Copernican Revolution at the Fed

Includes: ERO, EU, GRE, TLT
by: Erwan Mahe

Make no mistake about it: I have been avoiding the sea of confusing statements from Europe these days, which defy any attempt at logical analysis.

Government leaders appear content to contradict others and even themselves, regardless of the country or institutions (Germany or the ECB).

Just consider this afternoon's comments by Martin Kreienbaum, spokesman for the German Finance Ministry:

“Situation serious but euro not at risk”

Apparently he hasn't spoken to Chancellor Angela Merkel, who declared just yesterday:

"euro in 'exceptionally serious' situation".

Not to mention...

German Finance Minister Rainer Bruederle:

Don't know about emu bond restructure clause plan; would be wrong to set date for restructure clause.”

But, Ministry spokesman Martin Kreienbaum had just stated a few minutes earlier:

"EU commission working on crisis mechanism; EU to decide on crisis mechanism on dec 16".

In short, the visibility in Europe is a big zero, as peripheral nation debt remains under pressure. The spread between Portuguese and German debt is now hovering near 450-bps, the dangerous threshold at which it may face new margin calls by LCHClearnet, thus tightening the vicious circle in which European construction has enclosed itself. In the meantime, the spread on Spanish debt has climbed to 235 bps. At a 5% nominal rate, it is dangerously close to the quasi-binary threshold of 6%.

In contrast, the Fed made a significant revelation yesterday evening, not in the minutes themselves, but in the transcription of the previously unreported videoconference meeting of 8 October.

In the passages below, the emphasis (in yellow) is mine:

Videoconference Meeting of October 15

The Committee met by videoconference on October 15 to discuss issues associated with its monetary policy framework, including alternative ways to express and communicate the Committee's objectives, possibilities for supplementing the Committee's communication about its policy decisions, the merits of smaller and more frequent adjustments in the Federal Reserve's intended securities holdings versus larger and less frequent adjustments, and the potential costs and benefits of targeting a term interest rate. The agenda did not contemplate any policy decisions and none were taken. Participants agreed that greater public understanding of the Committee's interpretation of its statutory objectives could contribute to better macroeconomic outcomes.

Participants expressed a range of views about the potential costs and benefits of quantifying the Committee's interpretation of its statutory mandate to promote price stability by adopting a numerical inflation objective or a target path for the price level. In the end, participants noted that the longer-run projections contained in the Summary of Economic Projections, which is released once per quarter in conjunction with the minutes of four of the Committee's meetings, convey considerable information about participants' assessments of their statutory objectives. Participants discussed whether it might be useful for the Chairman to hold occasional press briefings to provide more detailed information to the public regarding the Committee's assessment of the outlook and its policy decision-making than is included in Committee's short post-meeting statements.

In their discussion of the relative merits of smaller and more frequent adjustments versus larger and less frequent adjustments in the Federal Reserve's intended securities holdings, participants generally agreed that large adjustments had been appropriate when economic activity was declining sharply in response to the financial crisis. In current circumstances, however, most saw advantages to a more incremental approach that would involve smaller changes in the Committee's holdings of securities calibrated to incoming data. Finally, participants discussed the potential benefits and costs of setting a target for a term interest rate. Some noted that targeting the yield on a term security could be an effective way to reduce longer-term interest rates and thus provide additional stimulus to the economy. But participants also noted potentially large risks, including the risk that the Federal Reserve might find itself buying undesirably large amounts of the relevant security in order to keep its yield close to the target level.

William B. English


In my opinion, this has profound implications for future American monetary policy, should deflationary risk persist.

In such a case, the Fed will not hesitate to use everything at its disposal as a sovereign monetary authority with control over its own currency, ie, its ability to arbitrarily set the yield curve, depending on its macroeconomic goals.

This is good news, especially compared to the Austrian school bent of recent comments by ECB Board of Governors members, who appear stuck in their "store of value" vision of money, like in the epoch of the gold standard.

However, money today is no more than a medium of exchange whose value relates to the goods and services that it can acquire.

As it is, the Fed and US Treasury can create as much money as they want as long as the sums comply with the economic goals they have set.

Some will object that only the Fed can issue money, which is independent of the Treasury and thus of the government.

It is true that this power was delegated to the Fed to limit the temptation of government leaders to create money, who are more worried about getting re-elected than the inflationist consequences of their actions.

However, this independence must be reappraised in view of two phenomena which have cleared not be accounted for by the debt ayatollahs:

· In the context of largely under exploited production utilisation capacities and unemployment way above the NAIRU's most pessimistic estimates, transforming investor portfolios in this way is very far from creating inflationist risk.

· Second, it is absolutely crucial to view, balance sheet wise, the Fed and the US Treasury as a single aggregated entity. In fact, all the Fed's results will directly impact the Treasury's accounts. After all, 90% of its gains ($56.5bn for the first nine months of the year by the way, after $46.1bn in 2009 and $31.7bn in 2008) are transferred to the Treasury. And in case of huge losses, as some sad people continue to fear, the Treasury will have to orchestrate the fed's recapitalization. Except for the fact that the Treasury will never have to ask the Taxpayers for this kind of ‘Bail Out’ money. The FED can create ex-nihilo as much capital (dollars) as it wants. If the Treasury were to recapitalize the Fed, it would only be to fend of inflationist risk, i.e. to withdraw money from circulation via impromptu taxation.

Remember that the Fed's government security purchases (or of other instruments) does not constitute money creation per se, as some unhappy souls would have us believe.

These operations simply convert the bond holdings in bank balance sheets into surplus reserves.

Given the aggregate nature of the Fed's and Treasury's accounts, that simply means a change in the maturity of assets held by private-sector agents.

The Fed indeed compensates these surplus reserves at 0.25%. As a matter of fact, that is eventually the true cost of the Treasury financing, because of the profits and losses transfer between these two institutions.

In conclusion, thanks to this Fed program, the American government is obtaining financing at 0.25% (yield on reserves) on a one-day maturity, instead of, for example, at 2.5% via the issuance of 7-10 year debt instruments.

This amounts to a major reduction in the aggregate maturity length of American sovereign debt (Treasury + Fed), which is totally warranted, given the Fed's oft-stated determination to maintain short-term interest rates low for an extended period.

Some warn against the danger of such a shortening of debt maturity, given the potential refinancing problems stemming from action by bond vigilantes, which could push the United States into default.

This attitude denies the reality of a sovereign currency, like the dollar (pound sterling, Swiss franc, yen, etc... but not the euro), which are not gold convertible. All the debt issued by the American government is nothing more than a promise to pay back these debts in American dollars, so the American government benefits from inexhaustible monetary reserves.

Now, I would like to return to the Fed's video conference.

If inflation continues to remain below target levels and unemployment too high, the challenge for the Fed will no longer be to maintain low short-term rates (0.25%), but to keep down long-term rates.

It simply needs to set an interest rate target -- let's say 2% on 10-year US Treasury Bonds -- and be prepared to buy whatever amount is needed of government debt with a maturity of less than 10 years paying over 2% interest.

All the money obtained by sellers of these government bonds will then end up in banks’ excess reserves accounts at the Fed, which pays 0.25% (for the time being), since there is nowhere else to put their dollars, aside from under-the-pillow investment, which would be only too sweet for the Treasury since it would pay no interest at all (Seigniorage).

The important thing in determining whether or not the Fed will make this Copernican step of fixing the maximum long-term rate is to watch closely deflation risk in the United States.

Given this criterion, check out yesterday's publication of Core PCE yesterday (minus food and energy items).

At 0% on the month, like the previous month and +0.9% on the year, this indicator is at its lowest level since it came into existence in the United States, as you can see in the graph below!

In the graph, we can clearly see the different inflation and deflation phases of the American economy since the 1960s:

· Very low inflation at the beginning of the 1960s, with the previous record low of +1.1% per annum.

· A gradual rise in inflation leading to the transmission of surging oil prices to finish goods prices (1975-1981)

· Volcker's shock treatment with disinflation following the plunge in oil prices, as inflation averaged 4% (1983-1992)

· A second wave of disinflation, with the general pursuit of monetarist policies, the continuation of low commodity prices and globalisation, leading to average inflation of 1.9% (Fed's official target) from 1996.

· And today, a new price decline to 0.9%, fuelled by the deflationist and mercantilist policies of Germany and China, a negative shock on aggregate demand while oil is still at over $80 per barrel!

I would even make a bit of an iconoclastic comment, but which is perfectly consistent with my long-held macro-monetary argumentation in these lines.

If we consider that these interventions by the Fed (QEs) are taking income (interest) from the pockets of private-sector economic agents (in reality, the Fed's profits and losses), they are basically reducing aggregate private-sector demand.

And the end result is quite the opposite of inflationist.

Core PCE in the United States

The Fed has reason to be concerned…

Asset allocation biases and advised option strategies

Ø Bund, Bobl, Shatz: Bear Flattening, Schatz vs 10-year Bund. On options basis, given sovereign debt vibrations.

Long December Schatz puts vs Bund puts (premiums received, net delta short).

A nightmarish yield curve

Ø Eurostoxx 50: Continue to bet on correction towards2750/2700. And even lower.

December puts 2700 or December put spreads 2800/2650.

Disclosure: Long 20 years OAT and 30 years BTP Zero Coupons, EDF Corp 5 Years 4.5%, Grece 2 Y and 10 Y bonds, Thaler's Corner.