Stephen Williamson and Current Fed Behavior

 Professor Williamson, VP of the St Louis Fed said this in a comment to his blog article, to a fellow who said NeoFisherism won't work, but may result in less consumer spending and just a bidding up of assets:

Your comment illustrates the problem with what David is looking for, which is some "intuition" that will somehow convince people who are not on board with the idea. Any "intuition" that people have comes from thinking about some model that is familiar to them. In some cases, that seems to be some undergraduate IS/LM/Phillips curve model with fixed inflation expectations. In that type of model, tighter monetary policy makes the interest rate go up, spending goes down and, via a Phillips curve effect, inflation goes down. If that's your "intuition," then nothing will convince you that higher nominal interest rates make inflation go up. Checking our ideas for internal consistency involves constructing rigorous models, and trying to understand what these models have to say about the real world, and whether or not the models fit the facts as we know them. That's the level at which the convincing gets done, not in telling "intuitive" stories. I have no idea why you think the underlying assumptions behind the idea are "unrealistic," but the theory is what macroeconomists have worked on for some 40+ years - it's boilerplate.
 I responded to the Fed VP, who is willing to get to the heart of some major issues:

40 years ago, Prof, we didn't have maddening bond hoarding. We didn't have banks and counterparties fearful that a little rise in interest rates would force collateral to decline in price, causing the need to hoard even more bonds, pushing the long yields down even further.

As far as NeoFisherism is concerned, the bond hoarding is what creates the conundrum, and Greenspan said this very thing in 2007:

"To be sure, the benefits of derivatives, both to individual institutions and to the financial system and the economy as a whole, could be diminished, and financial instability could result, if the risks associated with their use are not managed effectively. Of particular importance is the management of counterparty credit risks. Risk transfer through derivatives is effective only if the parties to whom risk is transferred can perform their contractual obligations. These parties include both derivatives dealers that act as intermediaries in these markets and hedge funds and other nonbank financial entities that increasingly are the ultimate bearers of risk."

Greenspan created, IMO, too big to fail, and put the risk squarely on the counterparties and off the TBTF banks. He wanted the S&L crisis to never happen to another bank. But what he failed to understand was that risk doesn't go away, it just goes to the counterparties and the clearinghouses that demand more and more collateral for derivatives.

So, I will bet you a dollar, Prof, that any efforts to raise short rates will continue the conundrum, which is really not a conundrum at all, but is exactly what Greenspan engineered to happen.

I honestly believe the Federal Reserve Bank knows long yields cannot go up, but it is in on this tantrum behavior.

The only thing I don't quite understand is if there is a real shortage of the treasury bonds as collateral, or if there are plenty of other bonds, like corporate bonds, which can be used with a haircut. I am thinking that Greenspan's investors don't want to pay that haircut premium, which is why Greenspan is now engaged in tantrums continually, to get weak hands to get rid of their long bonds.

I am sorry if I seem cynical, but how can anyone seriously not be cynical about this system.   

The banks want a little raise in yields so they can get a boost from IOR, which is like a welfare check to them from the people.

It is the counterparties and clearinghouses that are at risk. The banks are reporting less revenue and profits yoy,  but the folks with most of the collateral are counterparties to the banks. Greenspan wanted it that way. He wanted TBTF and he got it.

Of course, the counterparties can’t provide enough collateral to the casino if the Fed raises yields. You think bonds are hoarded now. Wait till short rates are raised and you will see a massive “conundrum” of demand for long bonds. And of course, really, it is not a conundrum at all. Even Greenspan knew this and said:

To be sure, the benefits of derivatives, both to individual institutions and to the financial system and the economy as a whole, could be diminished, and financial instability could result, if the risks associated with their use are not managed effectively. Of particular importance is the management of counterparty credit risks. Risk transfer through derivatives is effective only if the parties to whom risk is transferred can perform their contractual obligations. These parties include both derivatives dealers that act as intermediaries in these markets and hedge funds and other nonbank financial entities that increasingly are the ultimate bearers of risk.

It is clear that the counterparties could undermine the stability of the financial system. The betting and trading they do is a significant portion of all trades.As George Carlin once said, the elite don't care meaning the Fed (banker to the will of elite) doesn't much care. I have become more cynical and the Fed, first mispricing risk, then being slow to save the economy did more than destroy wealth. it transferred it from mainstreet to Wall Street. It almost looks preplanned, and there is a strong case that the Fed decided to liquidate the economy so that Wall Street could consolidate financial power in the Great Recession.

But of course, creating structured finance, bond hoarding and derivatives has just boxed the Fed in. It may be comfortable with that box, thinking not much could go wrong in the new normal it seems to relish. Although I am sure it is not without worry about what could go wrong.

If you read Stephen Williamson's blog (and by the way he has been very kind in posting my comments most of the time), you will see that the mind of the Fed as revealed by Prof Williamson is technical to the core, and involves just a little tinkering with rates and minimal Fed tools. The Fed really isn't worried too much about big moves, and as long as growth is slow, they seem fine with how things are, so far. And so far is no guarantee of future Fed success!

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