If we listen to the speeches and press conferences of ECB and Fed members, and in particular the latest Semi-annual Monetary Policy Testimony of Ben Bernanke, we can differentiate two types of monetary policies: fiscal dominance or tough love.
Broadly speaking, the ECB is clearly
- Keeping dry powder in case of a worsening of the economic situation or the emergence of an adverse external shock.
- Being tough towards fiscal policy. The idea of "tough love" here is that:
a. Accommodative fiscal policy reduces the incentive for fiscal adjustment.
b. Rising inflation expectations may increase interest rates hence making fiscal consolidation more difficult in the future.
As we have seen in Europe over the last year, tough love is clearly counter-productive, especially since fiscal multipliers are much higher when there is no leeway (or willingness) to cut rates - not to mention the fact that fiscal adjustment should not always be equivalent to austerity.
The Fed is in a completely different situation. During the Q&A session, Bernanke stressed that in Europe "austerity was not the problem" and that it was "possible to achieve short-term growth and long-term sustainability with the right combination of economic policy tool."
The Fed is engaged in what can be called a soft fiscal dominance: in theory, fiscal dominance depicts a situation in which the deficit is so huge that if there is no monetary financing, then the country will default. In its soft version, the fiscal dominance can be depicted as a partial monetization of the public debt. It can be part of a QE policy (please see this morning's Record) or a tentative cooperation between the central banks and fiscal authorities.
A good example of cooperation was the implicit Clinton-Greenspan agreement of the early 1990s when the Fed maintained short rates well below their Taylor-implied level to accommodate for the ongoing fiscal adjustment (another reason was the wreckage of the Saving and Loans crisis). This cooperation ended badly though as in 1994, when the unemployment rate fell down to a level close to its structural level market expected a rapid exit by the Fed and this led to a fixed income crash.
Today's situation is clearly different and even though the Fed is clearly willing to cooperate (urging in the meantime Congress to tackle the long-run fiscal issues), it is in fact in a clear state of dominance. One way of seeing this is the fragility of the combined Government-Federal Reserve balance sheet. By buying new long-term government bonds with newly created reserves, the Fed swaps long-term debt (U.S. Treasury bonds) for interest-bearing reserves of much shorter maturities. The day banks start lending again, the Fed may have to scramble in reducing excess reserves, limiting its ability to monetize public debt, hence the risk of another sharp rise in long-term yields.
This will be tough as, contrary to foreign central banks that carried out QE policies, the average duration of the Fed's balance sheet is close to 11 years whereas (against three years in the case of the BOJ and even ECB).
Ben Bernanke today told us that "to the extent that monetary policy promotes growth and job creation, the resulting reduction in the federal deficit would dwarf any variation in the Federal Reserve's remittances to the Treasury." It means that there could be "quasi fiscal" losses but as the Fed does not need to be recapitalized (contrary to the ECB). This is an excerpt from the Fed:
Remittances might be halted for a few years, reflecting the elevated interest expense on reserve balances and capital losses associated with sales of MBS, both of which offset the interest income from the portfolio. Federal Reserve Bank accounting rules stipulate that when income is not sufficient to cover expenses, remittances to the Treasury cease, and the Federal Reserve books a "deferred asset."
The deferred asset is subsequently realized as a reduction of future remittances to the Treasury (which are accounted for as interest on Federal Reserve notes expense). Thus, it is an asset in the sense that it embodies a future economic benefit that will be realized as a reduction of future cash outflows. If the realization of the asset is expected to occur over several years, some valuation technique, such as net present value, would be applied to measure the value of the asset.
To sum up
The Fed has definitely rejected the tough love option and is clearly willing to facilitate the forthcoming fiscal adjustment with an accommodative stance. This leads to a clear fiscal dominance of monetary policy. The risks have been listed by Ben Bernanke in front of the Senate today, but the message for markets is clear:
- The Fed will continue to partly monetize federal debt
- although underestimated, the losses linked to the exit would not cost anything to the federal government (just an "opportunity cost" as remittances would be stopped).
- Long yield may increase this year, but I would not expect them to go much above the 2.25% threshold
BERNANKE (2003): In a liquidity trap however, excessive money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for. [Under these circumstances] greater cooperation for a time between the central bank and the fiscal authorities is in no way inconsistent with the independence of the central bank". Let's see.