Trepidation About Quantitative Easing, Version 2.0

Trepidation About Quantitative Easing, Version 2.0

The Fed made official its move to quantitative easing today, and said it will take no prisoners until it has lowered rates and credit spreads further:
The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability... The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.I (literally) have a very bad feeling in my stomach. This move is a sign of utter desperation. And it is on such a massive scale that if it does not work well, we will have a great deal of difficulty containing its effects.A conventional view of how this plays out comes from Martin Wolf of the Financial Times: the Fed's extreme measures will of course prevail, but at the risk of considerable inflation:
Central banks may soon resort to their most powerful weapons against deflation: the printing press and the “helicopter drop” of money. It is a time for which Ben Bernanke, chairman of the Federal Reserve, has long prepared. Will this weaponry work? Unquestionably, yes: used ruthlessly, it will eliminate deflation. But returning to normality thereafter will prove far more elusive....Once inflation returns, the central bank will need to sell assets into the market, to mop up the excess money it has created in fighting deflation. Similarly, the government must reduce its deficit to a size it can finance in the market. Otherwise, deflationary expectations may swiftly turn into expectations of above-target inflation. This may also happen if the debt sold in efforts to sterilise the monetary overhang is deemed beyond the government’s ability to service.Countries without a credible currency may reach this point early. As soon as a central bank hints at “quantitative easing”, flight from the currency may ensue. As an aside, I had dinner with some well placed Japanese executives this evening (as in the host, for instance, co-authored papers with Eisuke Sakakibara, aka "Mr, Yen." and knows other policy officials personally), and all thought that the dollar would continue to be strong until the US economy started to recover, then investors would be more willing to hold riskier currencies. They dismissed the idea of a dollar crisis (there think there will be no substitute for over 20 years) or of the use of gold or commodities as possible substitutes/stores of value (not a gold standard, but increased monetization of "hard" assets), since those markets are small relative to the currency markets. I found the unwillingness to consider other than "business as usual" scenarios troubling. In addition, one of the executives was interviewing candidates from top schools in China for a US position, and asked what their outlook for the RMB was. To a person, they expect it to fall relative to the dollar. Each had his own reasoning, but the most consistent and compelling theme was that the Chinese government valued preserving employment above all, and was not going to let the RMB appreciate at a time when exports were weak.Now it is important to appreciate the Fed's emphasis in its version of quantitative easing, which we will call QE2. The Wall Street Journal Economics Blog gave additional detail from a press conference after the FOMC meeting:
But the senior Fed official said the central bank’s approach is distinct from quantitative easing and different from what the Japanese did. The Fed’s balance sheet has two sides, the official explained: assets with securities the Fed holds (including loans, credit facilities, mortgage-backed securities) and liabilities (cash and bank reserves). Japan’s quantitative easing program focused on the liability side, expanding cash in the system and excess reserves by a large amount. The Fed’s focus, however, is on the asset side through mortgage-backed securities, agency debt, the commercial paper program, the loan auctions and swaps with foreign central banks. That’s designed to improve credit-market functioning, the official said. By expanding the balance sheet by making loans, the official explained, the focus is not on excess reserves but on the asset side. That securities-lending approach directly affects credit spreads, which is the problem today — unlike Japan earlier, where the problem was the level of interest rates in general, the official said.What is NOT encouraging is the Fed has already made heroic measures in this direction, via the creation of its alphabet soup of facilities, and the results have been underwhelming. The results have been limited and short-lived (consider the successive acute phases of the credit crisis). Now admittedly, we do not appear to be having a year-end squeeze, which is a victory of sorts, but the Fed also expanded the Term Action Facility to massive size. A1/P1 commercial paper seems to be functioning reasonably well too, although the types not supported by the Fed are still under duress. Indeed, a Bloomberg story stresses the limited progress to date:
For all their efforts to liquefy credit markets, the Federal Reserve and the Treasury show no signs of ending the 18-month freeze, as evidenced by the unprecedented gap between what banks and the U.S. government pay to borrow money.The difference between the London interbank offered rate, or Libor, that banks charge each other for three-month loans and Treasury bill rates is six times wider than before markets began to seize up in June 2007. Even though the so-called TED spread narrowed to 1.82 percentage points yesterday from 4.64 percentage points in October, prices of contracts to borrow money months from now show investors don’t expect lending to recover until at least the second half of 2009.“If you take a full assessment of the credit markets, conditions have certainly eased from their worst, but they still are at extraordinary tight levels, which are far from normal,” said Michael Darda, the chief economist at MKM Partners LP in Greenwich, Connecticut. “Short-term funding spreads are all still very wide relative to historical norms. There is a massive pullback going on in the private sector.”Several experts also say they expect the new programs will help in six months, with no explanation as to why.Before we get to the conventional worry, that the Fed will be reluctant to put on the brakes soon enough once the economy starts to recover and wind up with pretty bad inflation. there are other issues that are getting short shrift.The first is that the prescription presupposes that the problem is a liquidity crisis. It does not take seriously the notion that at least part (if not all) of the problem is that a lot of people and companies took on far more debt than they can afford to repay. Anna Schwartz, who was co-author with Milton Friedman of A Monetary History of the US, which is one of the definitive works on the Great Depression. It argued the Fed erred fatally then by not providing enough liquidity, .Schwartz took the Fed to task:
Credit spreads -- the difference between what it costs the government to borrow and what private-sector borrowers must pay -- are at historic highs.......even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue....Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value."...[H]e's shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down."But the problem goes much further than "toxic securities". Remember the premise of how the Fed's program will work. It will buy various instruments to force spreads lower so as to lower cost to borrowers. The implicit logic is that if you lower rates enough, voila, the debt service cost drops and formerly dud borrowers are now viable. But how do borrowers get their hands on these new, better rates? Quite a few borrowers are up to their eyeballs already in debt, and no way to refinance. Take credit cards. Supporting credit card receivables may allow credit card companies to stop slashing consumer credit lines (although both Meredith Whitney and apparently industry sponsored studies agree that banks will cut credit card availability further due to pro-consumer changes that will make the product less profitable). But it does nothing for consumers carrying balances (unless we see a revival of, say, six month teaser offers). Similarly, for homeowners to get relief, they have to refinance. Now for many, that's a no-brainer. But the ones with no or negative equity have no ready solution, plus starting in 2009 and accelerating in 2010 are the option ARM resets. Even with low rates, many of these mortgages have enough negative amortization that consumers will suffer serious payment shock.But then again, we are assuming that lenders have more or less responsible standards. The powers that be may decide to run roughshod over that. As Accrued Interest noted:
The big wild card is government policy. There is talk that Treasury might allow for no-appraisal refinancing, basically lending based on original loan-to-value as opposed to current loan-to-value. Debate the wisdom of this policy as you might, it would case a massive refinancing wave that would make 2003 look like a a splash in the kiddie pool.And in other areas, stress is starting to get serious in types of debt not yet on the Fed's target list. From Eric Hovde in Institutional Risk Analyst:
One of the problems that is rapidly approaching is commercial real estate mortgages. Res mortgage are the largest asset class in the banking system. Commercial real estate mortgages are the second largest asset class in the banking system. Unfortunately much of the underwriting sins that started in the res market in 2002 crept into the commercial sector as well by 2004 and 2005, plus you never dealt with the massive excess inventory surplus of commercial office space post the Internet boom. Because financing costs became so low, real estate values kept shooting up and builders kept building more. So you have a national vacancy rate of 15%, which is moving higher every quarter. I think you are going to see major losses coming through the commercial real estate books of the banking industry.Commercial real estate is not yet on Bernanke's list. Neither is debtor-in-possession financing, and we and others have lamented that the death of it means that companies that fail and would ordinarily be able to get through Chapter 11 and preserve most of their employment will instead liquidate.Consider further: the Fed assumes it has no constraints, because it can bloat its balance sheet to any size. But it has limits of staff, focus, expertise that restrict what it can do. For it to succeed in its aims, it is going to have to intervene on behalf of every type of troubled credit and make allocation decisions among them. Going on auto pilot (that is, dealing with the "presenting problems", the ones that surfaced first, means that they get priority when that might not be the best use of collective resources (it is not desirable from a competitive standpoint to bloat our housing sector back to status quo ante).Other observers were lukewarm. The Economist questioned whether the Fed could in fact influence credit spreads as much as it hoped to:
....the creation and expansion of an array of lending programmes....have so far no doubt kept the interest rates that are charged to actual private borrowers lower than they otherwise would be, the effect has been difficult to detect, and certainly smaller than what the Treasury achieved through direct injections of public capital into banks.In theory, purchases of longer-term securities could have more impact by pulling down longer-term interest rates. The 10-year Treasury yield, for example, is 2.3%, and the 30-year conventional mortgage-rate is around 5.5%. But whereas the Fed knows more or less just what it has to do to move short-term interest rates up or down, it is in uncharted territory on longer-term interest rates. Indeed, theory suggests that the purchases would have to be spectacularly large to affect such large, globally integrated markets.A senior Fed official, briefing reporters after the FOMC meeting, rejected the notion that the Fed was trying explicitly to target lower long-term rates, and rather framed the Fed’s new actions as an extension of previous efforts at restoring liquidity and normal trading conditions. The official said that yields on Fannie’s and Freddie’s MBS, despite the explicit support of the Treasury, are much higher than Treasury yields because of a lack of liquidity. The Fed can narrow that spread, he said, by providing investors with the confidence that a committed buyer is in the market.Um, MBS have traded at high spreads at least in part due to volatility, which makes the prepayment option worth more, hence higher spreads. No doubt the Fed parsed that bit out. But as I understand it, foreign central banks, which used to be big buyers of agencies, have switched to Treasuries, not comfortable about the lack of a "full faith and credit" guarantee. The statutory authority for the conservatorship extends through the end of 2009, although it is widely assumed it will be renewed, plus Fannie and Freddie are NOT full faith and credit obligations of the US (the Treasury has instead entered into a "no negative net worth" guarantee. The differences may seem semantic, but they are seen as serious in some quarters. If that is the real issue, more Fed buying will not entice the key buyers, central banks, back into the pool.Jim Hamilton is also doubtful, and suggests that the Fed is working at cross purposes:
Will that strategy succeed if we just do it on a sufficiently large scale? I'm not at all convinced that it would. Our standard finance models treat interest rate spreads as governed primarily by fundamentals such as default risk and only secondarily by the volume of buyers or sellers.But while the Fed may have little control over the spreads between different interest rates, it does have a significant degree of control over the inflation rate. The 1.7% drop in headline CPI during November, and the -10% annual deflation rate for the last 3 months, should not be viewed as welcome developments in an environment where our primary concern is whether individuals and institutions are going to repay their debts. The Fed should want to generate enough inflation to pull those short-term interest rates above the zero floor. But to target inflation, the Fed would take exactly the opposite strategy from that outlined by the senior Fed official above. The goal would be to get cash into circulation rather than be hoarded by banks, and have the Fed's assets be ones that could be readily liquidated if the inflation starts to come in higher than desired.