Bernanke Blows Smoke

Larry Kudlow
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Posted: Dec 20, 2007 12:00 AM
Bernanke Blows Smoke

Ben Bernanke's Federal Reserve blew smoke at the markets last week, and markets blew smoke right back. Nothing was solved in terms of the growing global credit crisis, the result of a sub-prime virus that continues to infect money and capital markets everywhere.

Instead of taking aggressive action with a half-point shock-and-awe rate cut, the Fed opted for a timid quarter-point cut. The result was a sharp drop in stocks around the world. It then announced a more generous discount-window lending facility in coordination with global central banks. But that didn't work, either.

Money-market rates continue to rise. And as credit-clogged short-term funding grows shakier, the money-market "spread" against risk-free Treasury paper is widening in both London and New York. Consumer- and business-loan-backed corporate debt declined another $10 billion last week. Since early August, asset-backed commercial paper has dropped over $400 billion, or 34 percent. Euro-denominated loans rose 85 basis points to nearly 5 percent in the credit-frozen London Interbank overnight market (LIBOR), while very short-term dollar-denominated LIBOR rates climbed another 30 basis points.

It's important to understand that the biggest problem in the sub-prime market is the rising default and foreclosure rate. Even though sub-prime adjustable-rate mortgages (ARMs) make up only 4.4 percent of home loans, they represent 43 percent of foreclosures through the third quarter, according to University of Michigan professor Mark Perry. These are the troublemaking loans that were packaged and highly leveraged for sales to institutional lenders throughout the world. But the key point is that ARMs are tied to LIBOR and federal funds markets in London and New York. Thus, if global central banks are to relieve the sub-prime ARM problem, they must get their target rates lower.

All the discount-window rigmarole published by Bernanke & Co. -- aiming at perhaps $50 billion of new bank loans -- is nowhere near a solution. The Financial Times reports that the Federal Home Loan Bank -- a New Deal agency -- pumped in an annualized rate of $746 billion to the private U.S. mortgage sector in the third quarter. Compare that to the Fed's $800 million of discount loans in the same quarter. It's only one-tenth of the home-loan bank's credit injection.

The bottom line remains simple: The Fed must right-size the inverted Treasury yield curve by bringing its 4.25 percent target rate much closer to the three-month Treasury bill, which is trading below 3 percent, and below all the other Treasury rates that are lower than the fed funds rate.

Financiers can't borrow short to lend long unless the key borrowing rate is well below medium- and short-term rates. Because the yield curve remains inverted, and money-market credit is frozen, the U.S. monetary base is growing at less than 2 percent. This is very tight money. (Incidentally, this is why no one should be worried about future inflation, even after last week's price-index flare-ups.)

Economic gurus Arthur Laffer and Steve Forbes say the Fed should float its target rate and pump in new money until the yield curve rights itself, money-market credit starts to flow, and the monetary base grows larger. This may sound radical, but it was done after the 9-11 bombings and again last August when the first credit-crunch episode developed.

Back in the 1980s, Paul Volcker floated the fed funds target in order to withdraw liquidity and halt inflation. Not only did Volcker let markets set the funds rate, when he went back to targeting the rate he tolerated a 50 to 100 basis point band, rather than a pinpoint price.

Pouring in new reserves and moving to a floating funds target is exactly the right move. It could be done for a short period until the crisis clears up, or it could be a major monetary reform. For the inflation hawks out there, the added liquidity can always be mopped up if upward price pressures develop.

Who knows if the Bernanke Fed is creative enough to take this approach. Many observers believe the former Princeton economist is lacking in leadership, that he is merely a consensus-taker. James Pethokoukis of U.S. News and World Report is even citing a number of Washington and Wall Street sources who think Bernanke is a one-term chairman. He is not getting the job done. Cynics believe the Fed is too full of academic bureaucrats and that it needs some real-world, hands-on policy advisors who have gotten their fingernails dirty in the day-to-day workings of the markets.

New economic data on strong retail sales, rising industrial production and increasing employment say the Goldilocks economy is doing reasonably well in spite of the deep housing recession and sub-prime virus. But Bernanke must think outside the box if he's to keep the future economy on track -- and keep his job, too.