ECB, After Hard Birth,
Comes of Age in Crisis

Europe Bank Gets Points
For First-Response Role;
War Games in Frankfurt

By JOELLEN PERRY, WSJ, Nov 6, 2007.

FRANKFURT -- At 12:32 p.m. on Thursday, Aug. 9, just past its ninth birthday, the European Central Bank grew up.

The summer's mounting financial crisis, sparked by rising defaults on U.S. subprime mortgages, had fully crossed the Atlantic that morning. European banks feared their counterparts were exposed to risky investments linked to these mortgages, and became unusually reluctant to lend to each other. Financial institutions were paralyzed.

Tasked with stopping such a meltdown was the European Central Bank, which sets monetary policy for 13 countries from Ireland to Greece. The institution has been dogged since inception by criticisms that it valued consensus over decisiveness. Early on, it had been called slow-footed, disorganized and prone to miscommunicating its intentions.

But that day, the ECB swooped to the rescue. The bank offered unlimited overnight loans at its policy rate of 4%. By day's end, it had lent €94.8 billion -- about $131 billion -- which was more than it had put into money markets the day after Sept. 11, 2001. The first response by a major central bank to the summer's crisis, it stunned markets for its size. It also surprised counterparts at the U.S. Federal Reserve, who followed the ECB's injection with a smaller $24 billion one of their own later that day.

Observers credit the ECB and its head, Jean-Claude Trichet, with making a trenchant decision that calmed markets. The move shored up confidence in the bank's ability to keep markets functioning for the U.S. dollar's most significant rival. With its boosted credibility, the ECB could enhance the euro's standing in world markets. Continued confidence in the currency could ultimately come at the expense of the dollar, the current favorite of big world investors thanks in part to the size, liquidity and stability of U.S. markets.

"There were always worries that the ECB would be a stereotypical European institution, slow to decide and going off in multiple directions at once," says Adam Posen of the Peterson Institute for International Economics, a Washington think tank. "Mr. Trichet has put that to rest in this situation."

The ECB now faces fresh challenges. Global stock markets are swooning as the credit-market fallout deepens, with big write-downs and CEO departures at Citigroup Inc. and Merrill Lynch & Co. spurring fears that other banks could post more big losses. European bank shares fell yesterday, helping to bring down major indexes. And, as in the U.S. and United Kingdom, the gap between the rates euro-zone institutions charge each other for longer-term loans and the ECB's target rate remains unusually wide, suggesting markets remain tense.

A FORMER BANKER COMMENTS

"When 9/11 happened, there was some skepticism that we weren't prepared, because we were too new. We knew we could do it, but we had no track record. I think the ECB has done a perfect job."
-- Read more from former ECB board member Otmar Issing's interview with The Wall Street Journal.

This complicates the picture for ECB policy makers, who meet Thursday. Prior to the summer's credit-market unrest, robust euro-zone growth had the bank set for at least one more interest-rate rise this year. Now policy makers are caught between worries that inflation pressures are building, while the economy has yet to feel the full effect of credit-market turmoil, bank-sector write-offs and the euro's surge. In contrast to the Fed, which has cut rates by 3/4 of a percentage point since September, the ECB is likely to keep its key rate on hold Thursday. Investors see a protracted pause, but some policy makers have said the rate still could rise.

A portrait of the ECB's August response to the financial crisis emerges from documents, public statements and people familiar with the bank's workings. The ECB had been primed for a liquidity lockup, running Pentagon-style war games with such scenarios as early as April 2005. Its president, long-time French central banker Mr. Trichet, had warned loudly that investors were underestimating the danger of risky holdings. After market tremors earlier in the summer, ECB staffers who monitor markets were on high alert.

Some observers criticized the ECB for inciting panic with its intervention, saying the scope of its response suggested the bank was bracing for a catastrophe. A few still say the ECB overreacted, arguing that the offer of unlimited funds at the ECB's target rate -- the central-bank equivalent of a fire sale -- rewarded the type of risky investments that spurred the subprime debacle to start with.

The ECB still has vulnerabilities, of course, as separate events over the past three months have demonstrated. A communication gaffe by the bank left financial markets confused for days in mid-August about whether the ECB intended to raise rates. A fragmented system of bank supervision left it without detailed information about bank balance sheets at a moment of crisis. And it faces persistent sniping from politicians as it refuses to restrain a rise in the euro on foreign-exchange markets that is provoking yelps from some exporters.

Derided From Start

The ECB was established on June 1, 1998. Critics derided the institution as unworkable from the start. To shore up credibility, the ECB modeled itself after Germany's inflation-phobic Bundesbank. Like the U.S. Federal Reserve, the ECB sets a target for interest rates on overnight loans between banks. But unlike the Fed, whose dual mandate makes it attentive to both inflation and growth, the ECB's prime focus is on keeping prices stable. It aims to keep inflation at just under 2% in the 13 countries that now share the euro currency.

The ECB's rate-setting body includes the six members of its Executive Board, who oversee the bank's day-to-day operations, plus the 13 heads of the euro-zone's national central banks. Rather than voting on interest-rate decisions and publishing the minutes of their meetings, as Fed officials do, the ECB's 19 Governing Council members make decisions by consensus. The bank explains its thinking in a news conference after each decision.

The euro debuted with fanfare, and an initial value of $1.17, in 1999. Although the ECB's primary focus is inflation, not the exchange rate, a falling currency can be read as a market vote of no-confidence in an economy and its managers. Over the next 22 months, amid scattershot communication from ECB policy makers, the euro deteriorated to 83 cents.

The bank's now-deceased first president, Wim Duisenberg, initially reinforced the perception of disorganization. Although he had been an accomplished former Dutch central-bank head, the lanky policy maker with a mop of white hair became known at the ECB for a colloquial candor, uncommon in central-banking circles, that repeatedly steered markets the wrong way. British tabloids dubbed him "Dim Wim."

War Games

Since late 2003, the ECB's public face has been Mr. Trichet. A poetry buff who studied economics and mining engineering, the 64-year-old Mr. Trichet is long on practical experience, from the French Treasury to the World Bank. He was president of the Paris Club of creditor nations from 1985 to 1993, an era in which Latin American, African and Russian debts were restructured, and head of the French central bank for a decade.

By 2005, the ECB was preparing for potential market chaos. That April, at its 37-story glass-and-metal headquarters in Frankfurt, 65 participants spent two and half days in exercises aimed at honing their response to a future crisis. About a year later, some 150 people took part in a conference from their home countries to play out shocks to the financial system. In 40 teleconference calls over half a week, the group responded to various scenarios, including a prescient case in which banks sought emergency loans but policy makers didn't know whether the banks were solvent. Top policy makers were barraged by rumors, sometimes contradictory, and by actors playing inquisitive journalists.

The real thing arrived this summer. For months, U.S. homeowners with subprime mortgages -- high-interest loans extended to high-risk borrowers -- had been defaulting in rising numbers. Investors who had bought opaque securities backed by these mortgages ran into trouble as the securities became difficult to value and thus potentially hard to trade.

By late July, there were mounting clues that continental European banks were vulnerable. On July 27, the little-known German IKB Deutsche Industriebank AG revealed it had major exposure to the U.S. subprime-mortgage market, prompting an emergency weekend €3.5 billion bailout organized by Germany's financial regulator, with contributions from major German banks.

Markets lurched into early August. Even as European business slowed for vacation, the ECB's team of market monitors -- usually about 15 people, whittled to around a dozen because of vacations -- was on alert. Working on the second floor of the bank's high-rise, the team watches everything from global stock-exchange movements to copper prices.

Some five members of the team monitor money-market rates, the interest banks charge each other for loans. In the afternoon of Tuesday, Aug. 7, rates on loans ranging from overnight to a year started rising. This was puzzling: Just that morning, the ECB had conducted its regular weekly refinancing operations. That should have provided banks with enough cash to last them the week -- and, by extension, kept the rates between banks relatively flat.

In phone calls with the market monitors, commercial bank treasurers confirmed their banks were antsy.

Wednesday brought more jitters. Though the ECB had set its target rate at 4%, overnight money-market rates continued rising above that. Investors were fleeing to havens such as two-year German government bonds. Data showed commercial banks' reserves with the central bank had fallen, another sign that banks might be hoarding cash.

U.S. VS. EURO ZONE

Projected 2007 GDP*:
U.S.: $13.794 trillion
Euro zone: $11.905 trillion

Unemployment:
U.S.: 4.7% (October)
Euro zone: 7.3% (September)

Consumer prices, growth from year earlier:
U.S.: 2.8% (September)
Euro zone: 2.6% (October)

Current account deficit as % of GDP, second quarter:
U.S.: 5.5%
Euro zone: 0.1%

Population, 2006
U.S.: 299.4 million
Euro zone: 316.7 million**

*Converted to U.S. dollars at current rate.
**Includes population of Slovenia, admitted to the euro zone Jan. 1, 2007.

Sources: IMF World Economic Outlook database, Eurostat, Bureau of Labor Statistics, Commerce Department, U.S. Census

By Wednesday evening, staffers had suggested that the six-member Executive Board consider taking the unusual step of injecting cash to restore calm. By then, Mr. Trichet and Lucas Papademos, the ECB's vice president, were in touch with U.S. Fed governors.

The ECB prefers to stage major interventions before noon, when commercial-bank treasurers are sure to be at their desks. The bank decided to wait until the morning and act if markets were still tense.

They were. At 8:30 a.m. on Thursday, Aug. 9, major French bank BNP Paribas announced it was suspending withdrawals from three investment funds because it couldn't value them amid the subprime crisis. Rumors flew that other banks were in trouble.

"I've never experienced anything like it," says Christoph Rieger, interest-rate strategist at Dresdner Kleinwort in Frankfurt. The fear "ground the market to a halt."

Extraordinary Tension

Interest rates on overnight loans between European banks soared. Typically, market monitors snap to attention if the overnight rate moves a few hundredths of a point away from the bank's policy rate. Now, rates hit 4.7%, far above the ECB's 4% target, signaling extraordinary tension.

Convening at 8:45 a.m., the ECB liquidity group decided to recommend intervening that morning and taking the unprecedented step of pre-announcing that the bank would honor every bid it received. To send a clear signal that the bank was covering the market's back, the committee settled on offering funds at the bank's 4% policy rate rather than a variable rate or a higher penalty rate. Taken together, the moves would show the ECB just how high the demand for cash was, because banks, in principle, would bid for exactly what they felt they needed. The ECB could use the information to judge future injections more accurately.

The six Executive Board members approved the move within 90 minutes.

At 10:26 a.m., the bank told markets it stood "ready to act." At 12:32 p.m., it flashed its decision on trading screens across the euro zone. The notice said the ECB would accept bids for funds until 1:05 p.m. Response was immediate. At 2 p.m., the ECB publicized the total take of €94.8 billion. The overnight rate fell back down to around 4%. In subsequent days and weeks, the ECB continued to add funds to money markets to keep the market liquid.

But challenges continued to arise, in part because the ECB doesn't have detailed insight into the euro zone's banks. While the Fed effectively supervises most of the biggest U.S. banks and has access to detailed information on these banks' books, the ECB cedes banking supervision to each member country.

Days after its Aug. 9 fund injection, the central bank sent commercial-bank supervisors across the euro zone a questionnaire asking about their subprime exposure. The basic question: Were banks basically sound and just having a problem with short-term liquidity? Or were some of them in deeper trouble?

Some responses were returned quickly and fully. Others came back late or without sufficient numbers. In the end, the ECB learned enough to be confident that banks were sound. But some people in and out of the ECB are unsure that the bank would get the information it needs in a bigger crisis.

In the following weeks, another old ECB problem resurfaced -- communicating intentions clearly to the market. Mr. Trichet had been getting high marks for predictability, but that changed on Aug. 22.

On the back of the ECB's continuing cash injections, overnight lending rates had fallen back to around the 4% target. But three-month interbank rates still hovered around 4.7%, a sign that banks were reluctant to lend to each other for longer periods.

At 3:34 p.m. that day, the ECB released a surprise statement saying it would hold an auction the following day, accepting bids for €40 billion in extra three-month funds. Markets greeted the announcement with relief. But the statement's last sentence caused confusion. "The position of the Governing Council of the ECB on its monetary policy stance was expressed by its president on 2 August 2007," it read.

That was a reference to a briefing held by Mr. Trichet weeks earlier, at which he indicated that the bank, at the time, was inclined to raise short-term rates at its next meeting on Sept. 6. In the intervening turmoil, however, markets had steadily revised down expectations of an ECB interest-rate rise. The late August statement seemed to put a hike back in play.

"To say markets didn't know how to interpret it is putting it mildly," says Dresdner Kleinwort's Mr. Rieger.

Crossed Signals

The communication problem was compounded two days later, on Aug. 24. Anonymous sources at several national central banks leaked word to Reuters that markets had misinterpreted the sentence about the ECB's monetary-policy intentions: ECB policy makers were not set on raising rates. Speaking in Budapest a few days later, Mr. Trichet intervened to clarify the message, essentially telling markets that policy makers hadn't decided whether to move rates.

On Sept. 6, the bank kept its policy rate unchanged at 4%.

Observers say that while the bank proved its chops with its early August moves, it still has room to master the subtle art of communicating its intent. "It's as important as moving rates well," says Luigi Buttiglione, a former Bank of Italy economist, now with New York-based investment fund Fortress Investment Group in London, who praised the August intervention. "You not only have to do the right thing, but you have to explain why this is the right thing. If you're not able to do that, then markets can take a different direction -- and you can achieve the opposite result."

Gulf States and the Dollar Link

Andrew Critchlow, WSJ:

PEGGED DOWN

• The News: Saudi Arabia, the United Arab Emirates, Qatar, Kuwait and Bahrain followed the Fed's decision to cut interest rates by a quarter percentage point.
• Background: The Gulf states' exchange rates are pegged to the dollar, whose decline has diluted the benefit of record oil prices.
• What's Next: Rampant inflation in the region has increased pressure, particularly on the U.A.E., to sever ties with the dollar, which could further add to the dollar's woes.


DUBAI, United Arab Emirates -- Oil-rich Arab sheikdoms, risking new inflation pressure, followed the U.S. Federal Reserve's lead by lowering official interest rates to keep their currencies aligned with the dollar.

Saudi Arabia, the United Arab Emirates, Qatar, Kuwait and Bahrain followed the Fed's decision to cut interest rates by a quarter percentage point.

Because their exchange rates are pegged to the dollar in fixed trading ranges, monetary policy in the Persian Gulf states must mirror U.S. moves to avoid pressures from capital drifting to the currency with the most favorable interest rates.

The moves came despite concerns over rampant inflation in the region, which suggest central banks should be raising, instead of lowering, rates. Bankers said the policy conflict is building pressure on the Gulf states to unbind from the dollar.

In European emerging markets, meanwhile, the Central Bank of Iceland raised its key rate 0.45 percentage point to a record 13.75% in an effort to slow annual inflation, running at a 4.5% rate, down closer to its 2.5% target rate. It was the 19th time since 2004 that the Icelandic central bank has raised rates to keep its economy from overheating. The Romanian central bank Wednesday raised its key rate by one-half percentage point to 7.5%, fighting a 6% inflation rate the bank blamed on soaring household income and rising public spending.

In Asia, meanwhile, sharper-than-anticipated consumer-price inflation last month -- 3% above year-earlier levels -- prompted speculation the Bank of Korea will raise its policy rate, now at 5%, in the first quarter next year. The Hong Kong Monetary Authority, also struggling to balance domestic considerations with pressures from overseas investors, has been intervening to keep its currency from rising above publicly set bands.

Nowhere in the Middle East are the strains more acute than in the U.A.E., where investors are betting on a "depegging" of the dirham as domestic inflation pressures increase.

"Speculators are definitely bidding on a depegging, and that's why they're increasing their dirham deposits," Henry Azzam, Middle East chief executive at Deutsche Bank AG, told Zawya Dow Jones Newswires in an interview.

Attracting that money are chances of a quick profit once the peg snaps. Deposits held in the emirates' banks have exceeded one trillion dirhams ($272.3 billion) for the first time, more than is deposited in the region's largest economy, Saudi Arabia, latest central-bank figures show.

"The probability of depegging has increased," said Kamran Butt, Dubai-based chief economist at Credit Suisse Group. "The market consensus is for the U.A.E. to depeg." A decision by the U.A.E. to sever ties with the dollar could alienate the U.S. and add to the dollar's woes at a time of economic uncertainty and record oil prices.

The dollar, which fell to all-time lows against the euro and 26-year lows against sterling in the aftermath of Wednesday's rate cut, was at $1.4437 against the euro, from $1.4486 Wednesday. The U.K. pound was at $2.0787, from $2.0793 Wednesday.

The dollar's slump has pushed up the cost of imports to the Gulf, fueling inflation. The dollar's decline has watered down the benefit of record oil prices in the region that is expected to accrue a surplus in excess of $500 billion this year, according to Saudi lender Samba Financial Group.

Kuwait, the region's third-largest Arab oil producer, was the first to break ranks with its Gulf peers in May when it shunned its peg with the dollar by allowing the dinar to float against a basket of currencies and in a range against the dollar. It retains a loose dollar peg and joined other states in cutting rates yesterday.

The seven emirates are Abu Dhabi, 'Ajman, Al Fujayrah, Sharjah, Dubai, Ra's al Khaymah and Quwayn.

With inflation expected to exceed 10% for a second consecutive year in the U.A.E., the emirates' ruling sheiks face the region's greatest fiscal policy challenge since the U.K. devalued sterling in 1967, forcing Gulf states to turn to the dollar as a benchmark.

When the emirates created the dirham in 1973 they linked it effectively to the dollar. Now bankers such as Deutsche's Mr. Azzam are unsure whether the U.A.E. is ready for another such change. "I don't think a depeg will happen because that's a regional decision and it has served the U.A.E. so far," he said.

Fed Policy and Moral Hazard

Harvey Rosenblum, WSJ:

Accusations of moral hazard have been tossed around quite a bit since the Federal Reserve lowered the federal-funds rate by half a percentage point a month ago today. Moral hazard, if you’re neither an actuary nor a practitioner of the “dismal science,” occurs when investors or property owners are protected from the downside risks of bad investment decisions, thus encouraging them to take still more unwise risks in the future.

As entertaining as this discussion of the nexus between the Federal Reserve and moral hazard has been, the analysis is incomplete because it lacks one key element — something called the Taylor Rule. The namesake of this bit of economic wisdom is John Taylor, perhaps the best scholar on monetary policy in our times. His rule, a description of monetary policy decision-making formulated a decade and a half ago, has a good deal of relevance to any discussion of Fed policy and moral hazard.

So what exactly is Taylor’s Rule? Put simply, it prescribes higher interest rates when inflation crosses certain thresholds and the economy is near full employment; and lower rates when the opposite is true. When these goals are in conflict the Rule provides guidance on how to adjust rates accordingly.

But before we get to why Mr. Taylor’s work matters, we’ve got to better understand moral hazard, which, as Mr. Bernanke defined it in a textbook he coauthored, is “the tendency of people to expend less effort protecting those goods that are insured against theft and damage.”

Why has moral hazard reared its head after the Federal Open Market Committee cut interest rates at a time of turmoil and uncertainty in financial markets? If the FOMC decision has provided an insurance policy that protects investor portfolios against damage, and if investor behavior takes this insurance into account in advance, then the FOMC, I will argue, does create a moral hazard each and every time it makes a monetary policy decision. This proposition is equally true whether the FOMC lowers rates, raises rates, or leaves them unchanged. Moral hazard goes with the territory.

Some writers go a step further and blame the Fed for intentionally creating moral hazard with the “Bernanke put,” an updating of the “Greenspan put.” A “put” cushions an investor against a decline in the price of a security through an option to sell at some specified price before the put’s expiration date. Former Fed Chairman Alan Greenspan’s name was attached to the concept in the mid-1990s, when stock-market investors supposedly began to believe that the FOMC wouldn’t raise the federal-funds target rate to restrain a rising stock market but would lower rates — quickly, vigorously, and intentionally — to stem stock-market declines.

If the Fed practiced such one-sided intervention, stock-market investors would suffer little or no downside risk. Sounds too good to be true and it is, as any investor who rode the roller coaster of the 80% drop in the Nasdaq in 2000-2002 would verify.

Greenspan or Bernanke “puts” make good copy, but they’re at odds with how the FOMC operates. By law, the Fed has a dual mandate to promote maximum employment and price stability. In practice, the FOMC seeks to foster an economic environment characterized by low and steady inflation, a low unemployment rate and a sustainable rate of economic growth. To carry out its mandate, the Fed needs a healthy, smoothly functioning banking and financial system.

After all, this financial infrastructure constitutes the conduit — or plumbing — through which the early actions of monetary policy flow to the rest of the economy. If the flow of money and credit is blocked, the Fed’s ability to achieve its mandates is compromised.

Financial turmoil is an impediment that must be addressed as a prerequisite to achieving the FOMC’s other goals. In a modern, credit-dependent economy like ours, a sharp reduction in the willingness or ability of lenders to grant, extend or renew credit can set off a contraction of economic activity and employment. Imagine the reduced spending in our economy if the electricity went off and we couldn’t use our credit cards for a week.

The Fed’s mandate makes no mention of the stock market, bond market, housing market or any other asset market. But these markets matter for their financial flows and for their psychological and wealth impacts on consumers and businesses. The stock market and other asset markets matter for monetary policy only insofar as they impact consumer and business spending, employment and inflationary pressures.

The Federal Reserve does not conduct monetary policy to influence stock prices, regardless of whether the stock market is rising or falling. The Fed does, however, try to create the macroeconomic stability needed to achieve its mandates — and this is where Mr. Taylor’s work comes in. Over the past couple of decades, the FOMC’s interest-rate behavior has been replicated closely by a forward-looking Taylor Rule, developed by my Dallas Fed colleague Evan Koenig.

Mr. Koenig’s version of the Taylor Rule suggests that the FOMC boost the federal-funds rate by roughly two percentage points if inflation is expected to rise by one percentage point or if the unemployment rate is expected to fall by one percentage point. Other things equal, the FOMC should raise the federal-funds rate by 0.7 percentage points if GDP growth is expected to rise by one percentage point. Without ever taking any account of the stock market or other asset markets, this version of the Taylor Rule, using publicly available forecasts, mimics quite closely the setting of federal-funds rates by the FOMC over the last 20 years.

Over the last two decades, when FOMC actions correlate strongly with a forward-looking Taylor Rule, the economy has been remarkably stable. Inflation has trended down, and recessions, while unavoidable, have been short, mild and infrequent. The chart nearby depicts one measure of the macroeconomic stability tied to the FOMC’s systematic reference to a Taylor-type rule. As the chart clearly points out, because of the Taylor Rule and students of it, the U.S. economy spends a lot less time mired in recession.

To the extent that the FOMC sets the federal-funds target rate in accordance with some form of the Taylor Rule, there is no central-bank “put.” There is, however, a gain in macroeconomic stability, which can be thought of as an insurance policy that reduces the risk of recession for every worker, employer and investor.

If there is any true moral hazard in our economy right now, this is its source: Americans spend, save and invest in the belief that recessions, if they occur, will be short, mild and infrequent. People believe that unemployment is something that happens to someone else. Indeed, the younger generation in the work force has, for all intents and purposes, had almost no experience with the unpleasantness of a recession. To them, it’s just a word that begins with “R” but they cannot define it or describe it. That’s real moral hazard, because it drives their consumption and investment behavior.

So what’s the bottom line? Simply that moral hazard is an inevitable, inescapable and unavoidable byproduct of the FOMC’s provision of macroeconomic stability. The better the FOMC’s job performance, the greater the recession insurance and the moral hazard that accompanies it. And the closer we are to price stability, the fewer resources we need to expend to protect ourselves from the theft of purchasing power that stems from inflation.

So let’s stop the complaints about moral hazard and the “Bernanke put.” Who wants to be the first to volunteer to live in a world like the first quarter of the Fed’s post-World War I history, when the economy was in recession over 40% of the time? There was a lot less moral hazard then, but there was also a far more volatile economy. As long as Taylor’s Rule reigns, Fed easing should be regarded as a macro blessing, not a hazard to be avoided.

Fed Plans Transparency Steps

Greg Ip, WSJ:

Federal Reserve officials are nearing consensus on several steps to make their deliberations more transparent to the public, but are likely to defer one of Chairman Ben Bernanke's longstanding goals: an explicit inflation target.

The centerpiece of their new communications steps would be the release of economic forecasts of policy makers four times a year, instead of the current two times, with additional detail and background... Moreover, the horizon for those forecasts would be extended to three years from two.

The ... Fed had hoped to finalize them by this month. But the fallout of the market turmoil that erupted in August has complicated the agenda of next week's meeting of the policy-making Federal Open Market Committee and it may defer decisions on its communications policy to a later meeting. ...

While the idea of setting an inflation target hasn't been shelved, officials say it needs more discussion. ... For Mr. Bernanke, deferral of an inflation target represents a setback, but he can chalk up a tactical victory for forging a consensus on other steps. ...

At his nomination hearing in 2005, Mr. Bernanke restated his preference for a target while promising "extensive discussion and consultation" and "no precipitate steps." ...

The FOMC as a whole is still not ready to take the step. One concern is that Congress, having taken a more populist turn since Democrats took power in 2006, could perceive a target as subordinating the Fed's responsibility for employment, despite Mr. Bernanke's insistence to the contrary. Another is that officials don't think the current system is broken.

At present, the FOMC meets eight times a year, and at two of its meetings, members submit forecasts for the current and next year on growth, inflation and unemployment that are included in a report to Congress. The "central tendency" of those forecasts -- a range that excludes the extreme projections -- garners the most attention. ...

At present, the post-meeting FOMC statement and the minutes aren't expected to be altered significantly.

Understanding the impact of credit market problems on the macroeconomy

Banks' New Credit Austerity To Help Set Economy's Path, by David Wessel, WSJ:

The outlook for the U.S. economy turns on two factors: One is how much worse the nation's housing market gets. ... The other is how much of the continuing disturbance in financial markets infects the rest of the economy. ...

The key is what banks will do and how much impact it will have. There's irony in that because ... banks have become increasingly less important players.

In the old days, banks made loans carefully -- because they got burned if the borrower didn't repay. ... Today, banks make loans, turn many of them into securities, and sell them to investors, pocketing the fees. Someone else gets burned if the borrower defaults. ...

But, it turns out, banks may not have unloaded as much of the risk as they thought. And that's the rub.

Wall Street firms and commercial banks ... hold about $250 billion in bridge loans made to finance acquisitions -- loans they intended to lay off in markets that are no longer quite so interested in them. The banks may be stuck with those merger loans. ...

Then there's the mushrooming problem -- one hardly anyone saw coming -- of entities called structured investment vehicles and conduits. Many of them hold subprime mortgages and related securities, and counted on selling more than $1 trillion in short-term IOUs called commercial paper to finance their holdings. Investors no longer want that commercial paper.

So what do these entities do now? They turn to U.S. and European banks, some of which sponsored the conduits, and remind them of the commitments the banks made to provide credit if the commercial-paper market dried up. ...

Suddenly, banks find themselves with all sorts of unanticipated loans on their books. So what? In the antiseptic language of central bankers, Mr. Bernanke explained, "These banks" -- the ones stuck with merger loans they didn't intend to hold and those providing backup lines of credit to conduits -- "have become more protective of their liquidity and balance-sheet capacity." They are hoarding cash or buying short-term Treasurys, and that means making fewer new loans. ...

Saddled with loans to finance mergers or back-stop conduits that can't sell commercial paper, banks are likely to be less willing to lend to ordinary consumers and businesses or, at the very least, will be charging more for those loans. So, consumers and businesses are likely to borrow a little less -- and spend a little less -- and a financial disturbance could be transmitted through the banking system to the rest of the economy.

No wonder there's growing worry the U.S. is going to slide into recession. ...

As if that wasn't enough, there's another layer: Everyone knows banks have a lot of loans on their books that they'd like to sell, but can't -- or won't at today's prices. So some deep-pocketed speculators, the ones who buy when prices plummet and then help bring them back up, are waiting for prices to fall further. And that increases the risk of a prolonged period of financial market turmoil which, in turn, increases the risks to the rest of the economy which, in turn, makes bankers -- understandably -- a little more wary about lending.

The issue isn't whether all this is happening. It is. The issue is how big an impact banks' behavior will have on the economy. ...

No doubt it will be one of the big issues on the table when Mr. Bernanke and his colleagues meet next week to ponder how much to cut interest rates to offset the markets' tightening of the credit spigot.

China's Income Disparity

China's Gini coefficient reached 0.47, according to a survey in 2001. This is higher than the US's 0.408, Britain's 0.36, and Japan's 0.249. The comparison suggests that China's level of income inequality has surpassed these countries.

Source: Wall Street Journal Dec 18, 2006.

Edward Prescott: Five Macroeconomic Myths

The sky is not falling. No need to panic and start playing around with all sorts of policy responses. Despite the impression created by some economic pundits, the U.S. economy is not a delicate little machine that needs to be fine-tuned with exact precision by benevolent policymakers to keep from breaking down. Rather, it is large and complex, with millions of people making billions of decisions every day to improve their lives...

On the one hand, it's difficult to screw up all these well-intentioned people by crafting bad policy, but, on the other hand, it is of course entirely possible to do so. And once things are broken, they are much harder to fix. For example, all those doomsayers predicting a recession will get their wish if taxes are suddenly raised, new productivity-strangling regulations are enacted, the U.S. turns against free trade, or some combination thereof. Otherwise, we should expect 3% real growth, based on 2% increases in productivity and 1% population growth. This economy is fundamentally sound.

So we have to be careful that we don't believe everything we read in the papers. ...[P]olicy should not be revised at every turn, nor rules changed by political whim. ... One of the great disciplines of economics is that it challenges us to question status quo thinking. So let's take a look at five pillars of contemporary conventional wisdom that have current standing, and see how well they hold up.

Myth No. 1: Monetary policy causes booms and busts. ...

One of the mysteries of the 1990s is how to explain the economic boom when the increase in capital investments -- as measured by the national accounts -- grew at a subdued pace. The numbers simply don't add up. However, it turns out that something special happened in the 1990s, and it wasn't monetary policy. In a recent paper, ... Ellen McGrattan and I show that intangible capital investment -- including R&D, developing new markets, building new business organizations and clientele -- was above normal by 4% of GDP in the late 1990s. ... Output, correctly measured, increased 8% relative to trend between 1991 and 1999, which is much bigger than the U.S. national accounts number of 4%. ...

What about busts? Let's begin with the assumption that tight monetary policy caused the recession of 1978-1982. ... To accept the myth, you have to accept a consistent relationship between monetary policy and economic activity -- and ... this relationship is simply not evident in the data. ... Our obsession with monetary policy in the conduct of the real economy is misplaced.

One caveat: I am not saying that there are no real costs to inflation -- there certainly are. And if we get too much inflation we can exact high costs on an economy (witness Argentina as an example). However, I am talking here of the vast majority of industrialized countries who live in a low-inflation regime... It is simply impossible to make a grave mistake when we're talking about movements of 25 basis points.

Myth No. 2: GDP growth was extraordinary in the 1990s. Even though I referred to the expansion of the '90s as a boom, inasmuch as it was a period of above-trend growth, and I noted the strong gains due to unmeasured investment, we have to put things into historical context. So let's return to the data. GDP growth relative to trend in the early 1960s was 12%, and in the famous 1980s boom (from the end of 1982 to mid-1989) it was a very impressive 9.7%. ...

So we have to be careful about mythologizing the 1990s and drawing misguided policy lessons; yes, it was a boom, and it was better than we think, but let's keep that boom in perspective.

Myth No. 3: Americans don't save. This is a persistent misconception owing to a misunderstanding of what it means to save. ... Our traditional measures of savings and investment, the national accounts, do not include savings associated with tangible investments made by businesses and funded by retained earning, government investments (like roads and schools) and business intangible investments.

If we want to know how much people are saving, we need to look at how much wealth they have. ... Viewing the full picture -- economic wealth -- Americans save as much as they always have... We're saving the right amount.

Myth No. 4: The U.S. government debt is big. ... Let's turn to the historical data once again.

Privately held interest-bearing debt relative to income peaked during World War II, fell through the early 1970s, rose again through the early 1990s, and then fell again until 2003. Even though that number has been rising in recent years (except for the most recent one), it is still at levels similar to the early 1960s, and lower than levels in most of the 1980s and 1990s. ... From a historical perspective, the current U.S. government debt is not large.

Myth No. 5: Government debt is a burden on our grandchildren. There's no better way to get people worked up about something than to call on their sympathies for their beloved grandkids. ... But we should stop feeling guilty -- at least about government debt -- because we are in better shape than conventional wisdom suggests.

Theory and practice tell us that the optimal amount of public debt that maximizes the welfare of new generations of entrants into the workforce is two times gross national income, or GDP. ... Currently, privately held public debt is about 0.3 times GDP, and if we include our Social Security obligations, it is 1.6 times GDP. In either case, we could argue that we have too little debt.

What's going on here? There are not enough productive assets -- tangible and intangible assets alike -- to meet the investment needs of our forthcoming retirees. ... The fix comes from getting the proper amount of government debt. When people did not enjoy long retirements and population growth was rapid, the optimal amount of government debt was zero. However, the world has changed, and we in fact require some government debt if we care about our grandchildren and their grandchildren.

If we should worry about our grandchildren, we shouldn't about the amount of debt we are leaving them. We may even have to increase that debt a bit to ensure that we are adequately prepared for our own retirements.

There are at least three lessons here. First: Context matters. Take what you read in the paper with a many grains of historical salt. Second: Current data often provide poor guidance for effective policy making. To make forward-looking policies you have to understand the past. Finally: Establish good rules, change them infrequently and judiciously, and turn the people loose upon the economy. Booms will follow.

China's economy shifted in 10 years

Between 1995 and 2005, China's total trade has increased from 37.1% of GDP to 62.4% of GDP (Exports increased from 19.4% to 33.4%, and imports increased from 17.4% to 29%). Gross investment has increased from 33% to 41.5%. Total FDI has increased from 3.2% to 5% of GDP. Consumption, on the other hand, has dropped from 44.9% of GDP to 38%.

It is no doubt that China's economic growth now hinges more and more on two pillars: foreign trade and domestic physical investment. What is worrisome is the latter: one wonders how much of the investment is driven by the fervor of local officials, and if those projects will ever turn up any real profits. If bad projects are financed by state banks as before, more trouble is ahead.

The Fed's Confession

When it comes to admitting error, central bankers tend to emulate Benjamin Disraeli, who famously said "never complain, never explain." So it was nothing short of astonishing last week for Richard Fisher, President of the Federal Reserve Bank of Dallas, to confess in public that the Fed had blundered by keeping monetary policy too easy for too long in 2003 and 2004.

Speaking to bankers in New York, Mr. Fisher issued a mea maxima culpa that deserves wide attention: "In retrospect, the real fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer than it should have been." As the nearby chart shows, a Fed worried about possible "deflation" moved the overnight interest rate it charges banks in June 2003 to an extraordinarily low 1% and kept it there for another year.

Mr. Fisher blamed this mistake on "poor data" that underestimated inflation, leading "to a policy action that amplified speculative activity in the housing and other markets. Today, as anybody not from the former planet of Pluto knows, the housing market is undergoing a substantial correction and inflicting real costs to millions of homeowners across the country." In other words, the Fed itself is responsible for the current housing bust because its over-easy policy created a real estate frenzy that was bound to end once the Fed tried to regain control over inflation expectations.

From: Wall Street Journal

Why Money Matters, by Milton Friedman

The third of three episodes in a major natural experiment in monetary policy that started more than 80 years ago is just now coming to an end. The experiment consists in observing the effect on the economy and the stock market of the monetary policies followed during, and after, three very similar periods of rapid economic growth in response to rapid technological change: to wit, the booms of the 1920s in the U.S., the '80s in Japan, and the '90s in the U.S.

The prosperous '20s in the U.S. were followed by the most severe economic contraction in its history. In our "Monetary History" (1963), Anna Schwartz and I attributed the severity of the contraction to a monetary policy that permitted the quantity of money to decline by one-third from 1929 to 1933. Since 1963, two episodes have occurred that are almost mirror images of the U.S. economy in the '20s: the '80s in Japan, and the '90s in the U.S. All three episodes were marked by a long period of rapid economic growth, sparked by rapid technological change and the emergence of new industries, and accompanied by a stock market boom that terminated in a crash. Monetary policy played a role in these booms, but only a supporting role. Technological change appears to have been the major player.

These three episodes provide the equivalent of a controlled experiment to test our hypothesis about what we termed the Great Contraction. In this experiment, the quantity of money is the counterpart of the experimenter's input. The performance of the economy and the level of the stock market are the counterpart of the experimenter's output... The three boom episodes all occurred in developed private enterprise market economies, involved in international finance and trade, and with similar monetary systems, including a central bank with power to control the quantity of money. This is the counterpart of the controlled conditions of the experimenter's laboratory.

The Money Supply: In addition, history has provided a close counterpart to the kind of variation in input that our hypothetical experimenter might have deliberately chosen. As Fig. 1 shows, monetary policy ... was very similar in the three boom periods, and very different in the three post boom periods, with settings that might be described as low, medium, high.

To measure the quantity of money, I use M2 in the U.S. and the conceptually equivalent M2 plus certificates of deposit in Japan. To express the data for the two countries and the widely separated periods in comparable units, I use as an index of the money stock the ratio of the quantity of money to its average value for the six years prior to the cycle peak... Finally, the data are plotted to align the dates at the cycle peak.

Fig. 1 shows a striking contrast between the period before the cycle peak and the period after the cycle peak. There are some differences before the peak -- money growth is slowest on the average for the earlier U.S. episode, fastest for Japan -- but the differences are small and there is reasonably steady money growth in all three episodes. The contrast with the period after the cycle peak could hardly be greater. Money supply declines sharply after the cycle peak in the first episode, goes from stable to rising mildly in the second, and rises steadily and sharply in the third. Our hypothetical experimenter planned his experiment well.

The GDP: The results of the third episode of this natural experiment are now all in. Fig. 2 shows how GDP in nominal terms (dollars or yen in current prices) behaved during the boom and post boom periods. I use nominal GDP rather than real GDP because M2 is also a nominal magnitude. How changes in nominal GDP are divided between prices and output is an important question but one that is not directly relevant to this experiment...

As in Fig. 1, there is a striking contrast between the boom and the post-boom periods: roughly similar growth during the booms, widely variable growth during the post-boom. Both before and after the cycle peak, nominal GDP growth paralleled monetary growth. During the boom, money and nominal GDP grew most rapidly in Japan, most slowly in the first U.S. episode, and at an intermediate rate in the second U.S. episode...

After the cycle peak, money fell sharply in the first episode and so did nominal GDP; money growth stagnated in the second episode and so did GDP; money grew at a rapid rate in the third episode and, after a brief lag (corresponding to the mild 2001 recession) so did GDP. ...

The Stock Market: The peak of the stock market, as measured by S&P's index, coincided with the cycle peak in the first episode, both occurring in the third quarter of 1929... However, that was not the case in the later episodes. ... Accordingly, Fig. 3 plots the data to align the series at the stock market peak.

The near identity of the three stock market series during the boom is truly remarkable. ... Of more interest for our purpose is what happened after the peak. For a year after, the three stock-price series fell in tandem, responding to the inner dynamics of a collapsing bubble. Then, the differences in monetary policy began to have an effect. Beginning in late 1930, the S&P index started falling away from the others under the influence of a collapsing money stock. For another year and a half, the other two indexes move in tandem. Then the much more expansive policy of the Fed in the '90s than of the Bank of Japan in the '80s takes effect and pulls the S&P 500 away from the Nikkei, which stabilizes in response to the passive monetary policy of the Bank of Japan...

The results of this natural experiment are clear, at least for major ups and downs: What happens to the quantity of money has a determinative effect on what happens to national income and to stock prices. The results strongly support Anna Schwartz's and my 1963 conjecture about the role of monetary policy in the Great Contraction. They also support the view that monetary policy deserves much credit for the mildness of the recession that followed the collapse of the U.S. boom in late 2000.