Tuesday, December 13, 2016

Why We Shouldn't Trust the Federal Reserve

Updated March 2017

While the financial world sits on pins and needles waiting for the next economic pronouncement from the world's most influential central bank, the Federal Reserve, one has to wonder how truthful and insightful the statements coming from the Fed's leadership really is and if it can be counted on to give us an accurate understanding of where the economy is headed.  A paper by Mark Thornton at the Ludwig von Mises Institute entitled "Transparency or Deception: What the Fed Was Saying in 2007" gives us a glimpse into how the Fed publicly handles "truthiness" by looking back at the communications from the Federal Reserve during late 2006 and early 2007, one year before the beginning of the financial crisis.  While I realize that this posting is rather lengthy because of the quotes from Federal Reserve "management", they are necessary to gain a better understanding of how we were duped by our monetary policy masters.  My apologies.

Let's open by looking at this graphic from the Fed's own database showing the how the Great Recession evolved using the year-over-year change in real gross  domestic product:

As you can see, the economy as a whole began to contract in the last quarter of 2007 and first quarter of 2008.

Here is a graphic showing what happened to the median sales price of houses in the United States over the same timeframe:

Obviously, the decline in house prices really took hold in late 2006 - early 2007, one year prior to the economic contraction of the Great Recession.

Now, let's look at Mark Thorton's paper, keeping in mind that there is extensive empirical evidence that pronouncements by central banks do have significant impacts on both the bond and stock markets and that, in the words of the author:

"Central banking is a confidence game. The Federal Reserve runs a monetary system where money has no traditional backing, such as gold or silver. It runs a banking system that has, until the housing bubble-financial crisis, had no reserves to back deposits, other than drawer money....The Federal Reserve seeks to maintain our confidence in its system and to encourage people to not take proper precautions against the negative effects of its policies. Printing up money and lowering the value of dollar-denominated assets while simultaneously providing benefits to special interest groups is a deception that is a major part of the confidence game."

In other words, this means that the Federal Reserve needs to maintain our confidence in itself and in the economy as a whole.  As such, you will very rarely see a Federal Reserve official who is bearish about the economy, other than an occasional dissenting member or low level publishing, in-house economist  It is most important to remember that in the Fed's cloistered world, the "economy always looks good, if not great".  If you think otherwise, fear not, for the great minds at the Federal Reserve will come to your rescue by "printing money" and easing credit.

Now, let's look at some examples of how Ben Bernanke, Chairman of the Federal Reserve before, during and after the Great Recession, handled us over the period between late 2006 when the housing market began to collapse on itself and early 2008 when the U.S. economy officially entered recession and the American banking sector nearly imploded.  When reading these comments from the mouth of the world's most influential central banker, please keep in mind that he has enormous resources at his disposal including thousands of economists and data on every aspect of the American economy.

1.) In a speech to the Annual Meeting of the Allied Social Science Association on January 5, 2007, here's what Mr. Bernanke had to say about how the Federal Reserve supervised the American banking system:  

"Finally, many large banking organizations are sophisticated participants in financial markets, including the markets for derivatives and securitized assets. In monitoring and analyzing the activities of these banks, the Fed obtains valuable information about trends and current developments in these markets. Together with the knowledge obtained through its monetary-policy and payments activities, information gained through its supervisory activities gives the Fed an exceptionally broad and deep understanding of developments in financial markets and financial institutions....

In its capacity as a bank supervisor, the Fed can obtain detailed information from these institutions about their operations and risk-management practices and can take action as needed to address risks and deficiencies. The Fed is also either the direct or umbrella supervisor of several large commercial banks that are critical to the payments system through their clearing and settlement activities....

I have described several ways in which the Fed’s supervisory authority assists it in performing its other functions. In my view, however, the greatest external benefits of the Fed’s supervisory activities are those related to the institution’s role in preventing and managing financial crises."

Basically, Mr. Bernanke was assuring us that the Federal Reserve knew everything about the market and the banking system yet, as we found out by early 2008, that system was built on the proverbial foundation of sand and the Fed was nearly powerless to prevent the crisis

2.) In a speech to the National Italian American Foundation on November 28, 2006, here's what Mr. Bernanke had to say about the already deteriorating U.S. housing market:

"No real or financial asset can be counted upon to pay a higher risk-adjusted return than other assets year after year, and housing is no exception. Thus, a slowing in the pace of house-price appreciation was inevitable. Moreover, the sustained rise in prices, together with some increase in mortgage interest rates, sowed the seeds of the correction by making housing progressively less affordable. Declining affordability ultimately served to limit the demand for housing, leading to a deceleration in house prices and slowing home purchases....

The timeliest data on house prices do not fully account for changes in the composition of home sales by location, size, and other characteristics. Moreover, the data do not capture hidden price cuts, as when builders try to stimulate sales through the use of "sweeteners" such as paying the customer's mortgage points or upgrading features of the house at no additional cost. Nevertheless, there can be little doubt that the rate of home-price appreciation has slowed significantly for the nation as whole. Some areas have continued to experience gains--albeit smaller ones than before--while other markets have seen outright price declines....

Although residential construction continues to sag, some indications suggest that the rate of home purchase may be stabilizing, perhaps in response to modest declines in mortgage interest rates over the past few months and lower prices in some markets. Sales of new homes ticked up in August and increased a bit further in September. The University of Michigan's survey of consumers shows an increase in the share of respondents who believe that now is a good time to buy a home, from 57 percent in September to 67 percent in November. Meanwhile, an index of applications for mortgages for home purchases has been trending up since July. Although these developments are encouraging, we should keep in mind that even if demand stabilizes in its current range, reducing the inventory of unsold homes to more normal levels will likely involve further adjustments in production. The slowing pace of residential construction is likely to be a drag on economic growth into next year."

No further comment needed.

Let's now look at some comments from Fred Mishkin, a governor of the Federal Reserve Board.  On a speech given at the Forecaster's Club on January 17, 2007 he said the following about the state of the U.S. housing market and whether an asset bubble had developed:

"Over the past ten years, we have seen extraordinary run-ups in house prices. From 1996 to the present, nominal house prices in the United States have doubled, rising at a 7-1/4 percent annual rate.  Over the past five years, the rise even accelerated to an annual average increase of 8-3/4 percent. This phenomenon has not been restricted to the United States but has occurred around the world. For example, Australia, Denmark, France, Ireland, New Zealand, Spain, Sweden, and the United Kingdom have had even higher rates of house price appreciation in recent years.

Although increases in house price have recently moderated in some countries, they still are very high relative to rents. Furthermore, with the exception of Germany and Japan, the ratios of house prices to disposable income in many countries are greater than what would have been predicted on the basis of their trends. Because prices of homes, like other asset prices, are inherently forward looking, it is extremely hard to say whether they are above their fundamental value. Nevertheless, when asset prices increase explosively, concern always arises that a bubble may be developing and that its bursting might lead to a sharp fall in prices that could severely damage the economy. 

This concern has led to an active debate among monetary policy makers around the world on the appropriate reaction to the run-ups in house prices that we have recently seen in many markets: Should central banks raise interest rates? And how should they prepare themselves to react if housing prices decline?

There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability. House prices are far less volatile than stock prices, outright declines after a run-up are not the norm, and declines that do occur are typically relatively small. The loan-to-value ratio for residential mortgages is usually substantially below 1, both because the initial loan is less than the value of the house and because, in conventional mortgages, loan-to-value ratios decline over the life of the loan. Hence, declines in home prices are far less likely to cause losses to financial institutions, default rates on residential mortgages typically are low, and recovery rates on foreclosures are high. Not surprisingly, declines in home prices generally have not led to financial instability. The financial instability that many countries experienced in the 1990s, including Japan, was caused by bad loans that resulted from declines in commercial property prices and not declines in home prices. In the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble."

Again, no further comment needed.

Lastly, let's look at some comments from Federal Reserve Vice Chairman, Donald Kohn, from a speech given at the Exchequer Club Luncheon on February 21, 2007 on the subject of managing financial crises:

"In such a world, it would be imprudent to rule out sharp movements in asset prices and a deterioration in market liquidity that would test the resiliency of market infrastructure and financial institutions. 

While these factors have stimulated interest in both crisis deterrence and crisis management, the development of financial markets has also increased the resiliency of the financial system.  Indeed, U.S. financial markets have proved to be notably robust during some significant recent shocks, such as the sharp decline in equity prices beginning in 2000 and the failure of some large firms, including Enron and Amaranth.  New computing and telecommunications technologies, along with the removal of legal and regulatory barriers to entry have heightened competition among a wider variety of institutions and made the allocation of funds from savers to investors more efficient.  Technology also has helped financial market participants better understand the risks embedded in assets and develop instruments and systems for managing those risks, both individually and on a portfolio basis.  Together, these developments have allowed suppliers and demanders of funds and the intermediaries that stand between them to diversify their risk exposures, reduce their vulnerability to sector- or region-specific shocks, and become far less dependent on specific service providers.  In short, market developments that have altered the character and transmission of financial shocks have at the same time spread risks more widely among a greater number and broader range of market participants and given them the tools to better manage those risks."

And, once again, no further comment is needed.            

Obviously, pronouncements from the world's most influential central bank can have significant impacts on investors around the globe; this is particularly important in the cases of Mr. Bernanke, Ms. Yellen and a plethora of leaders currently calling the Federal Reserve "home".  Being able to trust those pronouncements is key to maintaining confidence in the world's financial markets, particularly in this time of unprecedented central bank intervention.  Obviously, no one expects that central bankers can provide forecasts with 100 percent accuracy about the future of the economy, particularly given that economics is more art than science.

Let's close this posting with the closing paragraph from Mark Thornton's paper:

"However, all this evidence does not rule out the other explanations for their behavior. They could be just incompetent; they could genuinely think they are acting in the public interest, or it might not be humanly possible to run such a monetary system and they were just hoping that unwarranted confidence could save all of us from a genuine disaster."

I could not have said it better myself.  For some reason, when it comes to paying heed to comments from central bankers, the words caveat emptor come to mind.

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