Analyzing Fed Critic Paul Kedrosky

It was a day when many questions would be raised, and a few were actually answered.

It was a time of financial crisis, with liquidity in doubt at several financial institutions. The Bear Stearns (BSC) "bailout" is fresh in the minds of all, with many stories asking "Who is next?" The Fed rate decision was imminent and this time the answer was not known in advance. Before the opening the world would hear from Goldman Sachs (GS) and Lehman (LEH). Many expected big losses and further write-downs of financial assets.

Most of those in the financial community have turned very negative, particularly on the Fed. Since the ranks of blogging public policy analysts are so thin, we really have a minority viewpoint. Even our own loyal readers think that we are naive and clueless! (see Monday's comments).

Our Purpose

We are trying to help investors make money. This is not via specific investment advice, which we would not offer en masse, but insights about how to use the available information. This frequently means some careful analysis of prevailing investor and pundit sentiment.

Fed Critics

Readers can do their own tally of Tuesday's Fed commentators and pundits. It would seem to be tough to criticize on a day when the market had a big rally, but most of that was the result of the Lehman and Goldman reports. Let us take a typical reaction from a leading voice, Paul Kedrosky. We choose this comment not because Kedrosky is a poor analyst. Quite the opposite. Like nearly everyone else, we read Infectious Greed every day, enjoying both the breezy, wide-ranging commentary and the suggested weekend readings that highlight articles we would otherwise miss.

Having given this measure of well-deserved respect, we are going to disagree completely with his analysis and conclusions. Furthermore, we believe that Kedrosky's thinking (Is the Fed Confused, or Just Being Confusing?) is quite typical of most trader and fund manager types. He starts by criticizing both the concept of compromise and academics by writing, "Ben Bernanke has compromised, like any good academic chair should."

He continues as follows:

...(T)his strikes me as somewhat confused. Is it inflation you're worried about? Is it the financial services industry bailout? What is it? Why not get in front of the 2-year and call it a day? Why dodder around fretting about inflation if you really think you're facing a credit market meltdown? And to have two dissenters is definitely material, both citing inflation as a concern. When is the last time we had two dissenters on a Fed rate cut/increase?

Our Reactions

• The criticism of compromise makes sense only if one has a very simplistic view of government. Kedrosky, like most other critics, turns the FOMC into a unitary actor. He then expects the group consensus to reflect his personal viewpoint and to quash any dissent.
  
  Wow! Our government is pluralistic and participatory. Most institutions are structured to reflect a range of interests. The FOMC is actually much more insulated and narrow than most. Despite this, there are often genuine policy disagreements. When this happens, the resulting action reflects a compromise. In the case of the Fed, anything more than two dissents is a revolution, so there may have been serious compromising on the inflation language.
  
  We wonder why Kedrosky finds this strange. He has been a member of various corporate committees and board. Our experience (on many boards including public companies, private companies, and non-profits) is that even when the votes are unanimous, there is often bargaining to achieve consensus. The world of government is not so different from the world of business in this respect.
  
  Put another way, what is Kedrosky's approach to the lack of a consensus on the FOMC? The Chair has no power to expel members. Should we not be seeking alternative viewpoints?

• Financial services bailout. The Fed has been clear -- quite clear -- that it is treating the reduction of interest rates and the efforts to direct liquidity as two different problems. This approach is much more insightful and sophisticated than that of the average trader and pundit. They dealt with the financial issue over the weekend.

• Why not get in front of the 2-year? This is simple. The majority of the committee does not agree with Kedrosky on the economic need. It is possible that none of them do. We watched many pundits today who thought that the Fed should cut only 50 bp's. Whatever the FOMC does will be attacked by many if not most traders, pundits, columnists and managers.

• The vague objection about dissenters. We are not sure what Kedrosky thought should be done about this. These members have viewpoints that disagree with his personal notion of the best policy. The dissent is meaningful to anyone more interested in understanding and predicting Fed behavior than in commenting on what they should be doing.

Conclusion

We thought the two dissenting votes, from more hawkish regional bank presidents who happen to be in the 2008 rotation of presidents who are voting members of the FOMC, were important. Here was our comment, minutes after the decision, on RealMoney:

The FOMC meetings usually result in a consensus decision. This often means a compromise, including aspects of the policy statement. Today's action had two dissents (favoring less easing). There have been two dissents only twice in the last ten years. The last occasion was in September of 2002.

Those interested in predicting future Fed moves should take note of this. Some members probably believe that actions already taken will begin to show effects. This would be the typical six to nine-month lag.

Here is part of Tony Crescenzi's analysis from RealMoney (subscription required to get all of his worthwhile economic analysis):

While the Fed's decision was not exactly a line in the sand on inflation --- the Fed did cut the funds rate by 75 basis points, after all -- it was strong enough, especially given the two dissents, to put the U.S. dollar on better footing and threaten speculators in the commodities markets.

I expect the dollar to be buoyed and commodities to fall in response to today's action and the Fed statement, if not immediately, then in hours or days.

We agree with Crescenzi and expect the Fed to emphasize the difference between rate-cutting and directing liquidity. We continue to emphasize this fact:

Investors should focus not on pundits who opine on what the Fed should do. To profit, it is more important to understand the Fed and predict what they will do.

Comments

[Tie D]

The FRB are idiots. Thank goodness for them, that the American taxpayers are bigger idiots. The US Dollar Index traded at 76.156 less than a month ago. Due to their slash and burn policies, it was 71.198 yesterday. That is a 6.5 percent drop in the value of all US currency. Given there is about $820 billion dollars of U.S. currency in circulation, that means that $53 billion dollars in wealth was destroyed for the sake of Lehman (a $30 billion company). Once again, we all pay so that a greedy few Lehman investors don't lose their assets.

[Malkiel]

Many commentators from the financial industries are clueless about the nature of the FED and Treasury as political entities because they are trained and educated in an environment where simple-minded anti-government rhetoric reigns supreme. Everyone around them will toss off pejorative phrases like "government regulation" and "government gone wild" as unexamined truths, so everyone is excused from having to put any serious thought into what is more rightly called the "public sector" and is an integral and indelible part of the economy, even a capitalist economy.

Though the FED is quasi-independent of the Executive branch it must unfailingly consider the sentiments of Congress and the Executive when deliberating its moves. Treasury is not independent of the Executive Branch, and we saw how quickly Paulson had to snap his "no bailout" rhetoric to line up with Bushes' 180-degree turn on that subject a couple of weeks ago. Understanding the deference the FED feels it must pay to Congresses' preferences would go a long way toward understanding what priorities they will mark off in the future. This is why the commentators who talked in the Fall about holding the line with no interest rate drops were doomed to be wrong; Congress and the President were under pressure to act, so inaction was not an option, regardless of objective discussion of the effect of the action. Bernanke got it about the political nature of the FED long before any of you guys did, academic though he may be...