed to the use of leverage and maturity mismatches and hence the scale of the crises. A central bank that sets monetary policy on the bases of inflation and expected inflation alone is a poor place to house a systemic risk regulator.

Evidence of Fed Target Fixation

A speech by Rajan “Has Financial Development Made the World Riskier?” and a response by Kohn at the Jackson Hole Conference of 2005 allows us to get a read on how open the Fed was to less sanguine views of the condition of the economy and the financial system. These presentations took place well after well-known economists had already sounded alarms re the housing sector (e.g., Schiller and Gramlich), the financial sector and the economy in general (e.g. Roubini and White ), and international imbalances (e.g., Roach).

In opening paragraphs, Rajan argued that the transformation of the financial sector had made it more efficient, but at the expense of increased tail risk. He cited four factors increasing tail risk: 1)changes in incentive structures of investment managers, 2)the tendency of asset managers to exhibit herding behavior, 3)the ability to disguise the level of risk in some classes of assets, and 4)the reduced ability of the banking system to provide sufficient liquidity should tail risks be realized. The balance of the Rajan paper was a succinct development of these ideas along with the presentation of a considerable amount of supporting evidence.

Fed Vice Chairman Kohn was a discussant for Rajan’s paper at Jackson Hole in 2005, but the response was not discussion or rebuttal of the Rajan theses. There was no discussion of the implication of the changes in incentive structures or herding behavior. Kohn dismissed concerns about tail risk, citing reduced volatility of output and inflation over the previous twenty years. (As if tail risk in financial markets, if it existed, would have had to manifest itself in macro data in a twenty year period.) No mention was made of LTCM or the tech bubble. Concerns that low interest rates may contribute to increased risk in the financial system were dismissed on the grounds that those policies contributed to greater stability in output and inflation. Kohn never addressed the point that a shift away from banks as the center of finance might leave the system short of liquidity should real risks materialize.

Kohn’s response is summarized in the following passage:

My perspective on this interesting paper by Ragu Rajan has been very much influenced by observing Alan Greenspan’s approach to the development of the financial systems and their regulation over the past 18 years. I believe that the Greenspan doctrine, if I may call it that, has reflected the Chairman’s analysis and deeply held belief that private interest and technological change, interacting in a stable macroeconomic environment, will advance the general welfare.

Ignoring or dismissing opposing arguments in speeches, papers and seminars is one thing, but there is also reason to believe that policy decisions also reflected view that only inflation/deflation was of concern to the Fed. This is reflected in Fed adherence to, and lack of adherence to, the Taylor Rule.

Taylor-type rules have become the standard by which monetary policy is introduced in macroeconomic models both large and small. They have been used to explain how policy has been set in the past and how policy should be set in the future. Indeed, they serve as benchmarks for policymakers in assessing the current stance of policy and in determining a future policy path. ( Orphanides BOG Staff working paper 2007-18.),

However, post the bursting of the tech bubble, Fed adherence to a Taylor-type Rule, the policy benchmark, evaporated. The targeted Fed funds rate was below the rates implied by most if not all variants of the Taylor rule from 2001 to late in 2006. In dismissing the concerns voiced by Rajan etal, and in response to those who questioned the wisdom of setting a fed funds target well below that implied by Taylor-type rules, the Fed response was simple: What problem? Inflation and inflationary expectations are well behaved.

Monetary and Regulatory Policy

There are two possible explanations for the Fed failing to adjust policy despite the warnings:

1. the Fed saw and appreciated the risks (in addition to inflation/deflation) and chose to do nothing even as the risks and imbalances grew: or
2. the Fed never saw/appreciated the other risks and imbalances even after they were pointed out.

The first possibility allows for the FOMC seeing and appreciating the risks, but viewing its mandate as inflation only. Financial stability and external balance were someone else’s responsibility- aka “Not my job. If this is the case, whose job did the Fed think it was to control/mitigate those risks? What agency did the FOMC think had the responsibility, the authority, and the tools to act to prevent asset bubbles, insure financial stability, and prevent global economic and financial developments from undermining US economic growth? The Fed’s mandate assumes the world as it exists, not an otherwise perfect world waiting for the Fed to provide the final piece of the puzzle: price stability. Saying that monetary policy was fine and that lax regulation alone was to blame for the crises ignores their dynamic interdependence as well as market and institutional failures and imperfections.

The second possibility is kinder and probably closer to the truth. The Fed had become so fixated on inflation and hitting its inflation target/avoiding deflation that it failed to appreciate the risks to growth and financial stability building up in the financial sector, the housing sector, or in the non-sustainable behavior of private savings and external imbalances. The inability to see the hazards may have been enhanced by the fact that the Fed was counting on the asset price boom and the housing bubble to foster consumption, close the output gap and thereby stabilize prices, while assuming regulation and market discipline would insure finance stability.

The financial crises: beyond lax US regulation

There is more to the story of the crises of 2007 than lax US regulation. The financial crisis of 2007 was virtually a world-wide phenomenon. The crises took place despite a variety of regulatory regimes and structures. They took place in US regulated institutions and institutions not subject to US regulation. They affected relatively highly regulated markets and instruments and less heavily regulated markets and instruments. They took place in markets and institutions were regulatory control had been relaxed and they took place where regulation was unchanged, e.g. the auction rate securities market and insurers.

The numerous crises were not unrelated or unique. They shared a few common elements. Two of the elements that were common to all the crises in all the affected countries, markets, and instruments: high degrees of leverage and maturity mismatches. While relaxed regulation permitted some institutions to use more leverage, it begs the question: why did firms want to employ more leverage? Why did home buyers increasingly choose mortgages which embedded higher degrees of leverage? Why did regulated firms lobby their regulators to allow them to use more leverage? Why did economic agents of all types “demand” more leverage even when they had not previously been constrained by regulation? Answer, at least in part: the low cost of funding leveraged positions.

Early in the crisis the Fed, as part of an international effort, increased its swap facilities with foreign central banks. The use of these swap facilities peaked in late 2008 at over $500 Billion. Why? US regulation is not the answer. The foreign banks-were not subject to any US regulation, but had chosen to buy long dated US dollar denominated paper and the fund the positions with short-term Dollar borrowing. When the crises hit, they could not rollover their positions. They needed Dollar liquidity: hence the swaps. The problem was not relaxed US regulation of banks or the repeal of the Glass-Steagall Act; it was leverage and maturity mismatches.

The insurance subs of AIG levered up buying RMBS. The funds were raised by short-term borrowing via securities lending operations. Losses for the securities lending operations were almost as costly to AIG as was AIGFP. The auction rate securities market grew because investors perceived their real after-tax return on traditional money market instruments to be too low. The investment house sold this structure which promised investors a higher than money market rates of return with money market liquidity. Borrowers were promised long term funding at closer to money market rates. Needless to say this pseudo-maturity transformation structure ended in tears all around.

Low short-term interest rates (disproportionately Dollar-based because of reserve status, but also Euro, Swiss, etc) changed the behavior of a wide variety of economic agents in a wide variety of markets in a wide variety of countries. They sought out riskier positions, compressed credit spreads, rode carry trades, and used more leverage. The financial leg of the monetary transmission mechanism changed. Previously existing regulatory structures were insufficient or were evaded. The Fed acted as if it was unaware of any of these developments.

This argument is not an argument in favor of no or low regulation. It simply states the obvious: monetary and regulatory policies do not exist in separate worlds. Regulation will affect how monetary policy works. Financial innovation will alter how monetary policy is transmitted via markets and financial institutions to the real economy. Regulation that is adequate in one monetary policy regime may prove inadequate in another. Hence the position that monetary policy has been fine and that the problem was the failure of regulation alone is wanting. Monetary policy and regulatory policy are intertwined.

TARGET FIXATION AND POLICY SPECIALIZATION

A thought experiment will highlight the interplay between regulation and monetary policy.

If the Fed had come to appreciate the downside risks to the system in 2002, what should it have done? (Taylor’s counterfactual exploration of the economy with adherence to the Taylor Rule has higher Fed funds targets starting in 2002. See Taylor’s paper delivered at the2007 Jackson Hole conference.) Should it have continued as it did on the interest rate front and call for regulatory reform? Or should it have moved to a less accommodative stance, perhaps one consistent with a Taylor–type rule or higher?

If this hypothetical Fed set policy as they in fact did, we would be where we are today. (Did Congress ever do anything, but promote the housing bubble? Would Congress have approved regulation that took the punch bowl away?)

If the Fed had changed the course of interest rate policy in 2002 with an eye to reducing leverage and maturity mismatches even without any change in the regulatory structure, then some if not all the crisis and disruptions in markets that we have experienced probably would have occurred earlier and would have been smaller and more manageable. Incomes would have been lower than they were in the immediate aftermath, but we would not have experienced the worst recession since the Great Depression. Furthermore, monetary policy and the economy would be less encumbered by failing financial institutions.
If the FOMC remains fixated on inflation to the extent that future monetary policy

1)will entail negative short-term real rates of interest over long periods of time, or
2)will induce unsustainable asset price bubbles or bubbles in interest sensitive sector of the real economy,

then any regulatory regime that can guarantee financial stability will need to be much more extensive and encompassing than any regulatory structure we have had to date. It will have to be more robust than would be the regulatory structure required if the Fed takes developments in the financial sector as well as inflation in to account when setting interest rate policy.

This is not a rejection of inflation targeting. To misquote a long-dead US president: Inflation targeting may be appropriate for some economies some of the time. Inflation targeting may appropriate for some economies all of the time. But given the inability of the exchange rate to maintain external balance and the existing regulatory structure, the inflation targeting fixation was inappropriate for the US economy during the time period in question.

Furthermore, if the Fed wants to continue to design and execute monetary policy as it has during the last nine years, then the arguments to make the Fed the systemic risk regulator are very much weakened. If specialization – the inflation only mandate – enhances the Fed’s ability to carry out monetary policy, would not a regulator with a financial stability only mandate be better able to carry out its mandate? If the Fed is unwilling to adjust monetary policy in light of financial stability and regulatory concerns, what is the advantage of having the Fed do both?

Given the implied mandate, the systemic risk regulator must take the broadest possible view of the sources of risk to the system and consider all possible avenues to mitigate the risks. Recent history suggests that the Fed incapable or unwilling to view the economic and financial landscape through a wide enough lens and is too unwilling to alter pre-planned policy responses.