Sunday, June 23, 2013

The Sword of Greenspan

According to an ancient Greek parable, Dionysius, the tyrant of Syracuse, had a courtier named Damocles who complemented Dionysius on his wealth and power. Dionysius asked Damocles if he would like to experience the kingly lifestyle. Damocles accepted the offer, and was enjoying the great luxury, until he noticed, hanging above him by a single horsehair, a gleaming sword. He then begged Dionysius to be allowed to leave the throne and return to his position as a courtier.

Common usage of the phrase "sword of Damocles" often misses the point of the story. According to classics scholar Daniel Mendelsohn, the sword of Damocles has come to refer to impending doom, even though:
"The real point of the story is very clearly a moral parable. It's not just, oh, something terrible is going to happen, but it's about realizing that what looks like an enviable life, a life of wealth, a life of power, a life of luxury is, in fact, fraught with anxiety, terror and possibly death.
And so that's the moral lesson of the original story, which has completely, I would say, gotten lost in the common usage. We all use that expression, oh, it's a sword of Damocles. But the point was all this stuff is meaningless, power, luxury and wealth, and if you know what's good for you, you'll be happy to be a much lesser kind of person."
The sword of Damocles frequently is used and misused in economic references. An Irish news article in 2011 titled "Inflation is sword of Damocles over Irish economy" uses the expression just to reference (alleged) impending doom. In "The Sword of Damocles hangs over Cyprus," the expression is slightly more correctly, as an analogy is made between Cyprus' decision to join the EU and Damocles' decision to try out the life of a king: "Like Damocles, some older Cypriots are now longing for their old farming lives, where living off the land was part and parcel of living here." And of course, the sword is used in the context of the Federal Reserve. Andy Kessler, for example, writes "The Fed’s inevitable Sword of Damocles could be brutal for bonds and stocks. Some of us recall the massacre of 1994."

Now, the original sword of Damocles was not used for massacre or brutality, so I think Kessler misuses the reference, missing the moral lesson of the story. He actually makes two sloppy allusions-- first to the sword, and second to 1994. Gavyn Davies writes that "The 1994 example, when the Fed failed to guide the markets about the likely pace of tightening, is of course part of the folklore of the bond market." Just as with the ancient parable of the sword of Damocles, the real lessons of the "parable" of 1994 are getting lost--dangerously--in the common usage.

Lately, the Fed's tightening actions in 1994 are coming into the spotlight as people wonder, and worry, about when the Fed will taper its bond buying program. The problem is that the more nuanced points of the 1994 episode have been lost to a simpler, cruder interpretation: that a move by the Fed (to slow the pace of purchases, for example) will be shortly followed by a succession of rate hikes. The lesson of 1994 is not that once the Fed starts tightening, it will just keep going, but unfortunately that is the lesson the markets choose to remember.

Let's look back at the Federal Reserve transcripts from 1994, when Alan Greenspan himself alluded to the sword of Damocles on multiple occasions. At the first meeting of the year, on February 3-4, the federal funds rate was at 3%, after having been lowered repeatedly since 1989. Discussions centered around how much to raise the rate. Mostly it was a question of raising by 25 or 50 basis points.
Vice Chairman McDonough: ... It seems to me that the question is not so much whether we should tighten but by how much...I think there are two downside aspects to a 50 basis point firming. First of all, it could be interpreted--and in my own view would be interpreted by a fair number of market participants--as a one-time fix, a one-time adjustment which would be followed by a "Fed-on-hold" period. Secondly, I think it could be deemed, especially in light of some of the discussion in this town and others, a macho response, and I've always thought macho responses confused brains and bravado. A 25 basis point move, on the other hand, I believe would send the right signal in the sense that the Federal Reserve, the central bank, is being watchful, as it should be...I think it would be interpreted as the first of a series of moves and thus would be deemed, in my view, to be a stronger signal than a 50 basis point increase--if the 50 basis point increase were seen, as I believe it would be, as a one-time adjustment to be followed by the "Fed on hold."
President Jordan: ... I would come down on the side of 50 basis points even though Bill McDonough's argument about that being viewed as a one-time adjustment followed by the "Fed on hold" is interesting. The other side of that would be that 25 basis points would be viewed clearly as the first of a series of moves. And if the market quickly built in pricing and expectations of the next 25 basis point move, then the equilibrium rate would move
at least as much as our move, implying de facto that we eased conditions relative to where the market is if it's ahead of us. I don't know what the timing might be as to market expectations, but if it's a fairly short horizon--maybe no further out than the next FOMC meeting--we may find that 25 was not enough to restrain reserve growth...
Chairman Greenspan: I thought about 50 basis points, or I thought about it in the sense of trying to move the rate to where we want to put it and then sticking with it. But I think it may be very helpful to have anticipations in the market now that we are going to move rates higher because it will subdue speculation in the stock market; at this particular stage having expectations hanging in the market that we may move again, and move reasonably soon, could have a very useful effect. If it is in any way contemplated that we have moved and are going to stop, that could create the type of erosion in the economy that I've watched over the past decades, which is precisely what we don't want. If we have the capability of having a Sword of Damocles over the market we can prevent it from running away... If we're going to move, I would not mind moving again at the next meeting or the meeting after that, for example. That depends on the evolution of events, frankly.
Greenspan got his way, after imploring the committee to "act unanimously." The February 14, 1994 New York Times reported that "in the two weeks since the rate action, it appears that rather than reassuring traders and investors, the Federal Reserve has managed to leave them with a worse case of the jitters. The financial markets seem to have increased their focus on inflation amid a general consensus that the Federal Reserve will have to raise short-term interest rates again soon. Both factors have led to a sharp selloff in the bond market and a jump in both long- and short-term interest rates." Later the article adds,
The interest rate hike validated the market's inflation fears," said Matthew F. Alexy, a government securities specialist at CS First Boston. "The market must have asked itself: Why would the Fed move to raise interest rates unless there was, in fact, a problem with inflation?"  
The added sensitivity was demonstrated Thursday when traders and investors chose to overlook the positive report on consumer prices in January, which were unchanged, and instead focused on a Federal Reserve Bank of Philadelphia report that suggested that prices had been on the rise in early February. 
The markets saw inflation where there was none. By the March 1994 meeting, Greenspan raised the case of the missing inflation. "...we are pretty far along in this business cycle. So why is inflation not showing its head a little more? Now, the next set of numbers may come out and I'll be sorry I said this, but the earlier experience raises the question: Is it automatically the case that when the economy is tightening up that inflation takes hold?" He recognized that inflation was nowhere to be seen, but halfway expected it to rear its head at any minute. And then he brought it up again: the Sword of Damocles!
Greenspan:  One of the elements that I think we have all been observing with respect to the markets--and one of the reasons why there has been such a level of instability in the markets--is that when we were perceived as moving on the basis of economic data, the markets had a certain sense of what it was we were doing...Now they are worried that they don't know when we are going to move, so we have this Sword of Damocles hanging over the market. They don't know whether we are going to move in 2 days, 5 days, or 12 days; they have no basis to judge and they are understandably nervous. So the question is, having very consciously and purposely tried to break the bubble and upset the markets in order to sort of break the cocoon of capital gains speculation, we are now in a position--having done that and in a sense succeeded perhaps more than we had intended--to try to restore some degree of confidence in the System. And that means we have to find a way, if at all possible, to move toward a policy stance from which we will not be perceived as about to move again in any short period of time.
The distinction between Greenspan's two uses of the sword is astounding and tragicomic. In February, the Sword is his tool; he controls it to serve his purpose. "If we have the capability of having a Sword of Damocles over the market we can prevent it from running away." By March, the Sword still hangs over the markets, but it is not Greenspan's tool; it works against him instead of for him. Greenspan is king of the markets, and the sword hangs above the throne. In February he speaks of the Sword as useful, and by March he wants it removed. He proposes this plan to remove it:
I think there is a certain advantage in [raising the rate by] 25 basis points because the markets, having seen two moves in a row of 25 basis points at a meeting, will tend almost surely to expect that the next move will be at the next meeting--or at least I think the probability of that occurring is probably higher than 50/50. If that is the case and the markets perceive that--and they perceive we are going to 4 percent by midyear, moving only at meetings--then we have effectively removed the Damocles Sword because our action becomes predictable with respect to timing as well as with respect to dimension. 
The plan is what in today's lingo we'd call "calendar objectives" as opposed to data objectives. Greenspan thought interest rates ultimately needed to get up to 4 or 4.5%, and wanted to set up a timeline to get there in movements of 25 basis points at each scheduled meeting. He thought that by moving by 25 bps at two meetings in a row, the markets would catch on and expect 25 bps at subsequent meetings (regardless of inflation, or lack thereof.) This timeline was not to be. At a conference call on April 18, before the next scheduled meeting, the rate was raised another 25 bps, then 50 in May, 50 in August, and 75 in November. Overall, 1994 was a bad year for bond investors and speculators (including Orange County, CA, which went  bankrupt after the rise in interest rates), but decent for the real economy. The Fed's actions that year were not ideal, but they also were not disastrous, except for certain categories of investors.

The real economy today faces a shakier recovery which could more easily be thrown off course. Inflation has not "shown its head" no matter how hard the markets and the Fed have looked for it. Since the data give no impetus toward reducing accomodation, the Committee, eager to exit, has switched to a calendar-based policy. President Bullard's press release describing his dissent to the FOMC decision announced on June 19, 2013, includes the following:
President Bullard also felt that the Committee’s decision to authorize the Chairman to lay out a more elaborate plan for reducing the pace of asset purchases was inappropriately timed. The Committee was, through the Summary of Economic Projections process, marking down its assessment of both real GDP growth and inflation for 2013, and yet simultaneously announcing that less accommodative policy may be in store...President Bullard felt that the Committee’s decision to authorize the Chairman to make an announcement of an approximate timeline for reducing the pace of asset purchases to zero was a step away from state-contingent monetary policy.
Tim Duy summarizes,
Bullard clearly felt the mood in the room was something to the effect of "We know the data is soft, but we want out of this program by the middle of next year, so we are going to lay out a program to do just that."...After weeks of being soothed by analysts saying that the data was key, that low inflation would stay the Fed's hand, Bernanke laid out clear as day a plan for ending quantitative easing by the middle of next year. Market participants then concluded exactly what Bullard concluded: It's the date, not the data.
Perhaps Chairman Bernanke looked up and glimpsed Greenspan's sword suspended above his head. I hope he can react to it with composure and not panic. The Committee in 1994 tried to manipulate market expectations through actions and through cryptic communications. While the expectations instrument was powerful, it was not precise. Although the Fed has improved its communications strategy since 1994, its messages still can have unintended consequences; 10-year yields rose sharply following the latest FOMC statement. Very clearly state-contingent monetary policy would be less confusing, and would project more confidence in the economy's eventual recovery, than semi-state-contingent, semi-calendar-driven policy. And if bond market participants look back to 1994 and expect a rapid succession of interest-rate hikes in the near future, the Fed should clearly communicate that this time will be different.

3 comments:

  1. Great post

    I might append this

    Relatively minor
    Gyrations in rates
    ..viewed by actual prospective borrowers and lenders
    Are quite a bit less sensitive then speculators
    With over leveraged positions

    That the fed attends to the "interests "
    Of these specs rather then the agents operating
    the " real" economy
    Deserves a deep ponder

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  2. Greenspan was aa master of obfuscating his meaning -- if he ever had any. He managed to make it sound as if he had reasons for what he was doing, but in every case his reasons, if a meaning could even be found for them, could be read in several ways.

    The Fed has been saying since they started QE3 that they were NOT going to wait for the data. In other words, they were saying (nudge, nudge, hint, hint) that they were NOT going to be irresponsible in the future by allowing inflation to rise above their 2% ceiling (what it really is) despite the terrible employment data. This is the main reason why the program had no effect.

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Comments appreciated!