Last week, I started a series on my visit in Washington, a research trip to analyse the aftermath of the last elections. In my first installment I gave my general impressions from the visit, in My Trip to Capital Hill. This week, I am covering my encounters at the Treasury and the Fed. In both places we met with lawyers to discuss the implication from Dodd-Frank. At the Fed, we also met with a senior Monetary Affairs economist. As you will be able to appreciate by reading my notes from the two meetings, it is difficult to learn something meaningful and interesting from a lawyer; economists are at least interesting.
Visit at the U.S. Treasury
Following the financial crisis, a new set of regulatory measures were adopted. The objective of the regulation is to heighten prudential standards in order to avoid a repeat of the crisis. Under Dodd-Frank, the cornerstone of the new regulatory environment, new institutions were created; among them the office of financial research to address the issue of systemic risk.
In response to criticism about the success of its recent interventions and the current fiscal situation, the Treasury official we met with offered the following explanation: The large deficits and the huge financial crisis had started in 2008 under another administration. People seems to have forgotten what happened since. The Treasury had to intervene quickly to prevent a total meltdown of the economy. The situation is not perfect today and certainly not as good as one could have hoped but disaster, which we came very close to, was avoided.
Thoughts on the debt ceiling legislation. The Tea Party folks could make it difficult to get an extension. Allowing the federal government to go into default however is a scary prospect as there are no gimmicks to avoid default beyond a few days.
There has been efforts by the federal government to lengthen its debt maturity to 5-6 years. Given that the Fed is larger buyer of government debt these days, we asked about the potential coordination between the two organisations? The answer: Although they talk, the Fed and the Treasury are pretty much independently deciding what to issue and what to buy.
On the prospects of pension and state bailouts: Bailing-out anybody is pretty much out of the question right now. Politically there is no appetite and the Treasury has no authority to do it.
Assessment of TARP: investments in the big banks have paid off. Smaller banks are another matter. TARP was a very successful operations overall but it is unlikely to happen again given the political environment.
Was this mainly a terrible liquidity crisis or is there something fundamentally wrong with the US financial system? Dodd-Frank and other regulations are meant to address this. Financial innovations created regulatory gaps and Dodd-Frank is meant to close these gaps.
Some actors have committed actions to bring the collapse of the financial system and the economy and have mainly escaped unscathed. Has the Treasury judged that bringing these people down was posing too great a risk to the rescue efforts? According to Treasury officials, many of the business leaders and directors who were heading the financial institutions at the time have been replaced and suffered great financial loses.
What is being done about foreclosures? Mitigation efforts are under way through the office of financial stability to minimize foreclosures.
On the prospects of GSEs reforms. The reforms will reflect what should be the home ownership policy for the U.S. in the future, a question which is still being debated.
Visit at the Federal Reserve
Dodd-Frank implies a lot of changes and the Fed is at the forefront of many these changes. The new focus is on systemic risk, macro and prudential risks rather than individual institution risks. Some significant changes:
1. Financial oversight council. Institutions with more than 50 billion in assets are submitted to enhanced standards and the Council is allowed to designate others institutions for further scrutiny.
2. Volker rule prevents banks from engaging in proprietary trading.
3. Securitizers will have to retain some portion of what they issue.
4. Consumer bureau. Consumer Financial protection agency housed in the Fed but independent. Reports to Congress and is mainly a regulation and compliance body.
On the dual mandate of the Fed (1978 Humphrey Hawkings) and its effect on price stability. Concentrating solely on inflation targeting might not affect policy significantly. Taking out the objective of maximising employment from the mandate of the Fed is up to Congress. Yet, keeping inflation in check has always remained a priority. Nothing has changed in years.
On QE2. QE was effective in 2009. Officials believe it should be effective again this year.
On the prospects and risks of selling securities at a loss when interest rates start rising. First, the sale of Agency assets and Mortgage Backed Securities will only happen gradually. Second, sales could happen at a loss as there is considerable income currently to cover these losses. Third, the strategy of the FED to increase rates will be to rise rates on reserves, not to sell assets. Thus, there won't be much mass forced sales of assets by the Fed.
Thoughts on credibility as the Fed is monetizing the debt. It is a misunderstanding. If the Fed was purchasing the debt to hold it forever, it would be a policy to monetize the debt. But the Fed has been very clear that this is a temporary measure.
On the ability to predict financial crisis. The great moderation that occurred from 1990 to 2006 made all us believe that volatility was lower permanently. This was a mistake but very few people were able to predict and understand what was happening. Going forward Congress has put in place a series of measures to ensure that such a crisis will not happen again. To ability to foresee crises should be improved; especially in areas where risks were not regulated like in the shadow banking system. The new regulation also now provides for robust prudential supervision of systemic important institutions. The regulation also focuses now on structural issues as opposed to only micro issues in different institutions and ensures that regulators do not fail to see the overall picture; it is not perfect but it is better. Moreover, with new capitalisation rules, we should be better able to respond if a crisis were to happen. Finally, by bringing in economists and market experts, the office of stability and research will have more cross-field expertise and will cast a broader net to do horizontal reviews and to look at a wide range of issues including European debt and the linkages of various exposures.
On NAIRU (natural rate of unemployment or, officially, the Non-Accelerating Inflation Rate of Unemployment): Fed officials recognise that there might be some increase in the NAIRU due to reduced worker mobility as the housing crisis makes it more difficult to sell one's home and relocate and because unemployment lasts longer and leads to depreciated skills. Although we did not discuss it at the Fed (we should have but we ran out of time), this might be a real problem sooner than later. For all we know, the new NAIRU may now be standing at 7.5%; nobody really knows. When the U.S. economy reaches this level of unemployment, will the Fed start raising rates and will it stay put in the hope that the NAIRU is much lower? Politically, the job of raising rates might be very difficult as it may be impossible to accept that an unemployment rate of 7.5% should be considered the full employment level.
Recent back-up in the bond yield. Many factors can explain it. The two most important factors are a revision in the baseline forecast and the increased uncertainty about these forecast.
On using Core Inflation to set monetary policy in an era where the items that are excluded from the core (food and energy) are trending upward. According to the Fed officials we met, there is no evidence that energy and food prices are trending up (I have a hard time believing this) and, ultimately, the Fed is looking at maintaining headline inflation constant, not core inflation. True, but by focusing on the core in the short term, there is a risk that headline inflation will eventually slip away; especially if policy makers are counting on the usual mean-reverting trend of food and energy prices which, this time around, may fail to materialize due to the pressures of globalisation.