Understand the Fed's Actions by Examining the Past

The First Amendment gives everyone the right to free speech and assembly. This means that it is just fine to criticize government. Especially during the last year, a favorite sport among financial pundits has been second-guessing the Fed.

Discussing policy can be fun, but it is not the road to investment returns. It is much better to study and to understand. If we pay attention, we can make some successful predictions.

Criticizing the Fed

Barry Ritholtz has some sharp words for what he calls "the Fed's Folly". He asks, "Was it a misunderstanding of their mandate, inexperience, or just plain hubris?"

He goes on to describe his personal interpretation of the Fed's mandate and characterizes the Fed move as panic. In addition, since we now all know that there was some SocGen (SCGLY.PK) selling on Monday to cover for the rogue trader, Ritholtz claims that the Fed move was unnecessary.

We would be most interested in what some of the technical experts think would have happened on Tuesday and Wednesday in the absence of Fed action. Does anyone really believe that the markets would have suddenly calmed when the rogue trader story came out two days later?

But why speculate? Let us learn what the Fed members themselves think about their dual mandate and how it is affected by "financial disruptions." That will help us to understand their actions. Two weeks ago Governor Frederic Mishkin spoke on precisely this topic. He stated as follows:

In particular, the Congress has given the Federal Reserve a specific mandate (often referred to as the dual mandate) of fostering the objectives of price stability and maximum employment. Therefore, when the economy faces a disruption in financial markets, monetary policy must aim at balancing the risks to both economic growth and inflation. In the remainder of this speech, I will elaborate a bit further about why financial market disruptions can pose significant risks to the macroeconomy. Then I will explain how the science of monetary policy can help provide a conceptual framework for a systematic approach to managing these risks, and I will briefly discuss how that framework can be useful for understanding the course of Federal Reserve policy over the past few months.

The speech gets quite technical, but the quoted paragraph is pretty clear. The Fed reacts because financial disruptions affect both parts of the mandate. It is not correct to call this a guarantee of market prices.

Inside a Fed Meeting

It will be a few years before we know exactly what the FOMC members were thinking during this week's meeting. As a substitute, let's go back to an inter-meeting rate cut in 1998, in the wake of the emerging debt crises and the Long-Term Capital Management meltdown.

Taken from the actual meeting transcript, the following are two good examples (emphasis added):

MR. MCTEER. Regarding the issue of fundamentals in the District, in the last two days I made a speech in Austin and two in Houston, to different kinds of groups. I also attended our San Antonio and our Dallas board meetings, and I have a report this morning from our Houston board meeting. In all cases people are not interested in what is going on in the real economy because everybody assumes, and I think probably correctly, that what is going on in financial markets is going to break the link between our recent and present situation in the real economy and that in the future. There is a great increase of anxiety and pessimism in our region. I don’t think that just looking at the fundamentals gets at the problem. It is all about troubled financial markets right now.

MS. MINEHAN. This is Cathy Minehan, Mr. Chairman. Let me just follow up on Tom Hoenig’s comments because, as we see things here in the First District, there is some similarity. On the downside, our large manufacturers-Gillette, Polaroid, and Raytheon--are all issuing negative notices about their current quarter earnings and planned layoffs. In the financial services industry, we have reports of some layoffs and branch closings, in Asia largely, by the Bank of Boston and of some small layoffs by Fidelity. There is an enormous amount of fear, obviously reflecting the Wall Street related concerns here in the financial community. That kind of fear tends to build on itself and it seems to be spreading beyond the financial sector, certainly through the media locally. So we are beginning to hear increasingly from nonfinancial companies about their concerns over, not just the present, but the future as well.

Readers will note that both speakers directly related the negativity in markets to future economic effects.

Fed members were also concerned about public perceptions and the resulting economic effects. They are well aware that they seem to be ready to act when needed.

MR. FERGUSON. This is Roger Ferguson speaking. ...The financial markets do seem to be showing signs of a great deal of fear and uncertainty. They seem actually to have gone beyond a state of concern and uncertainty and to have seized up in important ways. There are counterparties that no longer seem to be standing on the other side of important trades. I am fairly certain that the result will inevitably be some impact on the real economy. ... Additionally, in a period of great uncertainty, I think it is important for us to be shown in a leadership role and one in which we are prepared to be as flexible and as vigilant as the markets and circumstances in the real economy require.

These comments were from almost ten years ago, but they might have been spoken this week.

Conclusion

There is a lot of information available about the Fed including some very good books. Former governors are frequently interviewed by the

Comments

[BarryRitholtz]

You think "Price stability and maximizing employment" is my "personal interpretation of the Fed's mandate?"

Seriously? Your position is that's not the Fed's mandate? That its some kind of subjective, personal whim?

[droskoph]

Can anyone explain the blind faith in the Feds after witnessing how asleep they usually are at the helm? They're no better than the BOJ as it chased it's bubble down the economic drain. I am hard pressed to understand this misplaced culture of Fed worship as it becomes more apparent that we are on the brink of national bankrupsy.

[Jeff]

Barry - As a lawyer, you know that it is possible to make a narrow and literal interpretation, and that is what you are doing. I think my article makes it quite clear that the Fed sees market disruption as an important factor affecting the dual mandate.

I believe that you should read the article again, starting with the part with "But why speculate?"

For investors who want to profit from following the Fed, they should pay more attention to what Fed members think rather than to what you, or I, or a bunch of other pundits think they should do.