Friday, 25 January 2008

Reduce rates in haste; repent at your leisure

This week proved, if any proof were needed, that the Federal Reserve is run by clowns.

The week starts with a public holiday in America. But while Americans were honouring the memory of Martin Luther King, stock markets around the world were engaged in a major sell-off.

Coco Bernanke gets into the office early on Tuesday morning, he switches on his bloomberg terminal and sees a tidal wave of selling. Overcome by panic, he calls his fellow FOMC members and tells them that the US is on the brink of the greatest recession since the war. Only decisive action will do. So, the FOMC announces the biggest interest rate cut in 25 years.

Back over at the markets, the news of a 0.75 percent cut is greeted by a mixture of shock and incomprehension. In an efforts to explain the Fed's action, a consensus gradually emerges; perhaps the Fed knows more about a rapidly approaching recession. Perhaps, the FOMC had some advance warning of some shocking US macro data, pointing to the inevitability of a slowdown.

Shift forward two days and that interpretation of events looks extremely generous. France's second largest bank announces a $7 billion "fraud". Eventually, it emerged that this fraud is rather more like a huge trading loss than a criminal conspiracy.

As more details emerge, we find out that Societe Generale knew about the problem on Saturday, while on Monday, the beleaguered bank tried to unwind their exposure.

Suddenly, an entirely new explanation emerges. The sell off on Monday was almost certainly provoked by Societe Generale's desperate attempts to establish the extent of their losses before they announced their difficulties to the rest of the world. As Societe Generale were offloading their positions, others jumped in and started to sell.

Back over at the fed, it knew nothing of Societe Generale's difficulties. Instead, the Fed reacted with a mad and totally unjustified rate cut without any clue about that was actually happening within the world's financial markets.

The Fed is now trapped. It can not reverse this rate decision, since that would be an admission that it over-reacted on Tuesday. It is now stuck with an excessively expansionary monetary policy. It all goes to prove the Fed simply does not know what it is doing.


Lord Wragley of Mire said...

The Fed didn't have a choice; it had to act, and act quickly. The pressure from government and media made it all but a foregone conclusion that rates would come down like a collapsed lung. Of course, the world will pay for this faux pas sooner rather than later. Pip! Pip!

Bob said...

Your lordship, I can't agree, a 0.75 percent was just nuts. No justification for that.

Josh said...

How did you convince Bernanke to put on the clown's costume?