Is the Fed Taking a Step Toward Explicit Quantitative Easing?

Dull times these are not – Monday was another whirlwind that culminated with another steep drop in equity markets, despite clear indications that Bernanke & Co. are ready for a broader campaign of quantitative easing.

The day brought more recession news, of the official variety, as the NBER declared the recession began in December 2007. My own estimation was closer to the middle of this year, consistent with the research of our colleague Jeremy Piger, but differing with the NBER is pointless.

Typically, I would take an odd comfort in the NBER’s declaration, thinking that it would presage an end to the recession in the near future. In the current environment, such comfort is lacking as data that we typically see closer to the beginning of recession is just emerging. Case in point – the steep drop over the past three months in the ISM index. As expected, the low headline reading of 36.2 for November pretty well summarizes the sad state of US manufacturing. Moreover, the details were weaker almost across the board. About the only good take away is that it can’t get much worse. Maybe. Hopefully.

The early news provided an appropriately sanguine backdrop for the speech delivered by Federal Reserve Chairman Ben Bernanke. The Fed chief summarized the near term outlook with a simple paragraph:

The likely duration of the financial turmoil is difficult to judge, and thus the uncertainty surrounding the economic outlook is unusually large. But even if the functioning of financial markets continues to improve, economic conditions will probably remain weak for a time. In particular, household spending likely will continue to be depressed by the declines to date in household wealth, cumulating job losses, weak consumer confidence, and a lack of credit availability.

This is an outlook that calls for additional easing, but of what variety? Bernanke admits what all realized long ago:

Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited.

With traditional policy at an end, Bernanke provides a glimpse of his next moves:

Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates.

Second, the Federal Reserve can provide backstop liquidity not only to financial institutions but also directly to certain financial markets, as we have recently done for the commercial paper market. Such programs are promising because they sidestep banks and primary dealers to provide liquidity directly to borrowers or investors in key credit markets.

Of course, these are not exactly new policies; the examples provided by Bernanke are programs already in operation, which amount to quantitative easing without an announced policy target. The new addition is the suggestion that the Fed purchase large quantities of longer term Treasuries, a sentence that prompted a fresh rally in those securities.

I admit to a certain preference for the latter approach to quantitative easing. The Fed can establish specific targets, such as a 2% yield on the benchmark 10 year Treasury, or a promise to purchase $100 billion of Treasuries every other week until clear signs of economic stabilization emerge. It meshes nicely with the expected fiscal stimulus. And it does not deeply embed the Federal Reserve into specific credit markets, a fairly risky policy direction in my opinion. Indeed, I suspect the Fed will not find it easy to withdraw its support from the credit markets. One interpretation of last week’s initiative to support the mortgage markets is that the Fed created a right to low cost mortgages, which will go straight into the Constitution next to the right to cheap gas (it’s in there – look closer). Just try to take that away.

(On a purely selfish level, Bernanke did finally provide the kind of stimulus I needed to refinance my own mortgage into a lower rate – after a year of this crisis and no relief for my own admittedly meager mortgage, I was becoming a bit bitter.)

Note that Bernanke does not mention a promise to hold rates lower for a sustained period of time, a possible candidate for inclusion into the next FOMC statement. Not surprising, as he already indicated in 2002 that this was not his top choice:

One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields.

A promise is less impressive than action. Moreover, I suspect he feels a promise would limit future policy flexibility. He pays at least lip service to the dangers of excessive monetary stimulus:

Expanding the provision of liquidity leads also to further expansion of the balance sheet of the Federal Reserve. To avoid inflation in the long run and to allow short-term interest rates ultimately to return to normal levels, the Fed's balance sheet will eventually have to be brought back to a more sustainable level. The FOMC will ensure that that is done in a timely way. However, that is an issue for the future; for now, the goal of policy must be to support financial markets and the economy.

No reason to make a two year promise if you feel even an outside chance that you would have to renege after only a year, especially when other tools are available.

I have two additional points on Bernanke’s speech. First, his outlook of the future is, in my view, disappointingly simplistic:

Although the near-term outlook for the economy is weak, a number of factors are likely over time to promote the return of solid gains in economic activity and employment in the context of low and stable inflation. Among those factors are the stimulus provided by monetary policy and possible fiscal actions, the eventual stabilization in housing markets as the correction runs its course, and the underlying strengths and recuperative powers of our economy. The time needed for economic recovery, however, will depend greatly on the pace at which financial and credit markets return to more-normal functioning.

This sounds as if Bernanke continues to believe the current environment is all cyclical, with limited structural factors at play. Policy is simply smoothing a gap. I tend to believe something more fundamental is in play, as the economy transitions away from debt-fueled consumption growth. Moreover, if economy simply returns to its previous state, fundamental imbalances will remain a threat to future stability.

Second, Bernanke denies any responsibility for the debacle of the Lehman Brothers (LEH) collapse:

To avoid the failure of Bear Stearns, we facilitated the purchase of Bear Stearns by JPMorgan Chase (JPM) by means of a Federal Reserve loan, backed by assets of Bear Stearns and a partial guarantee from JPMorgan. In the case of AIG (AIG), we judged that emergency Federal Reserve credit would be adequately secured by AIG's assets. However, neither route proved feasible in the case of the investment bank Lehman Brothers. No buyer for the firm was forthcoming, and the available collateral fell well short of the amount needed to secure a Federal Reserve loan sufficient to pay off the firm's counterparties and continue operations. The firm's failure was thus unavoidable, given the legal constraints, and the Federal Reserve and the Treasury had no choice but to try instead to mitigate the fallout from that event.

This sounds like a direct response to Brad DeLong’s criticism:

In retrospect, this was a major mistake. ... With that guarantee broken by Lehman Brothers' collapse, every financial institution immediately sought to acquire a much greater capital cushion..., but found it impossible to do so. The Lehman Brothers bankruptcy created an extraordinary and immediate demand for additional bank capital, which the private sector could not supply.

I suspect that if the Fed and Treasury had wanted to facilitate a smoother transition for Lehman Brothers, they could have. In hindsight, a mistake was made…although incoming Treasury Secretary Timothy Geithner was reportedly very discomforted with outgoing Treasury Secretary Henry Paulson’s line in the sand on Lehman…a good sign for the future policy.

In short: More bad economic news, although not unexpected. Although the NBER declared that the US has already been in recession, there is no end in sight. We are left to patiently wait for fiscal stimulus for a significant boost next year. A weak economy pushes the Fed toward further action, and with traditional policy at its end, Bernanke looks to be laying the groundwork for a more explicit policy of quantitative easing.

Comments

[Moon Kil Woong:]

Quantitative easing didn't help Japan. It just got it stuck holding up bad banks, construction companies, and the like. A situation it is unable and politically unwilling to fix for decades. A US foray into this will have us bailing out industries as they rot away into oblivion as well. As Duy points out, the Fed and Treasury are embarking on a course that leaves the US mired in more problems.

If they want a fix, increase transparency, let their bad buddy banks fail, and create some regulatory scheme to flush out the bad CDO and CDS contracts that are what's choking the entire economy. This is not just a cyclical decline. It's a structural problem that is causing more and more destruction every day. I would even suggest re-implementing Glass Stegal and nullifying any CDO or CDS contract that can not or will not be placed into a transparent tradable market format. No new CDS or CDO contractsshould be allowed to be written even to roll over the contracts.

From 2007 to 2008 CDO and CDS grew even though it was already $40+ trillion and everyone knew the problems they had. Now it appears a gambling game hoping to hold out closing the position long enough for the taxpayer to pay $10 or more trillion to bail them out. We should let them know that is not about to ever happen and purposefully making the situation worse in hopes of getting your paycheck and a bailout for your company will result in prosecution, not congratulations in the boardroom like AIG and Citibank got.

Like Duy mentioned, it is sad that the market is fixated on the government givaways and not on sussing out the gutter and clearing the rot so we don't end up drowning in red ink.

2008 Dec 02 05:03 AM

[UbaTuba:]

Wish I better understood exactly HOW the mechanism of the Fed "buying longer term treasuries" works. What does it accomplish? What motivations (among buyers/sellers) does it change, i.e. what value is supposedly added? What are it's risks?

2008 Dec 02 06:29 AM

[Pipo:]

As Jim Rogers says they should abolish the FED. Buy us government bonds on the market? Are they out of their mind?

jimrogers-investments....

2008 Dec 02 06:49 AM

[Its going t...:]

Great article. The Fed is now addressing the fundamental problem:most Americans cannot afford their debt and are terrified it will overwhelm them. When mortgage rates fall and people refinance you see increased confidence in the average American. The fear of a mortgage blowing their head off goes down due to more stable financing and in many cases they will have more cash flow.

In effect the Fed is increasing the money supply to prevent a debt-deflationary spiral where prices go down, production goes down, wages go down, and everyone is looking for a job. They have plenty of room for "quantitative easing" because so much capital destruction has occurred. The goal is to maintain prices, maintain wages, and make debt more affordable. It's going to work but the day of reckoning will come if some of the inertia put into the economy is not spent retiring personal and private debt.

2008 Dec 02 07:48 AM

[SW Richmond:]

The Fed prints money and uses it to buy Treasuries. The Fed will print enough to buy whatever Treasury issues, so there is never a need for rates to rise in the face of a skeptical market. In other words, using circular monetary reasoning that only a central banker could love, we will create brand new money and use it to buy investments from ourselves, printing our way to prosperity. All that is required for this to work is a massive global suspension of disbelief, and lots of people educated in public schools who no longer understand what capital is.

In this manner Treasury rates can be kept low; since Treasury will be issuing at least $2 Trillion to cover next year's deficit, all one has to do is watch the Fed's balance sheet balloon.


On Dec 02 06:29 AM ItsAMegaFlopper wrote:

> Wish I better understood exactly HOW the mechanism of the Fed "buying
> longer term treasuries" works. What does it accomplish? What motivations
> (among buyers/sellers) does it change, i.e. what value is supposedly
> added? What are it's risks?


Note to the article's author: quantitative easing started a few weeks ago.
blogs.reuters.com/grea.../

2008 Dec 02 07:53 AM

[SW Richmond:]

The act of "making debt more affordable" means, by definition, making money less valuable. When money becomes less valuable, real things cost more. You just agreed with condemning people on fixed incomes to slow starvation. Either that, or you are among the majority who believe that we can lie about math.


On Dec 02 07:48 AM Its going to work wrote:

> Great article. The Fed is now addressing the fundamental problem:most
> Americans cannot afford their debt and are terrified it will overwhelm
> them. When mortgage rates fall and people refinance you see increased
> confidence in the average American. The fear of a mortgage blowing
> their head off goes down due to more stable financing and in many
> cases they will have more cash flow.
>
> In effect the Fed is increasing the money supply to prevent a debt-deflationary
> spiral where prices go down, production goes down, wages go down,
> and everyone is looking for a job. They have plenty of room for "quantitative
> easing" because so much capital destruction has occurred. The goal
> is to maintain prices, maintain wages, and make debt more affordable.
> It's going to work but the day of reckoning will come if some of
> the inertia put into the economy is not spent retiring personal and
> private debt.

2008 Dec 02 07:58 AM

[User 143167:]

Where is the money that the Fed uses to purchase Treasuries coming from? Is this equivalent to say that the Fed will print unlimited money until the financial market stablizes?

2008 Dec 02 08:11 AM

[jepittman:]

In a word, yes. The fed accepts a US Treasury obligation (bond) and credits the Treasury with dollars. The treasury then spends the dollars in the economy thus creating demand. Holders of mortgage bonds can also sell to the fed for dollars which they can then spend. It will work for whatever asset the fed agrees to accept. The result is masive growth in the money supply which we are seeing. We will reach a tipping point where falling demand will stabilize and begin to grow again. The question is not IF it will work it is WHEN it will work. At the rate the fed is moving my guess is sooner rather than later.


On Dec 02 08:11 AM User 143167 wrote:

> Where is the money that the Fed uses to purchase Treasuries coming
> from? Is this equivalent to say that the Fed will print unlimited
> money until the financial market stablizes?

2008 Dec 02 11:18 AM

[bearfund:]

Bernanke and company obviously have no idea how they're going to reduce the Fed's balance sheet when they finally decide the time has come to do so. Not only will it probably be too late by that time anyway, but the balance sheet will then likely be so huge that any timely reduction to a reasonable size would throw the markets into far greater turmoil than they are in today. There is a limit to how many long bonds the market can absorb at any one time, and we're talking here about hundreds of billions of dollars worth of bonds. At least. When the Fed belatedly realises that it's time to rein in their inflationary policies, it will probably have at most a few months to dump those bonds if it wants to prevent hyperinflation. Treasury normally auctions off around $10b in long bonds two to four times a year. We're talking about dumping at least twenty times that amount of bonds in the span of two quarters or less. Worse still, demand for these instruments will already be under siege as inflationary pressures build up.

The Fed is talking about acting to reinforce a cyclical trend. That's very unusual behaviour for a central bank, and very dangerous. If the Fed wanted to help restore normal market conditions, it should be selling Treasuries, not buying them. Or do they think the 10-year at 2.6% is "normal"? If so, we need to check the air inside their buildings. They are continuing to make the fundamentally incorrect assumption that lower interest rates on Treasury debt spur investment. This is simply false. It is not even clear that it makes people stop buying Treasuries - just look at the last 6 months. All it does is inflate the Treasury bubble to even greater dimensions and ensure that its bursting will be all the more catastrophic.

In short, it's hard to think of a worse plan. Dropping money from helicopters actually sounds refreshingly sane and effective after hearing this one.

2008 Dec 02 12:15 PM

[secmaven:]

If the banking system does not create the money needed to fuel the economy by its circular lend money, take in deposits and lend the money out again, etc, etc. then the Fed will have to step up to the plate and buy Treasuries to create the money. Why is the bank's money creation good, ie. not inflationary, and the Fed's money creation bad, ie. inflationary? With excess productive capacity for everything from cars to shoes to copper ingots going begging how can creation of money by the Fed cause inflation? If this country maintains a rule of law and a respect for government that gets the world's attention our money can go on and on and on. With Obama's election and assertive action on the economic front we are moving in the right direction here.

2008 Dec 02 02:14 PM

[bearfund:]

secmaven, seems to me that there's plenty of money out there. First of all, go apply for a loan today. Chances are very good you'll be approved. I know several people who've had no trouble obtaining credit. If you have a history of paying your bills and a good job, you will have no trouble. Second, if you think credit is still too tight, why not start by looking at where the money has gone. Looks to me like it's all locked up in Treasuries. I mean, someone had to buy a big old pile of 'em to get yields down to all-time lows. I'm guessing they weren't paying for them in gold. More importantly, there is obviously plenty of money out there to push those yields even lower. So don't tell me there's no money out there; there's plenty. The problem is that it's all being used to buy one of the two assets that produce nothing: Treasuries and gold.

Having the Fed buy more Treasuries only rewards people for doing the wrong thing (buying worthless securities at absurd prices). Worse, it places a floor under Treasury prices, removing the risk for those who purchase them now and thereby tying up at least as much money in them as the Fed would release by buying them. To the extent that lending has been curtailed, it's not because there's no money available to lend. It's because the borrowers have exhausted any conceivable ability to take on additional debt. Making more money available or lowering the yields (such as they are) on Treasuries won't help; there is simply no rate of interest at which one can profitably lend to a man whose liabilities exceed his assets and whose debt service requirements exceed his income. People aren't buying Treasuries because they want to earn 1% for the next 3 years, they're buying them because everything else looks risky and - perhaps most importantly - because they feel the trend is their friend.

The way for the Fed to get more money into the hands of marginally qualified borrowers - especially corporations - is to punish people for holding Treasuries instead of corporate paper. Shock them. Anger them. Breed their distrust. And by doing so, make them sell. Let's see some margin calls at the bond desks like we've seen in the commodities pits and the stock exchange floors. Let's see some angst. Let's see some pundits calling bottom after bottom and being proved wrong each time. Let's see people losing their shirts on paper yielding 2% ask themselves why they're not buying Goldman's FDIC paper for 185 more basis points, or GE's AAA notes for 450 more. Until we see that, nothing will change. Buying Treasuries will serve only to make more money available for the buying of more Treasuries. Remember, ordinary individuals can gear up anywhere from 3x to 30x on Treasuries. So for every dollar the Fed puts into circulation by buying notes, as much as $20 might end up in notes. Yields will plunge, but the only winners will be the usual winners in bubbles: those who got in early and out on time.

Get it through your head: Treasuries are crap. They pay nothing. They produce nothing (less than nothing, in fact: future taxes collected to pay interest on them reduce economic activity). Rewarding people for holding them is insanity.

2008 Dec 02 11:20 PM

[SA Guest:]

Another very good article over at RgeMonitor on Quantitative Easing by Edward Harrison

www.rgemonitor.com/fin...

2008 Dec 03 10:00 AM

[andrey:]

Let's see. 70%+ of aggregate demand in the US economy is consumer spending and the US/Europe probably represent a similar percentage of global aggregate demand. These same consumers are rapidly loosing the income they need to maintain, never mind grow demand, because they are loosing jobs and the debt driven sources of funding, like the home equity ATM. Business is collapsing because the consumer is collapsing. So .... either the consumer needs to restart buying or someone else. If it is the consumer, how exactly is all this quantitative easing going to get into the hands of the consumers. And if it is someone else, who? Businesses have over-capacity, thus no reason to spend more. Investors are already screwed and their investments tend to be for the fraudulent financial economy (which just about done disappearing up its own orifice) rather than the real economy. So who exactly is to restart the spending/demand and how exactly is monetary easing going to ignite the spark? It seems to me that we need to get money directly into the hands of consumers via wage increases, stop at least temporarily job destruction and home foreclosure in the short term, and provide an new economic vision for the long term. This new vision should not be the consumer junk product, fancy shoes and bags and cars, but a sustainable and growing value economy - education, health services, ecologically sound infrastructure, real technological innovation rather than fancy new ways to play music or get exercise via video games.

2008 Dec 10 12:44 PM