Sunday, March 15, 2009

Back to square one

This may not be news to those who have recently tried to raise money for their small business, refinance their mortgage or entertain a family shopping trip only to opt for a game of charades, until they feel a bit wealthier… Financial conditions feel tight!

What might be a surprise is that they are even tighter than six months ago—despite the Fed’s 1.75% worth of rate cuts to practically zero and despite the doubling of its balance sheet over the same period! Basically, we're back to square one and, if I were to guess, Ben must be having trouble sleeping.

The concept of “financial conditions” is an extension of the framework of “monetary conditions” used by a number of central banks to monitor how tight or loose monetary policy is. (As recently as last week, the Swiss National Bank cited the “inappropriate tightening” on monetary conditions as one of the reasons behind its decision to depreciate the Swiss franc to help loosen up things).

The general idea is that the focus on a central bank’s target interest rate is too narrow to capture the overall financial conditions in a complex economy. For example, in the US, where capital markets have been increasingly important in allocating capital, monitoring stock and bond market variables is essential for assessing the outlook for private investment and even consumption.

Of course you’d think these variables are closely linked to the Fed’s target interest rate—courtesy of the monetary transmission mechanism, whereby changes in the Fed’s policy rate are eventually reflected in asset prices across the board and across maturities.

But that’s precisely why a financial conditions index (FCI) can be very handy when the transmission mechanism is broken (read “today”) and/or the Fed’s policy rate is zero (read “today” again). In such an environment, an FCI framework may be the only way to monitor changes in the monetary stance, its impact on the growth outlook and whether the Fed should do more.

Which brings us to the numbers.

Bill Dudley, current president of the New York Fed, came up with a Financial Conditions Index for the United States back in the 1990s, during his stint at (where else?) Goldman Sachs. (You can see one of his early exposes on the index here).

Goldman’s subsequently refined the index but the basic principles remained the same: The index is a linear combination of four indicators: The short-term interest rate (the three-month LIBOR rate); a long-term reference rate to reflect borrowing costs for corporates (the 10-year US Treasury plus the ten-year CDX spread, which tracks the cost of protection against the default for a basket of US companies); the US dollar trade-weighted exchange rate; and the S&P500 index to capture equity prices.

In case you were about to ask, the intuition behind including the exchange rate is to capture the adverse impact of a real exchange rate appreciation on the demand for domestic goods. The rationale for including equity prices is, as Dudley explains, to capture the impact of movements in stock prices on household wealth (and thus consumption) and on corporate investment (via the impact on the cost of capital).

So what do the numbers tell us? After reaching a low in May ’08, Goldman’s index has seen a relentless increase ever since (i.e. conditions are now tighter). This is not that surprising in light of the collapse in equity prices, the rise in corporate spreads and the reversal in the fate of the dollar, which has strengthened sharply since last July.

But worryingly, the index is somewhat higher than back in October, despite the Fed’s rate cuts and despite its numerous acronymed facilities to support financial intermediation.

Unfortunately, the situation may be even worse than Goldman’s numbers suggest. As Dudley acknowledged back then, the index is not designed to capture the availability of credit (i.e. the quantity, rather than the price, of credit). But this can be extremely important.

Indeed, its importance is highlighted in a more recent paper by Andrew Swiston at the IMF. Swiston uses the results of the Fed’s quarterly Senior Loan Officer Opinion Survey (SLOOS) to create a measure of credit availability. He then combines this measure with a set of financial indicators to create a FCI and estimate its impact on growth.

The paper finds that an enhanced FCI, i.e. one that includes banks’ lending standards along with short-term interest rates, interest rates on corporate debt, equity returns and the dollar real effective exchange rate, has a meaningful impact on future growth. The impact of tighter lending standards in particular is important both because of its direct effects on credit and growth and (more so) because of its implications for other financial variables.

This latter point is critical: Swiston finds that tighter lending standards can magnify the adverse impact of lower credit supply on GDP growth due to their undesirable effects on stock markets and on the prices of corporate credit.

What should we make of this? I personally see a couple of implications, that keep me awake at night (along with Ben). The first is that commercial banks have been tightening their lending standards since October 2007, and continued to do so meaningfully during the last quarter of 2008. Unless we see a stabilization (or reversal!) on this front, a sustained improvement in the growth outlook (and bond and equity markets for that matter) will remain in the realm of Hope.

The second is a policy implication. The Fed’s TALF, to be launched this Thursday, is designed to support credit supply by deploying non-bank investors such as hedge funds into the credit and securitization markets. The idea is partly that, if commercial banks (which are the ones covered by the SLOOS) can’t function properly –hey, let’s just bypass them and ensure that credit continues to flow and GDP growth is not undermined.

My reading of the above paper tells me that this would be wishful thinking. Banks continue to play a critical role in financial intermediation and unless we try to fix them we will be bouncing up and down the market bottom for a (long) while before we can lift off again.

Evidently, this is not news to Geithner & co. But the delays in designing and implementing the TARP (which, by the way, was announced before the TALF) tells me they might need a reminder.

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