THE FED IS FRACTURED
There is much debate these days about the powers of the Fed and what they can do to strengthen the economy (if anything). Regular readers are familiar with my position – monetary policy matters little in times of a balance sheet recession. It is not the supply of money that matters, but the demand of money when the private sector is experiencing a period of deleveraging. This renders the Fed largely powerless.
I’ve been beating this dead horse since long before Ben Bernanke initiated his outrageous trickle down bank bailout policies, but it’s only just now becoming evident to the mainstream media that this might be the case. The bank bailout and the gross ballooning of the Fed’s balance sheet has done practically nothing for Main Street. If that isn’t clear by now then people need to pull their heads out of the sand. Despite this, we continue to hang on every word out of this powerless Federal Reserve. We are all waiting for Ben Bernanke to save us from economic downturn. Why?
What’s even more absurd is that the shrieking for more quantitative easing is growing ever louder. I know QE is very fancy sounding and even more confusing sounding, but it is nothing more than an asset swap. The Fed swaps particular interest bearing assets for deposits. When will people realize this and stop making QE out to be something it is not? It is not inherently inflationary. It is not the “printing of money” that the deficit terrorists ignorantly label it as. In its very simplest form it is nothing more than an asset swap. That is all. The Fed swaps deposits for interest bearing assets. If anything, you could argue that this is an inherently deflationary event.
Next time you hear someone shrieking about the dangers (or worse, the benefits) of QE just put them on mute. Take them off your list of credible sources. STOP LISTENING TO THEM. These are clearly people who have a very low level of understanding when it comes to the way our monetary system works and what we are currently experiencing. The Fed is practically powerless in this environment. Mr. Bernanke predicted NONE of this. When will we stop relying on him to get us OUT of this? The sooner the better in my opinion.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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26 Comments
I’d like to hear the argument that QE is inherently deflationary.
You’re removing an interest bearing asset from the private sector. Perhaps deflationary is too strong a word, but inflationary it is not.
A bank has Treasuries on its balance sheet. The government pays interest on these Treasuries. This is inflationary, as money is injected into the economy. If the Fed purchases the Treasuries, now there’s just cash sitting on the bank’s balance sheet. The government pays the Fed interest, but this is really a meaningless transaction, as one part of the government is paying another part of the government. So Treasury interest paid to the private sector is money being created. Take away that Treasury interest (QE) and it’s actually deflationary.
But isn’t the price paid for said interest bearing assets the PV of all future CF?
The Fed and treasury together (or maybe just one or the other) could put pressure out along the yield curve to reduce rates in the 3 to 5 year maturities or even longer, but I agree that it is Fiscal policy which must be used to alleviate the demand and consequential employment reduction effects of private sector (mainly household) deleveraging.
Recently, using Robert Shiller’s monthly data, I calculated that the earnings yield on stocks was double the yield on 10 year bonds, but this has changed as rates have increased a bit from below 3% and the stock market has increased about 5%.
Reducing long rates is all the rage now. Has no one studied Japan? How is the low long bond working out for them?
The economic movement over the last 25 years has instilled this belief in Americans that the central bank is all powerful. You would think that belief was destroyed when Greenspan admitted the failure in his “model”, but no – it continues under Bernanke. And it continues to fail us.
TPC,
Any thoughts on Krugman’s NY Times article yesterday? http://www.nytimes.com/2010/07/12/opinion/12krugman.html
Same as my comment to Paul. Krugman’s greatest contribution to economics in the last year was the term Bernanke-san. It has a very nice ring.
I’m not so sure Krugman quite gets it though. He wrote 5 or 6 paragraphs all kind of leading to nowhere. His final conclusion is that we might have to buy long bonds to “manipulate” the bonds we sell anyway. That strategy doesn’t work because it doesn’t fix the problem you consistently point out – weakness in private sector borrowing demand. Does he get it?
” The Fed swaps particular interest bearing assets for deposits. When will people realize this and stop making QE out to be something it is not? It is not inherently inflationary.”
I agree that current QE is an asset swap for many financial companies and is clearly an “accounting trick” to help the banking sector. But, this trick does have the implicit faith that the marginal money velocity is zero, i.e the cash at the financials stays put and the cash flows as well. Here is one real world example where it is not zero. My SoCal megahome with no money down is foreclosed; I go backrupt and my debts are cleared. Fannie/Freddie/Anonymous CLO/ABS/MBS get’s stiffed; the gov gets stiffed. I start spending my mortgage payments on buying oil futures. Oil goes up and some of the accounting trick cash leaks to the prop desk and they start trend following oil futures.
I think we often get into a debate about what is inflationary and potentially inflationary … this is a matter of psychology but also there is one historical truth … any assumed liability where there is no attempt to mitigate it is potentially inflationary … which then becomes inflationary when the market realizes that individually they don’t want to be the last person holding the bag.
[My SoCal megahome with no money down is foreclosed; I go backrupt and my debts are cleared. Fannie/Freddie/Anonymous CLO/ABS/MBS get’s stiffed; the gov gets stiffed. I start spending my mortgage payments on buying oil futures.]
Where exactly are you then living at the time? Sure you may not be kicked out of that home for a while (banks not wanting to foreclose) but how sustainable is that situation in the long run? Eventually your mortgage payments (or lack thereof) will need to be rental payment – unless you move back in with mom and dad.
Furthermore if you declare bankruptcy, where’s the money coming from for you to buy oil futures, let alone pay rent?
It’s not inflationary at the moment as the M being created by the Fed goes back on deposit at the Fed and V is going down I.e. No credit growth but credit contraction & de-leveraging. Once/IF V picks up it will become very inflationary if M doesn’t come down I.e. Fed starts selling it’s securities. BUT V picking up could be years into the future. That said what would Mr. Market do if the Fed would start buying Muni’s and let’s say it’s balance sheet expands to 5trl next time round? Does Mr. Market still deposit cash at the Fed or does it get spooked and V goes up as people don’t want to hold cash anymore and credit start going? I don’t know the answer but once V starts going up the M on the Fed’s balance sheet will be multiplied many times by private money creation (fractional reserve banking) at which point it will be very inflationary but there are a lot of IF’s and probably more importantly WHEN’s in the whole deflation/inflation debate.. Government spending and deficits are just as important in the debate but looking at history it’s a fact that large government deficits (threshold on average being government borrows 40c per 1 USD they spend) lead to future inflation and QE makes stimulus spending and deficits a lot easier. Fiat money inflation in France by Andrew DickSon White is a good read for some thought on the subject.
TPC,
One example of QE would be the Fed creating new USDs and purchasing Treasuries with those USDs. Said money flows into the US Treasury, the US Treasury pushes those newly created USDs back out into the economy via payments and benefits of various sorts. That process is a) money printing, and b) inflationary. However, the inflation created by that process may or may not be enough to offset deflationary pressures over a given time frame. It depends. For example, the previous QE actions were directly and indirectly extremely inflationary in nature. Which is why they were able to offset the extreme deflationary forces at work and produce a (perhaps temporary, we shall see) net positive inflation rate.
Do you agree with that?
That’s the process of deficit spending. Treasury spends. The Fed sells bonds. Spending can be inflationary. I don’t think TPC would argue that. But QE can only be inflationary if there is borrowing. The idea was that we could improve bank balance sheets and they would then we more willing to lend. But the problem isn’t on the supply side. It’s on the demand side.
So after the swap, the Fed has a bank’s interest bearing assets and the bank has cash. The bank then goes out and buys more treasuries. Isn’t this just a round about way of monetizing the deficit?
What’s the difference? They had tsys or MBS before, then they swapped for cash, then they swapped for tsy’s. Kind of defeats the purpose of the whole scheme.
If the Fed swaps Treasury securities for MBS or CRE securities that are illiquid and worth $.70 on the dollar isn’t there a boost both to liquidity and value of tradeable assets (inflation) in theory? I won’t argue that with low velocity of money the effects may be smaller than anticipated.
All you did was change the term structure. That asset (assuming it doesn’t go default) will expire and net to zero. What is inflationary there?
Could you dumb this down a little bit.
That was the whole goal. Save the banks and save the world.
Sorry to jump in TPC. Correct me if I am wrong about anything and thanks as always for your excellent work.
Captain, you nailed it. Feel free to jump in any time. It’s nice having readers that are smarter than myself….
The Fed is impotent for the time being, given their current tool chest.
The spigots are wide OPEN the credit supply side, and totally CLOSED on the credit demand side. We are throwing lighter fluid all over the campsight, but the wood is wet. (careful don’t stand too close, if this fire ever gets lit with all the lighter fluid on it -Kaboom!!)
I might be naive, but I just don’t think we’re truly Japanese. Only imagined and anecdotal, but my 65 year old father is sooooooo different than the 65 year old Japanese retiree I have created in my head. And the next generation spends every dime they have. Doesn’t make for stability, but it certainly doesn’t spell deflation either. The point is, we as a Nation have 50+ years of wild orgiastic consumerism in our bones, in our blood. Can that change over night? Are our demographics as profound as Japans? We shall see.
If their ever were a time for deflation, wouldn’t it be now? And CPI and wages are just flattish…..
I know, if it looks like a duck and quacks like a duck, its a duck – but my spidey senses are telling me this movie has an alternate ending.
Could the people alive in 1933 ever have envisioned 1953?
stream of consciousness – OFF.
QE can be very stimulative if it is done right. Suppose the Fed bought 1 trillion worth of 2% 30 year bonds that were solely for the financing of new toll highway and high speed train construction. This would finance new spending that would hire new workers, and the revenue from the completed projects would eventually cover the bonds. The projects could even be private, but would require government action to take the land, etc… In reality, the biggest obstacles to projects of this sort are the environmental laws, and the fact that this Administration is staffed with environmental extremists. It can take many years to get all the required enviro approvals for transportation projects, and no stimulus takes place at all until the project is approved. Hell, it took over 2 decades to approve the ICC. And this may be the real reason that this Congress did not put too much into construction when they passed the Stimulus.
In a deflation the FED is pushing on a string. People aren’t willing to borrow, so, the FED can’t persuade people to borrow. And banks aren’t willing to lend. So, the FED is powerless.
Mr. Bernanke predicted NONE of this. When will we stop relying on him to get us OUT of this?
The idiots and FED bigots largely outnumbering the smart and independent thinking people, this is not about to change in the foreseeable future. The FED has made huge mistakes and is partly responsible for the current crisis, no worries! Just give it a small slap on the hand (on the one not writing the checks), don’t do any audit and give it more power to help its buddies in WS! All this would be laughable if it was not too disgusting…