Nearly ten years ago the
Federal Open Market Committee convened a special meeting to address the
problems in U.S. financial markets regarding the failure at Long Term Capital
Management. It is not without irony that one decade later the Fed and the
U.S. Treasury are addressing an infinitely more complex problem with respect
to Fannie Mae and Freddie Mac, while at the same time contemplating the
potential failure of major investment and commercial banks.
Unlike the special meeting
that occurred over a decade ago, there is little doubt that the Fed will
remain on hold ahead of the September 16 FOMC meeting. Due to the issues with
inflation that still are at the forefront of Fed considerations, there will
be no rate cut to assuage a market still reeling due to the ongoing problems
in the financial system.
We expect that the statement
will forthrightly acknowledge the actions taken by the U.S. Treasury and
employ language regarding positive market reaction in light of the
unprecedented move by the Federal Government. The FOMC will probably seek to
place light on the narrowing in swap spreads and the decline in long-term
mortgage rates that have occurred in the aftermath of Mr. Paulson's statement
on Sunday September 7.
Without a doubt the actions
taken by the U.S. Treasury will provide a major subject for discussion either
in the formal meeting or any prospective special meeting that the statement
may announce. The systemic risk posed by the issues at Fannie and Freddie are
such that we went back and examined the transcript from the October 15, 1998
meeting surrounding the problems at Long Term Capital Management to ascertain
the possible shape of the upcoming statement and the ensuing minutes to the
meeting that will be released on October 7.
In that meeting committee
members had a three primary concerns that provide an eerie parallel to the
current crisis. First the committee was primarily concerned about a potential
spillover of instability into the non-financial community. Like today, fear
and uncertainty in the markets prevailed.
Second, the committee was
concerned with major problems at other banks that were not acknowledged.
William McDonough, who was the head of the NY Fed at that time openly,
wondered if there were "skeletons still rattling around in the closets
that have not been revealed."
Third, the committee was
concerned with the issue of moral hazard caused by the bailout.
We think that this provides a
good frame or reference in which to evaluate the upcoming FOMC statement. One
year into the domestic financial crisis, the market has only observed partial
spillover into the greater non-financial community that has largely been
responsible for keeping the economy afloat during the crisis. And it is quite
clear that many of the financial players singed by the heat from the meltdown
in the housing industry have yet to come clean and mark to market their
losses.
Given that the financial
industry continues to access "temporary credit facilities" at the
Fed we would not be surprised to see in a few years when the transcripts for
this meeting are released if the committee is found to be considering opening
access to such facilities to the non-financial community.
Our Senior Economic Advisor
William Poole has made a very persuasive case that the Fed has inadequately
defined the post Fannie and Freddie financial world. Concerns over moral
hazard still prevail. After saving Bear Stearns we wonder if the Fed might be
tempted to say yes, should a large auto company, a large insurance company or
a major metropolitan area suddenly need emergency financing. We believe that these
are but a few of the ideas behind the interesting discussion taking place in
markets regarding the credit quality of the United States.
Thus, we anticipate that the
committee will utilize language reinforce its intent to provide adequate
liquidity should conditions in the market change in the aftermath of the
action taken by the U.S. Treasury.
The committee should note the
deceleration in economic activity in the context of weak labor markets and
the ongoing stress in financial markets. The statement should retain language
regarding the efficacy of past monetary policy with respect to fostering
market liquidity and moderate economic growth.
We expect that the committee
will note the recent decline in the prices of energy and some commodities,
while reaffirming their expectation that inflation will moderate later this
year, although that outlook will remain highly uncertain.
The assessment of risks should
remain balanced between risk and growth. Even with the basic Taylor Rule
implying that monetary policy remains accommodative by at least 150 basis
points, the Fed will continue to hold rates steady as it modestly attempts to
reduce the money supply after a long period of accommodation.
