This from the Financial Times on the morning of Friday, November 20, 2009: “Short-term US interest rates turned negative on Thursday as banks frantically stockpiled government securities in order to polish their balance sheets for the end of the year.” (See: http://www.ft.com/cms/s/0/52e0f72c-d575-11de-81ee-00144feabdc0.html.)
“The development highlighted the continuing distortions in the financial system more than a year after Lehman Brothers’ failure triggered a global crisis.”
“With the Federal Reserve maintaining an overnight target rate of zero to 0.25 per cent, investors are demonstrating a willingness to completely forgo interest income—or even to take a small loss—to own securities that are seen as safe.”
Just how “safe” do these banks have to appear?
The way they are acting indicate that they are not very “safe” at all.
Total reserves at depository institutions for the two weeks ending November 18 averaged $1,106 billion of which $1,068 were reserve balances with Federal Reserve Banks and $38 billion was vault cash used to satisfy required reserves.
The Fed has pumped roughly $350 billion into the banking system over the past 13-weeks primarily through the purchase of open market securities.
The effective Federal Funds rate has fallen steadily through the fall from August and averaged 11 basis points toward the end of the latest banking week.
Putting this information together indicates, to me, a banking system that is still seriously threatened and desirous of all the spare cash that it can attain. This is not a situation of quantitative easing but of bankers that are overly concerned with their solvency. The Federal Reserve is supplying reserves “on demand.” They are not, at this time, initiating the supply.
And, why might this be so?
Well, take a look at some of the headlines of the past week: United States mortgage delinquencies reach a record high; bankruptcies continue to remain near record levels; commercial real estate to remain major problem for years; commercial real estate too complex for government to bail out; unemployment at 25-year high; credit card delinquencies remain at record levels; and bank failures will continue to average about 3 a week for the next 12 to 18 months.
President Obama is even talking about the possibility of a “double-dip” recession.
The distortions in the financial system continue to be enormous. Even given these attitudes within the banking system, as the Financial Times reports, “many” of the leading US banks are “sitting on big trading profits.”
And, why not? When they can borrow for less than 35 basis points and lend out at 350 basis points who cannot make profits. When they can engage in the “carry” trade and profit from the declining dollar as well as earn large spreads, who cannot make profits.
Stock markets have been living off of momentum trading. There are so many unknowns about the future of business and industry, let alone finance that the justification for the rise in stock prices since March can continue to be questioned.
The real problem that exists in the market right now is the huge overhang of uncertainty. Not only are there unknowns about the recovery of industry and finance right now, there are also unknowns related to the huge cloud of government budget deficits that hang over the financial markets for the future and the concern over the ability of the Federal Reserve to “exit” from all the reserves it has put into the banking system.
The risk that is incorporated in this environment shows itself from time-to-time. Of course, the massive rise in the price of gold has been one place that investors have flocked to this year. Another continues to be the world-wide demand for United States Treasury securities. And, like yesterday, enough bad news causes currency traders to move rapidly back into United States dollars for “reasons of safety.”
I know many measures of market risk have declined substantially over the past six months or so. One has to go back to November 2007 to see a spread between Aaa and Baa yields as low as they are now. Likewise, with spreads on high-yield securities. The VIX index has fallen, once again, around its 52-week low. My belief is that these measures are so low because of the Fed’s interest rate policy. Interest rates, in general, are lower than they would be if the Fed was not forcing low rates on the market, and interest rate spreads are low for the same reason.
Still, there is much to be wary of. The only certainty that exists right now is that the Federal Reserve, and other central banks around the world, will keep short term interest rates low for an “extended period.” But, at some point, these rates are going to have to rise. Until they do, the interest arbitrage opportunities will remain and large financial institutions will continue to take away large profits from the financial market. Furthermore, the carry trade will continue to prosper using funds from the United States.
The question here is, when will all the investors that are “making it” through government support and government guarantees head for the doors. It is only logical that when there is an indication that the Federal Reserve is going to start letting interest rates rise that there will be a rush to get out of the market or move to the other side of the market. In such a situation, the financial firms that are big in the trading area cannot afford to be second or third getting to the door to pull their own exit.
How will this leave the banks that are written about in the Financial Times? If these banks, generally the smaller ones, have “stockpiled” government securities, how will they handle the decline in the prices of these securities once interest rates begin to rise? If they are concerned about their solvency now, what will their condition look like under this kind of scenario?
If there is a rush to get out of bonds, will the Federal Reserve back off its exit strategy?
Uncertainty continues to rule the markets. And, on top of the basic market insecurity, there seems to be a growing insecurity about our governmental leaders (Geithner and Bernanke to start with), and about the institutions of our government (see House attack on secrecy in the Federal Reserve). Uncertainty is bad enough but if people have little or no confidence in our leaders and our institutions where are they to turn?
Friday, November 20, 2009
Tuesday, November 17, 2009
Excess Capacity and the Slow Economic Recovery
Ben Bernanke spoke in New York yesterday and, depending upon which paper you read this morning, he basically said one of two things. First, he said that the Fed was interested in a strong dollar and would continue to keep the value of the dollar in mind in deliberations concerning monetary policy.
Chuckle, chuckle.
Second, Bernanke said that the pain in the labor market was going to last for a long time and that we shouldn’t expect the unemployment rate to fall anytime soon.
That is, don’t expect interest rates to begin to rise in the near future.
Remember, the number one policy goal of the Federal Reserve (and the federal government) is full employment and don’t you forget it. Put inflation, commodity prices, and the value of the United States dollar on the back burner.
So much for an independent Fed!
But, we knew that.
The problem with the economic recovery and unemployment is captured by an article in the Wall Street Journal, “Auto Industry Has Room to Shrink Further,” (see http://online.wsj.com/article/SB125832250680149395.html?mg=com-wsj.) Although the article focuses upon the auto industry, the situation that is described can be extended to many other major (and minor) industries throughout the world.
“Over the past two years, the global auto industry has endured one of the worst downturns in its century-plus history. Auto makers around the world have consolidated, restructured and slimmed down—and yet they still have too much of just about everything, especially too many brands and too many plants.”
“According to CSM Worldwide, the auto industry has enough capacity to make 85.9 million cars and light trucks a year—about 30 million more than it is on track to sell this year, the equivalent of more than 120 assembly plants.”
Furthermore, an auto analyst is quoted as saying, “government intervention to save auto-related jobs has forestalled the inevitable—broad and deep restructuring that would shut down unneeded plants and close loss-making enterprises. Not as much capacity has come out that should have.”
This is just talking about the auto industry. But, it is true of industry in general. The United States and the global economy have become leaner due to the current contraction: still, much excess capacity remains.
Even though capacity utilization for all industry is up in the United States (note that capacity utilization for manufacturing in October did not change from September), giving further indication that the recession is over, the problem of too much capacity lingers. As I have mentioned many times before, every economic recovery since the 1960s has seen a pickup in capacity utilization as economic growth increased, but the peak reached in each cycle was no higher, and was generally lower, than the peak reached in the previous cycle.
That is, capacity utilization rose during the expansion phase of each economic cycle since the 1960s but the trend in the United States was for more and more plant and equipment to remain idle.
In addition, this contributed to the under-utilization of labor as is evidenced by the rising trend in those of the population that are labeled underemployed .
Also, as the federal government, and the independent Federal Reserve System, tried to pump up the economy so that fuller employment could be achieved, the pressure was always on for inflation to rise. Since January 1961, the purchasing power of the dollar has fallen by about 85%. This is not a coincidence!
Furthermore, these policy efforts just put people back to work in the jobs they had been in and reduced the incentive for companies to innovate and change moderating productivity growth.
The performance of industrial production in the United States carries with it the same story. (Industrial production is up in October, but at an anemic 0.1% rate.) The growth rate of industrial production rises and falls through the swings in the economic cycle, but each rebound does not bring with it the same expansion as was achieved in previous cycles. This is just another indication that although recovery takes place, the overall trend in the productive utilization of resources in the United States continues to wane.
This fundamental weakness resource utilization is resulting in changing attitudes throughout the world. David Brooks writes in the New York Times about the underlying optimism that seems to be present in China these days, an optimism that used to be present in the United States. Simon Shama writes in the Financial Times about how China is now “wagging its finger at the United States about it wayward monetary and fiscal policies, as yet, still unaccustomed “to being the strong party in the relationship.” Clive Crook, also in the Financial Times, writes about the looming political battle in the United States concerning the “big questions” that voters have to answer “about the entitlements they demand and the taxes they are willing to pay.”
The United States is strong and will continue to stay strong. But, its relative position is changing. And, the way its leaders go about attempting to resolve problems is missing the point.
The United States economy is recovering. But, unless policy prescriptions change, there will continue to be an under-utilization of capacity, a weakness to productivity growth, a bias towards inflation, further declines in the United States dollar, and the threat of protectionism.
It is said that people and a nation do not change their habits until there is a real crisis. Right now it looks as if we have wasted a pretty significant financial crisis in returning to our old ways and old policy prescriptions and will just have to be content with an economy that produces mediocre results. No one seems anxious to change how we attack our problems.
Chuckle, chuckle.
Second, Bernanke said that the pain in the labor market was going to last for a long time and that we shouldn’t expect the unemployment rate to fall anytime soon.
That is, don’t expect interest rates to begin to rise in the near future.
Remember, the number one policy goal of the Federal Reserve (and the federal government) is full employment and don’t you forget it. Put inflation, commodity prices, and the value of the United States dollar on the back burner.
So much for an independent Fed!
But, we knew that.
The problem with the economic recovery and unemployment is captured by an article in the Wall Street Journal, “Auto Industry Has Room to Shrink Further,” (see http://online.wsj.com/article/SB125832250680149395.html?mg=com-wsj.) Although the article focuses upon the auto industry, the situation that is described can be extended to many other major (and minor) industries throughout the world.
“Over the past two years, the global auto industry has endured one of the worst downturns in its century-plus history. Auto makers around the world have consolidated, restructured and slimmed down—and yet they still have too much of just about everything, especially too many brands and too many plants.”
“According to CSM Worldwide, the auto industry has enough capacity to make 85.9 million cars and light trucks a year—about 30 million more than it is on track to sell this year, the equivalent of more than 120 assembly plants.”
Furthermore, an auto analyst is quoted as saying, “government intervention to save auto-related jobs has forestalled the inevitable—broad and deep restructuring that would shut down unneeded plants and close loss-making enterprises. Not as much capacity has come out that should have.”
This is just talking about the auto industry. But, it is true of industry in general. The United States and the global economy have become leaner due to the current contraction: still, much excess capacity remains.
Even though capacity utilization for all industry is up in the United States (note that capacity utilization for manufacturing in October did not change from September), giving further indication that the recession is over, the problem of too much capacity lingers. As I have mentioned many times before, every economic recovery since the 1960s has seen a pickup in capacity utilization as economic growth increased, but the peak reached in each cycle was no higher, and was generally lower, than the peak reached in the previous cycle.
That is, capacity utilization rose during the expansion phase of each economic cycle since the 1960s but the trend in the United States was for more and more plant and equipment to remain idle.
In addition, this contributed to the under-utilization of labor as is evidenced by the rising trend in those of the population that are labeled underemployed .
Also, as the federal government, and the independent Federal Reserve System, tried to pump up the economy so that fuller employment could be achieved, the pressure was always on for inflation to rise. Since January 1961, the purchasing power of the dollar has fallen by about 85%. This is not a coincidence!
Furthermore, these policy efforts just put people back to work in the jobs they had been in and reduced the incentive for companies to innovate and change moderating productivity growth.
The performance of industrial production in the United States carries with it the same story. (Industrial production is up in October, but at an anemic 0.1% rate.) The growth rate of industrial production rises and falls through the swings in the economic cycle, but each rebound does not bring with it the same expansion as was achieved in previous cycles. This is just another indication that although recovery takes place, the overall trend in the productive utilization of resources in the United States continues to wane.
This fundamental weakness resource utilization is resulting in changing attitudes throughout the world. David Brooks writes in the New York Times about the underlying optimism that seems to be present in China these days, an optimism that used to be present in the United States. Simon Shama writes in the Financial Times about how China is now “wagging its finger at the United States about it wayward monetary and fiscal policies, as yet, still unaccustomed “to being the strong party in the relationship.” Clive Crook, also in the Financial Times, writes about the looming political battle in the United States concerning the “big questions” that voters have to answer “about the entitlements they demand and the taxes they are willing to pay.”
The United States is strong and will continue to stay strong. But, its relative position is changing. And, the way its leaders go about attempting to resolve problems is missing the point.
The United States economy is recovering. But, unless policy prescriptions change, there will continue to be an under-utilization of capacity, a weakness to productivity growth, a bias towards inflation, further declines in the United States dollar, and the threat of protectionism.
It is said that people and a nation do not change their habits until there is a real crisis. Right now it looks as if we have wasted a pretty significant financial crisis in returning to our old ways and old policy prescriptions and will just have to be content with an economy that produces mediocre results. No one seems anxious to change how we attack our problems.
Monday, November 16, 2009
A Critique of Quantitative Easing
Yesterday, I posted a report on the strategy of the Federal Reserve to exit its position of excessive monetary ease. (See http://seekingalpha.com/article/173556-federal-reserve-exit-watch-part-4.) In that report I mentioned that since August, the total reserves in the banking system had shown a substantial increase.
Looking a little further into the data we find that the Monetary Base, defined as all financial assets that serve as bank reserves or could become bank reserves, rose from an average of $1,649 billion in the two weeks ending August 12, 2009 to an average of $2,001 billion in the two weeks ending November 4. (These data are on a nonseasonally adjusted basis, but the seasonally adjusted data are not significantly different.)
The Monetary Base rose by $352 billion during this period of time. (This was both on a
seasonally adjusted bases as well as a nonseasonally adjusted basis.)
What I am interested in reporting on is the total amount of reserves available to the commercial banking system.
Technical Note: To get the figure for total reserves we must subtract the currency component of the money stock from the reported data on the Monetary Base. This amount, according to the Federal Reserve System, is total reserves (of the banking system from the H.3 release) plus required clearing balances and adjustments to compensate for float at Federal Reserve Banks plus an amount representing the difference between current vault cash and the amount of vault cash used to satisfy current reserve requirements. This total reserve amount is different from the total bank reserves reported in the H.3 release on Aggregate Reserves of Depository Institutions and the Monetary Base.
This calculated measure of total reserves in the banking system rose by $351 billion during the time period under review. In other words, currency in circulation outside of commercial banks increased by only $1.0 billion from the August 12 information to the November 4 data.
Excess reserves in the banking system increased in this 13-week period from $709 billion to $1,059 billion, a rise of $350 billion. Thus, all the increase in bank reserves during this time period came in excess reserves, the required reserves held behind the deposits of the banks remained flat!
The truly remarkable thing is that the Monetary Base averaged around $848 billion in the two weeks ending August 13, 2008 while the total reserves in the banking system calculated using the method discussed above amounted to $72 billion.
Thus, in the time between August 12, 2009 and November 4, 2009, the Federal Reserve added $352 billion to the reserves of the banking system, a system that only averaged $72 billion in total reserves in the two weeks ending August 13, 2008. That is, the Federal Reserve added about 5 times as many reserves to the banking system in a 13-week period in 2009 as the complete banking system had in total in August 2008!
However, during the later time period, total bank credit in the banking system dropped by about $150 billion, loans and leases falling around $142 billion.
While bank reserves were increasing rapidly, the effective Federal Funds rate remained relatively constant. It averaged 16 basis points in August 2009, 15 basis points in September and 12 basis points in October. It continued to average around 12 basis points in the first half of November.
The question that needs to be asked is whether or not this scenario was what the Federal Reserve hoped to achieve when it initially went into what it called Quantitative Easing. My understanding of Quantitative easing was that Fed actions were required to combat a Liquidity Trap, a situation in which interest rates could not be pushed lower by adding more reserves to the banking system. Because interest rates could not be pushed lower, aggregate economic demand could not rise. However, it was argued that as the central bank continued to add reserves to the banking system, loans would still be granted to customers and the money stock would increase. Having more funds available, even though the interest rate on the loans could not go lower, was the quantitative effect desired, and as these funds were added to balance sheets spending would increase and the economy would be stimulated.
I don’t sense in the figures presented above the presence of a liquidity trap. The banking system seems to be demanding reserves and, in order to keep interest rates from going up, the Federal Reserve is very abundantly supplying banks reserves. That is, rather than exhibiting a fear that short term interest rates cannot decline any further, the Fed is afraid that short term interest rates (as well as rates on longer term Treasury securities and mortgage rates) might actually rise. This is consistent with the almost obsessive effort the Fed is making to be sure that the market knows the Fed is not going to let interest rates rise and that it is going to keep interest rates at current levels for “an extended period” of time.
This, to my mind, is not Quantitative Easing. It is just a continuation of the strategy the Fed has been following since September 2008: in policy actions, do not err on the side of providing too little stimulus.
This is not a refined, sophisticated monetary policy. Throwing everything you can against the wall to make sure a sufficient amount of what you throw against the wall sticks to the wall is something one does when one is desperate and unsure about what one is doing. You can achieve your goal with this strategy but the problem is that you have a big mess to clean up afterward.
And, if I am correct in this analysis, the Federal Reserve is currently only exacerbating the size of the mess that will have to be cleaned up.
Looking a little further into the data we find that the Monetary Base, defined as all financial assets that serve as bank reserves or could become bank reserves, rose from an average of $1,649 billion in the two weeks ending August 12, 2009 to an average of $2,001 billion in the two weeks ending November 4. (These data are on a nonseasonally adjusted basis, but the seasonally adjusted data are not significantly different.)
The Monetary Base rose by $352 billion during this period of time. (This was both on a
seasonally adjusted bases as well as a nonseasonally adjusted basis.)
What I am interested in reporting on is the total amount of reserves available to the commercial banking system.
Technical Note: To get the figure for total reserves we must subtract the currency component of the money stock from the reported data on the Monetary Base. This amount, according to the Federal Reserve System, is total reserves (of the banking system from the H.3 release) plus required clearing balances and adjustments to compensate for float at Federal Reserve Banks plus an amount representing the difference between current vault cash and the amount of vault cash used to satisfy current reserve requirements. This total reserve amount is different from the total bank reserves reported in the H.3 release on Aggregate Reserves of Depository Institutions and the Monetary Base.
This calculated measure of total reserves in the banking system rose by $351 billion during the time period under review. In other words, currency in circulation outside of commercial banks increased by only $1.0 billion from the August 12 information to the November 4 data.
Excess reserves in the banking system increased in this 13-week period from $709 billion to $1,059 billion, a rise of $350 billion. Thus, all the increase in bank reserves during this time period came in excess reserves, the required reserves held behind the deposits of the banks remained flat!
The truly remarkable thing is that the Monetary Base averaged around $848 billion in the two weeks ending August 13, 2008 while the total reserves in the banking system calculated using the method discussed above amounted to $72 billion.
Thus, in the time between August 12, 2009 and November 4, 2009, the Federal Reserve added $352 billion to the reserves of the banking system, a system that only averaged $72 billion in total reserves in the two weeks ending August 13, 2008. That is, the Federal Reserve added about 5 times as many reserves to the banking system in a 13-week period in 2009 as the complete banking system had in total in August 2008!
However, during the later time period, total bank credit in the banking system dropped by about $150 billion, loans and leases falling around $142 billion.
While bank reserves were increasing rapidly, the effective Federal Funds rate remained relatively constant. It averaged 16 basis points in August 2009, 15 basis points in September and 12 basis points in October. It continued to average around 12 basis points in the first half of November.
The question that needs to be asked is whether or not this scenario was what the Federal Reserve hoped to achieve when it initially went into what it called Quantitative Easing. My understanding of Quantitative easing was that Fed actions were required to combat a Liquidity Trap, a situation in which interest rates could not be pushed lower by adding more reserves to the banking system. Because interest rates could not be pushed lower, aggregate economic demand could not rise. However, it was argued that as the central bank continued to add reserves to the banking system, loans would still be granted to customers and the money stock would increase. Having more funds available, even though the interest rate on the loans could not go lower, was the quantitative effect desired, and as these funds were added to balance sheets spending would increase and the economy would be stimulated.
I don’t sense in the figures presented above the presence of a liquidity trap. The banking system seems to be demanding reserves and, in order to keep interest rates from going up, the Federal Reserve is very abundantly supplying banks reserves. That is, rather than exhibiting a fear that short term interest rates cannot decline any further, the Fed is afraid that short term interest rates (as well as rates on longer term Treasury securities and mortgage rates) might actually rise. This is consistent with the almost obsessive effort the Fed is making to be sure that the market knows the Fed is not going to let interest rates rise and that it is going to keep interest rates at current levels for “an extended period” of time.
This, to my mind, is not Quantitative Easing. It is just a continuation of the strategy the Fed has been following since September 2008: in policy actions, do not err on the side of providing too little stimulus.
This is not a refined, sophisticated monetary policy. Throwing everything you can against the wall to make sure a sufficient amount of what you throw against the wall sticks to the wall is something one does when one is desperate and unsure about what one is doing. You can achieve your goal with this strategy but the problem is that you have a big mess to clean up afterward.
And, if I am correct in this analysis, the Federal Reserve is currently only exacerbating the size of the mess that will have to be cleaned up.
Sunday, November 15, 2009
Federal Reserve Exit Watch: Part 4
This is the fourth month that I have posted something about the performance of the Federal Reserve with respect to their exit strategy, the strategy it is following to remove the massive amount of reserves it put into the banking system in 2008 and beyond. On November 11, 2009, the Fed was supplying $2,176 billion in reserve funds to the banking system. (This is from the Federal Reserve release H.4.1, Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.)
This was down slightly from the $2,233 billion total on October 14, 2009, but up from the $2,055 billion on August 12, 2009.
Commercial banks had $1,041 billion in Reserve Balances at Federal Reserve Banks on November 11 and the banking system averaged $1,059 in Excess Reserves for the two week period ending November 4, 2009. On October 14, Reserve Balances were $1,049 billion, but on August 12 this number was only $772 billion. Excess Reserves in the banking system averaged $918 billion in the two weeks ending October 7, and averaged $766 in the month of August.
Thus over the last 13-week period and over the past 4-week period total assets remained form around $2.1 trillion and $2.2 trillion.
However, Total Reserves in the banking system rose from $829 billion in August to $981 in the two week period ending October 7, to $1,124 billion in the two week period ending November 4.
This is an increase of over 35% in the total reserves of the banking system!
Of this $295 billion increase in total reserves, a total of $293 billion went into excess reserves!
Just a side note, Required Reserves rose by only $2 billion over the same time period!
No lending going on here!
The composition of the Fed’s balance sheet is changing, however. Securities held outright by the Federal Reserve has risen from $1,556 on August 12, 2009 to $1,673 billion on October 14 and $1,702 on November 11.
As reported in early editions of the Exit Watch, the Fed is letting the special assets it created run off as the need for them retreats and is replacing these reserves by marketable securities. Not all of these will run off in the near term as the credit and value issues surrounding assets at AIG and other institutions may take some time to disappear. However, these special assets have declined from somewhere in the neighborhood of $550-$500 billion on August 12, to $420-$380 on October 14 to around $340-$300 billion on November 11.
The largest decrease came from the reduction in the use of the Term Auction Credit which was instituted in December 2007 as a part of the dislocations in the financial markets that surrounded the problems at Bear Stearns. On August 12, this facility totaled $233 billion. The total dropped to $155 billion on October 14 and $109 billion on November 11.
Thus, the Fed is reducing the special assets portion of its balance sheet and is substituting for these asset, ownership of securities--Treasuries, Federal Agency issues, and Mortgage Backed securities.
In pursuing this path, the Fed is taking securities out of the open market, from banks and other financial institutions, but the funds it is using to pay for these securities is just going, so to speak, into bank vaults.
Commercial banks are basically saying, “If we don’t make any loans with this money, then the loans we don’t make cannot turn into bad loans!”
Another way of saying this is that the banks have enough bad assets on their books now and they don’t need to add any more. They’ll sell securities, but they won’t do anything with the money they receive back from the sale.
This seems to be creating a very uncomfortable situation. As the Fed reduced special facility assets over the last 13-week period and increased its holdings of open-market securities, it forced $300 billion reserves on the banking system.
Note that in August 2008, Total Reserves in the banking system amounted to $45 billion.
In 13 weeks the Fed forced 6.67 times more reserves into the banking system than the banking system had accumulated in all its history in the United States! And the banks did nothing with the reserves! And, the recession ended in the third quarter!
This is not a liquidity problem!
And the Federal Reserve says that it will continue to keep its target interest rates at its current level for an extended period of time. This is “QUANTATIVE EASING”!
Interest rates are going to start rising at some time. What is the Fed going to do with all the open-market securities it has on its balance sheet? What kinds of losses will the Fed have to take to eventually reduce reserves to reasonable levels once the economy begins to pick up steam?
Well, we really don’t need to worry about the Fed because the can just print money at a cost of zero in order to cover any losses they take.
But, what about those investors, what about the Chinese, what about anyone, who purchased United States Treasury securities during this summer and fall? How are they going to cover their losses when interest rates finally begin to rise?
The Federal Reserve got us here. There is no painless way to get us out of the situation they put us in…at least as far as I can see.
Thanks, Ben!
This was down slightly from the $2,233 billion total on October 14, 2009, but up from the $2,055 billion on August 12, 2009.
Commercial banks had $1,041 billion in Reserve Balances at Federal Reserve Banks on November 11 and the banking system averaged $1,059 in Excess Reserves for the two week period ending November 4, 2009. On October 14, Reserve Balances were $1,049 billion, but on August 12 this number was only $772 billion. Excess Reserves in the banking system averaged $918 billion in the two weeks ending October 7, and averaged $766 in the month of August.
Thus over the last 13-week period and over the past 4-week period total assets remained form around $2.1 trillion and $2.2 trillion.
However, Total Reserves in the banking system rose from $829 billion in August to $981 in the two week period ending October 7, to $1,124 billion in the two week period ending November 4.
This is an increase of over 35% in the total reserves of the banking system!
Of this $295 billion increase in total reserves, a total of $293 billion went into excess reserves!
Just a side note, Required Reserves rose by only $2 billion over the same time period!
No lending going on here!
The composition of the Fed’s balance sheet is changing, however. Securities held outright by the Federal Reserve has risen from $1,556 on August 12, 2009 to $1,673 billion on October 14 and $1,702 on November 11.
As reported in early editions of the Exit Watch, the Fed is letting the special assets it created run off as the need for them retreats and is replacing these reserves by marketable securities. Not all of these will run off in the near term as the credit and value issues surrounding assets at AIG and other institutions may take some time to disappear. However, these special assets have declined from somewhere in the neighborhood of $550-$500 billion on August 12, to $420-$380 on October 14 to around $340-$300 billion on November 11.
The largest decrease came from the reduction in the use of the Term Auction Credit which was instituted in December 2007 as a part of the dislocations in the financial markets that surrounded the problems at Bear Stearns. On August 12, this facility totaled $233 billion. The total dropped to $155 billion on October 14 and $109 billion on November 11.
Thus, the Fed is reducing the special assets portion of its balance sheet and is substituting for these asset, ownership of securities--Treasuries, Federal Agency issues, and Mortgage Backed securities.
In pursuing this path, the Fed is taking securities out of the open market, from banks and other financial institutions, but the funds it is using to pay for these securities is just going, so to speak, into bank vaults.
Commercial banks are basically saying, “If we don’t make any loans with this money, then the loans we don’t make cannot turn into bad loans!”
Another way of saying this is that the banks have enough bad assets on their books now and they don’t need to add any more. They’ll sell securities, but they won’t do anything with the money they receive back from the sale.
This seems to be creating a very uncomfortable situation. As the Fed reduced special facility assets over the last 13-week period and increased its holdings of open-market securities, it forced $300 billion reserves on the banking system.
Note that in August 2008, Total Reserves in the banking system amounted to $45 billion.
In 13 weeks the Fed forced 6.67 times more reserves into the banking system than the banking system had accumulated in all its history in the United States! And the banks did nothing with the reserves! And, the recession ended in the third quarter!
This is not a liquidity problem!
And the Federal Reserve says that it will continue to keep its target interest rates at its current level for an extended period of time. This is “QUANTATIVE EASING”!
Interest rates are going to start rising at some time. What is the Fed going to do with all the open-market securities it has on its balance sheet? What kinds of losses will the Fed have to take to eventually reduce reserves to reasonable levels once the economy begins to pick up steam?
Well, we really don’t need to worry about the Fed because the can just print money at a cost of zero in order to cover any losses they take.
But, what about those investors, what about the Chinese, what about anyone, who purchased United States Treasury securities during this summer and fall? How are they going to cover their losses when interest rates finally begin to rise?
The Federal Reserve got us here. There is no painless way to get us out of the situation they put us in…at least as far as I can see.
Thanks, Ben!
Friday, November 13, 2009
A Strong Dollar?
“It is very important to the United States that we have a strong dollar.”
So said the United States Secretary of the Treasury.
Yes, Paul O’Neill said that.
Oh, yes, John Snow said that.
And, Hank Paulson.
Oh, you say, that the quote is attributed to Tim Geithner, who made the statement yesterday at a news conference of Asia-Pacific finance ministers.
As my good friends would say, “you have to walk the walk, not just talk the talk!” Or, in the case of those looking on, “watch the hips, not the lips!”
The only public person alive today that, in my mind, has any credibility on this issue is Paul Volcker. And, it is Paul Volcker that has written, “A nation’s exchange rate is the single most important price in its economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity. So it is hard for any government to ignore large swings in its exchange rate…” (This quote is found on page 232 in the book “Changing Fortunes: The World’s Money and the Threat to American Leadership” by Paul Volcker and Toyoo Gyohten, Times Books, 1992.)
The United States government has no credibility left when it comes to the value of the United States dollar.
During the administration of Bush 43, the value of the United States dollar fell by 37% against an index of major currencies from February 2002 to March 2008 while the dollar fell in value by 45% against the Euro from February 2002 to July 2008.
The United States dollar did rebound at the time of the financial crisis: up 19% against the index of major currencies and up 23% against the Euro.
However, since February of this year the United States dollar fell back by about 13% against the index of major currencies and by about 15% against the Euro.
In watching the hips, not the lips, we see, for the United States government, potential cumulative fiscal deficits of $15 to $20 trillion over the next 10 years. We have a banking system with almost $1.1 trillion in excess reserves during the two week period ending November 4, 2009. We are faced with an unknown “exit strategy” to remove these excess reserves on the part of the Federal Reserve System.
And all this with several other “shocks” on the horizon. Obama “owns” Afghanistan now and it is totally unknown what his “new strategy” for that country will mean in terms of more government spending. Then there is the health care initiative. Obama has said that the program should not add “one dime” to the deficit, yet all indications are that whatever is passed will add to the deficit, although we don’t know what that amount will be. Then there is the climate change bill along with some other proposals that are setting in the wings.
Oh, yes, people within the administration have suggested that the rest of the TARP money, whatever that amounts to, can be applied to reducing the deficit. Whoopee!
I hear the Obama administration talking the talk. I don’t see them walking the walk.
And what about Bernanke. He is staying particularly silent these days. Oh, yes, we learned from the New York Times earlier this week that he is letting Barney Frank do all his talking for him.
The strong dollar is, at present, a myth!
It will continue to remain weak and its value will continue to trend downward for the foreseeable future.
How far am I looking forward?
I will continue to believe that the dollar will remain weak until someone emerges that has some credibility. Right now, I don’t know where that person is going to come from.
So said the United States Secretary of the Treasury.
Yes, Paul O’Neill said that.
Oh, yes, John Snow said that.
And, Hank Paulson.
Oh, you say, that the quote is attributed to Tim Geithner, who made the statement yesterday at a news conference of Asia-Pacific finance ministers.
As my good friends would say, “you have to walk the walk, not just talk the talk!” Or, in the case of those looking on, “watch the hips, not the lips!”
The only public person alive today that, in my mind, has any credibility on this issue is Paul Volcker. And, it is Paul Volcker that has written, “A nation’s exchange rate is the single most important price in its economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity. So it is hard for any government to ignore large swings in its exchange rate…” (This quote is found on page 232 in the book “Changing Fortunes: The World’s Money and the Threat to American Leadership” by Paul Volcker and Toyoo Gyohten, Times Books, 1992.)
The United States government has no credibility left when it comes to the value of the United States dollar.
During the administration of Bush 43, the value of the United States dollar fell by 37% against an index of major currencies from February 2002 to March 2008 while the dollar fell in value by 45% against the Euro from February 2002 to July 2008.
The United States dollar did rebound at the time of the financial crisis: up 19% against the index of major currencies and up 23% against the Euro.
However, since February of this year the United States dollar fell back by about 13% against the index of major currencies and by about 15% against the Euro.
In watching the hips, not the lips, we see, for the United States government, potential cumulative fiscal deficits of $15 to $20 trillion over the next 10 years. We have a banking system with almost $1.1 trillion in excess reserves during the two week period ending November 4, 2009. We are faced with an unknown “exit strategy” to remove these excess reserves on the part of the Federal Reserve System.
And all this with several other “shocks” on the horizon. Obama “owns” Afghanistan now and it is totally unknown what his “new strategy” for that country will mean in terms of more government spending. Then there is the health care initiative. Obama has said that the program should not add “one dime” to the deficit, yet all indications are that whatever is passed will add to the deficit, although we don’t know what that amount will be. Then there is the climate change bill along with some other proposals that are setting in the wings.
Oh, yes, people within the administration have suggested that the rest of the TARP money, whatever that amounts to, can be applied to reducing the deficit. Whoopee!
I hear the Obama administration talking the talk. I don’t see them walking the walk.
And what about Bernanke. He is staying particularly silent these days. Oh, yes, we learned from the New York Times earlier this week that he is letting Barney Frank do all his talking for him.
The strong dollar is, at present, a myth!
It will continue to remain weak and its value will continue to trend downward for the foreseeable future.
How far am I looking forward?
I will continue to believe that the dollar will remain weak until someone emerges that has some credibility. Right now, I don’t know where that person is going to come from.
Thursday, November 12, 2009
Discipline is Needed for Real Economic Performance
There is an interesting article inside the Wall Street Journal this morning comparing the fortunes of Brazil and Argentina. (See “Argentina Falters as Old Rival Rises,” http://online.wsj.com/article/SB125798960525944513.html#mod=todays_us_page_one.) In the article a research paper published in Argentina is quoted: “Since the middle of the last century, Argentina’s economy has endured a notable decline relative to the rest of the region, falling into ‘insignificance in the international context.’”
During this time period the government of Argentina followed a very undisciplined approach to economic policy while it kept itself in power and suppressed dissent. In 2001, Argentina declared the largest sovereign debt default in history. Things have not gotten much better since.
Brazil’s government, on the other hand, after years of self-serving activity started to get its act in order about 15 years ago under the leadership of former President Fernando Henrique Cardoso. Runaway inflation was brought under control and more orthodox and conservative economic policies were put into place. The current president, Luiz Inảcio Lula da Silva, has maintained these policies. (See ”Olympic Accolade Sets Seal on Progress” in Financial Times: http://www.ft.com/cms/s/0/d16a27a6-c8d9-11de-8f9d-00144feabdc0.html.)
The central bank in Brazil is treated as independent and the stability that has been created has brought about lower interest rates and a growing mortgage market that has stimulated a construction boom. An emerging middle class has emerged and has supported the effort to obtain the Olympics and other international initiatives that will lead to a vast expansion of the Brazilian infrastructure in upcoming years.
Over and over again we see examples of the benefits of discipline in economic and financial affairs. We also see that the loss of discipline does nothing but eventually lead the undisciplined into undesirable situations in which all of the alternative options that are available to correct the condition are undesirable. In other words, there are no good choices to get one out of the difficulty in which one finds oneself.
Inflation represents a loss of discipline that always ends up hurting a large number of people. Furthermore, the consequences of inflation can leave a wreckage in which policymakers are left with no good alternative policies to follow. Often, the path of least resistance in such situations is to reflate.
Historically, governments have always excelled in spending more than they could bring in through taxes and other levies. Thus, going into debt is a normal governmental activity. Other than outright default on debt, governments got very good at inflating themselves out of excessive amounts of debt. And, the ability to inflate was helped in the twentieth century by developments in information technology: so governments got better and better at inflating their economies. (See “This Time is Different” by Reinhart and Rogoff: http://seekingalpha.com/article/171610-crisis-in-context-this-time-is-different-eight-centuries-of-financial-folly-by-carmen-m-reinhart-and-kenneth-s-rogoff.)
Philosophically, this bias toward inflation was supported by Keynesian economics as the argument was made that twentieth century governments could not allow wages and prices to fall. (See http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.) (Also see op-ed piece in Wall Street Journal “The Fed’s Woody Allen Policy”: http://online.wsj.com/article/SB10001424052748704402404574529510954803156.html.) So the twentieth century saw not only an improved technology to inflate but also a respected philosophy that supported a government policy that had a bias toward inflation.
The point is that inflation creates an incentive for economic units to grow and to take on greater and greater amounts of risk. This is, of course, because inflation favors debtors versus creditors. It pays individuals and businesses to take on more and more debt. And, this policy is particularly successful, at least in the early stages, when the central bank forces interest rates to stay excessively low.
Risk is minimized because inflation creates a situation of moral hazard by “bailing out” people who take on large amounts of exposure to risk. For example, one rule of thumb that floats around the banking world from time-to-time is that “In a time of inflation, anyone can become a contractor for building houses. One only learns who is bad at it is when inflation slows down or stops.” The idea can be expanded to say that in inflationary times, anyone can appear to be successful. As Citigroup’s CEO Charles O. Prince III blithely stated: “As long as the music is still playing, we are all still dancing…” Risk takes a back seat.
Second, size becomes all important! Since inflation reduces the real value of debt it becomes silly for individuals or businesses not to leverage up. What is it to create $30 of debt for $1 of equity you have? And, why not $35…or, $40? Using such leverage magnifies performance! Using such leverage magnifies bonuses! Using such leverage allows us to reach a size where we become “Too Big to Fail”!
Finally, inflation allows individuals and businesses to forget about producing good quality goods and services and diverts attention to “speculative trading” and “financial games”. Since outsize rewards and bonuses go to areas that prosper during inflationary times, more and more “talent” moves into areas connected with finance or with trading. Less and less emphasis is placed upon production and quality because rising prices contribute more to profits than does improvements in what goods and services are offered. As a consequence, the composition of the nation’s workforce becomes tilted toward finance and the financial industries.
In effect, inflation destroys discipline. And, once discipline is reduced, problems occur and until discipline is renewed the problems just cumulate and re-enforce one another. This happens in families, in businesses, and in governments.
But, as is usual in economics, the consequences associated with destructive incentives are not always easy to identify. (See “Feakonomics” or “Superfreakonomics”: http://seekingalpha.com/article/166993-the-power-of-unintended-consequences-superfreakonomics-by-steven-d-levitt-and-stephen-j-dubner.) It is so much easier to blame executive greed for the troubles we have been experiencing. This explanation covers so much territory: the growth of finance in the economy relative to “productive” jobs; the taking on of more and more leverage; the taking on of more and more risky deals; the emphasis on speculative trading rather than productive producing; and the payment of excessive salaries and bonuses.
In fact, it is often hard to identify the benefits of greater discipline unless examples of that discipline are placed alongside examples of a lack of discipline. This is why the Argentina/Brazil contrast caught my attention.
Such stories, however, cause one to worry about whether the United States will once again be able to regain its economic discipline. The fear is that as long as governmental policies contain an inflationary bias, the solution to the problems caused by this inflationary bias will continue to be re-flation. If this is so, discipline will continue to be lacking in this country, both personally and corporately. Maybe it is not so surprising that Brazil won the voting for the Olympics over the United States!
During this time period the government of Argentina followed a very undisciplined approach to economic policy while it kept itself in power and suppressed dissent. In 2001, Argentina declared the largest sovereign debt default in history. Things have not gotten much better since.
Brazil’s government, on the other hand, after years of self-serving activity started to get its act in order about 15 years ago under the leadership of former President Fernando Henrique Cardoso. Runaway inflation was brought under control and more orthodox and conservative economic policies were put into place. The current president, Luiz Inảcio Lula da Silva, has maintained these policies. (See ”Olympic Accolade Sets Seal on Progress” in Financial Times: http://www.ft.com/cms/s/0/d16a27a6-c8d9-11de-8f9d-00144feabdc0.html.)
The central bank in Brazil is treated as independent and the stability that has been created has brought about lower interest rates and a growing mortgage market that has stimulated a construction boom. An emerging middle class has emerged and has supported the effort to obtain the Olympics and other international initiatives that will lead to a vast expansion of the Brazilian infrastructure in upcoming years.
Over and over again we see examples of the benefits of discipline in economic and financial affairs. We also see that the loss of discipline does nothing but eventually lead the undisciplined into undesirable situations in which all of the alternative options that are available to correct the condition are undesirable. In other words, there are no good choices to get one out of the difficulty in which one finds oneself.
Inflation represents a loss of discipline that always ends up hurting a large number of people. Furthermore, the consequences of inflation can leave a wreckage in which policymakers are left with no good alternative policies to follow. Often, the path of least resistance in such situations is to reflate.
Historically, governments have always excelled in spending more than they could bring in through taxes and other levies. Thus, going into debt is a normal governmental activity. Other than outright default on debt, governments got very good at inflating themselves out of excessive amounts of debt. And, the ability to inflate was helped in the twentieth century by developments in information technology: so governments got better and better at inflating their economies. (See “This Time is Different” by Reinhart and Rogoff: http://seekingalpha.com/article/171610-crisis-in-context-this-time-is-different-eight-centuries-of-financial-folly-by-carmen-m-reinhart-and-kenneth-s-rogoff.)
Philosophically, this bias toward inflation was supported by Keynesian economics as the argument was made that twentieth century governments could not allow wages and prices to fall. (See http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.) (Also see op-ed piece in Wall Street Journal “The Fed’s Woody Allen Policy”: http://online.wsj.com/article/SB10001424052748704402404574529510954803156.html.) So the twentieth century saw not only an improved technology to inflate but also a respected philosophy that supported a government policy that had a bias toward inflation.
The point is that inflation creates an incentive for economic units to grow and to take on greater and greater amounts of risk. This is, of course, because inflation favors debtors versus creditors. It pays individuals and businesses to take on more and more debt. And, this policy is particularly successful, at least in the early stages, when the central bank forces interest rates to stay excessively low.
Risk is minimized because inflation creates a situation of moral hazard by “bailing out” people who take on large amounts of exposure to risk. For example, one rule of thumb that floats around the banking world from time-to-time is that “In a time of inflation, anyone can become a contractor for building houses. One only learns who is bad at it is when inflation slows down or stops.” The idea can be expanded to say that in inflationary times, anyone can appear to be successful. As Citigroup’s CEO Charles O. Prince III blithely stated: “As long as the music is still playing, we are all still dancing…” Risk takes a back seat.
Second, size becomes all important! Since inflation reduces the real value of debt it becomes silly for individuals or businesses not to leverage up. What is it to create $30 of debt for $1 of equity you have? And, why not $35…or, $40? Using such leverage magnifies performance! Using such leverage magnifies bonuses! Using such leverage allows us to reach a size where we become “Too Big to Fail”!
Finally, inflation allows individuals and businesses to forget about producing good quality goods and services and diverts attention to “speculative trading” and “financial games”. Since outsize rewards and bonuses go to areas that prosper during inflationary times, more and more “talent” moves into areas connected with finance or with trading. Less and less emphasis is placed upon production and quality because rising prices contribute more to profits than does improvements in what goods and services are offered. As a consequence, the composition of the nation’s workforce becomes tilted toward finance and the financial industries.
In effect, inflation destroys discipline. And, once discipline is reduced, problems occur and until discipline is renewed the problems just cumulate and re-enforce one another. This happens in families, in businesses, and in governments.
But, as is usual in economics, the consequences associated with destructive incentives are not always easy to identify. (See “Feakonomics” or “Superfreakonomics”: http://seekingalpha.com/article/166993-the-power-of-unintended-consequences-superfreakonomics-by-steven-d-levitt-and-stephen-j-dubner.) It is so much easier to blame executive greed for the troubles we have been experiencing. This explanation covers so much territory: the growth of finance in the economy relative to “productive” jobs; the taking on of more and more leverage; the taking on of more and more risky deals; the emphasis on speculative trading rather than productive producing; and the payment of excessive salaries and bonuses.
In fact, it is often hard to identify the benefits of greater discipline unless examples of that discipline are placed alongside examples of a lack of discipline. This is why the Argentina/Brazil contrast caught my attention.
Such stories, however, cause one to worry about whether the United States will once again be able to regain its economic discipline. The fear is that as long as governmental policies contain an inflationary bias, the solution to the problems caused by this inflationary bias will continue to be re-flation. If this is so, discipline will continue to be lacking in this country, both personally and corporately. Maybe it is not so surprising that Brazil won the voting for the Olympics over the United States!
Wednesday, November 11, 2009
Fannie, Freddie, and Feddie?
Will the Federal Reserve System join the ranks of other government public supported agencies like Fannie Mae and Freddie Mac?
One could argue that they are on the verge of such ignominy.
Never before has the Federal Reserve been under such attack and from all sides. The attacks have gotten so severe that the subject even made the front page of the New York Times today. (See “Under Attack, Fed Chief Studies Politics,” http://www.nytimes.com/2009/11/11/business/11fed.html?hp.) The legislative attack on the Fed continues with the new proposals on financial regulation coming from the Senate Banking Committee. (See “Senate Democrats Seek Sweeping Curbs on Fed,” http://online.wsj.com/article/SB125786789140341325.html?mod=WSJ_hps_LEFTWhatsNews.)
Certainly the leadership of the Federal Reserve seems to be deserving this scorn. Henry Kaufman states bluntly that “there is the Fed’s legacy of its inability to limit past financial excesses. By failing to be an effective guardian of our financial system, it has lost credibility.” (See, “The Real Threat to Fed Independence,” http://online.wsj.com/article/SB10001424052748703574604574501632123501814.html.)
Of course, Alan Greenspan gets his share of the blame for “keeping interest rates too low for too long in the early years of this decade”; for his failure to understand the changes in the financial markets coming from financial innovation; and for his role in the repeal of the Glass-Steagall Act.
But, Ben Benanke must also bear his share in the decline of Fed credibility. He was Greenspan’s co-conspirator, serving on the Board of Governors of the Federal Reserve System during the 2002 to 2005 period in which the Federal Funds Rate was kept below 2.00% from the time he joined the Board until November 2004. For much of the time this Fed Funds rate was around 1.00%. Bernanke was a strong defender of keeping the rates so low, both in terms of economic analysis and speeches.
After Bernanke assumed the position of Chairman he was slow responding to the possibility that the bubble was bursting in the subprime market. Then, Bernanke reacted very strongly to the financial collapse, possibly over-reacted, in the week of September 15, 2008. (See my post of November 16, 2008, “The Bailout Plan: Did Bernanke Panic?” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)
Congress certainly saw Bernanke in action that week. According to a Wall Street Journal article, which I quoted in the post, “(Hank) Paulson called the leadership in Congress and asked them to have a meeting with himself and Bernanke on Friday evening. The few members of Congress that talked with the press after that meeting said that Bernanke did most of the talking and ‘scared the daylights out of everyone.’ Bernanke got his wish in that Congress ultimately passed the TARP bill, although they did not pass the bill by the next Monday as Bernanke had originally pressed for.
I’m not completely convinced that Congress, deep down, has all that much confidence in a Ben Bernanke-led Federal Reserve System going forward even though President Obama seems to.
Then, the Federal Reserve, under Bernanke’s guidance, flooded the banking system with reserves, leading up the current time where excess reserves in the banking system total more than $1.0 trillion. His concern over this time period has been the liquidity of financial markets. (See my recent post, “Dear Fed: the Problem is Solvency, not Liquidity,” http://seekingalpha.com/article/171826-dear-fed-the-problem-is-solvency-not-liquidity.)
As Kaufman points out in his Wall Street Journal article, the Federal Reserve now has another major conundrum: “How will the Fed reduce its bloated balance sheet?” This is a real problem because the Federal Reserve has subsidized the financing of massive amounts of federal debt and has also provided massive support to the markets for mortgage-backed securities and federal agency issues. As of November 4, 2009, the Fed owned outright $777 billion in U. S. Treasury issues, $774 billion in mortgage-backed securities, and $147 billion in Federal agency debt securities, roughly $1.7 trillion.
In supporting these markets, the Federal Reserve has kept the interest rates on these securities below the level they would have attained without the support of the central bank. The first question is, what will happen to these rates once the Fed stops supporting these securities. Will their rates ratchet upwards?
And, then, what will happen once the Federal Reserve finally decides it needs to let interest rates move up as the economy gains strength? If the Federal Reserve pursues its exit policy of removing reserves from the banking system it will have to take a loss on these securities. No matter though, it will just reduce the amount of funds (its profits) it returns to the Treasury Department at the end of the year.
In a sense, this will make the Fed like Fannie and Freddie in that it can absorb losses deemed necessary by the government for good social reasons. However, the Fed will not have to go to the Treasury with its hand out, as Fannie and Freddie has to, in order to cover its losses because the Fed makes so much profits by being able to create money whenever it wants to.
But, there is another problem: how much upward pressure will the liquidation of the mortgage-backed securities put on interest rates. How much will Congress resist this upward movement in interest rates? What will the housing lobby do to counter-act this move in rates because such a move will certainly not be good for a recovering housing market.
There is another concern: billions and billions of dollars of government debt have been purchased at subsidized interest rates. Helping this along was the extremely low short-term rates resulting from the Fed’s “close to zero” interest rate policy. If I can borrow for six months at, say, 50 basis points or so, and lend these funds out at around 3.00% on 7-year Treasuries, with a “guarantee” from the Fed that the 50 basis points will remain for “an extended period” of time, I have a pretty nice deal.
And, making money in this way doesn’t even include the returns that are available on the “cover” trade.
But, what will happen to those that “underwrote” the placing of the federal debt when the Fed begins to let rates start to rise? How extensive and deep will be the capital losses? Not everyone can make it through the “exit door” at the same time. Will Congress hear about this?
There are additional regulatory issues relating to institutions that are “too big to fail”. These, too, get us into the political realm. Congress is going to want to get their hands into this “solution” as well.
Has the current leadership at the Fed (Republican appointed) brought us to the brink of the government making the Fed into another Fannie Mae or Freddie Mac? Printing money is sure an attractive way to try and achieve social goals. It is interesting that the political party (the Republicans) that was supposedly the strongest supporter of free-market capitalism has brought us to the edge of greater government control of industry (like autos and housing) and financial institutions (like large banks and the Fed).
One could argue that they are on the verge of such ignominy.
Never before has the Federal Reserve been under such attack and from all sides. The attacks have gotten so severe that the subject even made the front page of the New York Times today. (See “Under Attack, Fed Chief Studies Politics,” http://www.nytimes.com/2009/11/11/business/11fed.html?hp.) The legislative attack on the Fed continues with the new proposals on financial regulation coming from the Senate Banking Committee. (See “Senate Democrats Seek Sweeping Curbs on Fed,” http://online.wsj.com/article/SB125786789140341325.html?mod=WSJ_hps_LEFTWhatsNews.)
Certainly the leadership of the Federal Reserve seems to be deserving this scorn. Henry Kaufman states bluntly that “there is the Fed’s legacy of its inability to limit past financial excesses. By failing to be an effective guardian of our financial system, it has lost credibility.” (See, “The Real Threat to Fed Independence,” http://online.wsj.com/article/SB10001424052748703574604574501632123501814.html.)
Of course, Alan Greenspan gets his share of the blame for “keeping interest rates too low for too long in the early years of this decade”; for his failure to understand the changes in the financial markets coming from financial innovation; and for his role in the repeal of the Glass-Steagall Act.
But, Ben Benanke must also bear his share in the decline of Fed credibility. He was Greenspan’s co-conspirator, serving on the Board of Governors of the Federal Reserve System during the 2002 to 2005 period in which the Federal Funds Rate was kept below 2.00% from the time he joined the Board until November 2004. For much of the time this Fed Funds rate was around 1.00%. Bernanke was a strong defender of keeping the rates so low, both in terms of economic analysis and speeches.
After Bernanke assumed the position of Chairman he was slow responding to the possibility that the bubble was bursting in the subprime market. Then, Bernanke reacted very strongly to the financial collapse, possibly over-reacted, in the week of September 15, 2008. (See my post of November 16, 2008, “The Bailout Plan: Did Bernanke Panic?” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)
Congress certainly saw Bernanke in action that week. According to a Wall Street Journal article, which I quoted in the post, “(Hank) Paulson called the leadership in Congress and asked them to have a meeting with himself and Bernanke on Friday evening. The few members of Congress that talked with the press after that meeting said that Bernanke did most of the talking and ‘scared the daylights out of everyone.’ Bernanke got his wish in that Congress ultimately passed the TARP bill, although they did not pass the bill by the next Monday as Bernanke had originally pressed for.
I’m not completely convinced that Congress, deep down, has all that much confidence in a Ben Bernanke-led Federal Reserve System going forward even though President Obama seems to.
Then, the Federal Reserve, under Bernanke’s guidance, flooded the banking system with reserves, leading up the current time where excess reserves in the banking system total more than $1.0 trillion. His concern over this time period has been the liquidity of financial markets. (See my recent post, “Dear Fed: the Problem is Solvency, not Liquidity,” http://seekingalpha.com/article/171826-dear-fed-the-problem-is-solvency-not-liquidity.)
As Kaufman points out in his Wall Street Journal article, the Federal Reserve now has another major conundrum: “How will the Fed reduce its bloated balance sheet?” This is a real problem because the Federal Reserve has subsidized the financing of massive amounts of federal debt and has also provided massive support to the markets for mortgage-backed securities and federal agency issues. As of November 4, 2009, the Fed owned outright $777 billion in U. S. Treasury issues, $774 billion in mortgage-backed securities, and $147 billion in Federal agency debt securities, roughly $1.7 trillion.
In supporting these markets, the Federal Reserve has kept the interest rates on these securities below the level they would have attained without the support of the central bank. The first question is, what will happen to these rates once the Fed stops supporting these securities. Will their rates ratchet upwards?
And, then, what will happen once the Federal Reserve finally decides it needs to let interest rates move up as the economy gains strength? If the Federal Reserve pursues its exit policy of removing reserves from the banking system it will have to take a loss on these securities. No matter though, it will just reduce the amount of funds (its profits) it returns to the Treasury Department at the end of the year.
In a sense, this will make the Fed like Fannie and Freddie in that it can absorb losses deemed necessary by the government for good social reasons. However, the Fed will not have to go to the Treasury with its hand out, as Fannie and Freddie has to, in order to cover its losses because the Fed makes so much profits by being able to create money whenever it wants to.
But, there is another problem: how much upward pressure will the liquidation of the mortgage-backed securities put on interest rates. How much will Congress resist this upward movement in interest rates? What will the housing lobby do to counter-act this move in rates because such a move will certainly not be good for a recovering housing market.
There is another concern: billions and billions of dollars of government debt have been purchased at subsidized interest rates. Helping this along was the extremely low short-term rates resulting from the Fed’s “close to zero” interest rate policy. If I can borrow for six months at, say, 50 basis points or so, and lend these funds out at around 3.00% on 7-year Treasuries, with a “guarantee” from the Fed that the 50 basis points will remain for “an extended period” of time, I have a pretty nice deal.
And, making money in this way doesn’t even include the returns that are available on the “cover” trade.
But, what will happen to those that “underwrote” the placing of the federal debt when the Fed begins to let rates start to rise? How extensive and deep will be the capital losses? Not everyone can make it through the “exit door” at the same time. Will Congress hear about this?
There are additional regulatory issues relating to institutions that are “too big to fail”. These, too, get us into the political realm. Congress is going to want to get their hands into this “solution” as well.
Has the current leadership at the Fed (Republican appointed) brought us to the brink of the government making the Fed into another Fannie Mae or Freddie Mac? Printing money is sure an attractive way to try and achieve social goals. It is interesting that the political party (the Republicans) that was supposedly the strongest supporter of free-market capitalism has brought us to the edge of greater government control of industry (like autos and housing) and financial institutions (like large banks and the Fed).
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