S Timid Fed And Jeremy Stein And Potholes

The Timid Fed, trying to muster the fortitude to raise interest rates by a measly .25 percent, does not listen to Harvard Professor Jeremy Stein. Before getting into Jeffrey P. Snider's examination of Professor Stein and shortages of collateral, it would be good to see some of the things Dr. Stein was proposing as a help to the real economy, through his research at the Federal Reserve.

Stein retired from the Fed, and he gave this assessment upon his exit from the institution:

If your only real concern is monetary policy implementation and controlling rates, I think then there’s lots of ways you can do it.

For example, suppose the RRP rate is 5 basis points and it’s creating a pretty tight floor at five. Meanwhile the interest on reserves is 25 basis points, so the federal funds rate is going to be between 5 and 25.

Now, suppose you wanted to raise rates a lot. One thing that would work perfectly well is to raise both of these things by 200 basis points. The fed funds rate would still be somewhere in the middle.

Professor Stein first appears heroic in his desire to see rates raised by 200 basis points. His focus of research reflects his concern about the real economy more than about the derivatives economy. Prof Stein acknowledged what Kevin Erdmann has been saying, that during the Great Recession, there were not enough treasury bills in the Fed's war chest. Kevin goes on to say that this forced the Fed to terminate subprime, even the good subprime.

Stein said this:

If you think of financial stability policy, and some of the problems that we had leading up to the crisis, it was the search for safe assets. There weren’t enough T-bills so money funds went around searching for things that look like T-bills. If the government won’t make safe assets, then the private sector will make things that resemble safe assets, such as broker dealer repo, hedge fund repo, asset-backed commercial paper. [Emphasis mine]

My argument was that the Fed should have bought commercial paper way earlier than it did, as that market, which funded subprime, cratered in August 2007. Certainly, one would hope that if more paper of any kind is created, and considered safe assets, that the Fed would act as the lender of last resort, not waiting for the middle class to lose their assets while the Fed fiddles around. Many subprime loans were soundly underwritten.

It seems to me that creation of private, safe, assets is a superior exercise than fiscal deficit spending that could put the government at risk, all to give banks more of the new gold, UST's. 

I am not sure Stein is on board with the Fed being lender of last resort, saying everyone should not run to the Fed. He is likely talking about avoiding creation of safe assets that turn out to be not so safe, like many MBSes of the hurtful housing bubble which led to the Great Recession.

But damage can be done to the real economy when the Fed is not the lender of last resort. Stein seems to be a procyclical kind of guy, and that doesn't help much in times of trouble.

But the professor is clear about one thing, that the Fed should pay less attention to treasury bond holders than to the real economy.  He said:

“Society would be better off appointing a central banker who cares less about the bond market...”

But then Stein ruins this entire concept, turning less than heroic, by saying, along with his research partner, Adi Sunderam:

“We do not believe our model has much advice to give with respect to the near-term question of how rapidly the Fed should lift rates in the months following its liftoff from the zero lower bound,” they write. “It may be something that is better undertaken over a longer horizon, or at a time when the economy is in a less fragile state.”

So, when is this fragility expected to end? Truth is, readers, the economy is slow, but I believe it is far less fragile than the derivatives market. In other words, Stein is quite aware of the shortage of treasury bonds, of collateral for derivatives, that are hoarded. He wants that shortage situation relieved with private paper creation more than he wants rates raised by any significant amount.

The Fed is stuck in timidity. The contrarian researcher, Stein, who stirred the pot for main street's needs, admits it. And the Fed is happy to be stuck because the Fed apparently either is giving up and is moving toward negative rates, or it thinks it has put an end to the business cycle and we will never have recessions again. What else are we to think? Those are the two goals spoken of from time to time in the financial media. Stein is likely one of the sharpest tools in the shed, and if he cannot figure out a way to grow the economy without hurting collateral starved bond hoarders, er I mean bond holders, nobody can.

Jeremy Stein was also mentioned by Jeffrey P Snider on an article he posted on Talkmarkets, entitled Still Talking Collateral and Implying Shortage.

In that article, Jeffrey shares some very interesting charts regarding repo collateral fails. He indicates that since the toxic bonds are off the banks' balance sheets, these repo fails prove that there are shortages of said collateral. These repo transactions are anchored by UST's and by sound MBSes, so the fails indicate shortages.

But one thing is for sure, the creation of private, secure, asset-backed private paper facilitates more good derivative behavior and more bad derivative behavior. But it would be nice if someday, fewer treasury bonds would be needed for use as collateral so that their price action would reflect traditional values before derivatives became such a huge part of big finance.

And we hope that bad derivatives behavior and counterparty weakness, a worry of Alan Greenspan, won't come down on the small progress we have made in growing the real economy. And, lest the Fed become too complacent about the real economy, it seems obvious that there is loose money, easy money within the financial system and relatively tight money at the level of the real economy.

That tightness in the real economy could undermine the casino, home of the good and bad derivatives. Weak counterparties often have to do real business in the real economy. The Fed should think of Jeremy Stein once in awhile, as he at least made an attempt to make the Fed relative to MainStreet, and remember, those weak counterparties to the banks could come back to rattle the entire system.

I am not a big fan of the New York Post, but these signs listed from author Michael Gray are worth watching, to see if the Fed really knows what it is doing, or ever will know again. If your pothole is being fixed that is a good sign, but if not, one has to wonder about a slow decline in the real economy. So far, restaurants in Las Vegas seem to be holding on, but the decline in road quality since I moved to the city is a red flag. It is a mixed bag, as the economy is not in recession, but GDP needs to accelerate going forward. 

Disclosure: I am not an investment counselor nor am I an attorney so my views are not to be considered investment advice.

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