The Fed's announcement of a "term auction facility" [TAF] caught the market by surprise this morning, despite the advance leak of likely moves which we reported yesterday. Those unwilling or unable to trade in the off-hours market missed the big initial rally.
We think the timing of the Fed action significantly colored market reaction. Traders were justifiably unhappy over the Fed's lack of attention to the market impact.
Why the Sloppy Timing?
Traders, especially those who had stopped out positions or gone short, assigned various reasons to the Fed's timing. Some thought they were reacting to Tuesday's selling with a hastily created plan. Others emphasized the lack of attention to markets.
We think that this reads too much into the timing of the Fed policy announcements. Government organizations follow set procedures. The FOMC releases a statement that follows a pattern. It is not their normal vehicle for other announcements, so they did their standard thing.
Also, as we noted in our comments yesterday, they were probably surprised by the market reaction. They were taking an action that was in line with publicized majority expectations. James Hamilton has an especially good analysis of these expectations, with a careful look at Fed fund futures. (Hamilton's work, along with co-writer Menzie Chinn, is a consistent source of thoughtful economic reasoning).
Obviously the announcement timing could have been better coordinated. The fact that it involved several countries was a factor in making a joint announcement. The proposal was following a separate track from the interest rate cuts. It required a vote at the meeting and a coordinated press release which was actually determined a week ago.
Much of what happens in government is the result of organizations following standard procedures, not the result of some unitary planning. Traders tend to think of government action as following the reasoning and speed they would use in their own decisions. This is not realistic.
The Policy Substance
Traders, fund managers, and pundits are almost universal in their criticism of the Fed action. They would have preferred a bigger rate cut, a policy with a clear-cut interpretation and market reaction. Leading critics, including the influential media personalities Jim Cramer and Larry Kudlow, are skeptical of the Fed move. They believe that the Fed is responding in an academic fashion to real-world issues.
Should we be surprised that many astute economic observers disagree with the traders? The consensus of their thinking is that the Fed action is more targeted than a general rate cut. Here are some typical responses:
Mark Thoma writes, "The Fed has now taken another creative, and likely useful step in getting liquidity to the "choke points" outside the traditional banking system..." This is something that he has highlighted as a problem.
Felix Salmon points out the unique feature of the TAF program, that the Fed is accepting a wide range of collateral.
Steve Waldman thinks the TAF is a "really, really big deal." In widely-cited comments he points out several advantages over other bailout-style plans.
Greg Ip explains the nuts and bolts of the proposal in his typical clear and incisive fashion.
James Hamilton correctly views this as an "improved discount window" and looks at the possible effect on illiquid assets.
The Public Policy Viewpoint
There are few experts in public policy commenting on this. Since that is our sweet spot, we shall offer some observations about how government handles complex problems.
What we will see is not a coordinated master plan, but a patchwork of actions where each addresses one aspect of the problem. Different agencies are responsible for different pieces. The Paulson plan, for example, goes after one small aspect of the problem, and it does so without requiring legislation.
A few months ago the Fed attempted to encourage use of the discount window and accepted new forms of collateral. It did not work, so they are trying something else. There are some who believe that a big part of the problem is getting existing liquidity where it is needed. If the Fed plan works, it will reduce LIBOR and the TED spread. Since LIBOR affects many loans and mortgages, this would be a good result. It may also help the market for mortgage securities.
We do not know if this plan will work and neither does the Fed. Governments move incrementally, using trial and error. While we traders think of a day as a long time, government agencies have a completely different time frame. The agreement announced today probably took months to plan and negotiate. For government, that is fast work!
What We Like
There are several good features of this proposal.
It is targeted. It helps the TED spread. It gets CMO's in the market. It opens liquidity for many banks that would otherwise be closed off.
It is expandable. Some have criticized the initial size of the offerings. These will change rapidly if the facility works.
It is flexible. It can be altered or abandoned if it does not work.
It shows commitment. This innovative approach shows that the Fed is not "behind the curve." The proposal is certainly not a complete solution, but it was not intended as such. If this does not work, the Fed will try something else.
We think that the new policy might show some results in the first auctions, leading to a positive market reaction. Everyone is so negative, it is a good time to embrace the possible.