The first real warning that growth in the global economy was set to decline came in April. And since then, the signs of distress have only increased. In the US, the distress is everywhere – in the housing data, the employment figures, and the manufacturing numbers. You can see the slowdown in retail sales and GDP too. What, if anything, can policy makers do? What will they do?
The monetary authority in the US was front and centre with quantitative easing – and even credit easing – the last time we saw a big push from government to prevent a deflationary spiral. I believe we may be on the cusp of a second big push and that the Federal Reserve will take the lead. One possibility few have mentioned is of the Federal Reserve buying municipal bonds. Given the talk about federal and state budget woes, this could be something they will consider. The ECB has begun to buy up Greek, Portuguese, Irish and Spanish debt in the secondary market. Why can’t the Fed buy up California, Illinois, New York and New Jersey munis?
Now, I am going to take an agnostic view in this post on what the Fed should or should not do. I just want to lay out the possibilities.
Let’s review what led us here and why I think this could happen.
QE1, credit easing and other liquidity support
In November of 2008, soon after the Lehman collapse and at the height of market panic the term quantitative easing was all the rage in policy circles. This was the policy tool that the Japanese employed early last decade after a decade of depression. The Japanese goal was to flood the banking system with liquidity by buying up government bonds with newly printed money in order to promote lending.
Ben Bernanke went one better than the Japanese with credit easing. In a famous speech at the London School of Economics, he explained what credit easing was. Reporting on this at the time I said:
Federal Reserve Chairman Ben Bernanke gave a speech at the London School of Economics today in which he outlined the measures the Federal Reserve was prepared to take in order to deal with the financial crisis. Of particular note, Bernanke indicated that the U.S. central bank would keep interest rates low and that it would buy mortgage-backed assets in order to increase its direct control over the interest rates borrowers actually see.
Bernanke also clarified his position on quantitative easing (QE), explaining that the Fed is more concerned about the asset side of the balance sheet than the BOJ (Bank of Japan) was when Japan engaged in quantitative easing. One could take this to mean that the Fed is engaging in both qualitative easing as well as quantitative easing. The Fed means to supply liquidity to the financial system and to buy poorer quality assets (i.e. Mortgage-Backed Securities instead of Treasury bonds), whereas the BOJ was merely supplying liquidity.
Of course, this is really fiscal policy more than monetary policy. In my view, the Obama Administration knew its hands were tied on fiscal policy and they leaned on the Fed to take up the slack. Moreover, the Administration was prepared to assist with its own programs. Larry Summers and Tim Geithner had experience from the Tequila crisis in which they did an end-run around Congress in bailing out Mexico via programs that did not require Congressional approval. The administration of programs like TALF, TARP, and the PPIP were designed with the innovative coup using the "Exchange Stabilization Fund" in the Tequila crisis in mind.
I see the reliance on Fannie Mae and Freddie Mac in providing liquidity to the mortgage market as a similar innovation. To allow this liquidity to continue, the Obama administration pledged to provide unlimited financial assistance to Fannie Mae and Freddie Mac on the day before Christmas 2009 – when most people were already on holiday. This allowed it to exceed the $400 billion cap on government emergency aid to the two GSEs without seeking permission from Congress. At the time, Secretary Geithner said this was just a precaution. I called it manipulating mortgages.
The Fake Recovery
By April, the fix was in. I wrote:
How to engineer recovery is another question altogether. Here again there are a set of political constraints which make things more challenging. First, there are large swathes of the population that are uncomfortable with the huge debt load and deficit spending that a stimulus-induced recovery creates. Moreover, a government-sponsored nationalisation or recapitalisation plan would only increase this deficit spending and these debts.
As a result, the Obama Administration has crafted a plan to circumvent these obstacles…
The stimulus to come from these measures is still in the pipeline and, by the end of this year, will probably add a big kick to the economy. You should note that only the fiscal stimulus required legislative approval. All of the other ‘stimulus’ has been done without Congressional approval and largely without Congressional oversight. These activities have been specifically designed to be opaque. The government’s claims of wanting to increase transparency ring hollow (see my post on Bloomberg’s suit against the Fed as an example of what is really happening).
I should also mention that the Federal Reserve has been a large factor here. It is acting in concert with the executive branch in a non-arms length fashion which I believe will have consequences regarding Fed independence down the line…
You should be under no illusion that the coming rebound is permanent. Much of it is not. What we are seeing is the makings of a cyclical recovery that might begin as early as Q4 2009 or Q1 2010. How long or robust that recovery is remains to be seen.
The QE1 wrecks and the fake recovery stalls
We are now at a point where the stimulus provided by these measures has worn thin. Ambrose Evans-Pritchard wrote yesterday:
"The economy is still in the gravitational pull of the Great Recession," said Robert Reich, former US labour secretary. "All the booster rockets for getting us beyond it are failing."
"Home sales are down. Retail sales are down. Factory orders in May suffered their biggest tumble since March of last year. So what are we doing about it? Less than nothing," he said.
California is tightening faster than Greece. State workers have seen a 14pc fall in earnings this year due to forced furloughs. Governor Arnold Schwarzenegger is cutting pay for 200,000 state workers to the minimum wage of $7.25 an hour to cover his $19bn (£15bn) deficit.
Can Illinois be far behind? The state has a deficit of $12bn and is $5bn in arrears to schools, nursing homes, child care centres, and prisons. "It is getting worse every single day," said state comptroller Daniel Hynes. "We are not paying bills for absolutely essential services. That is obscene."
Roughly a million Americans have dropped out of the jobs market altogether over the past two months. That is the only reason why the headline unemployment rate is not exploding to a post-war high.
Let us be honest. The US is still trapped in depression a full 18 months into zero interest rates, quantitative easing (QE), and fiscal stimulus that has pushed the budget deficit above 10pc of GDP.
In essence QE1 has wrecked and caught fire. Evans-Pritchard says:
The Fed is already eyeing the printing press again. "It’s appropriate to think about what we would do under a deflationary scenario," said Dennis Lockhart for the Atlanta Fed. His colleague Kevin Warsh said the pros and cons of purchasing more bonds should be subject to "strict scrutiny", a comment I took as confirmation that the Fed Board is arguing internally about QE2.
Buying Munis
Whether by design or coincidentally, Evans-Pritchard’s remarks are that much more meaningful as they came on the day of America’s celebration of independence. It was his remarks about Illinois and California which caught my eye, however.
There has been a lot of talk about the anti-stimulus being provided by states and local municipalities. I have noted on a few occasions that Illinois and California bonds are trading with a high degree of default risk. But Michigan is up there too. New York has serious problems as does New Jersey to name the largest and most problematic states. Most every large state in the union is in fiscal trouble, which is why I have been warning that municipal bonds should be labelled buyer beware.’
But what if the Federal Reserve started QE2 with munis as the asset class of choice for credit easing? When the European experiment threatened to unravel, the ECB chose the nuclear option and stepped into the breach to start buying up the debt of its weakest debtor states. Now, the ECB claims these actions are unsterilized i.e. it is not just printing money. But, I have my doubts. In any event, the ECB is the New "United States of Europe" as Marshall Auerback puts it. And while the limited measures the ECB has taken have not caused the credit spreads or interest rates to decline for these debtors, I guarantee you a full effort of credit easing would do.
So that get’s me to the Federal Reserve. Here’s the train of logic.
The U.S. stimulus has worn thin and money supply is now decreasing. President Obama can’t even get a bill to extend unemployment insurance through Congress. Everyone is on to this. The President talks a good game. After the latest dismal jobs numbers, Business Week quoted:
“Make no mistake, we are headed in the right direction,” President Barack Obama said yesterday after the employment report. “We are not headed there fast enough for a lot of Americans. We’re not headed there fast enough for me either.”
Personally, I think this statement is preposterous as it leads to over-promise and under-delivery. But, the fact that the President is talking about stimulus tells you he is worried since he was talking about reducing the deficit to prevent double dip in November.
In short, the President has changed his tune because he’s worried. Yet, all indications are he is going to get zero traction. Let’s remember, the Republicans can play the cynical game of ‘creating’ more short-term economic hardship to stick Obama and the Democrats with the blame.
And people are saying that the Federal Reserve is ready to start another round of quantitative easing. Ambrose Evans-Pritchard reported about 10 days ago that the Fed may be ready to double the Fed’s balance sheet from $2.4 billion to $5 trillion. Andy Lees of UBS responded saying:
As I am sure you have seen the attached story suggests that Bernanke is preparing for a 2nd program of quantitative easing; the article suggests potentially expanding its balance sheet from USD2.4trn to USD5trn. This is far from certain with him facing opposition from some of the regional Fed governors, but I think it is becoming increasingly likely that they are required to do something. It is becoming increasingly obvious that fiscal policy in the West has reached a limit and that stimulus now has to come from default through monetary stimulus, the whole purpose of which is to lift asset prices and therefore strengthen people’s effective balance sheets and thereby increase spending. I think the figures mentioned above are not required at the moment, but the longer the Fed leaves it, the more stimulus maybe needed. It is also becoming clearer that China is slowing. As I said yesterday it has started to increase liquidity injections, but I would expect a cut in the reserve requirement in the not too distant future which would indicate a bigger and more sustained liquidity injection. I’m sure the BoE is also prepared to buy more gilts as austerity starts to bite, and the ECB too.
Moreover, there has been talk about the Fed buying up long-dated Treasuries as the next unconventional measure. However, now I am thinking more unconventional: munis. With the Federal Government out of the picture, the states could re-enter the picture if the Fed went QE2 and started to buy up municipal bonds the way they started buying mortgage-backed securities in 2009. And that would give states the green light on more spending.
What do you think: all aboard, QE2 is about to disembark?