As I read through the speech from 'the Bernanke' at Jackson Hole on Friday, I couldn't help but chuckle at the following reflection from the Fed:
Making monetary policy with non-traditional tools is challenging.
Chairman Bernanke, if you think making monetary policy with non-traditional tools is challenging, try investing around it.
Overall, the speech was what one would expect from a government agency providing a semi-formal review of itself—largely complimentary and ignoring serious unintended consequences of its actions. It was organized under the following five headings:
- Balance Sheet Tools - Reviewing how the Fed's balance sheet had been utilized in the crisis and to what end.
- Communication Tools - The effects of FOMC statements on the private sector.
- Making Policy with Non-traditional Tools: A Cost-Benefit Framework - The most informative section, more on this below.
- Economic Prospects - A slightly more upbeat section discussing hopes of returning to "full employment".
- Conclusion - The Fed really is doing God's work.
It is said that if one has to choose between an honest arrogance and an insincere humility, choose the former. The Fed has picked up on this and sets the tone from the start as a savior of the financial markets. Of course, this white knight narrative ignores the contributions the Fed made that caused the problem - such as abnormally low interest rates for an extended period of time - but cleaning up your own mess usually doesn't warrant the same level of recognition.
Specifically, the fed credits the Large Scale Asset Purchases (LSAP) of 1,700 billion and 600 billion with lowering the yield on 10-year treasuries 80 to 120 bps, an amount they deem to be "economically meaningful." They further go on to define that economic meaningfulness to equate to raising output by almost 3% and increasing private payroll employment by more than 2 million jobs. I'm surprised the Republicans haven't picked up on this, as that takes half the credit away from the Obama administration's 4 million jobs created/saved stat.
In fairness, the Fed recognized how difficult the counter-factual is to prove. That is, how would we ever know what would have happened had there been no stimulus or non-traditional monetary policy? Who really benefits from abnormally low interest rates? What is the true cost of the misallocation of capital through the disruption of the information contained in prices?
Players in the Bond Market: The Private Sector, The Fed, and Who?
Under the 'Cost-Benefit Framework' section of the statement the Fed outlines four costs of LSAP:
- Operations could impair the functioning of the securities markets.
- Larger balance sheet of Fed could reduce public's confidence of a smooth exit.
- Risks to financial stability by driving investors towards risky products.
- Fed could incur financial losses should interest rates rise to an unexpected extent.
There is much ado about the interaction between private market players and the Fed, but this misses the largest cost of abnormally low interest rates—the enabling of governments to continue with unsustainable fiscal policy.
Keeping interest rates at abnormally low levels = keeping government borrowing costs at abnormally low levels, as all other interest rates are set off of the borrowing cost of the U.S. Government, or the "risk-free rate." The U.S. Government, as well as the governments in Europe, have been able to avoid making the tough choices due to this collusion of unelected central bank officials and elected politicians.
Unfortunately, the longer these choices are put off, the larger the problems become. And as with any problem, there is a point which they become unsolvable. If they do reach this point, the central banks are to bear part of the blame, along with the useful idiots of the voting population and the officials they elected. But amazingly, the Fed didn't address this as one of their main concerns.
Exiting At A Profit Isn't Going To Happen
When addressing unwinding their bloated balance sheet, the Fed makes the following observation in their footnotes:
27. Remittances to the Treasury from the Federal Reserve have totaled about $200 billion over the past three years, well above historical average.
This was to add context to the statement that the Fed believes it can save the financial system while making a profit, which is transparently absurd. The reason the Fed has made a profit over the past three years is that it has been buying bonds, and due to other market participants buying bonds in expectations of the Fed buying more bonds, the prices of bonds have run up to 80-year highs. The question is how will the market react when it gets wind that the Fed is selling those bonds?
If it is anything like when the Fed was buying bonds, there is going to be a rush to the door. It is improbable that anyone who purchased a 10-year treasury bill will be happy with a sub 2% coupon payment, which almost guarantees a loss with inflation. The Fed acknowledges this themselves, noting that:
They (the Fed) will act decisively to execute exit their exit strategy at the appropriate time.
This implies they intend to get out the door first. Not knowing the duration of the Fed's holdings, it is difficult to assess the exact costs. But if they made $200 billion as they were buying into the largest bond bubble of all time, and have since increased the duration on their bonds with Operation Twist, you can expect losses to be order of magnitudes larger. This is where a printing press comes in useful.
In order to correct a problem, you first have to recognize the problem exists. Bernanke's statement at Jackson Hole indicates that despite employment being well above expectations and the Fed's policies falling short of their projects at the time they enacted them, they are positive they made the best choices at the time. They find a number of studies that support this viewpoint and footnote them, gloss over a few of the common objections to their policies, mention the plight of the unemployed, and wrap up the statement.
Interestingly, there is little to indicate that QE3 is in the works. It turns out my word clouds from an article earlier this week demonstrating a focus on the mandate at the Fed were not informative with regards to the likelihood of more monetary stimulus. Majority of this statement discussed the success of previous endeavors and that their unloading of their balance sheet was going to be smooth and profitable. The beige book earlier in the week reinforced this with a relatively upbeat outlook.
The Fed's conclusion includes an informative sentence:
Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve; in particular, it cannot neutralize the fiscal and financial risks that the country faces. It certainly cannot fine-tune economic outcomes.
With no signaling of new non-traditional monetary tools, interests rates at 0, and a self-assessed job well done, it appears Bernanke may be ready to let elected officials grab the reins of the economy. Or, depending on how you see it, let elected officials get the government out of the way of the market. In any event, the statement was much less aggressive than I expected, backward looking and didn't signal an imminent QE3 in the works.