A liquidity trap and more?

Considered as amongst the most powerful of tools within a Central Bank's arsenal, the effectiveness of monetary policy depends very much on the economic environment in which it is being applied. There are basically two situations in which monetary policy becomes totally ineffective:
When the transmission system is faulty, whereby a change in monetary policy fails to influence economy wide lending rates. A severe credit crunch, such as the one being currently experienced, can significantly diminish the effectiveness of a change in interest rates. Despite a rate cut, for example, the economy fails to be stimulated.
The second situation, known as the liquidity trap, is related to the differential between the target rate from the zero percent nominal rate. The closer the target rate is to zero percent, the less room a central bank has to further stimulate the economy using monetary policy as a tool. At some point close to zero, the effectiveness of monetary policy disappears.
The global economy is currently experiencing a credit crunch which is steadily eroding the effectiveness of monetary policy. The U.S. Federal Reserve is in a worse situation because it is facing a double whammy with a credit crunch on one hand and a potential liquidity trap on the other hand (considering that with the latest move, the target rate now stands at one percent, leaving very little room for maneuver if more stimulation is required). The situation is reminiscent of Japan in the 90's where the Bank of Japan became impotent as it lost the effectiveness of its monetary policy tool after the nominal rate was cut to zero.
The obvious remedy in the case of the U.S. would seem to involve solving the transmission problem as it would boost the amount of stimulation into the economy. Unfortunately it is more easier said than done as it would require restoring confidence that has been severely impaired.

Navigating in the dark...

Policymakers have so far failed to contain a crisis that began with the bursting of the housing bubble, rapidly spread into the credit markets and is now threatening to bring down employment through recession. The policy failures can be attributed to two related challenges that policymakers face, namely imperfect information and hesitancy to take decisive action.
Fact is that policymakers base their decisions on information that is imperfect in the sense that the information does not provide the full picture of the issue(s) at hand. Most economic indicators, for examples, provide information on the state of the economy of the recent past. A few indicators known as "leading indicators" provide information that gives at least some insight into the future direction of the economy. The most obvious leading indicator is the stock market itself but it is not infallible to the vagaries of, say, bubbles and therefore can at times provide erroneous information.
Basing decisions on imperfect information contributes to a hesitancy to implement policy because "blunt" policy frequently results in collateral damage that is not always known beforehand. A very good example of this is monetary policy. When a central bank decides to cut interest rates in order to stimulate the economy, it also raises the risk of sparking inflation down the line.
The unprecedented nature of the current crisis means that policymakers don’t have much to lean on in terms of experience in order to set the appropriate policy. The approach therefore has to be novel, which introduces even more uncertainty into the equation as these "new" tools have never been tested before and therefore it becomes more difficult to estimate if and what the collateral damage will be. We can therefore expect a lot of hesitancy amongst policyholders (which is what is being observed on the ground), which creates a huge dilemma as the time factor is of essence when trying to contain a crisis like the current one.
No wonder then that despite the government pledges to guarantee bank transactions, the TED spread still remains dangerously wide.

Two challenges to the crisis...

The most pressing issue at hand has been to put an end to the panic that has been gripping markets across the world, leading to a flurry of bankruptcies as companies struggle for liquidity. The liquidity crunch can only be unwound if the long lost confidence in the financial system is restored and this can only happen if the government steps in as the ultimate guarantor for the majority of interbank transactions (a proposition originally put forth by the British). What we are in fact witnessing right now is exactly that: an unprecedented degree of government intervention. The counterparty risk between banks is now shifting from the borrowing bank to the respective governments which should help eliminate any doubts that may still be lingering. One of the closely watched barometers that measures the degree of confidence amongst banks is what is known as the TED spread which measures the spread between LIBOR and Treasuries. Although it has declined a little since last week, it still remains at record levels and, until it drops significantly, the credit crunch can only continue to corrode the markets.
Notice that the global government bailout program is in stark contrast to what happened at the early stages of the great depression of the 1930's. The Federal Reserve of that time effectively left the banks to fail which, with hindsight, led to a significant worsening of the crisis. The risks of letting a bank fail are huge as observed most recently with the Lehman case which led to a full blown credit crunch. Bernanke, who is a scholar of that period, is clearly trying to avoid a repeat of the great depression which explains the shear scale of the bailout program (although I am skeptical that the amount that has been put forth will suffice to put things in order).
Resolving the confidence issue, however, does not mean that the crisis itself will be resolved. The economies are facing a real threat of a protracted recession on the horizon. Averting, let alone limiting, a full blown recession won't be easy considering the amount of deleveraging remaining and the fact that housing prices still have some distance to go before reaching bottom. As mentioned before, this won't happen at least until sometime in the second half of next year.

And the winner is...

Well it is a bit too early to give a final verdict on which asset class performed best in this very very difficult environment but with less than three months to go, I guess we can already draw some early conclusions.

To summarize our observations, the best performing asset class so far goes to bonds, more specifically U.S. treasury bonds (with European Government bonds a close second). Oh wait a minute, treasury bonds have stolen the spotlight from hedge funds by performing in a manner that is "characteristic" of hedge funds??? And all that at a fraction of the cost (2/20 was it?), without promising (or guaranteeing was it? please forgive my memory lapse) de-correlation from other asset classes (most notably equities) and (at least for some of them) without promising absolute returns (in my understanding defined as positive performances irrespective of the market conditions).

That is quite a feat if you ask me (see the year to date graph above showing bonds as the white line, equities as the green line and hedge funds as the red line sandwiched in-between if you don't believe me).

Well, surprise surprise! Just when we were all expecting hedge funds to perform like "hedge funds" should, they instead followed the equity route. That important role was relegated to government bonds. Are the hedge fund characteristics mentioned earlier just a myth? Well, to be fair, they still have a bit less than three months to prove that assumption wrong. So I will wait a while more before launching my diatribe.

Too little, too late?

The age old adage "Time is Money" should be heeded carefully by those that are attempting to bailout the U.S. economy. In an age where information travels at near light speed and where large transactions can be executed at the click of a mouse button, contagion can spread very rapidly, leaving little time to anticipate, let alone take action, when a crisis occurs. Rapid time decay requires rapid response but a casual observation of the current environment would seem to indicate that financial institutions are not up to speed with their reflexes. The Federal Reserve, despite novel approaches to handling the crisis, has been from the beginning struggling to stay ahead of the curve. It is no doubt a challenge to operate effectively when facing uncharted waters where past experience has no value, especially when being effective requires you to think at least two moves ahead.
Alas it is becoming increasingly clear (from the way the equity markets are behaving) that the 700 billion dollar bailout plan may be too little, too late to prevent a deeper recession (we will probably not know the final bill for a couple of years from now). This is because, not only does no one have a clue as to what the intrinsic value of the toxic debt outstanding is, but also because, with the ongoing credit crunch, every second that goes by raises the probability that a business that, in a "normal" environment would be considered to be healthy, collapses. Government institutions around the world may still have some more bailouts to perform in the near future.