Fragile Stability

We talk about the signals the economic data are sending out, but this is also a financial crisis that has to be resolved for there to be a broad-based recovery. As with the economy, the major panic of end-2008 has subsided somewhat, giving way to a fragile stability that will need a lot of TLC and a firm hand from the Fed and the government

1) Investors (mind, I say investors, not bank executives - that's another matter) have started to grumble about government and Fed involvement in markets. It's hard to hedge against government action - particularly given Congress' populist bent and limited attention span. Yet the mutterings are a massive shift from last year, when the cry "They (the administration or the Fed) must step in; they must do something" arose any time there was even a mere whisper of trouble. The patient, in other words, is out of intensive care, but still requires major attention. With the worst behind him, the patient is eager to leave the hospital and go home. But the doctors should refuse to discharge him - it will take a while longer to ensure a full recovery - and there is always the danger of relapse.

2) The bond market vigilantes this week stuck their heads over the parapet: punishing the BOE and the U.K. government for sending mixed messages and sending a warning signal to the U.S. and the Fed that there is a need to spell out the exit strategy. The bond market's early warning system is up and running - that's a good sign - but it bears remembering that the safe-haven bid remains an underlying support for government debt. The market's animal spirits remain subdued.
And, by the way, the exit strategy planning is well underway - in a little noticed joint press release issued by the Treasury and the Fed, the last sentence states that at some point, the Treasury will take over the three Maiden Lane vehicles that sit on the Fed's balance sheet - which would indicate that preparations are underway to rid the Fed off any credit exposure. Treasury also committed to helping the Fed achieve the tools it needs to fight inflation - i.e. withdrawing the trillions of dollars it is pumping into the system. One way to do that would be to sell Fed bills to mop up those dollars - which will require legislative action and where the Treasury's support will come in handy.

3) The Obama Administration's plan for regulatory reform. That was the most heartening of actions so far - the administration clearly has a plan and presented it forcefully this week: first on Wednesday, in testimony by Treasury Secretary Timothy Geithner, Fed Chairman Ben Bernanke and New York Fed President Bill Dudley, then again on Thursday in testimony by Geithner alone. It's a year since the downfall of Bear Stearns first made it clear that the regulatory system was woefully inadequate to deal with the turbo-charged financial industry - that we finally have an energetic administration that recognizes the need to address these deep-seated problems and isn't shy in tackling them is in my mind the most encouraging sign one could hope for.