JEFFREY BROWN: And for more on what was behind the latest plunge, we turn to Greg Ip, U.S. economics editor for The Economist magazine, and John Ryding, co-founder of RDQ Economics, an independent research and consulting firm for investors. He has worked as staff economist for the New York Fed and as an economic adviser to the Central Bank of England.
John Ryding, starting with you, if the Fed action was to some degree expected, what do you see explaining the strong drop today?
JOHN RYDING, RDQ Economics: Well, I think it was what the Fed said.
And the drop started after that 2:20 statement yesterday from the FOMC, where they said that there are significant downside risks to an economy that was already growing fairly slowly. And then the policy response was largely as expected. So it’s a bit like your doctor telling you, you are very seriously ill, but he’s only got an aspirin for you.
JEFFREY BROWN: So — staying with you, John, so investors, this is everywhere; investors are terrified of taking any risk at this point?
JOHN RYDING: I think that’s right.
The markets this year have been driven by whether people want to take risk or not take risk. They are terming the market risk-on or risk-off. And people started to take risk off after the S&P downgrade in early August of the U.S. Treasury debt and the problems with European sovereign debt and fears over European banks.
And we had a big plunge in the markets and a lot of fear measured by volatility. And we spent the better part of September climbing out of those fears and the Fed pushed us right back in.
JEFFREY BROWN: All right, now, Greg, you watch the Fed.
GREG IP, The Economist: Yes.
JEFFREY BROWN: Go back here a day at least. What did the Fed actually do?
GREG IP: OK.
Well, as you know, the Federal Reserve manages the economy usually by raising or lowering its short-term interest rate and thereby making people either spend more or spend less. But that short-term interest rate has been at zero basically since the end of 2008, so they have lost their ability to help the economy through conventional means.
Since then, they have been trying to help by pushing down long-term interest rates, the kind of rates that affect mortgages, for example, and the borrowing rates of companies. They first did it through what they called quantitative easing. They bought trillions of dollars of bonds. And they paid for them simply by printing money out of thin air.
But there was a lot of negative reaction to that, not just on capital here, but in other countries. So yesterday the Fed did something slightly different. They said we’re going to go out and buy $400 billion of long-term bonds, again with the intention of pushing up their prices, pushing down their yields and lowering everybody’s borrowing costs.
But instead of paying for it by printing money like we did last time, we will pay for it by selling some the shorter-term bonds that we own whose interest rates are already close to zero. They did one other thing that a lot of people have not sort of picked up on. They also own a lot of mortgage-related securities. And these have been basically shrinking as they mature.
What they have said is as those bonds mature, we are going to buy more of those and that will deliver an extra dollop of help to the mortgage market.
JEFFREY BROWN: Is this in essence pumping in more money or is it just shifting money in the hopes that it goes to the right place and lures investors?
GREG IP: In theory, it should actually have roughly the same impact that their previous quantitative easing operations did.
The idea of both of them is that long-term interest rates, although they are very low, they are still above zero. If we can push them down further, it will do two things. It will encourage some people to borrow and spend. And investors who are no longer happy getting such low returns on Treasury bonds may take, you know, the chance and buy something riskier like stocks or perhaps even invest in a new business.
JEFFREY BROWN: And you heard John Ryding refer to the language that they used. Does it sound like they are signaling, because that — it is always hard to read their language, but, of course, the great fear is a double-dip recession at this point.
GREG IP: Now, this is what is interesting, Jeff, is that historically the Federal Reserve would often say they were worried about the economy. But that didn’t cause the markets to fall, because investors always believed that no matter how bad the economy was, the Fed could do something to help it.
The thing that you have seen happening in the last month or two is that the Fed tells us the economy is in trouble, but people say, yes, but I don’t think you’re able to help us very much. The tools that you have left are somewhat kind of unconventional, a little bit desperate, and I think that’s adding to the sense of gloom out there.
JEFFREY BROWN: Does that sound right to you, John Ryding, that plus of course all the political gridlock?
JOHN RYDING: Oh, I agree with that assessment.
I mean, it went to — the Fed went to a 1961 policy that it tried called Operation Twist, this buying long Treasuries and selling short Treasuries. And the general wisdom from economists looking back at that period is it wasn’t a very effective policy. So it does seem something of a Hail Mary play.
But I would say this. The economy doesn’t have a monetary problem. Interest rates are very low. The banks have $1.7 trillion of excess reserves. So it’s not the level of interest rates that’s stopping people investing, stopping people from buying houses. It’s other aspects of economic policy in the economy.
And yes, the gridlock in Washington in other areas means that fiscal policy can’t address those issues. And so people are left saying, we have got to struggle through on our own. And I will add one more thing. These low long-term interest rates, perversely, may hurt the economy, rather than help the economy, because people have a lot of liquid assets and live off of fixed income, retirees. And it’s really hurting retirees, pushing interest rates down.
And so if you are not encouraging people to borrow, but you are hurting retirees, those lower rates can curtail demand.
JEFFREY BROWN: Well, Greg, coming back to the political issue here, there was a political issue, of course, in the Fed acting. We heard John Boehner refer to it. There was a letter written…
GREG IP: Yes.
JEFFREY BROWN: … asking that the Fed not act. Now, how does that play into what is going on?
GREG IP: So that is very unusual to have a letter from the leadership of a political party telling the Fed on the day that they are meeting, you know, we really think that it is a bad idea for you to act.
Now, it’s not new for the Federal Reserve to be under attack by Congress. I mean, the Federal Reserve is independent precisely so that it can do the right thing.
JEFFREY BROWN: All right, that — we have always heard that.
GREG IP: Yes. You know, in the ’70s and the ’80s, like, Paul Volcker was threatened with impeachment. The chairman of the House Banking Committee was always beating up on the Fed chairman.
What’s different now is that it’s not these lower-level people. It’s not people on the fringe like Ron Paul. It’s the leadership of the Republican Party. It’s their leading presidential candidates. And they’re essentially channeling the high degree of suspicion and skepticism of the Republican base of any form of government activism.
Now, I don’t seriously think that people at the Fed are letting this stop them from doing right now what’s necessary. And indeed we saw them move perhaps a bit more aggressively than we expected. But, over time, it does perhaps, you know, add a restraint on their willingness to act more aggressively.
More interesting I think is in 2014, when Ben Bernanke, the current chairman, when his term is up, who replaces him? It is entirely possible that if it were a Republican administration, he would be replaced by somebody with a much more hawkish and austere sort of view, vision about where monetary policy should go.
JEFFREY BROWN: All right, Greg Ip, John Ryding, thank you both very much.
GREG IP: Thank you.