I’m not likely to be able to comment when the FOMC announces its lack of action today.? The Fed will continue to keep policy loose, while slowly closing down ancillary lending programs, and bloating their balance sheet with mortgage backed securities [MBS] guaranteed by Fannie and Freddie, and ultimately by the Federal Government, which gets the profit or loss from the Fed’s financing (of the mortgages at 0% interest for now).
Going back to last night’s post, strip away the complexity, and what you have is the Federal Government intervening in the MBS market, and forcing down yields, at a cost of indebting future generations (should they decide to make good on those).? This will eventually fail as a strategy.? Unless the Fed wants to keep its balance sheet permanently larger, yields on MBS will rise when they stop buying.? And, the moment that they hint that they will start unloading, rates will back up significantly.? They are too large relative to the MBS market.
They can engage in fancy strategies where they try to remove policy accommodation either through rates or the size of the balance sheet, but one thing Fed history teaches us is that the Fed doesn’t know what will happen when a tightening cycle starts, but usually it ends with a bang — some market blowing up.
Two more notes: it doesn’t matter who the Fed Chairman is.? The structure of the Fed matters more than the man.? That said, Bernanke has promised transparency but has not given it at the most crucial times — those dealing with the bailouts.? All of the talk to audit/limit/shrink/end the Fed comes from abuse of those powers, which should be done by the Treasury and Congress, so that voters can hold them accountable.
Finally, one quick note on regulation of financials.? Laws don’t mean squat if regulators won’t enforce them.? There was enough power in prior laws for regulators to have curbed all of the abuses.? The regulators did not use their powers then; what makes us think that they will use expanded powers?? Regulatory capture has happened in the banking industry; regulators will have to get ugly with those that they regulate if they genuinely want to regulate.
This includes changing risk-based capital formulas to remove the advantage of securitizing debt.? I’m not saying penalize securitization, but put it on a level playing field so that the inherent leverage involved in securitization gets a higher capital charge relative to straight debt of a similar risk class.
That also includes not letting banks fudge asset values to give the appearance of solvency, but more on that tonight.? I gotta fly now on business.
Great post! You covered a lot of bases in a very succinct, understandable, and compelling way. Nicely done.
…and have a safe and enjoyable trip.
Spot on David. I often think about the path of the exits strategy the fed may take. In order, how may it look? What comes first what comes last? Clearly this world is addicted to guarantees on everything, zirp, and fed QE policy which is building a very dangerous US dollar carry trade.
Back to the original point, I would think the order of exit may look something like:
1. First they will slowly remove emergency credit facilities, starting with those of least interest, which were aggressively used to curb the debt deflationary crisis on our banking system. The added liquidity kept our system afloat and avoided systemic collapse that would have brought a much more painful shock to the global financial system. Lehman Brothers was a mini-atom bomb test that showed the fed and gov’t would could happen – seeing that result all but solidified the ‘too big to fail’ mantra.
2. Second, they will be forced to raise rates – that’s right folks, 0% – 0.25% fed funds rates is getting closer and closer to being a hindsight policy. However, I still think rates stay low until early 2010 or unemployment proves to be stabilizing. As rates rise, watch gold for a move up on perceived future inflationary pressures.
3. Third, they can sell securities to primary dealers via POMO at the NY Fed, thereby draining liquidity from excess reserves. I think this will be a solid part of their exit strategy down the road – perhaps later in 2010 or early 2011. As of now, some $760Bln is being hoarded in excess reserves by depository institutions. That number will likely come way down once this process starts. The question is, will banks rush to lend money that was hoarded rather then be drained of freshly minted dollars from the debt monetization experiment. For now, this money is being hoarded to absorb future loan losses, cushion capital ratios and take advantage of the fed’s paid interest on excess reserves – the banks choose to hoard rather then aggressively lend to a deteriorating quality of consumer/business amid a rising unemployment environment. This is a good move by the banks as the political cries for more lending grow louder. The last thing we need is for banks to willy-nilly lend to struggling borrowers that will only prolong the pain by later on.
4. And finally, as a final and more aggressive measure, we could see capital or reserve requirements tightened on banks to hold back aggressive lending that may cause inflationary pressures and money velocity to surge. Right now, banks must retain 10% of deposits as reserves and maintain capital ratios set by regulators. Either can be tweaked to curb lending and prevent $700bln+ from entering the economy and being multiplied by our fractional reserve system.
I think we are starting to see #1 now, in some form, and will start to see the rest around the middle of 2010 and into 2011. The last item might not come until end of 2011 or even 2012 when economy is proven to be on right track and unemployment is clearly declining as companies rehire.
Thoughts????
reminds of a quote from Frank Herbert’s Children of Dune
In other words, we depend – to an extent we probably do not appreciate – upon honor. On aspects of individual character and the tendency of empowered agents to possess an internal motivation to act consistently with a certain set of values. We depend on the existence of leaders who will make clear commitments and then fulfill those obligations when the time comes, even at the cost of personal sacrifice.
Insofar as financial regulation is concerned, is our “method of choosing leaders” serving us well? Is it redeemable with reform?
What are you worried about? We’ve got the “Man Of The Year” sittin’in the BIG CHAIR over at The Fed. What could go wrong????
UD, I think you have the Fed’s Order of Battle right. The questions will come from:
1) how much of the quantitative easing can be withdrawn without negatively affecting banks, or mortgage yields.
2) How much they can raise Fed Funds without something blowing up. Bank profits have become very reliant on low short term funding. I wonder who else relies on short-term finance to hold speculative positions today?
3) Finance reform to me would include bank capital reform, including changes to reflect securitization and derivatives, both of which should require capital at least as great as doing the equivalent transaction through non-derivative instruments.