.Yesterday, we learned that the Federal Reserve took an aggressive approach in extending its newest vehicles of monetary easing. In conjunction with President Obama’s recently announced mortgage modification program, this could add significant stimulus to the US economy.
I am trying to avoid getting mired in the short-term news cycle by avoiding the financial media as I concentrate on the medium- and longer-term issues to push this article out. In this Credit Writedowns Pro article I will outline why the Fed has taken these measures and what their impact could be on the US economy and asset markets. I have been anticipating economic weakness in the US in part due to less accommodative fiscal policy. However, I believe these recently announced efforts are bullish policy initiatives and that they could have a significant impact on asset prices and the real economy via the mortgage market.
Here are the key points to keep in mind:
- The Fed has said point blank that "[t]he maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market." This means the Fed is done and is passing the baton to Congress and the President. It cannot be any more aggressive.
- The Fed is out of bullets on interest rate policy and has turned to other nonconventional measures like targeting medium-term inflation and interest rates and using a communications strategy as an expectations anchoring mechanism to increase its influence on medium-term outcomes. This campaign began as early as last February with now-Vice Chair Janet Yellen’s Unconventional Monetary Policy and Central Bank Communications.
- The US President recognizes that the Republicans in Congress have his removal from office as a top priority and will not allow him to add to budget deficits, especially if it adds stimulus to the real economy. So, despite Bernanke’s saying the fed cannot do more, legislated fiscal stimulus is off the table. Therefore President Obama is using Fannie and Freddie as a vehicle to add stimulus via the mortgage market.
- The combination of the US President’s State of the Union mortgage announcement and the Fed’s aggressive monetary policy the very next day demonstrates a monetary agent and fiscal agent working hand in hand to achieve twin goals of full employment and price stability. We should expect the Fed to continue supporting fiscal policy rather than working at cross purposes to it. And this is the most important bullish point.
- As an investor, you should see this as risk-asset and interest-rate bullish but dollar bearish. As someone concerned about the real economy, guaranteed low rates and actual refinancing by underwater homeowner’s in greatest debt distress will add a kick to the economy.
QE1 vs. QE2 vs. QE3
First, we have to look at the Fed’s policy of quantitative easing. Last June, in anticipation of the Fed’s new policy of rate easing, which they initiated in August, I wrote an article outlining the differences between the various QE’s.
if I had to characterize QE1 I would say: the first round of large scale asset purchases by the Federal Reserve was intended to support economic activity. However, because the Fed focused on the asset side in increasing its balance sheet by buying assets it had not previously purchased in large quantities, the Federal Reserve worked to support the functioning of credit markets by providing liquidity to the private sector. Without this easing, the US and the global economy would have had a depression of indescribable severity with unknown attendant geopolitical and military consequences.
Was QE1 a bailout? Yes. But QE1 was also a legitimate lender of last resort operation. We should question the terms of QE1 i.e. "The Fed lent freely, but at a low rate, on dodgy collateral" not the operation per se.
Synopsis: QE1 was a legitimate operation brought upon by exigent circumstances. The Fed essentially became the interbank market as panic took hold and our financial system teetered on the verge of collapse.
QE2 was a different animal. The aim was to support economic activity in the US domestic economy.
But, as we have detailed many times here at Credit Writedowns, quantitative easing doesn’t actually have an impact on the real economy. It is an asset swap. The Federal Reserve buys Treasury bonds and sells dollars it has created expressly for that transaction. After the asset swap, the balance sheet of the primary dealer which sold the Treasuries to the Fed has not increased; it now has cash instead of Treasuries. So there are more reserve deposits and fewer Treasuries in the private sector. The Federal Reserve has Treasuries instead of the money it created in expanding its balance sheet. While the reserves can ostensibly be lent out, the reality is that this money will sit in a bank vault idle unless the demand for loans warrants otherwise. It is a misunderstanding of how the banking system works to assume the mere creation of reserves has any significance regarding lending. I would argue the swap drains the economy of higher interest-bearing assets that add to income, replacing them with essentially non-interest bearing assets.
Bottom line: QE2 was not good policy. It drained interest income from the economy and could not promote credit growth as intended. Credible lenders of last resort use price, not quantity signals. The only benefit from QE2 was the initial psychological lift associated with the Fed’s signal that the Fed intended monetary policy to remain accommodative.
Now QE3 is not about quantitative easing; it is all about rate easing. Again, credible monetary policy has the central bank target price not quantity. The Fed seems to recognize this. I wrote in the June article:
It is unlikely that the Fed will go back to the well for the same policy since QE2 has proved ineffective. So now that the economy is weak again, it will up the ante and target rates instead of specific easing quantities. This has the potential political benefit of the Fed’s not having to expand its balance sheet. The Fed would essentially guarantee a rate and let the markets move interest rates to that level. Of course, the Fed would promise to defend the rate(s) if and when necessary. The Fed may be tested initially, but punters would lose their shirts fighting a market player with a potentially unlimited supply of liquidity. So I would expect the balance sheet effects for the Fed to be muted. And clearly, if QE3 reduced rates in addition to having largely the same impact as QE2 as well, it would be a more powerful tool.
There could be internal dissent to such an aggressive policy. I do not expect QE3 now nor do I expect it unless the economy deteriorates further. So the Fed could start off by signalling to the market that it will conduct what I have been calling ‘permanent zero’. Look for how the Fed reinforces its commitment to "exceptional low levels for the federal funds rate for an extended period”. If Bernanke is forceful about this commitment in this week’s FOMC press conference, people will be forced to accept the likelihood of permanent zero and the term structure will flatten further and further out the curve.
This is exactly what has happened. The Fed is now focusing on price instead of quantity. In August, I told you the Fed has already begun its third easing campaign when it targeted medium-term yields out to two years, practically guaranteeing zero rates until mid-2013 unless the economy turns around.
Moving out the Curve
Yesterday, the Fed upped the ante and moved from a two-year guarantee of permanent zero to a three year guarantee – always subject to economic conditions, of course. I see this as extremely aggressive policy that means that the Fed is effectively targeting medium term rates. Moreover, in the press conference explaining his actions, Fed Chairman Ben Bernanke explained that this is exactly what he intends to do.
Watch the video below and look for where Ben Bernanke says that the Fed is going to increase its purchases of medium-duration Treasury assets. The totality of his remarks have to be considered an attempt to move further out the curve in targeting interest rates.
The Fed is:
- Explicitly engaging in what it describes as very accommodative monetary policy by leaving rates near zero percent through late 2014.
- Explicitly setting a medium-term inflation target consistent in time frame with its stated accommodative policy guidelines.
- Explicitly communicating it intends to purchase more medium-term Treasury assets and fewer short-term assets in a continuation of Operation Twist.
Conclusion: The Federal Reserve is now targeting medium-term rates in as explicit a manner as it can. We should anticipate that the Fed will use the same tools to move further out the curve if the economy cannot reach full employment and inflation falls below the Fed’s target.
America’s Version of Functional Finance
Randall Wray has been writing a bit about functional finance, an economic model in which the fiscal and monetary agents act in concert to achieve government’s policy objectives. He has noted that Milton Friedman advocated such a policy in a seminal 1948 paper. Wray notes:
[Friedman] thus proposed to combine monetary policy and fiscal policy, using the budget to control monetary emission in a countercyclical manner. (He also would have eliminated private money creation by banks through a 100% reserve requirement–an idea he had picked up from Irving Fisher and Herbert Simons in the early 1930s–hence, there would be no "net" money creation by private banks. They would expand the supply of bank money only as they accumulated reserves of government-issued money. We will not address this part of the proposal.) This stands in stark contrast to later conventional views (such as those associated with the ISLM model taught in textbooks) that “dichotomized monetary and fiscal policy.
I believe this is what we are seeing from the US government right now. It is no coincidence that the President’s mortgage proposal and the Fed’s inflation targeting and three-year rate easing announcement came on consecutive days. The two branches are acting in concert as functional finance would dictate.
What this means effectively is that the Republicans will not be successful in painting Obama into a corner economically. The US economy, now at stall speed, can only catch a tailwind from these policies. While rate easing alone is ineffective because it sucks interest income out of the economy, rate easing in combination with Fannie and Freddie-sponsored mortgage cramdowns effectively guarantees an expansion of credit. Those homeowners who qualify for a mortgage except that they are now underwater and cannot refinance, will now be able to refinance, saving what President Obama says could be up to $3,000 per mortgage. Some of this savings will be used to reduce debt. A lot of it will be added to the economy in the form of new purchasing power.
I said right from the start that Freddie and Fannie’s nationalisation also meant a nationalisation of America’s mortgage problem. We are now seeing this in ever starker detail. From a longer-term perspective, it is good if this results in credit writedowns that reduce household sector debt in the economy but it is effectively a bailout and a socialisation of losses. I will leave out the issue of fairness here. The important point is that a two-pronged approach of rate easing’s financial repression and loss socialisation through what are effectively GSE-sponsored cramdowns means that the Fed and the Obama Administration are working together to boost the economy and they will have some success using this approach.
Investors must still be worried about the fallout from the European meltdown. However, the situation in the US is looking much better than it did last week because of this aggressive policy response. That is bullish for stocks, bullish for Treasuries, bullish for housing and REITs, bullish for high yield and bullish for precious metals. it is dollar bearish. I wouldn’t call this a risk off environment yet but it could soon be.