Big Ben's hand cuts into moral hazard debate news
25 January 2008

The Fed's big rate cut has once again brought in to focus the 'moral hazard' debate. But do central bankers have a choice anymore? By Vivek Sharma

If you were a patient in a hospital bed, with an as yet undiagnosed affliction, you would be reassured if you were given modest doses of medicine by a doctor who appears to know his job. Your confidence will start waning if the early doses do not work and the doctor starts increasing the frequency of medicine. When even that doesn't work and the doctor appears to be getting nervous, you start wondering what is going on.  

Then the doctor decides to give you a very heavy dose, in what appears like a desperate measure. Your friends and relatives comfort you and say the strong medicine will work and you should feel happy and confident. But, you can't stop thinking that there is something seriously wrong with you. The doctor can sense that and that is why he gives that strong dose and still seems to be losing his nerve. You are not sure what to expect.  

Ben BernankeThis has been the story of the market reactions to the Fed's rate cuts over the last few months. When Bernanke announced his first cut, by 50 basis points last September, stocks rallied. The credit market crisis was gradually unfolding and the true extent of the crisis was mostly unclear at that point. Equity markets demanded more of the same, on hopes that lower interest rates would help brush aside concerns about the US economy, which had started showing signs of weakness after the housing meltdown.  

The two subsequent rate cuts of 25 basis points each, in October and December, were received with less enthusiasm. By then the credit crisis had taken its toll and the big banks were reeling under heavy losses. When credit markets failed to recover, despite the hundreds of billions of dollars in liquidity infusion by major central banks, it was clear that it will be a while before the troubles ease. 

As US economic data worsened, it was near certain that the Fed will look to cut rates at its meeting scheduled for last week of January. Bernanke confirmed this earlier this month, when he said more cuts are required and the Fed is ready to do so. But a rout in the global financial markets forced him to advance that decision by more than a week. 

Why the surprise big cut?
As one prominent economist said, this week's 75 basis points cut is a 'once in a lifetime' rate change. What makes it highly dramatic is that it is the biggest rate change by the Fed in nearly 24 years and the biggest ever between scheduled meetings! Back then, the US economy was actually in a recession and a big rate cut was called for. Even after the 9/11 terrorist attack, the Fed brought down rates by only 50 basis points.

Therefore the obvious question is what spooked the Fed into such a big rate cut? Is the US economic outlook worse than widely perceived? Are there any systemic risks, which could lead to a catastrophe? Or, was the Fed only trying to prevent a stock market meltdown? 

Most economists now believe that it will be mighty hard for the US economy to avoid a recession in 2008. Some say, the recession might have already started (See: After Merrill, Goldman Sachs issues "outright recession call" for 2008)

When the Fed met last time, employment was strong despite the weakness in housing.

The Fed governors were concerned about inflation and limited the rate cut to just 25 percentage points. But, jobs data has weakened subsequently as housing woes worsened. Strong export growth, backed by the weak dollar, might be protecting manufacturing jobs to some extent – but is not sufficient enough to offset the overall weakness. Hence, the Fed was all set to lower rates at its next meeting. 

Adding to the Fed's concerns were the challenges faced by bond insurers, also called 'monoline' insurers. These insurers cover investors against defaults by bond issuers. When insured, the credit rating of a bond will be the same as the credit rating assigned to the bond insurer. In other words, a bond, which will qualify for a BBB rating, will be treated as AAA when insured by AAA rated bond insurer.  

If the insurer loses its AAA rating, all the bonds insured by that insurer will have their ratings lowered. Institutional investors holding those bonds will have to write down the value of their holdings. As the top bond insurers have underwritten securities worth a massive $2.4 trillion, write-downs would have been huge. Such a scenario would have been another nightmare for the financial markets, comparable to the recent meltdown related to mortgage-linked securities.  

Major bond insurers in the US, who suffered losses in their CDO underwriting business, have been struggling to maintain their AAA ratings. Rating agency Fitch downgraded one of the insurers to AA earlier this month, strengthening the impression that other agencies are also reviewing their ratings. The only way for insurers to hold on to their ratings is to raise additional capital, which some of them have done in recent months. The situation was becoming increasingly desperate, forcing one insurer to raise money at a very high 14 per cent. Any decline in interest rates will help these insurers to raise capital at more affordable rates. 

Then came the global equities meltdown, which reached panic proportions on Monday when US markets were closed. When the global rout continued on Tuesday, US index futures pointed to a sharply lower opening. A sharp decline in stock prices would have added the final straw on the back of a US economy on the verge of a recession.  

Having already decided to cut rates at its next meeting, the Fed advanced the announcement to contain the rout in equities. The move did surprise, mostly in terms of size as many were expecting the Fed to act after the global market decline on Monday,  which is essential to make such decisions effective.  

There are many who argue that the Fed is hopelessly behind the curve and should have cut more aggressively last year. But, they conveniently forget that the full extent of the credit crisis was not known at that point. There were enough reasons to hope that the US economy will avoid a recession this year, even if it were to slow down considerably. It was difficult to ignore inflation risks, especially when the jobs data was strong and crude oil was close to $100 a barrel.  

On hindsight, yes, the Fed could have cut more aggressively. But, that would have been a very difficult call to take at that point.  

What about 'moral hazard'?
One obvious problem with this big surprise cut is that it reinforces the belief that the Fed stands ready to bail out financial markets, whenever they are on the verge of capitulation. It is this readiness, or 'moral hazard', which endeared Alan Greenspan to the markets and now Bernanke seems to be keen to outdo his predecessor. As economist Nouriel Roubini, who has been bearish on the US economy for quite a while said, 'there was the Greenspan put, and now there is the Bernanke put'.  

Creating and reinforcing this perception is dangerous for a central bank, because its policy decisions become much more predictable. Every time markets are in trouble, the Fed will be forced to act. Predictable policies lack punch and their effectiveness is diluted. When markets become confident that the central bank will not risk ignoring their demands, complacency and the tendency to take excessive risks will naturally increase.  

The Fed's rate decisions may be driven mostly by data and its outlook for the real economy, and less so by its eagerness to indulge financial markets. But, the timing of its decisions invariably crate the impression that financial market stability is paramount for the Fed. Relentless and excessive economic and financial market analysis in the media adds to this. Invariably, some of the analysts and commentators will end up urging the Fed to take action. So, when the Fed acts, it seems as if it is yielding to those demands – even if the decision is based on sound analysis and judgement.  

Therefore, in a way, concerns about 'moral hazard' are somewhat exaggerated. Indeed, such concerns maybe unavoidable in this age of intense media scrutiny. Analysing and predicting central bank decisions is a fast growing industry and the media frenzy will only increase in future.  

The only way a central bank can quell these concerns is by consciously moving against market demands, at least a couple of times in succession. For a central bank to even contemplate such a move, real economic data should be supportive. That is unlikely to be the case when 'consensus' market expectations are likely to reflect real data. There is very little leeway for a central bank to make sound monetary policy and 'establish its credentials' at the same time. 

The big risk of the big cut
The obvious risk from such a bold cut is that it may fuel inflation. Headline inflation is not exactly comfortable at above 4 per cent, though core inflation – excluding food and energy prices – is only modestly above the Fed's so called target range. Sharp rate cuts will lead to further dollar weakness and push up prices of imported goods.  

Oil prices have corrected from record highs of last year, but are unlikely to fall substantially as summer demand kicks in. Even if the US economy slips into a recession, prices are not expected to fall more than 25 per cent from current levels. For a weak economy, $70 per barrel will still be very costly. Though point-to-point inflation will come down if oil prices decline to that level, consumers may still feel that prices are high and unaffordable. In other words, 'inflation expectations' will remain high – something which central banks are more worried about. 

At this point, it is difficult to take a call on inflation trends – though the number of economists predicting a period of stagflation – rising inflation when growth is slipping - has increased. Some even believe that inflation will rise dramatically; forcing the Fed to hike rates substantially and a long recession will follow. But, such a prognosis seems highly alarmist and unwarranted – given the available economic data. 

The Fed had to take this big decision, even with all the associated risks. It is very likely that the Fed will have to bring down rates even further. In the end, if inflation gets out of control, the Fed will face a lot of flak. All those who sing praises now will bring out the knives. But that is an occupational hazard modern central bankers have to face.


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Big Ben's hand cuts into moral hazard debate