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A few months ago I was running through some out of the box thinking for how the Fed might be able to give quantitative easing more of an impact. Not that I think the Fed should go QE, but if they do, the question is what should they do. Here’s what I came up with: The Fed could buy municipal bonds.

There has been a lot of talk about the anti-stimulus being provided by states and local municipalities (see Federal largesse was countered by state and local cutbacks). I have noted on a few occasions that Illinois and California bonds are trading with a high degree of default risk. But Michigan is up there too. New York has serious problems as does New Jersey to name the largest and most problematic states. Most every large state in the union is in fiscal trouble, which is why I have been warning that municipal bonds should be labelled buyer beware.’

But what if the Federal Reserve started QE2 with munis as the asset class of choice for credit easing? When the European experiment threatened to unravel, the ECB chose the nuclear option and stepped into the breach to start buying up the debt of its weakest debtor states. Now, the ECB claims these actions are unsterilized i.e. it is not just printing money. But, I have my doubts. In any event, the ECB is the New "United States of Europe" as Marshall Auerback puts it. And while the limited measures the ECB has taken have not caused the credit spreads or interest rates to decline for these debtors, I guarantee you a full effort of credit easing would do.

-ECB credit easing by buying debt from Greece and Spain analogous to Fed buying California and Illinois munis

As I wrote in the Hussman-inspired post recently, normal quantitative easing is an asset swap of freshly minted non-interest bearing assets (money) for interest-bearing assets (bonds). As such, it can really only help the economy via a reduction in interest rates since reserves do not create loan demand. And QE drains interest income from the economy to boot. In short, QE is not going to have an appreciable effect on the real economy unless you really jam it on: $8-10 trillion worth as Paul Krugman was saying – or more.

Atlanta Fed President Dennis Lockhart says the US will get $1.2 trillion over the next year. Again, I have to reiterate that I don’t favour QE because some might take this paragraph as an endorsement. The point is that fiscal is better than monetary at reflating the economy – especially at the zero bound. Monetary works via interest rates and asset prices while fiscal affects the real economy. And sorry, $1.2 trillion of monetary easing ain’t gonna get it done in a $14-$15 trillion economy.

As David Rosenberg puts it:

The U.S. economy is caught in a classic liquidity trap. With additional fiscal stimulus no longer a viable political option, even though the government is better equipped to deal with many of the structural hurdles to growth than monetary policy, Mr. Bernanke clearly feels that the Fed is the only game in town.

Enter David Blanchflower. He is an MPC member at the Bank of England but also an American-British dual citizen professor who is very plugged in at the Fed. Here’s what he writes at Bloomberg (emphasis added):

I was at the Fed last week in Washington for one of its occasional meetings with academics…

The Fed is especially concerned about unemployment and the weak housing market. Chairman Ben Bernanke made that clear in his speech last week. It would be a major surprise if the Fed didn’t do more quantitative easing — creating money by enlarging the central bank’s balance sheet with the purchase of securities — at its next meeting. Failing to act now with such high expectations may throw the markets into a tailspin.

Out of Question

The economic models are telling us that we need more stimulus. Lowering interest rates and more fiscal stimulus are out of the question. Quantitative easing remains the only economic show in town given that Congress and President Barack Obama have been cowed into inaction.

The major questions about quantitative easing aren’t so much if, but how much will the Fed buy and of what type? There is little point in moving slowly. So $100 billion a month for six months seems a reasonable amount.

What will they buy? They are limited to only federally insured paper, which includes Treasuries and mortgage-backed securities insured by Fannie Mae and Freddie Mac. But they are also allowed to buy short-term municipal bonds, and given the difficulties faced by state and local governments, this may well be the route they choose, at least for some of the quantitative easing. Even if the Fed wanted to, it couldn’t buy other securities, such as corporate bonds, as it would require Congress’s approval, which won’t happen anytime soon.

Did you catch that? The Fed can legally buy as many municipal bonds as it wants without congressional approval. Talk about burying a lead. This is a big story. Blanchflower is essentially saying that the U.S. government can bail out both the housing market via Fannie and Freddie paper purchases and the state governments via Muni purchases. And, of course, the banks get to dump these assets onto the Fed who will hold them to maturity. I guarantee you this will have a very nice kick since it is the state’s where the biggest employment cuts are.

This is the Fed doing fiscal, friends. And I think it’s going to happen. Meredith Whitney take note.

Source: Blanchflower: The Fed Should Buy Munis and Monetize State Debt