Bankerpalooza (31 August 2007)

The annual conference of central bankers is about to begin in Jackson Hole, Wyoming -- an always exciting academic elucidation of macroeconomic research. If central bankers were indie rockers, this would be Bankerpalooza. This year it's attracting more attention than usual because the turbulent credit markets have crept out of their hiding spot deep in the financial section and made it to the front page, making collateralized debt obligations and asset-backed commercial paper into household words. (Okay, well, not really; but for business-press addicts, it has.) Observers have been especially eager to hear Bernanke give this speech about the what more the Fed might do to ameliorate conditions in the debt market. Will it risk generating moral hazard and bail out the financiers with a fed-funds rate cut?

When I used to study literature, my fellow graduate students and I would make a big deal about the centrality of language to experience and how much hung in the balance in the close reading of texts and in the teasing out of every possible nuance of words forged in the crucible of the author's intentions and the audience's expectations. But even while I was making those arguments, I never quite believed them; I didn't really think these skills had any bearing on real life -- they were just an elaborate way to try to justify spending one's time, say, reading Trollope novels without feeling like an idler. But it turns out that the skills weren't worthless; I was just reading the wrong sort of material. Clearly, careful parsing of the Fed's utterances leads to significant economic consequences. Millions of dollars are made or lost on these interpretations and how they play out on the market, as in what happened two days ago when Bernanke wrote a letter to Senator Chuck Schumer of New York. The Fed's language fashions economic realities, the way we always insisted Emily Brontë's shaped perceptions of gender in Victorian England or whatever. Only in the Fed's case, there's direct empirical evidence to support the claim. Not that those analyses of literature are superfluous or wrong; it's just that I personally wish I would have realized that analytical skills could be more profitably employed outside of English departments, on matters more pressing and more widely consequential than just what Thomas Grey might have meant when he was writing poems in the 18th century about his cat.

In the speech, Bernanke attempts a middle course, with a great deal of hedged language about future actions. These are the key paragraphs:

It is not the responsibility of the Federal Reserve -- nor would it be appropriate -- to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy. In a statement issued simultaneously with the discount window announcement, the FOMC indicated that the deterioration in financial market conditions and the tightening of credit since its August 7 meeting had appreciably increased the downside risks to growth. In particular, the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally.
The incoming data indicate that the economy continued to expand at a moderate pace into the summer, despite the sharp correction in the housing sector. However, in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country. Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers to manage the risks to their growth and price stability objectives. The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.

The first sentence declares the Fed's intention to forestall moral hazard; if risk has no consequences, then markets don't work properly. Risk was in danger of becoming meaningless, with investors treating credit markets as a perpetual-profit-making machine. Those looking for better yield had to assume larger risks (subprime loans hidden in AAA tranches of CDOs) at higher leverage. That's no longer true; spreads between risky and safe investments have widened again. As Bernanke says earlier in the speech, "Some increase in the premiums that investors require to take risk is probably a healthy development on the whole, as these premiums have been exceptionally low for some time."

But after that celebration of risk qua risk, he drifts into a fog of prognostication: past data will be "less useful than usual" and they will look instead to the unmentioned "timeliest indicators" and the unreported advice from unnamed "business and banking contacts." Then they will "act as needed." Apparently, that promise has been enough to comfort Wall Street: stocks on the Dow and the S&P 500 are up more than 1 percent so far today. But isn't that because the statement is vague enough that congenitally optimistic investors can read into it what they want to hear? Consider the typical headline (this one from Reuters): "Bernanke: Fed Ready to Act if Turmoil Hits Economy". This is not exactly news; this is the Fed's mandate. Presenting it as news, though, can do wonders for day traders.