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 (NYSE: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 (NYSE: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.