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Michael Brandl >
Macro Updates > Archives
> January 23, 2008
January
23, 2008
What is
happening in
financial
markets and what
to make of it?
The Facts
•
Volatility hits
Asian and
European equity
markets Jan. 22,
2008.
FTSE 100 was
down more than
300 points, or
5% in early
trading but
ended the day up
Indian equity
prices fell by
11% and were
down as much as
13% ending the
day down 5%
Hong
Kong listed
Chinese shares
fell 12%
Hong
Kong’s Hang Seng
index plunged
8.7%, now down
31% since its
high on Oct. 30th.
Nikkei saw its
worst two-day
decline in
nearly two
decades, losing
5.65 per cent
•
Before U.S.
equity markets
open, the Fed
announces an
“emergency” cut
in the target
for the Fed
Funds rate of 75
basis points, to
3.5%
Largest one day
cut since 1990
Emergency action
before Fed’s
next scheduled
meeting on Jan.
29th
and 30th
Fed statement
"The
committee took
this action in
view of a
weakening of the
economic outlook
and increasing
downside risks
to growth."
U.S. equity
markets
initially down
dramatically,
but finishes the
day off only
about 1%.
• Debate in
Washington over
fiscal
"stimulus"
package to ward
off U.S.
recession
Bush
Administration
is calling for @
$150billion
package of tax
rebates and
incentives (1%
GDP)
Debate is over
who should get
tax rebate and
incentives (i.e.
working poor,
middle class,
businesses,
etc.)
Bernanke has
endorsed the
fiscal stimulus
as long as it is
temporary,
timely and
targeted.
What to Make of
This?
Here are three
very different
takes on what is
happening:
I. Stimulus is
needed to fend
off a recession
in the U.S.
Who is saying
this:
popular press,
politicians, the
Fed, left
leaning
economists and
some
businesspeople.
Logic:
Tax rebates and
incentives will
give households
and businesses
more money to
spend. This
increase
spending will
result in higher
output and more
jobs. Thus, the
economy will
avoid a
recession. The
Fed’s cut in
interest rates
will lower
borrowing costs
for households
and firms which
will also lead
to more
spending, thus
again helping
the U.S. to
avoid a
recession.
Evidence:
Larry Summers of
Harvard argues
in FT (Jan. 7,
2008 "Why
America Must
Have a Fiscal
Stimulus") that
“a
$50bn-$75bn
package
implemented over
two to three
quarters would
provide about 1
per cent of
gross domestic
product in
stimulus over
the period of
its
implementation.”
So, a
$150billion
package will be
twice as
effective.
Bush tax cuts of
2001 helped to
make the 2001
recession mild.
Counter
Arguments:
Timing. The
Bush tax cuts of
2001 were not
about
stimulating the
economy in the
short run they
were about
budget
surpluses. If
the tax cuts of
2001 did help
end the
recession it was
more good luck
than perfect
timing. This
time around, can
Congress act
fast enough?
How long will it
take Washington
to get checks in
peoples’ hands?
CBO estimates
maybe, if lucky,
by summer. That
is 6-8 months
from now…that is
the average
length of
recession.
Impact. Given
the debt levels
of households
what if they use
the “extra
money” to pay
down debt and
not new
spending? Won’t
the increased
government
deficit cause
other financial
market
problems? Plus,
people and
businesses make
decisions based
on permanent
changes, not
temporary
changes that
they know will
disappear.
II. The Fed is
behind the
curve.
Who is saying
this:
some in the
business press,
financial market
participants,
financial market
analysts, and
economists
affiliated with
financial
markets
entities.
Logic:
there is a
massive lack of
liquidity in
financial
markets. The
markets are a
verge of a major
collapse and
this collapse
will spill over
into the real
(non-financial)
U.S. economy and
spillover to the
rest of the
world. The Fed
should have been
more
expansionary,
and it should
have done more
to minimizes
financial market
loses. The Fed
is the main
regulator of the
banking system
and these banks
are facing a
major crisis.
The Fed should
continue to cut
rates and
provide more
liquidity to
financial
markets.
Obviously the
Fed knows how
bad things are
since the Fed
has insight into
the economy that
financial
markets do not.
The Fed should
have acted
faster.
Evidence:
Housing markets
are contracting
around the
country.
Reinsurance
firms are on the
verge of
collapse.
Credit is hard
to come by even
for non-subprime
borrowers.
Counter
Arguments:
It is not the
job of the Fed
to target asset
prices. Many in
the financial
markets have
mispriced risk
and now they are
paying the price
of asset price
reduction. For
example, too
many houses were
built during the
real estate
bubble. Now the
prices of those
homes must fall
to restore
equilibrium in
the market.
By appearing to
respond to drops
in equity prices
the Fed is a
risk of losing
its reputation
as an inflation
fighter. Better
if the Fed
focused on
fighting
inflation and
correcting
global financial
market
imbalances than
worrying about
short term
swings in output
and asset
prices.
II. The Fed is
panicking.
Who is saying
this:
writers at The
Economist, some
economic
columnists at
the Financial
Times, and
several academic
economists.
Logic:
Bernanke’s
testimony in
favor a
temporary fiscal
stimulus is very
odd. Does
Bernanke, a life
long
neo-classical
economist, now
really believe
that Keynesian
fine tuning
works? Given
that the Fed is
going to meet in
a week why the
need for an
“emergency” rate
cut and why so
large? It all
looks like the
Fed is panicking
instead of
reassuring
markets.
Evidence:
Granted, if
Bernanke wants
to pursue an
expansionary
monetary policy,
he probably has
room to do so.
Given that the
PCE (Personal
Consumption
Expenditures
Index) is
measuring
inflation around
3.2% annual rate
the Fed has some
room to lower
rates. An
argument can be
made, that the
real Fed Funds
Rate should be
close to zero on
the eve of a
recession. So
the Fed did have
room to lower
rates at a
measured pace.
Yes, there is a
tightening
housing market
and the
unemployment
rate has ticked
upward, but
there seemed
little reason
for an
“emergency” cut
in rates. It
makes it appear
that the Fed is
pandering to
financial
markets and
politicians.
Counter
Arguments:
It is
unrealistic to
expect the Fed
to sit back and
let the economy
slide into a
recession.
Bernanke, as a
neo-classical
economist,
understands the
role of
expectations in
markets and
throughout the
economy. His
support of a
measured fiscal
stimulus package
was a signal
that he supports
moves to avoid
an economic
recession.
Similarly his
emergency move
was designed to
show that the
Fed will always
be forward
looking as well
as transparent.
If economic
agents have
confidence that
the Fed will be
out in front of
economic
downturns and
keep inflation
under control
then the Great
Moderation can
continue.
Where Do We Go
From Here?
Watch the debate
in Washington
• Can Congress
get their act
together and
form a fiscal
stimulus package
in time? How
will they make
it “temporary?”
How will they
pay for it all?
• Watch out for
pork barrel
spending
projects to be
added to the
stimulus
package.
• Will they
ever address the
long run issues
facing the U.S.
economy?
Watch for an
Asian Financial
Market Blow-up
• Many,
including
Greenspan, have
argued that the
Chinese equity
market is
suffering from
an asset
bubble. Will
that bubble now
burst?
• Given the
shaky state of
Chinese banks
can they with
stand cash
withdrawals?
• Minxin
Pei at the
Carnegie
Endowment
worries about
the potential
political
fallout in China
of a financial
market collapse.
Watch the dollar
fall
•
Fears of rising
U.S. inflation
due to energy
costs and
excessive
expansionary
policies.
•
If you are an
American, talk
to potential
European
investors.
What will happen
to the
reputation of
the Fed?
•
Will they
continue to
oversee the
Great
Moderation?
•
Will the Fed be
seen as a panic
ridden,
political and
financial market
lapdog.
•
Will it figure
out a way to
deal with the
systemic risk v.
moral hazard
trade-offs.
Regards,
M. Brandl
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