When Central Bankers Become Asset Managers

April 5, 2002

A highly significant article featured in last week's Financial Times. "Fed considered emergency measures to save economy' reports that a summary of the FOMC meeting of January 25-26 [minutes won't be available for 5 years] shows Fed officials were concerned that short term interest rates were so low that monetary policy would be rendered ineffective." The report goes on further to suggest that Fed officials proposed considering 'unconventional' policy measures to boost the economy. The FT reports a Fed official requesting anonymity, who says the 'unconventional' measures include buying stocks. The official further avers, "The Fed could theoretically buy anything to pump money into the system…state and local debt, real estate, gold mines, any asset."

On the same day that this report came out, Bloomberg Financial news reported Bundesbank President Ernst Welteke reiteration of the German central bank's desire to sell off some of its gold reserves when the Washington Accord expires in 2004. But this time there was a little twist in the tail: Welteke indicated for the first time that the Bundesbank might consider reinvesting some of the proceeds in equities:

"We must consider if in the mid term if we could to a limited extent and without pressurising the (gold) market convert some of our gold into equities," Welteke told the Frankfurter Allgemeine Zeitung in an interview. He said the bank would most likely buy Euro Stoxx 50 listed shares, or other standard blue chip stocks. The Bundesbank wants to manage its portfolio of gold and currency reserves more efficiently in the future, he said"

For an asset class that has been as persistently denigrated and deemed irrelevant as gold has apparently become, one is still struck by the kid gloves approach most central bankers seem to take in regard to the discussions on sales. At some visceral level the central bankers still guiltily accord it a modicum of monetary significance, their ongoing sales and leasing programs, their seemingly perpetual attempts to cap its rise notwithstanding.

Leaving aside that observation, with the creation of European Monetary Union many of the national European central banks' traditional monetary functions have effectively been usurped by the new powers of the ECB. So perhaps one could explain the Bundesbank's extraordinary departure from sound central banking practice to asset management simply as part of the process of justifying its continued existence. But taken in conjunction with what we now understand about the American Federal Reserve, we have to view these interrelated items as another sign that moral hazard is increasingly becoming the ideological glue underpinning most central banking activity. The Greenspan Put has in effect become internationalized.

The changing posture from outside the US is particularly striking. Until recently, concerns about a US stock market and credit bubble have been sounded repeatedly from the highest offices abroad: Former German head of State Helmut Schmidt, former Bundesbank Council Chairman Hans Tietmeyer, present Bundesbank head Ernst Welteke himself, head of the European Central Bank Wim Duisenberg, Bank of England governor Sir Edward George, former Japanese senior finance official Eisuke Sakakibara. All at various times have expressed reservations about a US bubble and its potential to take the global economy down with it. Similar concerns have been voiced, albeit more mutely, by official international organizations like the IMF and the OECD. The prestigious financial weekly the Economist devoted a lengthy article to such concerns in a 1999 issue with the cover title "Greenspan Trapped in His Bubble".

Well, Greenspan may be trapped, but he appears now to have some European company. We think these latest articles send out highly important signals, yet it is very striking that in the "land of the free", a country that views itself as the champion of liberal market economics, they have occasioned virtually no domestic comment. But while publicly decrying any involvement in the manipulation of markets, the Financial Times article clearly indicates that the Federal Reserve has evidently thought hard and thoroughly about these issues and may be coming closer to a stage where covert market manipulation becomes overt.

There are academic papers that pre-date this article by almost two years, so this is not just some passing fancy brought on by the aftermath of September 11. Furthermore, the comments by Welteke point to this becoming a global central banking phenomenon. The comments of the Bundesbank president and the partial publication of the January 2002 Federal Reserve minutes suggest today that there is a greater tendency amongst the world's central bankers to allow a moral hazard psychology to develop to keep this bubble afloat.

It would be naïve in the extreme to assume that a central bank notorious for its supine treatment of markets would be insensitive to the effect the news of these deliberations would have on the equity market. The January 2002 minutes clearly record that the Fed was especially alive to the possibility its movement to a neutral directive in January "could at this point be misread in financial markets as an indication of a much more optimistic view of the economic outlook than the members currently entertained. Such an interpretation might foster unwarranted and counterproductive adjustments in financial markets" (our emphasis). The latter sentence clearly implies an awareness on the part of the Fed of a highly unstable financial backdrop were rates to back up sharply. If the Fed was especially sensitive about this minor change in its policy, we cannot assume it was ignorant of the ramifications of revelations in the minutes about "unconventional policy measure" discussions.

This would be consistent with a model of "moral hazard melt-up" that we have sketched out in these pages in the past. In the first instance, we argued that any support lent to the market would likely remain covert providing that a sufficiently large critical mass of fund managers understood that there were support mechanisms at work in the market. The references to "unconventional measures" in the FT article help to create this "understanding".

Such an implicit understanding on the part of these managers would facilitate their ability to trade on the back of periodic covert interventions, thereby supporting government objectives. In these circumstances, policy makers would likely do nothing to disavow such a belief (and might in fact quietly encourage it), since the herding dynamics of these portfolio managers would enhance the authorities' objective of supporting the market. Only after this option has proved wanting would the authorities move to explicit intervention.

Why explicit? The public does not react to inferences and hidden coded messages by America's leading policy makers in the way in which a professional fund manager well attuned to the vagaries of the market would. The vast majority of private investors react adaptively to historic price trends. If returns for the equity market continue to disappoint (as they generally have over the past 2 years), the adaptive expectations of the public in regard to their expected returns for equities will diminish, creating widespread redemptions and ongoing selling pressure. The belief in the efficacy of the Greenspan put will accordingly begin to dissipate. Mr. Greenspan has told us since his Jackson Hole speech in 1999 that if the incipient dynamics of panic and crash reoccur (and thereby further threaten equity wealth and, by extension, consumption) the Fed will respond, and this time with a more explicit and transparent rationale.

Judging from the latest measured fund flows from AIG and Liquidity TrimTabs (which show sharply increased flows into mutual equity funds) we do not appear to be at the point at which the Federal Reserve, or any other G-7 central bank, is likely to be forced explicitly to step in to the equity market on the "too big to fail" grounds - even though this may be the ultimate outcome of current policy. At this stage, however, the game of expectations management appears to be sufficient to induce the long-suffering public to step back into the equity market again in a fairly significant manner. According to the Index of Investor Optimism, a joint poll conducted by UBS and the Gallup organization Optimism rose in March to its highest level since November 2000, as investors expressed renewed confidence in the economy and the financial markets.

Currently at 121, the overall Index increased 29 points from 92 in February. Conducted monthly, the Index had a baseline of 124 when it was established in 1996. Short-term expectations, over the next 12 months, jumped to 12.8 per cent in March from 9.5 per cent last month. The increase was most pronounced among average investors, those with $10,000 - $100,000 in investable assets, with expectations rising dramatically to 14.2 percent this month from 9.9 per cent in February. Among substantial investors, those with more than $100,000 in investable assets, expectations increased to 10.7 percent in March from 8.8 per cent last month.

This positive psychology has also been reinforced by the latest consumer confidence readings. U.S. consumer confidence surged in March, as optimism grew about the job market in a recovering economy. The Conference Board's gauge of sentiment rose to 110.2 for the month from 95 in February. This month's index was the highest since August and beat forecasts for a reading of 98. Consumer expectations for the economy six months from now soared to the highest level in 1 1/2 years.

As we noted above, this expectations management game is nothing new to the Fed, which has consistently sought outside advice as to how and when it could deploy unconventional methods to alleviate the threat of a Japanese style economic meltdown. When exploring in more detail the scenarios in which the Federal Reserve may be forced to deploy "extraordinary measures" in the midst of a zero interest rate environment (i.e. the "Japan scenario", a comparison that dare not publicly speak its name), one is struck less with a preoccupation of the precise limits of Fed action and more with the means by which such limits can be circumvented under exceptional circumstances.

In a paper dated November 27, 2000, "Monetary Policy When the Nominal Short Term Interest Rate is Zero", professors James Clouse, Dale Henderson, Athanasios Orphanides, David Small, and Peter Tinsley, all advisors to the Fed, consider the issues laid out in the FT article in great detail. The paper pre-dates the Financial Times piece by more than 18 months, indicating that this issue is not a sudden new obsession of the Federal Reserve. The paper notes:

"In an environment of low inflation, the Federal Reserve faces the risk that it may not have provided enough monetary stimulus even when it has pushed the short-term nominal interest rate to its lower bound of zero. Whether monetary policy can provide further stimulus depends on whether monetary policy can affect aggregate demand through channels other than short-term interest rates and with tools other than open market operations in Treasury bills."

The paper goes on to examine the alternative policy channels and tools available to the Federal Reserve in theory in the context of the practical limitations imposed by the Federal Reserve Act, including the purchase of treasury bills, open market purchases of private-sector credit instruments, unsterilized and sterilized intervention in the foreign exchange market, lending through the discount window and, in some circumstances, the use of options (which seems to be particularly germane in regard to now prevalent allegations about the rigging of the gold market). Although the authors acknowledge that there is no "express authorization for the Federal Reserve to purchase equities", the paper later seeks to explore how broadly the enabling legislation can be interpreted so as to provide the central bank with the broadest possible discretion to do virtually anything it likes under 'unusual and exigent circumstances' and provided that there are "at least five [who] governors voted to..." agree on a specified course of action.

And this seems to be the road that the Fed, and perhaps some of G-7 colleagues have decided to travel. One would think that if financial disruption has become increasingly frequent and severe (as has certainly been the case throughout the past 10-15 years), it would behove one to limit the propagation of financial fragility and its eventual eruption into instability and crisis, rather than perpetuate it. Perversely, central bankers seem to be moving in the opposite direction. Commenting on the Bundesbank's proposed purchases of "blue chip equities" Tim Wood notes: "The conflicts of interest and potential for abuse are too hideous to contemplate. Does anyone believe that a central bank invested in the equities market is not going to use its inside track on interest rates and money supply to fine-tune its holdings appropriately?" Wood is correct. It is hard to imagine that a member of the European Central Bank council considers this an appropriate message to send, let alone the Federal Reserve, especially to its pupils in the emerging world, which have been at the receiving end of many lectures on the dangers of crony capitalism. The FT disclosure is particularly ironic given that just last week the Fed chairman again professed his belief in market forces as the best means of curtailing weaknesses in the corporate governance exposed by the collapse of Enron. An incredible statement coming from a man who has become synonymous with the perversion of the very free market forces he regularly extols. Has any other central banker ever had a put named after him? But Mr. Greenspan and his colleagues seem dead keen to establish moral hazard precedents as far as the eye can see, leaving the rest of us to deal with its exceptionally messy consequences when these "extraordinary measures" stop working.

Small amounts of natural gold were found in Spanish caves used by the Paleolithic Man about 40,000 B.C.

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