Amateur Hour at the Federal Reserve

The following is a post I wrote earlier today at Naked Capitalism.

I liked Ed’s piece on QE called Does Ben Bernanke Believe The Stuff He Writes?. What caught my eye was his line, "As for monetary policy, while QE does not create new net financial assets, it is money printing because it is a swap of bonds for electronic credits of equivalent value i.e. money. The Fed is effectively ‘monetizing’ the government’s debt." Under that definition of money he is correct. But my point below will be that functionally it doesn’t do much of anything for aggregate demand.

As any student of Economics 101 realises, you can control the price of something, or the quantity, but not both simultaneously. In announcing its decision to purchase an additional $600bn of treasuries last week, the Federal Reserve presumably intended to create additional stimulus to an economy, since tepid growth has failed to make a dent in unemployment. Even Friday’s “good” unemployment numbers, where the US economy added 151,000 jobs, were not enough to reduce the current jobless rate of 9.6%.

So is a new round of “QE2” going to do the trick? It would be interesting to figure out how the Fed came to the magic number of $600 billion. Why not a trillion? Why not $250bn? Why $75bn a month? There’s an element of sticking one’s finger in the air and hoping for the best. The Bernanke Fed is slowly reaching Greenspan-like levels of incompetence.

Let’s go back to first principles: Quantitative easing involves the central bank buying financial assets from the private sector – government bonds and maybe high quality corporate debt. In this particular instance, the Fed has announced it will buy $75bn of treasuries a month. So what the central bank is doing is swapping financial assets with the banks – they sell their financial assets and receive back in return extra reserve balances. So the central bank is buying one type of financial asset (private holdings of bonds, company paper) and exchanging it for another (reserve balances at the central bank). The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.

Central bank demand for “long maturity” assets held in the private sector reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates. This might increase aggregate demand given the cost of investment funds are likely to drop. But on the other hand, the low rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.

Essentially, then, you have a supply side response to a problem of aggregate demand. The cost of investment funds might well drop, although that’s not 100 percent clear. Consider the following example: Let’s say the Fed simply targeted the 10 year treasury at 2.25%. The central bank would have a bid at that level and buy all the securities the market didn’t want to buy at that level. They may in fact buy a lot or a very few, and possibly none at all, depending on Treasury issuance, investor demand, and market expectations.

But the FOMC has announced a limit to the Fed purchase program, both in terms of the monthly amounts and the total quantity. How high will 10 year notes trade with the billions free to trade at market levels?

It could be at much higher yields, which presumably defeats the whole purpose of the program. Of course, if the Fed bought every single 10 year treasury, then for sure they could maintain that rate indefinitely; but then they would have to preclude announcing a specific amount that they wished to purchase. Of course, if the Fed did this, people would undoubtedly squawk about “printing money” and “creating inflation” but again, QE does not actually create new net financial assets.

In fact, the Fed has done nothing but TALK about its plans over the past several months, but has yet to initiate the program. There has been no widespread “money printing” or “currency debasement”. The Federal Reserve announced an INTENTION to do something and private portfolio investors took their cue from that. But as any Asian central banker can tell you, private portfolio preference shifts are notoriously fickle, with conflicting motives. The term structure of rates in Japan would imply a comparable intent to make holding yen unattractive, yet 10 year government bonds in Japan yield less than one percent and the yen remains resolutely strong against the dollar.

Is there another method by which the Fed could influence the long term structure of interest rates? Why not just stop issuing 10 year government paper? If the Treasury had announced they were eliminating everything longer than 2 year notes for new issues there would hardly be any screams of “money printing”?

And how low would the 10 year go?

If the objective is to allow the banks to earn their way out of insolvency, then QE2 is also an ineffective means of doing this, since it flattens the yield curve, but still engenders interest rate risk on the part of the banks which persist in “playing the yield curve”, especially via leverage. There is a more effective means of doing promoting bank profitability in a comparatively risk free way, as my colleague, Randy Wray, has noted:

[T]here is nothing wrong with offering longer-maturity CDs to replace overnight reserve deposits held by banks at the Fed. Banks are content to hold deposits at the Fed—safe assets that earn a little interest. They are hoping to play the yield curve to get some positive earnings in order to rebuild capital. If they can issue liabilities at an even lower interest rate so that earnings on deposits at the Fed cover interest and other costs of financing their positions in assets, this strategy might work. That is what they did in the early 1990s, allowing banks that were insolvent to work their way back to profitability. The Fed could even lend to banks at 25 basis points (0.25% interest) so that they could buy the CDs, then pay them, say, 100 or 200 basis points (1% or 2% interest) on their longer maturity CDs. The net interest earned could tide them over until it becomes appropriate for them to resume lending to households and firms.

To be clear, we are not necessarily advocating banks play the yield curve to restore profitability (far better to have a payroll tax cut for that), or that they get such an arbitrage from the Fed, only that it would work with less risk both to the bank and the financial system than what will result from QE. Ultimately, if the objective is to allow banks to restore profitability via traditional lending activities, then there are far more obvious ways to do so. Let’s first recall that BANKS DO NOT LEND THEIR RESERVES, as is always depicted in the economics textbooks via so-called “fractional reserve lending”. The Federal Reserve Bank is a bank, just like Citibank or Wells Fargo. The Treasury has an account at the bank, just as you or I have a checking account at our local bank. Other banks, like BofA and Wells Fargo have accounts at the Fed as well, and they are called reserve accounts (for more see here).

Reserve accounts are not made up of money held in reserve in case a loan goes bad, they are money held at the Federal Reserve for payment settlement. The reserves of money held in case loans go bad are capital. They are not lent out. The way banks actually operate is to seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share. But that’s a function of credit analysis (or the lack of it, as the cycle matures), NOT the bank’s reserve positions.

These loans are made independent of their reserve positions. At the individual bank level, certainly the “price of reserves” will play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the bank’s marginal cost of funds is sufficient, the bank will lend

So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend (for more explanation, see here).

Consequently, the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is ultimately dictated by the presence of creditworthy borrowers, which is a function of FISCAL POLICY. Instead of expending political capital on pointless accounting shuffles and financial guarantees, or programs such as TALF, TARP, Term Auction Credit, or the Commercial Paper Lending Facility, one could simply implement a $2 trillion tax cut (or spend it via the government, or do revenue sharing with the states), thereby generating increased spending power in the economy, providing significantly higher multiplier effects and ultimately shifting the economy back to self-sustaining growth. This would be far more effective than continuing an endless array of silly Fed programs, which do nothing but diminish the central bank’s credibility and have had minimal impact in terms of economic growth.

In many respects, the markets are already implicitly conceding the ineffectiveness of “QE2”. Within hours of the program being announced, there were stories of “QE3”. Instead of having a situation where the markets “buy the rumour, sell on the news”, it appears to have been more a case of buy the rumour and then double up on the news.

We’ve truly hit amateur hour at the Fed. We’re inciting speculation and the Federal Reserve is acting like the kid in his car seat who keeps turning his toy steering wheel as much as it takes to turn the car. Toy cars, however, won’t get you very far if you plan a long journey, and likewise QE2 is a pretty ineffective vehicle if one wishes to engender genuine economic growth. Eventually, investors will realize they’ve been conned (yet again) by the Fed and the end result won’t be pretty.