Here we are, again staring down the barrel of an FOMC meeting while deeply entrenched in a subpar equilibrium, with output well below the pre-recession trend and unemployment stuck in the high single digits. What will the Fed bring to the table this time around? Considering the magnitude of the economic challenge, expectations are low: A modification of the FOMC statement to reflect an increasingly pessimistic outlook couple with some version of “Operation Twist,” an effort to reduce longer-term interest rates by extending the duration of the Fed’s portfolio of Treasury securities. There is an outside change the Fed lowers interest on reserves, but I view that as unlikely at this juncture. Even more unlikely is another round of quantitative easing. I don’t think there is much appetite at the Fed for additional asset purchases given the inflation numbers and the stability of longer-term inflation expectations relative to the events that prompted last fall’s QE2.
Will additional Fed action accomplish much if anything? I admit to being increasingly skeptical that the Fed is doing much more than pushing on a string. Interest rates on are less than 1 percent out to five year, which pretty much means whatever the Fed is doing at that horizon is just shifting around the composition of risk free assets. There is some room as you move to the 10-year horizon – at least there you have 200 basis points to play with. But even with some room to maneuver, in order to have significant impact, I think they need to be throwing around some big numbers when it comes to Operation Twist. Via Marketwatch, former Federal Reserve Vice-Chair Alan Blinder:
Blinder agreed that “some version of twist” is “the likely next step.” The Federal Open Market Committee will meet for two days next week to determine whether and how to ease further.
Blinder said the program needed to be large to have a meaningful impact.
“The twist is a sufficiently weak instrument so to do it in tiny amounts it almost becomes laughable,” he said.
Likewise, the same holds for another round of quantitative easing. Recall that estimates of the interest rate effect of QE2 were relatively modest, on the order of 20bp. I am not sure that any of us believe that another 20bp will be the bullet that pulls us out of the slump.
So if the Fed wants to have any meaningful impact, they need to do something really, really big, and even then, a “meaningful” outcome is not assured. And, in any event, I have trouble seeing the FOMC doing anything really big at this point – it seems the center of the Fed questions the basic effectiveness of policy to do much more than raise inflation given what are increasingly perceived as structural impediments to growth. It could be the Fed is inclined to take additional actions only to look like they are doing something.
Moreover, there is this ongoing concern the Fed is doing nothing more than aggravating the lending situation by crushing down longer-term yields. The logic is that banks need some interest rate spread to justify lending. In the current environment, they see no reason to take on additional lending to any but the safest clients – not enough margin to justify the risk of a loan default.
What can be done to steepen the yield curve and this induce additional lending while at the same time holding long term rates low to encourage borrowers to line up at the bank? Override the zero lower bound to induce negative short-term interest rates. Blinder again:
Blinder said the Fed could first cut the interest rate on excess reserves to zero “just to make sure that there are not some unintended consequences that are horrendous,” he said.
The rate could then be pushed into negative territory.
The notion is strongly opposed by banks, who view it as a tax.
Blinder doesn’t disagree with that characterization.
“The whole notion is you should tax things you don’t like people to do, and subsidize things that are essential,” he said.
“One thing we don’t like is banks just piling up idle reserve,” he said. “We would like to push that money out of the banks and have them do something with it.”
Although some money will undoubtedly go into super-safe money funds, “the hope is that some fraction goes into increased lending,” he said.
You get the idea – whatever money the Fed has injected into the economy via QE2 has been reabsorbed by the Fed in the form of excess reserves rather than supporting loan growth in the economy. To solve that problem, charge banks for holding reserves at the Fed, thus inducing them to get their acts together and start lending.
Will it work, or will there be some serious, negative unintended consequences? Consider this story of soaring bank deposits (hat tip to CR):
Americans are pumping money into bank accounts at a blistering pace this year, sending deposits to record levels near $10 trillion on escalating fears that the U.S. economy is on the verge of another implosion.
There's no sign that the flood into checking, savings and money market accounts is slowing down. In the last three months, accounts at U.S. commercial banks have increased $429 billion, or 10%, almost double the increase for all of last year.
The money is coming in fast! Good news? No:
There's one big problem: Banks don't want your money.
"Banks and credit unions are doing everything they can to get rid of the cash except make loans," said Mike Moebs, a Lake Bluff, Ill., banking consultant.
He said banks are driving away deposits by refusing to renew CDs at higher rates and by imposing fees on checking accounts for depositors who don't use other, profitable financial services as well.
The banking sector is reacting to a flood of money by trying to push back the tide, not by opening up the loan spigot. If the Fed pushes the interest on reserves into negative territory, will that be enough to spur lending? Or will banks simply do more of what they are already doing? The path of least resistance is to keep doing more of the same.
And if consumers are only charged for money they hold in the bank, effectively earning negative interest rates themselves, will they spend more money, or just start stuffing their mattress? And maybe start stuffing it twice as fast. You know its bad when banks won’t take your money. Time to dust off the Roubini portfolio – dried food, ammunition, and gold. I guess that is how gold can go off the charts in both an inflationary or deflationary environment.
In short, it is not evident that more monetary policy will make its way down to the heart of the problem:
Bankers such as Robert H. Smith, former chairman of L.A.'s Security Pacific Corp., say the industry is being throttled by a combination of the weak economy and regulations that were tightened in the aftermath of the financial crisis.
"What little demand that is out there for loans is regarded very skeptically [by the banks] because of the pressures from the regulators," said Smith, who sold Security Pacific to Bank of America 20 years ago and is now a founding director of Commerce National Bank in Newport Beach.
Which came first, the chicken or the egg? Is the economy weak because lending is tepid, or vice-versa? The lack of potential borrowers with sufficient cash flow who actually want to borrow money clearly hampers the effectiveness of monetary policy through either traditional or nontraditional channels.
So what is left? I keep coming back to the same conclusion. That to be effective at this juncture, additional monetary policy must be coordinated with additional fiscal policy. The Fed creates the money, fiscal policymakers ensure it gets into the hands of someone who will spend it, boosting demand until interest rates rise and the pool of ready and willing borrowers swells. At that point the banking sector has someone to loan to and a spread to work with.
Bottom Line: When the Fed meets this week, will they accommplish anything more than rearranging the deck chairs? I increasingly see the need for dramatic action to decisively lift the economy off the zero bound. The comparisons to Japan and getting a little too close for comfort; it is easy to how the US economy limps along for the next decade characterized by rock-bottom interest rates and never-ending fiscal deficits.
