Category Archives: US Monetary Policy

Flash Point: Welcome to Hotel California

Bernanke expressed confidence in his Jackson Hole speech,  Monetary Policy since the Onset of the Crisis, that the Fed can “exit smoothly” when it wants to:

The FOMC has spent considerable effort planning and testing our exit strategy and will act decisively to execute it at the appropriate time.

In The Dilemma of the Impatient Trader, traders wishing to acquire or divest large positions quickly pay a premium for their impatience equal to the spread between average purchase and average sell prices minus the market bid/ask spread. Any exit strategy by the Fed must include the divestiture of their large securities position. This would begin if and when the economy were heating up and needled to be slowed. It might also become necessary if inflation takes off driving interest rates up. These would not necessarily be mutually exclusive scenarios.

From a balance sheet perspective, the cause of the exit is unimportant. What happens is the Fed sells securities to primary dealers (PDs) who pay for them from their excess reserves on deposit. These reserves were created by the Fed’s initial purchases of securities from the PDs. But the PDs are patient traders and the Fed is an impatient trader. The cost to the Fed, as its assets approach zero through sales, is the premium they paid on acquisition plus the premium they pay on sales. This means the PDs have a net balance left equal to this total premium. This is the money given to the PDs for their assistance in implementing Fed policy.

To balance assets and liabilities in true accounting fashion, the Fed’s capital position goes negative and the Fed becomes insolvent. Before this happens, however, by recent arrangement with the Treasury, the Treasury will backstop (bailout) the Fed.

The monetary base is considered the base of the money supply in the economy and is known as money with zero maturity. It is roughly the sum of the reserves on deposit with the Fed plus currency in circulation. Many have argues that if the excess reserves, currently standing at  about $1.5 trillion, enter the economy, large scale inflation will result. The caveat has been that the Fed could unwind its balance sheet. But as we have argued, it can’t entirely. The trading premium incurred will remain as a liability after assets are gone. It will also remain as part of the monetary base and the Fed cannot do anything remotely orthodox to fix this. The result: built in inflation.

So welcome to Hotel California where any central bank can check in but it can’t check out.

Update 20120917

It is always gratifying to get confirmation of our thinking from people much smarter and informed than we are. Today we got this eletter from Bob Eisenbeis, Chief Monetary Economist of Cumberland Advisors: We’ll Know It When We See It! These people understand the Fed, Fed operation and policies, and debt and bond markets as well as anyone and better than most. Bob wrote:

Certainly, the materials provided imply a long period of sustained asset acquisitions and a further substantial increase in the Fed’s balance sheet. This expansion will only exacerbate the Fed’s exit problem, and to the extent that it experiences capital losses on asset sales, those losses will accrue to the taxpayer through reduced remittances to the Treasury, and increase the deficit.

The “capital losses” are what we described as “premium paid” in The Dilemma of the Impatient Trader.

Flash Point: Where Does It End?

We had just finished our latest essay The Hole in Jackson Hole, when we got this article from Bloomberg: Fed Moves Toward Open-Ended Bond Purchases to Satisfy Bernanke. In our essay we presented our arguments that LSAPs (QE) have been ineffective in stimulating the economy. The Bloomberg article, however, suggests some new LSAP will be coming soon (something we agreed with as a result of our analysis of Bernanke’s speech).

LSAPs were introduced to manipulate interest rates because the traditional tool for doing this, the  Effective Federal Funds Rate (EFFR), became ineffective when it reached the zero lower bound. Since the EFFR was designed to manipulate short-term rates and these were effectively at zero, the Fed used LSAPs to affect longer dated maturities, eventually lowering rates across the entire yield curve to the 30-year bond. All have recently touched historic lows.

As we argued, there has been no observable effect of LSAPs on the employment situation. Bloomberg speculates that the Fed will soon introduce an LSAP policy that is open ended. Its goal will not be to acquire a certain class of assets in a specified quantity in a specified period of time as previous LSAPs have done, but to set an economic target for the program rather than an asset target. Jim Rickards suggested they would do this several months ago, targeting a certain level of GDP. Bloomberg suggests they may target a certain level of unemployment – say 7%.

In an economic environment where GDP and employment are in a cyclical downturn one might assume they will return to historic norms. If however, there are structural changes in the economy, this assumption is invalid. In our essay we showed a thirty year downtrend in GDP and employment growth. We argued that this is structural since it it spans four recessions or business cycles.

Bernanke’s bet is the recovery has a cyclical basis. We argue it has a structural basis*. If Bernanke is wrong and sets a policy objective for levels that are no longer relevant due to structural changes, then he will have created an open-ended ticket to money creation at the Fed bounded by a goal that is unattainable. But what is worse, he cannot realize that the failure of his policy is based on a fundamental misreading of the economy. Rather the danger is he will misread the situation as Paul Krugman has done and feel that the problem simply requires more money to be thrown at  it.

*Update: 20120914

We find today, Ambrose Evans-Pritchard arguing in The Telegraph in his essay Era of ‘jobs-targeting’ begins as Fed launches QE3, that the employment situation is due to a structural change. He quotes Bernanke’s concern as:

a grave concern, not only because of the enormous suffering and waste of human talent it entails, but also because high levels of unemployment will wreak structural damage on our economy that could last for many years

Then he quotes Minneapolis Fed chief Narayana Kocherlakota as saying that the lack of jobs skills imply less slack than assumed – known as an upward shift in the “Beveridge Curve”. The problem is “structural”.

In The Hole in Jackson Hole, Figure 4 shows that for the current ‘recovery’, the year-over-year change in GDP is at trend. This we interpret to mean the full recovery has happened and current employment numbers are the ‘new normal’. To support this notion, we note Ambrose’s statement America’s output is now well above its previous peak in late 2007, unlike Japan and most of Europe. If output has fully recovered, there is no room for any significant expansion in employment. Indeed, the larger levels of unemployed – the actual levels, not the official levels – will prove to be a drag on economic expansion as these people will require social service support while remaining unproductive.

The implication then for a QE program that targets a level of employment is that this level will be reached only when sufficient people drop out of the labour force to reduce the numbers and not by job creation. We have  a nagging feeling, not that QE will not be effective since we believe it won’t be, but that it will actually damage the economy at an accelerating rate. We’re thinking about it.

 

The Hole in Jackson Hole

Fed Chairman Ben S. Bernanke gave his annual address at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, August 31. We review the speech, Monetary Policy since the Onset of the Crisis, and suggest the Chairman has it wrong. As a consequence, the further policy intervention that he is signalling will likely not help the economy but will continue to distort markets making an inevitable market correction more severe. Call it building a Minsky moment.

Midnight Musing: Can the US End Up Owning Itself?

We have been pondering the Fed’s control over interest rates, why it is possible and more importantly, what are the limits.

What’s In Bernanke’s Toolbox?

We got this message from out friend JR:

“Bernanke said the Fed has three tools left in the box to promote growth. He can reduce the rate the Fed pays on reserves banks deposit overnight with the Fed. He said the Fed can communicate its intentions differently. And he said further asset purchases could happen.”

Thoughts? I think we already discussed Door #1. Door #2 – well, ok… he can wear a clown suit in his next speech. That might be more effective; Door #3. That’s the Lusitania door. Or maybe the Bismark. You know, it lost its rudder, then finally got blown out of the water.

Rather than limit our reply to an email, we thought we would share it with others.

What’s Going On Here?

When the Fed structured QE1, it resulted in the acquisition of approximately $1.2 trillion in Mortgage-Backed Securities (MBS) for the Fed’s balance sheet. (see WSHOMCB)

In this graph we see the rollover and decline of the total holdings beginning in 2010 after QE1 ended and as securities matured. However, in early 2011, the decline slowed and ceased at the end of the year. Since then, we have begun to see new purchases of MBSs. We wonder what strategy or policy the Fed is pursing here.

Living In a Hypothesis

In a recent speech at the National Association for Business Economics Annual Conference, Washington, D.C. March 26, 2012, Fed Chairman Ben Bernanke talked about the US job situation and monetary policy designed to rectify the problem. That Fed policy is consistent with central bank policy worldwide makes this speech worthy of study. The frightening aspects are that this policy represents untried economic theory – a “hypothesis”, the results to date are a failure, the future impact is unknown beyond some theoretical speculation, and central banks will continue to implement it magnifying future effects.

QE WTF

MarketWatch reported today that the Fed said to weigh new form of bond buying. The proposed Fed operation is in fact so bizarre, appearing to be some deviant twist of Operation Twist, that we think what has become twisted are the personal parts of Fed officials caused by the contortions they are going through to influence the economy and markets. Indeed, the novel twist involved is labeled as a form of sterilization. You, dear reader can surmise where the twist is applied. We explain below.

Note: All the sources we researched go back to an original story in the Wall Street Journal. We have searched the sites of the FRB and FRBNY and can find no news releases, speeches, articles or anything that discusses this alleged program proposal. The most recent minutes of the FOMC dated January 24-25, 2012, simply authorize the Fed to continue operations and programs already announced and in place. No new programs were discovered.

Tracking QE – Currency Wars

In our introduction to QE, “Quantitative Easing: Facts and Fallacies“, we did not support a call for QE3 because we could see no rationale for it. In a recent video broadcast, Jim Rickards said some form of QE3 will come as early as May. He sees this as a function of the currency wars – to cheapen the dollar. It presupposes that the Fed would choose to intervene directly in what he calls the currency wars. The Fed is certainly aware of the issues. We do not think they will intervene overtly. Rather, as Rickards suggests, it will be via some oblique excuse around the economy. Their mandate to maintain stable employment would allow such an intervention if the dollar rose too high against other currencies such as the euro or the yuan.

We think it important enough to track the signs of QE and its development, partly to keep the pundits honest and partly for its potential economic and market impacts. We think Rickards is right. So the things to watch are the USD and the EUOUSD cross charts. To follow developments over time, read on.

QE3: A Proposal

A turnaround in the housing market is key to a sustained recovery in the US. It can’t happen without it. The problem is that household balance sheets are severely impaired – hence no borrowing and the attendant consumption that drives the economy.

The Fed has helped repair the “too big to fail” (TBTF) banks’ balance sheets by throwing a huge amount of money at the problem – 1.25 trillion in QE1 alone. Moreover, their zero interest rate policy (ZIRP) at the front of the yield curve – that is short term interest rates – has allowed the banks to make huge amounts of profit in a carry trade. This created the opportunity for the banks to recapitalize themselves and repair their balance sheets (whether they did or not is another matter). So the Fed can channel money into bank balance sheets but they have no mechanism for repairing household balance sheets.

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