Why Is Bernanke Trying to Fight the Bear?
Last Tuesday, January 22, 2008, the US central bank lowered its federal funds rate target by a hefty 0.75% to 3.5%. The panicky decision to lower the fed funds rate target was made ahead of the Fed's meeting at the end of this month. Last Tuesday's cut by the Fed was the largest nonscheduled interest-rate cut in more than 20 years.
We suspect that the key reason for the panicky move by Fed Chairman Bernanke was big falls in world stock markets. On Monday, January 21, the FTSE100 was down 17.1% from its peak on June 15, 2007. The DAX fell 16.2% from its peak on July 16 last year. On Tuesday, January 22, the Nikkei was down 31.2% from its high on July 9, 2007, while on Friday, January 18, the S&P 500 was down 15.3% from its peak on October 9, 2007.
The Fed chairman is of the view that sharp declines in stock prices could produce a disruptive amplified effect on the real economy. So by providing support to stock prices he believes that serious damage to the real economy can be averted. According to Bernanke, the key for successful policy on the part of the Fed is a correct response from the central bank to the turmoil in financial markets and in particular the stock market. In his article in Foreign Policy (FP) magazine in October 2000, he argued,
History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse.1
In his October 2003 speech, Bernanke suggested that an easy monetary policy not only raises stock prices but also lowers risk premiums. Lower risk premiums cause consumers to trim their precautionary savings. This reduction in turn leads to more spending by households. The effect of more spending in turn on economic activity gets amplified through the Keynesian multiplier2. In Bernanke's framework of thinking, if the Fed wants to influence the stock market, the change in the federal funds rate target must be unexpected. (Note that this runs contrary to his policy of transparency.) Bernanke has estimated that
The stock price multiplier of monetary policy is between 3 and 6 — in other words, an unexpected change in the federal funds rate of 25 basis points leads, on average, to a movement of stock prices in the opposite direction of between ¾ percentage points and 1 ½ percentage points.3
The Fed chairman holds that it was the failure of the US central bank during the 1930s to counter financial market shocks that caused the Great Depression. In his various writings and speeches, he expressed his resolve not to repeat past Fed errors and be constantly on guard. In short, the Great Depression, Bernanke argues, could have been prevented if not for the Fed's failure to be on guard and keep monetary pumping strong. Hence any financial shock, according to this way of thinking, is regarded as a potential threat and must be dealt with swiftly.
But even if one were to accept this way of thinking, on account of the time lag, the aggressive lowering of interest rates is not going to make much of an impact on the real economy this year. At present, the economic scene is driven by the Fed's tight stance between June 2004 and September 2007. For instance, in 2001, on account of a weakening in economic activity, the Fed aggressively lowered the fed funds rate target from 6.5% in December 2000 to 1.75% by December 2001. The aggressive lowering of the target couldn't, however, prevent the slide in economic activity. The yearly rate of growth of industrial production fell from 0.4% in January 2001 to negative 5.7% in November of that year — the negative growth was in force until May 2002.
Despite the aggressive lowering of interest rates in 2001, economic activity was responding to the Fed's tight stance between May 1999 and December 2000. The US central bank raised the fed funds rate target from 4.75% in May 1999 to 6.5% in May 2000 (the 6.5% target was kept until December 2000). The yearly rate of growth of Fed's balance sheet fell from 14.1% in December 1999 to 1.5% by December 2000. As a result of this, the yearly rate of growth of our monetary measure, AMS, fell from 6.7% in January 2000 to negative 0.9% in December 2000. In short, on account of the time lag, the tight monetary stance between May 1999 and December 2000 was dominating the economic scene during 2001.
Also in 2001, among the reasons for an aggressive lowering of interest rates was the fall in stock prices. By the end of December 2000 the S&P 500 closed at 1,320.28 — a fall of 13% from the high of 1,517.68 at the end of August 2000.
Despite the aggressive monetary stance, the S&P 500 had continued to weaken, closing at 1,040.94 by the end of September 2001 — a fall of 21.2% from the end of December 2000. The fall in the share price index had continued until September 2002, when it closed at 815.28 — a fall of 46.3% from the end of August 2000. In short, despite the aggressive lowering of interest rates, both the stock market and the real economy continued to plunge during 2001.
Observe that, over time, changes in economic activity in terms of GDP reflect changes in money supply. It remains to be seen whether the aggressive cut in interest rates will produce an underlying strengthening of the rate of growth of money supply this year. The key to this is the expansion in the Fed's balance sheet (Fed Credit) and commercial bank credit. Now, if the pool of real funding is in trouble, then this is likely to result in a decline in commercial bank lending, which in turn is going to undermine the rate of growth of money supply. Within the case of a falling pool of real funding, it is quite possible that despite the Fed's loose monetary stance — on account of declining commercial bank lending — money supply could actually fall.
Obviously this is going to put more pressure on various false activities — bubble activities — keeping the pace of overall economic activity under pressure. For instance, the pace of the Fed's pumping in terms of the yearly rate of growth of its balance sheet (Fed Credit) jumped from 10.9% in August 1931 to 154% in July 1932. Yet bank lending had continued to decline — falling on average during this period by 22% (we suggest that this occurred on account of declining pool of real funding). As a result, the monetary measure AMS fell during this period on average by 11.3%.
Currently, despite the aggressive lowering of the fed funds rate target, in the week ending January 23, Fed Credit fell by $6.047 billion. (Remember the Fed lowered the target on January 22.) The yearly rate of growth of Fed Credit eased to 2.3% so far in January from 3.4% in December. Now if the growth momentum of the Fed's balance sheet were to remain under pressure then this could be indicative that economic growth is falling very rapidly and the fed funds rate target of 3.5% could still be too high. In short, to defend the 3.5% target, the Fed must actually take money from the economy. Year-on-year, in the week ending January 14, the monetary measure AMS fell by 0.8%. This was the first negative growth since January 2001.
Now, in the period January 1974 to August 1975, we had a declining growth momentum of Fed Credit while the US central bank had been aggressively lowering interest rates. The federal funds rate target was lowered from 11% in April 1974 to 5.25% in April 1975. Despite the easy interest rate stance the yearly rate of growth of Fed Credit fell from 12% in September 1974 to 1.1% in August 1975. The reason for that was sharp decline in economic activity. Year-on-year industrial production fell by 12.4% by May 1975. On average during the period January 1974 to August 1975, industrial production fell by 4.5% versus the previous period.
Let us say that the present aggressive interest rate stance by the Fed fails to prevent the economy from falling into a recession; what kind of action is Bernanke then going to undertake? In some of his writings, he has suggested that, under such circumstances, the Fed should adopt a very aggressive stance and start pushing money on a massive scale, i.e., helicopter money. Needless to say that if this were to happen, Bernanke would run the risk of badly damaging the foundations of the real economy.