FRB's Kohn: When the Unexpected Inevitably Occurs

Wednesday, June 15, 2005

Is there a rift developing in the Federal Reserve's Board of Governors (FRB)? Reading today's remarks of governor Donald Kohn to the Banker's Association for Finance and Trade there is a worrying footnote observed only once before. "The views I express here are my own and not necessarily those of other members of the Board," it says for the first time. Looking up other speeches of the FRB members, this note has only been used by Kohn once before this year. His speech from May 20, held in Frankfurt, included the same footnote, only replacing "Board" with "FOMC". As these footnotes might suggest split opinions in the FRB/FOMC, his key words were "when the unexpected inevitably occurs," and "our economy is in unexplored territory in many respects," as well as "we are in uncharted territory with respect to many aspects of our macroeconomic environment." Read this post to the end!
Kohn said in his remarks,
"the most important thing we can do ... is to develop systems for our actions and reactions that can accommodate the unexpected..."
In the next paragraph he said,
"the means of managing risk have broadened dramatically, but the resulting systems could well be challenged by developments over coming years," continuing that "the possibility that developments in our macroeconomic landscape might test these systems, and the steps you as private participants, and we as public policymakers, have been taking to raise the odds on preserving healthy financial systems and economies when the unexpected inevitably occurs."
After an excourse into financial history in the past decade - spanning from the Asian currency crisis over the Russian debt crisis to the default of Long Term Capital Management - and a reminder that the monetary policy of the US responded very aggressively to problems, Kohn went on to say,
"my message this morning, however, is that this is not a time for complacency. Financial-market innovations, some of which have not yet been rigorously stress tested, along with a macroeconomic environment that, while most likely stable and constructive, contains significant uncertainty, suggest that vigilance and adaptation by both market participants and regulators will be necessary to improve the odds of sustaining this era of damped economic cycles and supporting the orderly evolution of financial markets."
In case one is not worried by now, here come more orange alert warnings from Kohn. Being the balanced central banker Kohn does not anticipate any break in the pattern of generally favorable economic performance over coming years. After these sedating words his cautious tale continues.
"However, although the most likely outcome for the overall economy is good, a number of characteristics of the current situation suggest some greater-than-usual risks around that central tendency, and, in particular, raise questions about the pattern of asset price movements that might accompany even favorable overall economic performance. That caution flows from the existence of some unusual imbalances in the U.S. economy today. We are buying far more than we produce, and the extra purchases come from importing more than we export, financed by net borrowing from abroad. The resulting current account deficit has risen to a record level, in excess of 6 percent of gross domestic product. The counterpart of the current account deficit is low savings generated here at home; in the past year, household saving out of current income fell to the unusually low level of about 1 percent."
While this not exactly new, as are his remarks about the housing market, Kohn had the following advice for commercial bankers.
"I expect that the adjustment to more-sustainable patterns of spending and production and saving will occur in an orderly manner. The response of asset markets to changing attitudes and appetites will induce gradual adjustments in spending. But as you think about your risk-management challenges over coming years, you need to keep in mind that our economy is in unexplored territory in many respects. Historic patterns of movements in interest rates, exchange rates, and house prices may not be very good guides to future relationships."
Want some more? Here it comes!
"Who would have anticipated that the dollar would strengthen in 2001 as the Federal Reserve eased aggressively or that long-term interest rates would fall as we gradually reduced monetary accommodation over the past year? Even orderly adjustments may involve new combinations of market developments. And the risk of rapid adjustments and unusual configurations of asset price movements is higher than normal."
Tail events, that is, asset price movements that are much more extreme than our usual experience, were his next focus. Firms could no longer assume that they could reduce their risk by adjusting positions as trades might only be possible at smaller volumes.
"The challenges posed by tail events are not limited to market liquidity risk. They have broader effects on the measurement and management of market and counterparty credit risk, too. Managers of market risk typically mark positions to market and compute the value of positions under different assumptions about future price changes. During a tail event, wider bid-offer spreads are expected, reducing the accuracy of valuations of existing positions. More importantly, however, the dynamics of prices during tail events for individual assets and for assets in relation to each other likely are different from those observed in normal market conditions."
Kohn expects bankers to put in extra hours for stress testing.
"As I noted earlier, we are in uncharted territory with respect to many aspects of our macroeconomic environment. Prudent risk managers recognize the potential for tail events and prepare for that possibility. Such preparations involve stress testing, that is, simulating the portfolio's behavior during extreme yet plausible events to determine if losses are acceptable in those conditions. It is sometimes hard to know what types of events to use in this testing, and the choice of events will, of course, be a function of the underlying portfolio. That said, the current imbalances, along with the unusual asset price movements of recent years and the investor behavior and expectations they reflect, offer clues to some of the extreme but plausible events that management should be considering. Prudent risk management does not stop with stress testing, however. To be meaningful, the results of stress testing should be part of management's ongoing planning for future contingencies."
He ended his remarks with further cautioning.
"Our responsibility is to work to maintain a stable price level and economic environment. Your problems would be compounded many times over by a surge in inflation and economic instability. In our risk-management approach to monetary policy, we attempt to reduce the odds that our nation will experience damaging macroeconomic tail events. But our capabilities are limited; ultimately, we are working with only the overnight interest rate and we concentrate on the price level more generally, which may not always be compatible with the stability of the prices of particular assets. And, like you, we cannot reliably anticipate what will occur. All the more reason for both private parties and regulators to pay particular attention to possible sources of risk and stress over coming years."
Strong words all in all, a lot stronger than the warnings of chairman Alan Greenspan has voiced recently. Other Fed members shot off warnings too last week.
It is a confusing world it seems. The array of better-than-expected economic indicators released in the last 30 hours should not be taken as a sign of relief for the future. I have not had a look at the TIC data yet, but at 47 billion dollars they came in a lot below the financing needs of the carefree spenders in the White House.
A sum-up of the US' problems shows the following most pressing issues:
  1. Trade deficit
  2. Budget deficit caused by a growing government participation in the economy
  3. Current account deficit
  4. Employment
  5. Oil and energy induced inflation
  6. Education
  7. The nation will become a net food importer for the first time in history
  8. Two wars (Iraq, Afghanistan) without an exit strategy
  9. A changing political climate towards the Bush administration
  10. Housing bubble
  11. Interest rate conundrum
  12. Consumer indebtedness
  13. Long-term weakness of the currency
  14. Widening income gap
One can argue about the priority of these issues. But I guess it is undisputed that nothing unexpected has to occur as all problems are well known and show up on the road ahead in bold letters. The question is only which bomb will go off first and start a chain reaction.
The acting government has a long list of problems, but it focuses on the one issue that is the least pressing, Social Security. How long will the head-in-the-sand strategy work? Given the rising nervousness in this year's speeches of the Fed members The Prudent Investor fears we are much closer to the downturn than anybody wants to admit.
Don't spend a sleepless night worrying. The problems will reliably still be here tomorrow. And everybody will need all the energy to reinvent the American dream of liberty and innovation the fate of the whole world depends on.
For a little more reading about interpreting Fedspeak jump to "Growth Sector #1: Conundrums" and "Media star Alan Greenspan".


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