Now the global financial aftermath of last week's terrorist attacks are shaping up to be the perfect storm for the US dollar. And Alan Greenspan has totally lost control of the boat. On Monday he admitted as much, by stating that for the duration of the crisis he wasn't going to enforce the new interest rate level that he had just declared.
In the statement from the Federal Open Market Committee that accompanied Monday's rate cut, Greenspan said, "...the actual federal funds rate may be below its target on occasion in these unusual circumstances." And look what's happened: on the same day as he set the fed funds rate at 3%, funds traded at an average rate of 2.13% Monday, with some transactions taking place at rates near zero.
This means that interest-rate targeting has now become the latest in a series of failed experiments in how to regulate the nation's money supply in a post-gold world. Call it the Greenspan Standard -- and now we're off it. That's great, as far as I'm concerned. I've argued for years that the Fed shouldn't arbitrarily set the price of money -- interest rates -- any more than it should set the price of hamburgers or jet engines.
But now that we're off the Greenspan Standard, we're not on any standard at all. And that means that the potential for serious inflationary or deflationary error is now greater than ever, just when the economy desperately needs stability. And it means that Alan Greenspan has failed in his role as "banker of last resort," calming the panic with the steady hand of principled policy.
Yesterday's collapse in the bond market -- which had been rock-solid throughout the terrorism crisis -- and the continued collapse of the stock market, is probably mostly attributable to this new uncertainty, and to deep disappointment in Alan Greenspan's failed leadership.
Stop for a minute to appreciate how terrifyingly high the waves are in this perfect storm. Alan Greenspan isn't setting interest rates now. The world is. And yet the NY Fed's open market desk is in the market every day with its big, swinging billions -- doing what? Why?
Consider: in the wake of the horrors of last Tuesday, the market is so hungry for the safety of dollar deposits that it will accept any interest rate no matter how low -- even zero! -- in order to get them. And yet, officially, the fed funds rate is still 3% -- and until a couple days ago that would have been considered low.
But just think about what Alan Greenspan would have to do now to actually enforce that "low" official rate. At a time when the world is clamoring for liquidity, he'd have to be sucking liquidity out of the system by selling government securities in exchange for the market's dollars. But this is exactly the opposite of what the market has forced him to actually do in open market transactions: over the last week the Fed has executed overnight repurchase agreements dozens of times larger than usual, effectively buying government securities and lending the market newly printed dollars. And he's set up almost $100 billion in currency swaps with the central banks of Canada, Britain, and the European Community, which have much the same effect.
What choice does Greenspan have? On the one hand, he can hardly fail to meet the liquidity demands of the global marketplace at a time like this. After all, even before the terrorist attacks, for four years now, the market has been clamoring for more liquidity than he's been willing to give. But if he were to post a fed funds target that reflected the reality of today's liquidity demands, it would be about 2.25% -- that's the rate implied in the fed funds futures contracts on the Chicago Board of Trade. Can you see conservative old Alan Greenspan lowering rates by 125 basis points last Monday instead of 50?
Yes, conditions are in extremis to say the least. But this is proof writ large of how ineffectual rate-targeting is as a mechanism for regulating liquidity.
In the decade or so after the US abandoned the gold standard in 1971, the Fed went on a "money supply standard." Mechanistic targets were set for the level of monetary aggregates such as "M1" and "M2," and the Fed's open market operations were keyed to nothing but achieving those targets -- interest rates were free to do whatever they wanted to do. The result was the worst inflation in American history, and interest rates above 15%.
So that didn't work. In the early 1980s it was replaced by the "interest rate standard," in which the fed funds rate is targeted instead of the money supply. The Fed's open market operations are geared to move the market to the chosen interest rate -- and the money supply is free to do whatever it wants to do.
That's been Alan Greenspan's operating mechanism throughout his tenure as Fed chairman -- the Greenspan Standard. It seemed to work for a while there, long enough to make Alan Greenspan's reputation as a master of the universe. But it hasn't been working very well for the last four deflationary boom-and-bust years, and Greenspan's reputation has now almost entirely worn off. And in the global panic set off by last week's terrorist attacks, interest-rate targeting has been thrown into intellectual bankruptcy. And Alan Greenspan's reputation has been thrown in the dust-bin of history.
This is a time when markets -- just like the people who participate in them -- are hungry for stability, and for a clear vision of how terrifying problems are going to get solved. Instead, we've abandoned the Greenspan Standard and replaced it with nothing. There is no stability. There is no vision.
This is the ideal moment for George Bush to undo the horrible economic mistake that Richard Nixon made thirty years ago. It's time to make the dollar as good as gold again. I can think of no other single economic policy prescription that would serve us better in these troubled times.
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The chaos in the fed funds market crashed the bond market yesterday, storming the one little corner of the financial markets that had not been destabilized by last week's terrorist attack. Bonds are still very much in an uptrend -- but yesterday's huge move down was a clear signal that a risk premium for potential inflationary error has to get built into prices.
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With fed funds trading so far below the Fed's target rate, the predictions built into futures prices have to be understood in a new light. All futures prices ever tell us is the market's forecast for the funds rate in the future -- but normally the rate perfectly reflects the fed's target, so predicting the rate is the same thing as predicting the target. But not today!
For example, the September contracts are saying that there is a greater than 100% chance that rates will be cut by at least 75 basis points by next Monday. Does that mean that the Fed will formally lower rates that far, that soon? No... it simply means that the futures market is saying it will be as if the Fed lowered rates that much.
The October contracts are far-dated enough to wash out some of what is arguably a temporary disconnect between the target rate and the actual rate, so it's tempting to see them as policy predictions. They are saying that 25 basis points is in the bag, and that 50 bps is an 83% probability.
Longer-term contracts are now signaling the certainty of another 50 bps in cumulative rate cuts by year end, and not moving up again until next summer.
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The NASDAQ Composite drifted lower below the long term uptrend from October, 1998 (shown on the chart as a thick light gray line), and below the level of the April bottom. Those are resistance now.
Support now is at 1357, the lows of October 8, 1998. After that, it's only about 50 points till we reach the level at which Alan Greenspan first proclaimed "irrational exuberance" on December 5, 1996.
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The GSTI Semiconductor Index broke its long term uptrend from October, 1998 (shown on the chart as a thick light gray line) on Monday. And yesterday it finally broke below it's April lows, too.
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The AMEX Biotechnology Index had a horrible day, despite a generally very favorable news background. But its long term uptrend from October, 1998 (shown on the chart as a thick light gray line) is still intact. And it's still miles from breaking its April lows.
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Like the NASDAQ, the Dow wallowed lower, below the long term uptrend from the October 1998 bottom (shown on the chart as a thick light gray line), and its March lows.
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