WHAT’S A FED TO DO ON WEDNESDAY?

There’s much anticipation over this Wednesday’s FOMC decision.  As we all know by now, this is supposed to be the big unveiling of the Fed’s much anticipated third round of QE – now being dubbed “operation twist part deux”.   In a piece this morning, the Fed’s megaphone to the world, Jon Hilsenrath, discussed some of the likely actions:

“One issue high on the agenda: Detail what changes in unemployment and inflation it would take to make the central bank veer from its low interest-rate policy, according to people familiar with the matter.

…Fed officials are likely to consider other steps they might take to boost the ailing economy in the short-run when they meet Tuesday and Wednesday, including altering the composition of the Fed’s portfolio of securities so that it holds more long-term debt. The idea would be to push down long-term interest rates to stimulate more investment and spending. They also could try to encourage lending by cutting the 0.25% interest rate currently paid to private banks when they park money at the central bank.”

It sounds like Ben Bernanke is picking up President Obama’s strategy of speaking loudly and carrying a small stick.  The Fed can talk about the economy all they want.  They can set specific dates for specific policies, etc, but these are marginal policy changes that really have little to no impact on the real economy.  This is truly a sign that the Fed is desperate.  It’s like the husband who cheats on his wife repeatedly and pleads endlessly that she take him back.  Actions speak louder than words is an appropriate ending to that story in most cases.  The same can be said here.  And that’s been one of my primary gripes with monetary policy in recent years.  There has been no real transmission mechanism through which it works.  I was one of a handful of people who explained in great detail why QE2 would fail to revive the economy, but we continue to see faith and mythology surrounding the Fed’s new campaign efforts.  I won’t rehash these arguments today.  The bottom line is, these languages are refreshing in that it’s nice to see the Fed trying to be more transparent, but they’re not going to push a $15T economy in any sustained direction for more than a few minutes on Wednesday as the Wall Street trading desks go berserk over some minor statement change….

The second option Hilsenrath mentions is operation twist.  This involves pushing the long end of the curve lower in an attempt to flatten the curve and induce some borrowing/lending.  I’ve covered this thoroughly in the past.  It flat out won’t work unless the Fed is very specific in its execution.  They must target a specific long rate and be a willing buyer at that rate in any size.  I don’t think they’re willing to go that far as it would be seen as explicit money printing and debt monetization (more myths that we constantly read about these days – admittedly though, mythology was one of my favorite subjects in grade school – I’ve since grown out of that though).

There’s a substantial risk associated with this approach in that it could cause a seismic shift in the portfolio reblancing effect whereby investors are forced into hard assets and other higher risk assets which create market imbalances and potentially induce more of the cost push inflation we saw during QE2.  Besides, with long rates already at 2% on the 10 year bond, the Fed has to be wondering whether rates are really the problem (of course they’re not, aggregate debt is the problem, but let’s not include rational discussion in a conversation about Fed policy!).

In addition, recent CPI data has pushed the upper bounds of the Fed’s target rate of 2%.  That means they have to be increasingly concerned about stagflation.  Bernanke has been rather clear that he would only implement more QE if the deflation risks rose.  Last week’s core CPI of 2% has him thinking long and hard about more QE.  The bottom line is, even if they implement this program it’s unlikely to do much if anything.  And it has the potential to do more harm than good.  It will all depend on the implementation though.  If you hear explicit rates on long bonds, you might as well pile into every inflation trade you can find and wait for it to induce a further margin squeeze on the economy that essentially torpedoes our own ship.

Cutting the rate on excess reserves is another weak policy response.  Some advocates of this policy claim that the Fed can punish the banks by charging them to hold reserves.  This will supposedly force banks to use these reserves to lend and lead to economic expansion.  The Fed knows this is nonsense as banks are never reserve constrained.  So paying negative rates makes no sense.  The Fed could cut the rate on reserves to zero, but that serves little to no purpose as the effective Fed Funds Rate is currently 0.09% – already at the lower end of their current target range of 0-0.25%.   And as the NY Fed previously explained, there’s a simple logic behind paying interest on reserves – it serves as a de facto Fed Funds Rate in the current environment where the Fed’s balance sheet has expanded:

“Recently the Desk has encountered difficulty achieving the operating target for the federal funds rate set by the FOMC, because the expansion of the Federal Reserve’s various liquidity facilities has caused a large increase in excess balances. The expansion of excess reserves in turn has placed extraordinary downward pressure on the overnight federal funds rate. Paying interest on excess reserves will better enable the Desk to achieve the target for the federal funds rate, even if further use of Federal Reserve liquidity facilities, such as the recently announced increases in the amounts being offered through the Term Auction Facility, results in higher levels of excess balances.”

In addition, there could be negative effects here.  Izabella Kaminska at the FT has done some excellent work on the possible downsides of a cut in IOER (see here).  I highly recommend having a read.  It’s a bit dense, but it touches on some of the difficulties that could present themselves if the Fed is not explicit in its attempts to monitor the payments system.  She further notes that the current siren call for cutting the rate on reserves appears to be the last ditch efforts of the monetarist regime who has seen their precious theory essentially smashed to bits and pieces in the last three years:

“Finally, we think the driving force behind the call for lower IOER comes from monetarists who are frustrated that the reserve multiplier theory has been blown out of the water in recent years.”

In sum, it looks like the Fed is increasingly becoming the truly naked emperor.  As Warren Mosler likes to say, they’re like the child in the backseat of a car with the toy steering wheel.  Except this baby is crying all the way to the market and making a big fuss over nothing.  Unfortunately, everyone else in the car is being forced to listen to this endless bantering as we drive full speed into a wall.   Welcome to monetary policy in the 21st century.

 

 

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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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