I’m worried. I know this sounds strange. After all, we are in arguably the best growth phase in this economic cycle. And very few economists are predicting, let alone talking about, recession. I don’t see recession around the corner either. But, still, I am concerned. And my worry is about a recession and public pension crisis. I am even talking about the Fed buying up municipal bonds using quantitative easing. That was my last post.
Since I have put this out there so early, let’s talk about how the Fed actually does it. I mean, we are still a long way from recession or crisis. So think of this post as an OJ-style “If I did It” piece, with me ghostwriting for the Fed.
The most dangerous part of the business cycle
Here’s the danger. We have people talking about a bear market in bonds. Other people are talking about a meltdown in equities. The latest talk is of a trade war — with Donald Trump in the Herbert Hoover role. A lot of this is probably hyperbole, hype, doom and gloom.
But, still, we could be one major policy error away from a big financial crisis. If you believe the public statements of Dalio, Gross, Grantham Gundlach and many of the other market pundits, we are past a point of no return in financial markets. Eventually, this will end badly — at least, that’s the inference.
The trigger, you ask? We have a regime shift at the Fed right now, at the most dangerous point in this business cycle. And my own view here is that, if the Fed is as hawkish as Powell makes it seem, then this is what triggers a recession and crisis. Expansions don’t die in their beds of old age, they are murdered by the Federal Reserve.
In the past, I have said the Fed gets it. I know the Yellen Fed did. Just last year, they paused as the data deteriorated. And they certainly got the policy during the shale oil bust right. But we have a new sherif in town. And his tone is quite a bit different. Just maybe, the Fed will keep hiking until the market cries uncle. And then that’s when Dalio and Grantham and that lot will be proved right.
Muni Crisis postponed, not averted
So that gets us back to 2010. The municipal finance crisis that Meredith Whitney predicted some eight years ago never came to pass. And I said at the time, barring a double dip recession, it wouldn’t happen. You need an economic trigger to get the hundreds of billions of dollars of defaults that create a crisis. And you simply don’t have a trigger in an economic upswing.
The Fed could give us this trigger. And then what? The last post I wrote was thin on details surrounding the Fed’s flexibility in buying municipal bonds. But what I do know is that the Federal Reserve is prohibited for buying municipal bonds of maturities longer than six months. That’s not very helpful in a crisis.
Nevertheless, there are ways around this. First, back in 2012, three Stanford Law Professors wrote a piece in the New York Times urging a change in that law so that the Fed could buy municipal bonds instead of mortgage bonds. They argued “State and municipal bonds help finance new infrastructure projects like roads and bridges, as well as pay for some government salaries and services, by borrowing against future tax receipts.”
Their proposal never saw a robust defense in Congress.
QE for municipal bonds using the Fed’s emergency lending powers
But later, crisis Federal Reserve Chair Ben Bernanke revealed in his memoirs, the Fed considering buying municipal paper during the crisis.
Bernanke memoir re munis pic.twitter.com/hFTXWPoG74
— Sam Bell (@sam_a_bell) July 12, 2017
The real question is how to get around the six-month muni maturity rule. As Marshall Auerback reminded me today, the Federal Reserve Bank of New York agreed to lend JPMorgan Chase $29 billion to acquire Bear Stearns ten years ago. And the legal authority they used was Section 13(3) of the Federal Reserve Act. As Marshall put it: “That section seems to grant considerable wriggle room.”
The Fed has already said exactly this. In a press release dated 21 May 2015, the Fed says:
The Federal Reserve Board on Thursday proposed adding certain general obligation state and municipal bonds to the range of assets a banking organization may use to satisfy regulatory requirements designed to ensure that large banking organizations have the capacity to meet their liquidity needs during a period of financial stress.
Under the Liquidity Coverage Ratio (LCR) requirement adopted by the federal banking agencies last September, large banking organizations are required to hold high-quality liquid assets (HQLA) that can be easily and quickly converted into cash within 30 days during a period of financial stress. Subsequent study by the Federal Reserve suggests that certain general obligation U.S. state and municipal bonds should qualify under the LCR as HQLA because they have liquidity characteristics sufficiently similar to investment grade corporate bonds and other HQLA asset classes.
The proposed rule would allow investment grade, general obligation U.S. state and municipal bonds to be counted as HQLA up to certain levels if they meet the same liquidity criteria that currently apply to corporate debt securities. The limits on the amount of a state or municipality’s bonds that could qualify are based on the specific liquidity characteristics of the bonds.
Change the rules
But, if need be, Congress could change the rules altogether. Roosevelt Institute Fellows Mike Konczal and J.W. Mason suggested just that in a November report.
Their view:
In the new report, the authors argue that it is essential for the Fed to further expand its scope and develop an even broader monetary policy toolkit than was employed during the Great Recession. They suggest six approaches they believe the Federal Reserve—and Congress—should adopt:
- Setting long-term interest rates
- Increasing support for public borrowing
- Purchasing state and local debt
- Coordinating Treasury and Federal Reserve policy
- Purchasing a greater range of private debt
- Shifting from a monetary policy to a credit policy framework
As this new paper discusses, the economy’s ability to weather recessions, and to meet basic human needs even in good times, depends on the Fed thinking more broadly about its role to manage the economy and weather economic crises.
QE for munis is coming
I have argued that monetary policy is at the end of the line using unconventional policy. Unconventional policy won’t get us to the Nirvana of higher growth and low inflation that the Trump Administration wants.
But, we are beyond that now because the Fed has successfully moved off the lower zero bound. It is even beginning to shrink its balance sheet. Other central banks may soon follow its lead.
Nevertheless, we aren’t that far from zero. In the next recession, we are very likely to go back to zero rates. And then the Fed will be in the same position it was before – out of bullets. If, as I anticipate, muni bonds are hit or local governments even begin to default on their obligations, the Fed will move in. Section 13(3) of the Federal Reserve Act gives them authority to do so. And if they need even more authority, Congress will grant it.