Bernanke’s vision evokes investors’ frustration

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In the second week of August, the short-term fixed-income sales team at JPMorgan Securities sat stunned as the trillion-dollar market for asset-backed commercial paper began to collapse.

In normal markets, JPMorgan sells $25 billion (Dh91.7bn) of short-term IOUs for clients daily.

“Within the span of six or seven business days, every single investor stopped buying asset-backed commercial paper tied to structured investment vehicles,” said John Kodweis, a managing director at the New York bank.

How the Federal Reserve has responded to that credit debacle – the worst since the savings and loan crisis of the early 1990s – defines Chairman Ben S Bernanke’s reshaping of the world’s most important central bank.

With its focus on building consensus around long-term goals and attempts to separate liquidity from broader monetary policy, Bernanke’s approach evokes appreciation among some economists. He’s also caused frustration among traders trying to discern his intentions.

“The chairman walked into a job that I can best describe as trial by fire,” said Allen Sinai, President of New York-based Decision Economics Inc. Separating interest-rate policy from liquidity tools was “absolutely brilliant”, he said.

To critics, his failure to quickly recognise the economic impact of the market tumult exacerbated the slowdown and meant that when the Fed began cutting rates, reductions needed to be deeper and faster.

“It’s hard to be democratic in a crisis when leadership and image are so key,” said Karl Haeling, head of strategic debt distribution in New York at Landesbank Baden-Wuerttemberg, Germany’s fourth-largest bank.

“The Fed seemed awfully smug until August that this sub-prime issue was not a big issue. Then, they had to come out with both barrels blasting,” he said.

The 54-year-old Fed chairman will give his semi-annual testimony to the House Financial Services Committee today. His remarks will likely deal with risks to growth, while underscoring that inflation remains a threat.

In August, Bernanke defied traders’ predictions of an immediate cut in the federal funds rate, which affects borrowing costs for consumers and businesses.

Instead, as credit dried up, he responded with a $35bn cash injection into banks on August 10. Seven days later, he lowered the cost for banks to borrow directly from the Fed.

Officials waited a month before lowering the federal funds rate. Even then, they said “inflation risks remain”, leading some on Wall Street to complain Bernanke was out of touch.

“They stepped on their message in the first five months,” said Vincent Reinhart, former director of the Fed’s Division of Monetary Affairs.

“They were not willing to emphasise why, or how they arrived at that inflation risk.”

Meanwhile, the economy continued to weaken.

 As mortgage delinquencies rose to a 20-year high in the third quarter, Fed officials cut the federal funds rate just a quarter-point in October and said they thought inflation risks “roughly balance” risks to growth.

Coming after a half-point cut the previous month, the October action was seen by economists, including Stephen Stanley, as a signal that policy-makers thought they had eased credit enough to sustain the economic expansion.

“It really kind of scares me that the Fed had no idea things were going to get worse,” said Stanley, chief economist at RBS Greenwich Capital Markets Inc, and a former member of the Richmond Fed staff.

“They were totally blindsided by the deterioration in liquidity conditions after the October meeting,” he said. By December, investors were expecting some promise of year-end liquidity following the Federal Open Market Committee’s meeting on December 11.

THEY DID NOT GET ONE.

Instead, policy-makers again cut the benchmark rate a quarter point and maintained their view that “some inflation risks remain”.

Investors showed their disappointment, driving the Dow Jones Industrial Average down 2.1 per cent. Markets were setting up for a panic. The Fed again surprised Wall Street the following morning, announcing that the central bank would loan as much as $40bn for 28 days through a facility that would let banks borrow directly from the Fed.

The Fed also arranged swap lines with the European Central Bank and the Swiss National Bank, allowing them to channel dollars into their markets.

The Fed’s response to the credit squeeze “was not handled with the aplomb you would have liked”, said E Craig Coats Jr, co-head of fixed income at Keefe Bruyette and Woods in New York. Still, “it was pretty creative, and I give them credit for trying”.

Only after Fed officials saw the potential for higher unemployment and indicators such as retail sales declining did they have confidence that inflation risks were subsiding. They then cut the benchmark rate 1.25 percentage points in nine days in January, the fastest reduction in two decades.

Bernanke’s goal of keeping policy trained on a medium-term forecast, while flooding the banking system with short-term cash, shows how the chairman has adopted some of the discipline of inflation-targeting central banks in the United Kingdom and Sweden.

“Good central banking is not a matter of magic touch,” said Doug Elmendorf, a senior fellow at the Brookings Institution in Washington, and a former Fed staff economist under both Bernanke and former chairman Alan Greenspan. “It is a matter of doing something systematically right.”

The Bernanke system also includes changes in governance and communication.

Bernanke persuaded fellow members of the Federal Open Market Committee to publish their projections four times a year instead of two, and stretch out to a third year. The exercise transformed the undefined preferences of Greenspan into numeric priorities of an institution. (Bloomberg)

The Numbers

$25bn: Worth of short-term IOUs are sold by

JPMorgan to clients every day

$35bn: Cash injection into banks was made by the Federal Reserve on August 10 last year as credit started to dry up