If you've got the money, honey, I've got the time.
— Lefty Frizzell

We all know that time is money. When we are young, most of us have more time than money, and we're eager to exchange the former for the latter. As we reach a certain age — as time becomes scarcer and more valuable to us and money more plentiful — the opposite trade works better for us. We become more willing and better able to buy time with money.

Most of us value the certain present over the uncertain future, in other words we have what economists call a "positive time preference." But we differ on the degree of our positive time preference. Some of us must be compensated highly to forego present consumption for future consumption. Others of us are natural savers and can be bought off more cheaply. The trade-off is captured in the question of whether you'd rather have a fifth (of spirits) on the 4th of July or a quart — a fourth — on the 5th of July. Most Americans would probably choose a fifth on the fourth; most Chinese would probably choose a fourth on the fifth. Other things equal, this means that interest rates would likely be higher in the U.S. than in China, at least on the 4th of July.

An equilibrium constellation of interest rates implies that those rates just balance out our varied time preferences. At the margin, the relevant interest rate just compensates the most reluctant saver for deferring consumption. At that level of rates, some of us are compensated more than necessary while others aren't compensated enough to get them to save. Of course, equilibrium rates will change as circumstances change. Bad news on the horizon, or just greater uncertainty about the future, will cause equilibrium rates to rise.

This is not to say that interest rates are the only determinant of saving, or even the most important. Income is probably more important, but we are assuming that income and other relevant factors remain constant while we focus on interest rates.

The future has changed a lot recently. We have gone rather abruptly from a benign view of the future to a more uncertain view. The benign view generated low rates on average and little difference to reflect differing circumstances and outcomes. In other words, the spreads were small — the spreads between government debt and private debt and the spreads faced by private debtors of different circumstances.

The spreads were probably too low before, although they did a lot of good for a lot of people. They will probably end up too high now and cause unnecessary pain. But they will settle down soon and reflect our collective view of the future and our willingness to embrace it. Markets aren't perfect. They are just better than all the alternatives.

*Appeared in the Wall Street Journal on September 17, 2007.

The blame game has started. I refer to recent charges that former Federal Reserve Board Chairman Alan Greenspan caused the current financial market turmoil by pushing interest rates too low, touting variable-rate mortgages, and bailing out Long Term Capital Management.

I don't think so. Policymakers use cost-benefit analysis in making decision. They choose between likely alternatives A and B by comparing the expected benefits of each to the expected cost of each. Choosing A doesn't mean there were no benefits of B or no costs of A. It just means A's expected benefit/cost ratio was higher than B's.

Critics may later "discover" the chosen alternative A had costs or downsides. Well, of course it does; the point is they were deemed to be smaller relative to benefits than the B alternative. B's costs, however, remain invisible and are ignored because B wasn't chosen. Even so, alternatives are still relevant to evaluating outcomes.

Mr. Greenspan's Alternative A was to allow short-term interest rates to decline to very low levels when disinflation threatened to degenerate into outright deflation. Alternative B was to ignore that risk and take our chances. He was too good a student of Austrian economics to assume no costs to such low rates, and he often warned of the dangers of the dramatic lowering of risk spreads that accompanied low rates.

The chairman didn't give deflation a high probability of occurring, but he did expect the consequences of any such occurrence to be severe enough to justify preventative action. One might argue that the low rates required to sustain aggregate demand in 2003 were themselves evidence of the seriousness of the threat.

A more important point in his defense, however, is that disinflation and falling interest rates were a worldwide phenomenon. To attribute them to Alan Greenspan is parochial in the extreme. As the threat of deflation diminished, the Federal Open Market Committee (FOMC) raised its target Fed funds rate in 17 consecutive quarter-point steps over a two-year period. During that period of rising short-term rates, long-term rates remained flat or declined worldwide, not just here. That "conundrum," as the chairman famously called it, eventually was attributed to the extremely high saving rates of newly emerging economies worldwide.

As indicated above, the flattening of yield curves was accompanied by a dramatic decline in risk spreads worldwide, against which the chairman cautioned frequently. A memorable milestone of that period was the Mexican sale of peso bonds for less than 9 percent when not long before they couldn't get that rate even in dollar-denominated bonds.

When rising short rates failed to pull up long rates, the chairman, at least internally, focused on the impact on the 10-year bond yield. Dissection of its 10 implicit one-year tranches revealed that rates rose on the first few tranches, but actually fell in the out-years. Again, the conundrum of rising short rates and falling long-term rates and risk spreads was worldwide. As powerful as the Maestro was, it's still a stretch to blame him for single-handedly inverting the world's yield curve.

Now, what about the chairman luring unsuspecting consumers into adjustable rate mortgages they couldn't afford? The origin of this charge is his speech on Feb. 23, 2004, to the Credit Union National Association. In a technical discussion of "Mitigating Homeowner Payment Shocks," the chairman noted fixed-rate mortgages had the advantage of allowing homeowners to prepay debt when interest rates fall but don't require higher payments when rates rise.

His research indicated, however, that this advantage was probably overpriced by the market. "Homeowners pay a lot of money for the right to refinance and for the insurance against increasing mortgage payments. Calculations by market analysts of the 'option adjusted spread' on mortgages suggest that the cost of these benefits conferred by fixed-rate mortgages can range from 0.5 percent to 1.2 percent, raising homeowners' annual after-tax mortgage payments by several thousand dollars. Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward."

Somehow, I doubt the chairman's geek speak sent Joe Six-pack running off to apply for an ARM he couldn't afford. Affordability, let's remember, is primarily a matter of income. At the Economic Club of New York a week later, the chairman, asked about his earlier remarks on ARMS, emphasized that their focus and applicability was limited to a very small segment of households.

Finally, the Fed was not a party to any bail out of Long Term Capital Management, unless inviting its creditors to use the New York Fed's board room constitutes a bail out. LTCM's major creditors bailed themselves out in mid-September 1998 by adding good money after bad, leaving the original investors only a few cents on the dollar. I doubt they felt bailed out by anybody.

In addition to the charge of a specific Fed bailout, the Greenspan Fed is also accused of easing monetary policy to help LTCM even though its three quarter-point easing moves from Sep. 29 to Nov. 17, 1998, came after the resolution of LTCM by its creditors in mid-September and was motivated by the market impact of the Russian debt default and devaluation on top of the ongoing Asian crisis.

Insurance against Asian contagion seemed reasonable at the time and still does to me. Ironically, when pre-emptive policies work as intended, it makes them seem unnecessary in retrospect. But we should always remember that the way things turn out is not the only way they could have turned out.

*Appeared in the Washington Times on September 16, 2007.

What is it, a credit crunch?

I note that the term "credit crunch" is emerging as the label of choice for most people who talk about the recent turmoil in credit markets.  That was also the term used in the early 1990s in the aftermath of the S&L and banking crises.  However, back then Fed policymakers were reluctant even to use the term and held out longer than just about everyone. When they did give in, they used "so-called" or put quotation marks around the offending noun.

I was one of three Fed presidents asked to testify before a Congressional committee about its impact in our region.  As I recall, I was the only one of the three to accept the term-certainly to use it without quotation marks.  Later on, when all the Fed presidents were "invited" to testify before the Senate Banking Committee, I was the first to use the term in my prepared remarks, which prompted the Committee Chairman to interrupt my testimony to ask questions about it. 

My point:  Fed watchers can gain some insight into Fed thinking by listening carefully to the language and labels used by policymakers. Denials of reality often show up in the language including the use of terms like "so-called" and the use of quotation marks on words used freely by everyone else.

(I'm basing this on memory, so I can't swear to the details on a stack of Bibles.  I do believe it's accurate, however.)

Which is better suited to deal with a credit crunch-the discount rate or the Fed-funds rate?

Normally, the discount rate is better for a couple of reasons.  Borrowing at the discount window is done at the initiative of the borrowing bank; so the funds are more likely to go where needed. And, unless offset with open market operations, the new reserves to the borrowing banks will also represent an expansion of reserves to the banking system as a whole.  When banks get reserves from other banks in the Fed-funds market, they are just swapping around existing reserves.  Reserves gained by some banks will be lost to other banks.

Cutting the target Fed-funds rate is a more general, less focused, action.  It will stimulate the economy as a whole, and may be needed, but the impact on what's causing the credit crunch will not be very direct.

Was the Fed's reduction in the discount rate a good idea?

Yes, it was an excellent idea.  However, as it turned out, it led to very little borrowing.  This tells me that the problem wasn't one of liquidity where firms needed to convert sound, but illiquid, assets into cash. Neither is it reluctance to borrow.  Instead, the problem is turning out to be a reluctance to lend, based on uncertainty and fear of loss-fear that they won't be paid back.

If the problem was a reluctance to borrow, it might be helped by lower interest rates because borrowers like lower interest rates. But a reluctance to lend is not helped by lower interest rates. Lenders like high interest rates, along with the expectation of repayment. Lower rates are hardly an incentive to a scared lender.

Does this mean the Fed shouldn't lower the Fed-funds rate on September 18?

No, the Fed should lower the Fed-funds rate because it will stimulate the economy and help prevent or cushion a recession.  It may also help ease the shock of new mortgage resets.  However, I don't expect a general easing of monetary policy to have much direct effect on the credit crunch, which is caused by fear of lending, not an unwillingness to borrow.

How much should the Fed ease on September 18?

As a general rule (at least a general McTeer rule), policy changes should be front loaded, and can taper off later.  The FOMC should cut the Fed-funds target rate by 50 basis points, and perhaps cut the discount rate by 25 to 50 basis points as well.  When things start looking up, they can move to 25 basis point cuts if they wish.

One reason for a frontloading policy in general is that, early on, you know what is needed; so there's little reason to be cautious.  Later on, a time will come when there is less certainty whether more is needed-when you must worry about a bridge too far.  At that point, smaller changes are appropriate so any mistake will be a smaller mistake.  Remember:  bold early; more cautions later.

Of course, aside from the general frontloading rule, which calls for boldness now, we have an emergency situation that also requires boldness.  We have a credit crunch caused by fear of lending. Under present circumstances, shock and awe is warranted.

The recent crisis in financial markets growing out of the subprime mortgage mess generated calls for the Federal Reserve to "ease" monetary policy. What most people had in mind by easing was a reduction in the Fed's target federal funds rate from the 5.25 percent level that had prevailed for over a year. Instead, the Fed responded, at least initially, by reducing its "discount" rate from 6.25 percent to 5.75 percent and liberalizing collateral requirements and length of borrowing at the Fed's "Discount Window."  This is a good time to review the contents of the Fed's tool kit-it's three tools of monetary policy: open market operations and the Fed Funds rate; the discount window and the discount rate; and reserve requirements.

Open Market Operations and the Federal Funds Rate

Banks and other depository institutions are required to keep a percentage of their deposit liabilities as "reserves," either on deposit at the Fed or in vault cash.  The Fed's reserve requirement, the third tool of monetary policy even though it rarely changes, is, at the margin, 10 percent of deposits.  This means that each dollar of reserves in the banking system supports $10 of deposit liabilities, which are part of the money supply.  Banks must meet their reserve requirements over a two-week "maintenance" period.

At any given time, some banks will have more reserves than currently needed to fund their loans and investments and still meet their reserve requirement while others will have a need for more reserves. This has resulted in an inter-bank market in reserve deposits at the Fed-the Federal Funds market-where banks with excess reserves  lend (sell) reserves to banks with a potential reserve deficiency. The interest rate that clears this market daily is the Federal Funds rate. Upward pressure on the Federal Funds rate suggests a scarcity of reserves in the banking system.  Downward pressure suggests that reserves are plentiful.

The Federal Reserve normally conducts monetary policy by buying and selling (primarily) government securities with the motive of injecting new reserves into this market or withdrawing reserves from it, thus giving the banking system a greater or lesser ability to make loans and create new deposits that are used by the public as money.  The important part of these open market operations is the rate of reserve and money-creation they generate. Ideally, the nation's money supply should grow over time at about the same rate as the economy's potential to grow in real terms. With money creation and economic activity growing at about the same rate, the inflation rate should not rise.

While money growth is most important in its impact on the economy, as a short-term operating procedure, the Fed in recent years has based its operations on its "target" for the Fed Funds rate.  It buys securities to push the rate down toward the target and sells them to push it up. The decision about the level of the target rate will be is made by the Federal Open Market Committee (FOMC), composed of the Fed Governors and Presidents of the Reserve Banks.  The FOMC, in 17 consecutive meetings in just over two years beginning in June 2004, raised its target Fed Funds rate from 1 percent to 5.25 percent, where it has been for more than a year now, in an effort to prevent or offset inflationary pressures.

The Discount Rate and the Lender of Last Resort

When the Fed was established back in 1913-14, bank loans were typically in the form of "discounts" where the borrower signed a note for $100 but received only $94 in cash.  One of the intended roles of the Fed was to enable banks, when they had a need for liquidity, to "re-discount" those discounts, or customer notes, at the Fed.  The Fed charges an interest rate that came to be known as the "re-discount" rate.  Over time, the "re" was dropped, and the interest rate the Fed charges to borrowing banks became the "discount" rate.

Banks could also get funds (become more liquid) by borrowing reserve deposits from each other in the Federal Funds Market.  But the reserves gained by one bank would be lost by another.  Normally, that is not a problem, but is a good way to distribute reserves among the banks as needed for loan and investment growth.  But during times of stress, reflected by a shortage of liquidity in many banks, the whole banking system needed new reserves, hence the Fed's Discount Window.  New reserves borrowed from the Fed do not come at the expense of other banks.  They are new reserves to the borrowing bank as well as new reserves to the banking system as a whole.  This distinction is extremely important in times of stress.

Another important distinction between the Fed supplying new reserves to banks through open market operations vs. the discount window is that the former is a general injection, initiated by the Fed, while the latter is initiated by the borrowing bank in need of liquidity-a shotgun approach vs. a rifle approach.  For this reason, borrowing at the discount window is probably a better option for crisis management since the reserves are more likely to end up where they are needed.

In the modern era, large banks receive and pay out millions and billions of dollars throughout the day.  In normal times, the banker doesn't worry much as he pays out money whether he will receive the funds he has coming.  In times of stress, however, they do worry, and they are motivated to slow the outgoing payments to make sure they are fully matched by incoming payments. This behavior among banks is, of course, self defeating and causes the very problem it seeks to protect against.

The Fed's discount window is well suited to break this log jam, or freeze up, but it may also require a little Fed jawboning.  Following 9/11 and during the recent crisis, the Fed urged large banks, particularly, to keep the money flowing and use the discount window to make up any daily shortfalls that might result.

A Bothersome Technicality

My description of open market operations above was accurate, but it doesn't match up very will with the contemporary jargon surrounding recent events.  When the Fed wants to "ease" monetary or liquidity conditions, it purchases (normally) government securities in the open market.  This expands bank reserves and the money supply initially by the amount of the purchase.  Further multiple expansion of deposit money will ensue, other things equal, because each dollar of new bank reserves will support about $10 in deposits-which are used as money-in our example above.

Think of the previous paragraph as a description of a "permanent" injection of reserves and money.  More temporary, day-to-day injections are done with "repos" or "repurchase agreements." For example, the New York Fed, acting on behalf of the System, will offer to purchase government securities from dealer banks and sell them back the next day for a specified price that determines the repo interest rate.  The bank, for a day, or more, gives up an earning asset, in exchange for reserve balances that count toward its required reserves. If the Fed wishes to withdraw funds from the banking system temporarily, it might do a "reverse repurchase agreement," by selling securities to banks for a day with a reversal of the transaction the next day.

If you have found the press discussion-and my own-of repos confusing, part of the reason is that the nomenclature that has evolve is backwards. When people say the Fed injected reserves into the banking system with a repo, it really is a repo from the banks' point of view since it is the banks who agree to repurchase the securities. When the Fed withdraws liquidity by selling securities for a day and agreeing to buy them back the next day, it's a repo from the Fed's viewpoint, but it's usually called a reverse repo.  Go figure. (Hint: the language used usually is from the banks viewpoint.)

What Fed Has Done So Far

As an example of the real world use of its policy tools, the New York Fed, on Thursday, August 9, injected $12b of reserves with a 14 day repo plus another 1 day repo for only one day.  The next day it injected $3 billion in reserves for 3 days (Friday, Saturday and Sunday) and $2 more.

Several pendants on financial television, who were not familiar with the discount rate, got in the habit of adding all these sums up to get the total reserves added to the banking system.  They failed to subtract from the cumulative total when a previous repo expired, causing reserves to decline.  The total or reserves retained in the banking system was, therefore, less than the sum of the initial injections.

The big news on Friday, August 17, however, was an early-morning announcement by the Fed's Board of Governors that it was accepting the recommendation by 2 Reserve banks to reduce the Reserve Banks discount rate by 50 basis points from 6.25 percent to 5.75 percent.  The announcement also indicated that longer-than-usual borrowing would be tolerated and that collateral requirements would be liberalized to include paper under pressure by the crisis.  The announcement was received warmly by traders other than those caught with their shorts up-not referring to their underwear. They got wedgies big time.

The Fed also engaged in a bit of "jawboning," sometimes thought of as another tool of monetary policy.  In this instance, the jawboning took the form of urging banks to use the discount window if needed, emphasizing that it would not be regarded as a sign of weakness.  It apparently went further and arranged for four large banks to borrow $500 million each as a demonstration to encourage others.

The Fed's discount-rate cut did not result in significant increase in usage of the discount window, but it still had a major impact in reassuring market participants.  The markers became much calmer after the action.  Nevertheless, market participants and others soon renewed their cries for the Fed to ease monetary policy in the conventional way of cutting the target Federal Funds rate.  More that one such easing was soon reflected in rates for Fed Fund futures.  This pressure on the Fed to ease on or before its next regularly scheduled meeting on September 18 creates potential further instability if the Fed disappoints the markets.  Even if the Fed considers an easing a good idea, it will be somewhat reluctant to allow markets to dictate such moves because of the moral hazard problem it will generate in the future. 

*Appeared in the Harry S. Dent newsletter on September 1, 2007.