Thursday, March 29, 2007

. Donald L. Kohn. "Asset-Pricing Puzzles, Credit Risk, and Credit Derivatives", Conference on Credit Risk and Credit Derivatives, Washington, D.C. March 22, 2007.

Just over a decade ago, former Fed officials Manuel "Manley" Johnson and Robert Keleher published a book that added enormously to the global liquidity debate: Monetary Policy. A Market Price Approach (Westport, Connecticut: Quorum Books, 1996). According to the authors, globalization makes it almost irrelevant for the Fed to rely on quantity indicators such as GDP, employment, industrial production and monetary aggregates. Market prices such as the foreign exchange value of the dollar, the shape of the yield curve and commodity prices provide more timely and useful information.

For obvious reasons, the book has aged. The fast pace of financial innovation during the past decade means that more and/or different market prices require attention. But Johnson & Keleher's key insight appears to be more useful than ever — here's Fed vice-chairman Donald Kohn speaking at a conference on Credit Risk and Credit Derivatives:

... the staff at the Federal Reserve puts considerable effort into research on asset prices and into reporting the results of that research to policymakers. One reason we do so is to try to understand the expectations that households, businesses, and market participants have about the future. Expectations are critical to understanding the economy and developments in the financial system. Of course, we look at a great deal of data from the nonfinancial side of the economy, such as gross domestic product (GDP) growth, the unemployment rate, and changes in the prices of goods and services.

It's almost as if —within the Fed's hierarchy— GDP and other quantity indicators have been relegated to a distant second place behind ... asset prices. This challenges us "liquidity watchers" to pay more attention to credit derivatives. No problema. Meanwhile, here's some more liquidity talk from the Federal Reserve:

- Fed Governor Randall Kroszner on "Recent Innovations in Credit Markets". CDSs and CDOs have enhanced the transparency and liquidity of the credit markets. This is an important piece of the global liquidity puzzle: thanks to lower transaction costs and better risk diversification, the supply of loanable resources registers a permanent increase, thereby leading to lower long-term interest rates.

- The structured credit market & the supply of loanable resources. Adam Ashcraft and Joao Santos (Federal Reserve Bank of San Francisco) discuss the impact of structured credit markets on the overall credit market. They find evidence that "CDS trading helps borrowers issue syndicated loans more frequently and take on more leverage relative to a matched sample of untraded firms, consistent with an increase in credit supply".

- Timothy Geithner on "Credit Markets Innovations and Their Implications". Not to be undone, New York Fed president and CEO Tim Geithner discusses "the latest wave of credit market innovations". What is the main factor behind the so-called Great Moderation of the business cycle? Digital networks? Low inflation expectations? Nope, says Geithner. It's all down to financial innovation.

- Charles Plosser on the shape of the yield curve. Philadelphia Fed president Charles I. Plosser debates the shape of the yield curve. Here are the two key points: "On average, I expect the yield curve to be flatter than at comparable points in previous business cycles. While this flattening of the yield curve puts pressure on banks’ interest income, given the amount of financial innovation in the industry, banks will be able to adjust".


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