Fed Watch: A Step Towards Explicit Quantitative Easing

Tim Duy thinks about where the Fed is headed next:

A Step Towards Explicit Quantitative Easing, by Tim Duy: Dull times these are not – Monday was another whirlwind that culminated with another steep drop in equity markets, despite clear indications that Bernanke & Co. are ready for a broader campaign of quantitative easing.

The day brought more recession news, of the official variety as the NBER declared the recession began in December 2007. My own estimation was closer to the middle of this year, consistent with the research of our colleague Jeremy Piger, but differing with the NBER is pointless. Typically, I would take an odd comfort in the NBER’s declaration, thinking that it would presage an end to the recession in the near future. In the current environment, such comfort is lacking as data that we typically see closer to the beginning of recession is just emerging. Case in point – the steep drop over the past three months in the ISM index. As expected, the low headline reading of 36.2 for November pretty well summarizes the sad state of US manufacturing. Moreover, the details were weaker almost across the board. About the only good take away is that it can’t get much worse. Maybe. Hopefully.

The early news provided an appropriately sanguine backdrop for the speech delivered by Federal Reserve Chairman Ben Bernanke. The Fed chief summarized the near term outlook with a simple paragraph:

The likely duration of the financial turmoil is difficult to judge, and thus the uncertainty surrounding the economic outlook is unusually large. But even if the functioning of financial markets continues to improve, economic conditions will probably remain weak for a time. In particular, household spending likely will continue to be depressed by the declines to date in household wealth, cumulating job losses, weak consumer confidence, and a lack of credit availability.

This is an outlook that calls for additional easing, but of what variety? Bernanke admits what all realized long ago:

Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited.

With traditional policy at an end, Bernanke provides a glimpse of his next moves:

Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates.

Second, the Federal Reserve can provide backstop liquidity not only to financial institutions but also directly to certain financial markets, as we have recently done for the commercial paper market. Such programs are promising because they sidestep banks and primary dealers to provide liquidity directly to borrowers or investors in key credit markets.

Of course, these are not exactly new policies; the examples provided by Bernanke are programs already in operation; which amount to quantitative easing without an announced policy target. The new addition is the suggestion that the Fed purchase large quantities of longer term Treasuries, a sentence that prompted a fresh rally in those securities.

I admit to a certain preference for the latter approach to quantitative easing. The Fed can establish specific targets, such as a 2% yield on the benchmark 10 year Treasury, or a promise to purchase $100 billion of Treasuries every other week until clear signs of economic stabilization emerge. It meshes nicely with the expected fiscal stimulus. And it does not deeply embed the Federal Reserve into specific credit markets, a fairly risky policy direction in my opinion. Indeed, I suspect the Fed will not find it easy to withdraw its support from the credit markets. One interpretation of last week’s initiative to support the mortgage markets is that the Fed created a right to low cost mortgages, which will go straight into the Constitution next to the right to cheap gas (it’s in there – look closer). Just try to take that away.

(On a purely selfish level, Bernanke did finally provide the kind of stimulus I needed to refinance my own mortgage into a lower rate – after a year of this crisis and no relief for my own admittedly meager mortgage, I was becoming a bit bitter.)

Note that Bernanke does not mention a promise to hold rates lower for a sustained period of time, a possible candidate for inclusion into the next FOMC statement. Not surprising, as he already indicated in 2002 that this was not his top choice:

One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields.

A promise is less impressive than action. Moreover, I suspect the he feels a promise would limit future policy flexibility. He plays at least lip service to the dangers of excessive monetary stimulus:

Expanding the provision of liquidity leads also to further expansion of the balance sheet of the Federal Reserve. To avoid inflation in the long run and to allow short-term interest rates ultimately to return to normal levels, the Fed's balance sheet will eventually have to be brought back to a more sustainable level. The FOMC will ensure that that is done in a timely way. However, that is an issue for the future; for now, the goal of policy must be to support financial markets and the economy.

No reason to make a two year promise if you feel even an outside chance that you would have to renege after only a year, especially when other tools are available.

I have two additional points on Bernanke’s speech. First, his outlook of the future is, in my view, disappointingly simplistic:

Although the near-term outlook for the economy is weak, a number of factors are likely over time to promote the return of solid gains in economic activity and employment in the context of low and stable inflation. Among those factors are the stimulus provided by monetary policy and possible fiscal actions, the eventual stabilization in housing markets as the correction runs its course, and the underlying strengths and recuperative powers of our economy. The time needed for economic recovery, however, will depend greatly on the pace at which financial and credit markets return to more-normal functioning.

This sounds as if Bernanke continues to believe the current environment is all cyclical, with limited structural factors as play. Policy is simply smoothing a gap. I tend to believe some more fundamental is in play, as the economy transitions away from debt-fueled consumption growth. Moreover, if economy simply returns to its previous state, fundamental imbalances will remain a threat to future stability.

Second, Bernanke denies any responsibility for the debacle of the Lehman Brothers collapse:

To avoid the failure of Bear Stearns, we facilitated the purchase of Bear Stearns by JPMorgan Chase by means of a Federal Reserve loan, backed by assets of Bear Stearns and a partial guarantee from JPMorgan. In the case of AIG, we judged that emergency Federal Reserve credit would be adequately secured by AIG's assets. However, neither route proved feasible in the case of the investment bank Lehman Brothers. No buyer for the firm was forthcoming, and the available collateral fell well short of the amount needed to secure a Federal Reserve loan sufficient to pay off the firm's counterparties and continue operations. The firm's failure was thus unavoidable, given the legal constraints, and the Federal Reserve and the Treasury had no choice but to try instead to mitigate the fallout from that event.

This sounds like a direct response to Brad DeLong’s criticism:

In retrospect, this was a major mistake. ... With that guarantee broken by Lehman Brothers' collapse, every financial institution immediately sought to acquire a much greater capital cushion..., but found it impossible to do so. The Lehman Brothers bankruptcy created an extraordinary and immediate demand for additional bank capital, which the private sector could not supply.

I suspect that if the Fed and Treasury had wanted to facilitate a smoother transition for Lehman Brothers, they could have. In hindsight, a mistake was made…although incoming Treasury Secretary Timothy Geithner was reportedly very discomforted with incoming Treasury Secretary Henry Paulson’s line in the sand on Lehman…a good sign for the future policy.

In short: More bad economic news, although not unexpected. Although the NBER declared that the US has already been in recession, there is no end in sight. We are left to patiently wait for fiscal stimulus for a significant boost next year. A weak economy pushes the Fed toward further action, and with traditional policy at its end, Bernanke looks is laying the groundwork for a more explicit policy of quantitative easing.

Comments

[lark]

"I tend to believe some more fundamental is in play, as the economy transitions away from debt-fueled consumption growth."

Towards what? The bubble industries gave us employment (construction, real estate, finance) but that buzz has worn off. We've offshored, outsourced, union-busted, downsized everything else but health care. Health care will be rationalized and made more efficient - yes - through some sort of nationalization.

I think the advocates of dereg, globalization, offshore outsourcing, securitization, etc should be put into a room and kept there until they figure out how to fix this thing. This is their plan (and our disaster).

[mouse]

quant easing with continuous recession will lead to weimar hyperinflation

[bakho]

We keep getting increasing evidence that monetary policy does not work very well outside a narrow range of economic conditions where deft monetary policy can tweak an economy and keep it on track. When we hit recession and monetary policy has pushed interest rates to less than zero, monetary policy becomes impotent. It is then necessary to turn to regulatory and fiscal policy (job investment not tax cuts) to push the economy back into a range where monetary policy once again becomes effective. Are we not seeing the limits of monetarism?

At the other end of the spectrum, monetary policy can deal with wage-price spirals. However, monetary policy seems like a poor tool to deal with energy shocks. Volcker's double digit interest rates are much ballyhooed however, inflation was cured by the collapse of labor union and the collapse of energy demand due to Carter's energy policies. An alternative interpretation is that monetary policy became impotent to address the energy shock and interest rates went as high as they did because they failed to gain traction. Only after the tight oil market eased through conservation efforts did the economy move back into an area where monetary policy was once again effective.

Isn't monetary just one tool, like a hammer that pounds nails. But for problems that don't look like nails, monetary policy should take back stage?

[ken melvin]

Stability is essential, but don't kill the dynamics? Hell, we haven't found equilibrium yet. But we're gonna pretty soon.

[2]

"...another steep drop in equity markets, despite clear indications that Bernanke & Co. are ready for a broader campaign of quantitative easing."

So maybe the market doesn't see debasing the currency as the solution to this crises.

[1]

"We keep getting increasing evidence that monetary policy does not work very well outside a narrow range of economic conditions where deft monetary policy can tweak an economy and keep it on track."

Maybe it doesn't work at all. The economy may just recover on its own.

[2]

"I tend to believe some more fundamental is in play, as the economy transitions away from debt-fueled consumption growth."

There does not seem to be any plan to set up a sustainable quantity of credit. Domestic borrowers have an insatiable appetite for subsidized interest loans, but domestic savers are not willing to store their deferred consumption in the form of loans. Far too many years of inflation/negative real after tax interest rates have eliminated domestic circular flow.

The current imbalances cannot be balanced without positive real after tax interest rates. Demand for credit will always exceed supply at negative real rates.

[2]

Put another way, policy is attempting to create more domestic demand for credit (via lower rates), but the balance problem is a lack of domestic supply of credit. Lower rates will not create more supply. Inflating away the purchasing power of loaned resources will not encourage loans.

[john c. halasz]

"The early news provided an appropriately sanguine backdrop for the speech..."

Er, "sanguine" as in "hopeful", or as in "bloody"? (The latter should be "sanguinary").

says...

As long as the fed/treasury comedy team does not do anything to change the basic goal, we do not care what they do.

The goal is to return the economy to its previous glorious state.

For example, we must maintain the massive current accounts deficit, maintain relaxed banking regulation, maintain high household debt levels, prop up insolvent banks and businesses, prop up the entire economy, re-inflate asset prices, and perhaps push rates to zero for all debt, not just short term treasuries. Then things will be fine.

Quantitative easing is merely a tool, used by tools, to return the economy to its previous glorious state. The new administration will continue these practices. Things are looking up.

[Larry]

I'd like someone to describe for me the new "equilibrium". By that I mean what the economy looks like after the easing, after the stimulus, after the housing market bottoms, after the financial system finishes deleveraging, and after consumers find a comfortable spending level that isn't financed by their equity lines. While you're at it, tell me how long I'm going to have to wait for all that and how big the US national debt will be at that time. Extra points for the homeownership rate, the unemployment rate, GDP growth rate, exchange rates, and market indices. I want some change I can believe in.

[Patrick]

Larry,

IMO (and I'm not an economist), the hysteria in some circles about the public debt is overblown. It's like worrying about being 10 pounds too heavy when you have a gun shot wound to the chest. Lots of reputable economists with a history of getting it right are telling us that the real danger here is undershooting on the stimulus, and FWIW I would agree. If we go overboard, we get an inflation problem. Well, inflation is pretty well understood and can be controlled by central banks. Debt deflation, on the other hand, is like being caught between the Scylla and Charybdis. It's not well understood, and historically the only known cure is a massive fiscal stimulus (last time it was WWII).

This time around, it would be nice if the world could get itself out of the debt deflation spiral without killing 20 or 30 million people.

[Larry]

@Patrick - Agree with your sentiment (war: bad) but I'm really looking for someone to paint a bigger picture than "we have to do X now or the world will end".