To Be A Fed Chairman

By Nathan J. Burchfield
Monday, November 16, 2009

This report explains the method I use to interpret the financial markets, economics, and potential investment opportunities. I have found this method to be very helpful. Please Note: The econometric models used in this report are real. I created and tested them myself. If had to name my method, I would call it the Multiple Personality Financial Market Economic Investment Disorder, or simply (MPFMEID). The definition of Multiple Personality Disorder listed below, is courtesy of www.merriam-webster.com will help me explain why I would call me investment style (MPFMEID). Multiple Personality Disorder: “ a dissociative disorder that is characterized by the presence of two or more distinct and complex identities or personality states each of which becomes dominant and controls behavior from time to time to the exclusion of the others—abbreviation MPD; called also alternating personality, dissociative identity disorder” Within my approach there is a list of certain individuals to put it more crudely that I must become and, let their thought process dominant and control my interpretation of the financial markets, economics, and investments. This allows me to compartmentalize everything and then form specific schemata for possible reactions to events that unfold and the impact or possible impact to the financial markets, investments, or economic policy. It allows me to envision how certain key financial authorities may likely react to these events. The economic prescriptions they adhere to, and so forth. The key criteria to my (MPFMEID) approach is psychologically profiling and studying individuals who make the economic prescriptions i.e. monetary authorities, key politicians, key academics, and financial professionals. I do this by reading their books, essays, speeches, and whatever else I deem important as possibly to helping see the world as they do. As I am studying the specific individual, their essays, and books I begin to approach the markets as they do. The quote below from George Orwell’s essay titled. “Literature and Totalitarianism” express exactly how I feel about what individuals’ writings say about them, who they really are, and what they really feel and believe. “For writing is largely a matter of feeling, which cannot always be controlled from outside. It is easy to pay lip-service to the orthodoxy of the moment, but writing of any consequence can only be produced when a man feels the truth of what he is saying.” George Orwell: ‘Literature and Totalitarianism’ June 19, 1941. This leads me into the main point of this report. To show you how I implement my (MPFMEID) approach, and think like a specific key individual that is involved in the financial markets. The individual’s w perspective I am going to analyze is none other than Chairman of the Federal Reserve, Ben S. Bernanke. I have read all of his speeches, econometric studies, and his book, “Essays on The Great Depression”. I was able to gain insight into how Bernanke interprets, approaches economics, his monetary policy, and the powers of the Federal Reserve. It is now time to begin my analysis through the eyes of the Chairman of the Federal Reserve, Ben S. Bernanke. In my booked entitled, “Essays On the Great Depression”, I state at the top of page 6, I am a macroeconomist rather than a historian, and my book is intended to cover the broad economic issues of the Great Depression not historical details. On page 44 I mention how the U.S. banking system was extremely vulnerable, because it was made up of so many small independent banks, and that nations with only a few large banks Britain, France, and Canada never had the difficulties on the scale the U.S. did. The reason I brought that section of my

book up is to highlight being a nation with a few large institutions is better if a nation wants to limit their banking sector’s vulnerability. This is the last key point I will draw out from my book, it is on page 54. It has to do with the credit markets during the Great Depression, and what I used to gauge their stress. I use the yield differential between Baa corporate bonds and U.S. Treasury bonds. It is merely a measurement of preferences for safe “liquid” assets, but I must note that because it has no adjustment for reclassifying firms that should be in higher risk categories; it tends to greatly understate the yield difference between safe and risky assets. I must also note the indicator showed rather large moves from 1929-1930. The yield differential in July of 1932 jumped up to 7.93 percent. That was a drastic shift when compared to the fact during the 1920-1922 recession the yield differential never went above the range of 2.5%. The yield differential has a strong relationship to the banking crises. Milton Friedman and Ann Schwartz where the first people to point out how important the yield differential was during the banking crises that occurred during Great Depression. Below is a monthly chart from January 2007 through December 2008 of the yield differential (Baa yield minus the 10-Year Treasury yield constant maturity). I also calculated the Exponential Moving Average (EMA) for the same period, because that gives one a better grasp of what the yield differential actually was for the specific month. The data is courtesy of the Federal Reserve Bank of Saint Louis.

When Bear Sterns failed in March of 2008, the yield differential was 3.38 percent, and the EMA yield differential was 2.13 percent. For the month of September of 2008 when Lehman Brothers failed, the yield differential was 3.62 percent, and the EMA yield differential was 2.57 percent. The credit markets were seizing up and banks where under tremendous pressure. The financial system as we knew it was on the verge of a collapse if emergency action was not taken. Liquidity had dried up, and banks could not afford to risk the scarce capital they had.

Now I would like to examine a chart covering the last ten-months of 2009. The data is courtesy of the Federal Reserve Bank of Saint Louis. Below is the chart.

The EMA yield differential for October 2009 tells us yield differential is actually closer to 3.74 percent; that is higher than the yield differential was when Lehman Brothers collapsed in September of 2008 and when Bear Sterns collapsed in March of 2008. Lenders risk appetite has come back quite a bit, and the U.S. credit market and the global credit markets have thawed considerably over the last 10months. Below is a chart the S&P500 index’s performance over the last 10-months along with the yield differentials. The data is courtesy of the Federal Reserve Bank of Saint Louis and Standard & Poor.

The chart further highlights that credit conditions are improving due to the rise in the S&P and equity indices around the world .The yield differential must continue to shrink in order for credit conditions to normalize, and the credit allocation process is able to get credit flowing back at pre-Bear Sterns levels. The next thing in this report I would like to present is an econometric model I conceived to predict and use to indentify the recession that we exited here in the U.S. earlier this year. I will not bore you with the mathematical equation and process Involved in creating this econometric model. It does not fit in the scope of this report, so I will have to leave it for another time. I used the Fed Funds Rate data for this model, courtesy of the Federal Reserve Bank of Saint Louis. Below is a chart of my findings.

In the third quarter of 2007 the probability of a recession was 76.80%, and then it rose even higher in the fourth quarter to 86.65 percent. On December 1, 2008, the article headline, “U.S. officially in Recession since December 2007 according to NBER” December 1, 2008, from http://www.bankreorealestate.com proves my econometric model was accurate. Now to discuss everyone’s favorite subject, and area of great concern, the regulations of the financial markets. I am well aware of challenges we face in the coming years. So, I think it is imperative that every nation strives to work together in an effort to support and successfully join the micro-and macroprudential aspects of the regulatory framework, as well as the supervisory frameworks of the financial markets. For example developing and successfully implementing a capital buffer program into the architecture of the financial markets, so banks can weather the difficulties they are susceptible to due to the counter cyclicality that is commonly know to occur in free market economies.

The data used in the chart below is courtesy of Moody’s. The chart is of the key years for U.S., UK, and Euro Zone for shortened wholesale debt maturity profiles of many of their banks that are exposed to refinancing. The major refinancing years for the U.S. UK, and Euro Zone banks are the current year (2009) through the year 2012.

Being chairman of the Federal Reserve I am aware there is a lot of refinancing banks will need to do in the U.S., UK, and Euro Zone specifically in realm of shortened wholesale debt maturity well into 2012. I am also aware that the U.S., UK, and Euro Zone banks need the current monetary policy that is currently in place to stay in order to secure financing at attractive rates to refinance the large amounts in shortened maturing wholesale debt they are exposed to. I cannot comment on what the European Central Bank (ECB) or the Bank of England (BOE) should do, when it comes to monetary policy, and I think it would be rather inappropriate. If I had to make my decision about whether the Federal Reserve should change its monetary policy in the near future based off of all of the things mentioned so far in this report, I would tell you that the Federal Reserve needs to maintain its current stance of “accommodative” monetary policy for an extended period of time and leave the Federal Funds Rate where it is, currently at (0-0.25). I do not think many participants in the financial markets along with heads of the other central banks would think that the data I have talked about so far in this report is enough to justify accommodative monetary policy. I am well aware that my fellow colleagues at the Federal Reserve and ex-Federal Reserve members have repeatedly stated that the Federal Reserve has other tools it can use to tighten monetary policy besides raising the Fed Funds Rate. I have been wondering for sometime what would the affects be on the U.S. economy, and the global financial markets if the Federal Reserve did increase its Fed Funds Rate. I decided to create another econometric model to show what would happen if my colleagues and I at the Federal Reserves did increase the Fed Funds Rate. The data I used for this econometric model is courtesy of the Federal Reserve Bank of Saint Louis. The chart is located at the top of the next page.

The model shows that if my colleagues and I increased the Fed Funds Rate to 2.0-2.25 percent, the probability of dire reverberations occurring in the U.S. economy and global financial markets would most likely trigger an unthinkable chain of events all around the world. Numerous nations’ currencies would collapse just as Icelandic currency, the krona did in October in 2008. With the Fed Funds Rate set at the lower end to 2.00 percent the probability of the events mentioned above would be 75.36 percent, and 80.79 percent if we set the higher end of the Fed Funds Rate at 2.25 percent. When you average those two likelihoods out for the probability of a crash with the Fed Funds Rate set at 2.00-2.25, the probability would be 78.07 percent. That is higher than the probability was for the recession of 2007. With that said, I think it is it is not absurd or inappropriate to use hyperbole when speaking of the financial consequences Americans and citizens of every other nation around the world would have to endure. The Federal Reserve should not increase the Fed Funds Rate, because of what I call “phantom” inflation fears. The Fed Funds Rate is to blunt of a monetary tool to use during the current conditions in the financial markets, and the macroeconomic conditions in the U.S. Increasing the Fed Funds Rate is simply inappropriate until a robust recovery in the U.S. economy takes hold, unemployment peaks, we see considerable positive gains in monthly net job data, and substantial growth in nominal wages. My colleagues and I at the Federal Reserve are carefully monitoring CPI, PPI, and the methodically adjusted trimmed-mean CPI estimators that were created thanks to the Federal Reserve Bank of Cleveland. Price stability and full employment remain our most important objective. To achieve those goals we must be patient and let the well crafted government stimulus that consist of a combination of government spending, tax cuts, and credits passed by the senate on Friday, February 14th, 2009, and singed into law Tuesday, February 18th, 2009, by President Obama, as well as the Federal Reserves various lending facilities it created have time to fully take hold and rejuvenate the U.S. economy. We have seen many positive signs in the economy, third quarter nominal GDP was 3.5%; that is the first time GDP has been positive in over a year. Another positive sign (green shoot) to highlight is

seasonally adjusted industrial production and capacity utilization, which has posted three consecutive positive monthly gains since bottoming out in June at 68.3. We are aware it is highly possible we might have to extend the duration and size of our Term Asset-Backed Securities Loan Facility (TALF). The limit for the amount of loans the Federal Reserve Bank will make through TALF is currently set at $200 billion. I would like to note we already have expanded the scope of collateral we will except through TALF by authorizing an extension of the program until March 31, 2010, for loans using newly issued ABS and legacy CMBS, and through June 30, 2010, for loans against newly issued CMBS. The world has avoided another great Depression, thanks to the extraordinary monetary actions by the Federal Reserve and every central bank around the world; there are still a lot of things that need to be addressed in regards to the U.S. economy and the global economy. When the time is right the Federal Reserve will implement the proper monetary prescriptions to encourage the much needed rebalancing of the U.S. economy. It is totally up to Washington D.C. to implement the fiscal policies to get the U.S. government’s deficit to a sustainable level. I would like to take a moment to address the U.S. government’s creditors’ fears that the Federal Reserve is engaging in, and or supporting monetization of the U.S. government’s debt. We at the Federal Reserve strongly support a strong U.S. dollar. The recent decline over the past eight-months in the U.S. dollar’s exchange rate is due to exchange rate overshoot. It does not reflect the long-term strength and resiliency of the U.S. economy. The Federal Reserve will continue to closely monitor the activity in the financial markets. We will be in daily correspondence with President Obama, and his staff of economic advisors at the White House; the United States Secretary of the Treasury, Mr. Geithner, and his staff at the U.S. Treasury Department via our team of financial market specialist that has been put together at, and by the Federal Reserve Bank of New York, since the Federal Reserve Bank of New York is in charge of conducting the Federal Reserve’s Open Market Operations. The reports are aimed at thoroughly keeping President Obama and his staff of economic advisors and Mr. Geithner and his staff informed and up to speed on the conditions of the financial markets. I hope this report I wrote looking at things through the eyes of the Federal Reserve’s Chairman, Ben Bernanke is helpful, and it gives you some ideas on ways of looking at the financial markets, economics, and Investments potential opportunities.

Sources Essays on the Great Depression, Ben S. Bernanke, Published by Princeton University Press and copyrighted, © 2000 Federal Reserve Bank of Saint Louis http://research.stlouisfed.org/fred2 Moody’s Global Banking November 2009 Banks' Wholesale Debt Maturity Profiles Shorten, Exposing Many Banks to Refinancing Risks

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