Easy in, Hard out

My view is that there is no such thing as a free lunch, not even for governments or central banks.  Any action taken may have benefits, but also imposes costs, even if those costs are imposed upon others.  So it is for the Fed.  At the beginning of 2008, they had a small, clean, low duration balance sheet on assets.  Today the asset side of their balance sheet is much larger, long duration, and modestly dirty.  Let me give you a few graphs created from the H.4.1 data, obtained via the poorly designed and touchy Data Download Program at the Fed’s H.4.1 portion of their website.

The first graph gives the liabilities of the Fed over the last 4+ years.  The data is taken from table 1 in the H.4.1 release.  You can see the massive expansion of the liabilities, and the way the crisis unfolded.  Currency, and “Other Liabilities & Capital” build “slowly,” i.e. 6.9%/yr and 14.1%/yr, respectively.  The US Treasury steps in with the Supplementary Financing Account at a few points where the Fed could use money deposited there for further expansion of quantitative easing, and leaves when they are no longer needed.

But the real growth comes in the “Everything else” which grew at 33%/yr, and reserve balances with Federal Reserve Banks, which you can calculate an annualized rate of growth for, but a rate doesn’t do justice to the process, because it grew due the two events — QE1 & QE2.  The Fed bought assets from various parties, who now deposit at banks inside the Federal Reserve System.

The next two graphs come from Table 2 of the H.4.1 report.  These describe the assets that have a maturity, which comprise over 80% of the Fed’s assets over the time of the graph, and over 90% at present.  First, you can see the growth of the assets bought through QE, Treasuries, Agencies, and MBS.  Second, you see the crisis responses: 1) the loan programs in the US, which explode and trail away and 2) the Central Bank Liquidity Swaps, which explode, trail away, and have come back in what is presently a muted form today.

Perhaps the bigger change is that the Fed’s balance sheet has a lot more long-maturity assets than it used to.  This stems from the quantitative easing they have done, as well as their efforts to play God flatten the Treasury yield curve.

Now, almost all of the assets underlying everything 10 years and shorter pay out their principal all at the end, with no right of prepayment.  For 10 years and longer, at present 75% are Mortgage Backed Securities [MBS].  Those have average lives (weighted average time for payment of principal) considerably shorter than a bond that pays all of its principal at the end for three reasons:

  • Principal gets paid down slowly due to normal amortization.
  • Prepayments get made when it is advantageous to the borrower, which not only pays off principal today, but shortens the term of the loan, which accelerates the normal repayment of principal.
  • The final maturity of of the longest loan in the pool is the final maturity of the pool

So, in terms of actual interest rate sensitivity, the over 10 years bucket is probably only a little more sensitive to change in rates than the 5-10 year bucket.

In normal times, central banks buy only government debt, and keeps the assets relatively short, at longest attempting to mimic the existing supply of government debt.  Think of it this way, purchases/sales of longer debt injects/removes liquidity for longer periods of time.  Staying short maintains flexibility.

Yes, the Fed does not mark its securities or gold to market.  Under most scenarios, it is impossible for a central bank which can issue its own currency to go broke.  Rare exceptions — home soil wars that fail, orpolitical repudiation of the bank, where the government might create a new monetary standard, or closes the bank because of inflation.  (Hey, the central bank has been eliminated twice before.  It could happen again.)

The only real effect is on how much seigniorage the Fed remits to the Treasury, or, if things go bad, how much the Treasury would have to lend/send to the central bank in order to avoid the bad optics of negative capital, perhaps via the Supplemental Financing Account.  This isn’t trivial; when people hear the central bank is “broke,” they will do weird things.  To avoid that, the Fed’s gold will be revalued to market at minimum; hey maybe the Fed at that time will be the vanguard of market value accounting, and revalue everything.  Can you imagine what the replacement cost of the NY Fed building is?  The temple in DC?

Or, maybe the bank would be recapitalized by its member banks, if they are capable of doing so, with the reward being the preferred dividend they receive.

Back to the main point.  What effect will this abnormal monetary policy have in the future?

 

Scenarios

1) Growth strengthens and inflation remains low.  In this unusual combo, it will be easy  for the Fed to collapse its balance sheet, and raise rates.  This is the dream scenario; and I don’t think it is likely.  Look at the global economy; there is a lot of slack capacity.

2) Growth strengthens and inflation rises.  The Fed will likely raise the interest on reserves rate, but not sell bonds.  If they do sell bonds, the market will back up, and their losses will be horrible.  If don’t take the losses, seigniorage could be considerably reduced, or even vanish, as the Fed funds rate rises, but because of the long duration asset portfolio, asset income rises slowly.  This is where the asset-liability mismatch bites.

If the Fed doesn’t raise the interest on reserves rate, I suspect banks would be willing to lend more, leaving fewer excess reserves at the Fed, which could stimulate more inflation. Now, there are some aspects of inflation that remain a mystery — because sometimes inflationary conditions affect assets, rather than goods, I think depending on demographics.

3) Growth weakens and inflation remains low.  This would be the main scenario for QE3, QE4, etc.  We don’t care much about the Fed’s balance sheet until the Fed wants to raise rates, which is mainly a problem in Scenario 2.

4) Growth weakens and inflation rises, i.e. stagflation.  There’s no good set of policy options here. The Fed could engage in further financial repression, keeping short rates low, and let inflation reduce the nominal value of debts.  If it doesn’t run wild, it could play a role in reducing the indebtedness of the whole economy, though again, it will favor debtors over savers.  (As I’ve said before, in a situation like this, or like the Eurozone, all creditors want to be paid back at par on the bad loans that they have made, and it can’t be done.  The pains of bad debt has to go somewhere, where it goes is the argument.)

I’ve kept this deliberately simple, partially because with all of the flows going back and forth, and trying to think of the whole system, rather than effects on just one part, I know that I have glossed over a lot.  I accept that, and I could be dead wrong, as I sometimes am.  Comment as you like, with grace and dignity, and let us grow together in our knowledge.  I’ve been spending some time reading documents at the Fed, trying to understand their mechanisms, but I could always learn more.

Summary

During older times, the end of a Fed loosening cycle would end with the Fed funds rate rising.  In this cycle, it will end with interest of reserves rising, and/or, the sale of bonds, which I find less likely (they will probably be held to maturity, absent some crisis that we can’t imagine, or non-inflationary growth).  But when the tightening cycle comes, the Fed will find that its actions will be far harder to take than when they made the “policy accommodation.”  That has always been true, which is why the Fed during its better times limited the amount of stimulus that it would deliver, and would tighten sooner than it needed to.

But under Greenspan, and Bernanke to a lesser extent (though he persists in pushing the canard that the Fed was not too loose 2003-2004, ask John Taylor for more), there were many missed opportunities to stop the buildup of bad debts, but the promise of the “Great Moderation” beguiled so many.

Removing policy accommodation is always tougher than imagined, and carries new risks, particularly when new tools have been used.  Bernanke can go to his carefully chosen venues and speak to his carefully chosen audiences, and try to exonerate the Fed from well-deserved blame for their looseness in the late 80s, 90s, and 2000s.  Please, Mr. Bernanke, take some blame there on behalf of the Fed — the credit boom could never have happened without the Fed.  Painting the Fed as blameless is wrong; the “Greenspan put” landed us in an overleveraged bust.

I’m not primarily blaming the Fed for its current conduct; today, it is trying to deal with a lending bust — too much debt, and much of it is bad, with a government whose budget is out of balance.  (In the bust, there are no good solutions.)  I am blaming the Fed for loose policies 1984-2007, monetary policy should have been a lot tighter on average.  But now we live with the results of prior bad policy, and may the current Fed not compound it.

7 Comments

  • Redrut says:

    Unfortunately it was only bad monetary policy in hindsight. And it isn’t the FED thats guilty; every central bank conducted similar programs over the last 15 years, the key is how they deal with it.

    IMHO along with the adage, Bernanke has to “credibly promise to be irresponsible” which he has done by making interest rates more visible (and keeping them low for the forseeable future). Hopefully the govt will take the cheap funding hint and take on expansionary policies, picking up the slack in demand left by the deleveraging household before its too late.

    http://www.1percentblog.com

  • cig says:

    I believe the following propositions:

    (A) “Look at the global economy; there is a lot of slack capacity.” (you say this to disprove scenario 1, but I read you as meaning to say that it’s a general truth that applies in all scenarios.)

    (B) “inflation rises” (scenarios 2 and 4)

    are mutually incompatible. Inflation, is, essentially, too much money chasing too few goods. To get the required shortage of goods, you must exhaust the entire slack capacity, otherwise the excess money is sponged up by producing more goods, not by increasing prices. Commodity-driven inflation is peripheral and only matters if it is instrumental to exhausting the slack.

    So if (A) is true, and many people would agree it is, then inflation scenarios are not relevant. To be able to develop credible inflation scenarios, you must include along those paths a mechanism that successfully exhausts the slack, which is a necessary precondition for inflation.

    • I’m sorry, but I disagree. In the ’70s, after we left the gold standard, we had unused capacity, high unemployment, and high inflation. Stagflation happens. There is no fixed relationship between economic excess capacity and inflation. It may exist in theory, but it does not consistently work empirically.

      You can have a weak economy because of bad fiscal and regulatory policy; layer loose monetary policy on top of it, and you get stagflation. That was the ’70s, and I think it is the same now.

      Aside from that, CP inflation is already running at 3%/yr, and if were fairly measured 4-5%. It isn’t affecting the prices of homes because they are in excess supply, but food and fuel are not.

      • cig says:

        The 70s stagflation is indeed an interesting objection and I’m not sure we’ve achieved a full understanding of it, but I still think we’re not now in a comparable enough predicament. First, there were components of a supply shock (sporadic price controls, protectionism, resources, etc) that can explain too few goods despite idle capacity, but seem far fetched today. Resources shortage could be plausible but we’re far from a quadrupling of oil prices, and I think the economy is not as resource-intensive as it was then. Second, as in every real inflationary era, there was wage inflation, which interestingly preceded price inflation (from the late 60s). That’s also a bit of a mystery (unemployment should limit wage pressures) but whatever the reason then, we can surely agree that we’re not facing 5-7% wage inflation per annum at the moment.

        This is essential: we don’t have the “too much money bit” of the problem, so it would take a huge lot, way more than in the 70s, of the “too few goods” bit to get inflation. People get worried that central banks are “printing money” but this would only become a problem if the printed money reached the real economy. Did you get some? Where can I get some? Technical money that’s only used to slowly de-leverage the banking system isn’t going to create inflation, because it doesn’t reach your wallet.

        As for inflation not being fairly measured, do you have some actual data to back the assertion? Most such claims I’ve seen seem to come from conspiracy theorists claiming the government is cheating. I guess it could be, but price info is not secret and there are some independent measures, that don’t seem way off the mark. If inflation is being inaccurately measured, someone should be able to back the case with hard data.

      • Finster says:

        I think you are precisely right about the inflation problem, David. Slack capacity in the economy is too much of an aggregate assumption. The economy has slack, but in goods and services that are no longer in demand. There is a mismatch between goods and services offered and those demanded.
        In this scenario inflation happens where pricing power resides, in other words the price levels change according to elasticity of demand. So inflation in energy prices and insurance rates, as well as services with price setting power (health care) and power/information asymetries are completely compatible with wage stagnation and price deflation in discretionary.
        Lack of reinvestment in the U.S. due to misincentives (free money being made in frontrunning FED asset purchases is much easier than launching an actual business; Derivatives trading is much cleaner and more controlled than messy competition in the real economy) leads to less real capital leveraging the wealth creation power of the American worker. Net result is a declining standard of living.

        Central banks influence behaviour, especially the hypothecation of the future to pay and invest in the present through bank credit. I’m afraid the FED has presided over an abnormous living off future goods at the lowest discount rates, the proceeds of which were squandered on consumption and not invested to pay the future costs and forgone consumption required.

        Respectfully from Germany

      • “There is no fixed relationship between economic excess capacity and inflation.”

        The 1970s recessions were not debt-deflationary in a deleveraging macro environment.

        We are now. (c.f. Japan’s inflation over the last 20 years.)

        Some necessary components of inflation exist, but are not by themselves sufficient, and the the ones still needed to effectuate inflation (increasing household credit demand) do not yet exist. I do agree that the Fed’s balance sheet is a powder keg (Hussman is excellent on this topic), but the foreseeable economic conditions are keeping that powder keg damp.

        I think you need a credible explanation of how wage growth will cause demand-pull inflation, because absent massive exogenous shocks (bombing Iran), cost-push inflation simply drives the world back into recession and corrects itself.

        Over decades, commodity demand from another 2 billion people can certainly cause cost-push inflation to overcome Western deleveraging disinflation, but that doesn’t appear to be too threatening quite yet.

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