Decoding Kevin Warsh

I’m on the verge of changing my early morning routine of TV business news for the food network… The decision has been brewing for a while, but my "aha!" moment came last Friday, during an interview with a "market-intelligence" pundit, who was asked to interpret an op-ed piece by the Fed’s Kevin Warsh the day before.

So the guy goes on a spree of conspiratorial drivel about the Fed’s “true” intentions, following which, an unquestioning anchor likens his remarkable “code-breaking” skills to those of Robert Langdon!

Truth be told, Warsh’s article, and subsequent speech in Chicago, caused a bit of commotion and confusion in the market, for being seen as somewhat contradictory to the Fed’s official line a day earlier…. “exceptionally low”, “extended period” and all that.

Yet, all that Warsh did was to state the obvious… that the Fed is currently walking on a very thin line: Unlike back in March, when the “extended period” language was first introduced, the Fed’s management of downside risks on growth may be coming increasingly at odds with the management of upside risks on inflation.

At the crux of this tension is the level of banks’ excess reserves—currently at $850 billion (from $60 billion a year ago), by virtue of the Fed’s various asset-purchase and credit-easing schemes. In turn, the monetary base skyrocketed from $85 billion in August 2008 to around $1.7 trillion by end-2008, and has hovered around those levels ever since.

Is that a problem?

The standard argument would go that, yes, it is, because once banks begin to lend these walls of money, inflation will get out of control. Indeed, if you belong to the “mulish monetarists'” camp, you’ve been probably raising red flags ever since the Fed embarked on its various emergency facilities last year.

Clearly, that would have been wrong: The Fed was simply responding to a colossal, unanticipated increase in the demand for money in its most liquid form that nobody else was able or willing to provide.

But the story is different now. Risk aversion has been receding. Cash is becoming too expensive to hold and is gradually searching for higher returns—in stocks, bonds and the like. And, while commercial bank lending to the real economy—i.e. to companies and consumers—is stagnant at best, liquidity in capital markets is slowly coming back, repo markets are showing signs of life, and companies are increasingly able to raise money in the bond markets. Asset prices are "reflating".

Now, that’s not necessarily a problem. After all, the whole point of the Fed’s credit and quantitative easing operations was to catalyze the return of private-sector liquidity, help reverse the destruction in wealth from the collapse in asset prices and avoid a deflationary spiral.

What is the problem is the uncertainty about the fundamentals: Is the markets’ recent “exuberance” reflective of a true, steady improvement in the economic outlook? Or just wishful thinking, fuelled further by cheap money, and bound to correct itself?

The implications for policy in each case are different: The latter would justify the Fed’s low-for-long mantra; the former would call for an earlier reversal of the exceptionally accommodative monetary stance.

This uncertainty about the fundamentals is complicating monetary implementation. But uncertainty is nothing new when it comes to formulating monetary policy. What is different this time is that the mountain of excess reserves in banks’ books is an obstacle to the Fed’s traditional preference for playing it safe on growth. Basically, while the Fed would love to go for the “wait and see” approach, the level of excess reserves makes this a very risky route.

The reason is simple: $850 billion of excess reserves can do a much bigger damage, faster, than, say, $50 billion, if banks regain their appetite to recycle them into the system. Put differently, it would take a much smaller increase in the money multiplier (which has collapsed since the crisis began) to cause a much bigger damage, with excess reserves at these levels.

Up till now, the Fed had downplayed the size of reserves as a potential constraint to its policy implementation. As NY Fed President Bill Dudley said back in July:

“…in a world where banks could not be paid interest on excess reserves, these persistent high reserve balances would indeed have the potential to prove inflationary. […] But that is not the world in which we now live. Because the Federal Reserve now has the ability to pay interest on excess reserves (IOER), it also now has the ability to prevent excess reserves from leading to excessive credit creation.

“[..] For this dynamic to work correctly, the Federal Reserve needs to set an IOER rate consistent with the amount of required reserves, money supply and credit outstanding consistent with its dual mandate of full employment and price stability. If demand for credit exceeds what is appropriate, the Federal Reserve raises the IOER rate to reduce demand.” (my emphasis)

Right. Only that Dudley assumes that the Fed knows what the interest rate consistent with its dual mandate is! But, as I’ve been arguing here, right now the Fed doesn’t, because of the uncertainties above—uncertainties that Fed officials have themselves acknowledged.

The risk is that, guided by standard measures of slack (unemployment, capacity utilization etc), the Fed will keep rates at zero, even while banks begin to recycle excess reserves in the system.

Clearly, there is one way to go: Begin to unwind the reserves, soon. This will allow some flexibility in the interest rate decision—some room for a “wait and see” approach—until the data coming out of the real economy begin to look resolutely better.

As a matter of fact, that’s exactly what Ben & Co. seem to be planning, with reverse repos the latest word on the street. The idea is for the Fed to avoid selling the securities it owns outright (and any undesired price impact thereof), but place them directly with money market funds, which seem to have both the balance sheet capacity and the appetite to absorb large quantities of “safe” assets like US Treasuries or Agencies.

I see Warsh’s statements precisely in this light—and, therefore, not as inconsistent with the FOMC’s “extended period” message. The Fed still wants to play it safe on growth, but would prefer to avoid screwing up in the unlikely(?) case the financial system moves faster than the Fed expects based on traditional economic fundamentals.

So what I'd expect to see in the coming weeks is the Fed to start moving to drain reserves, while postponing the interest rate increase decision until fundamentals look more compelling.

That said, if the Fed wants to avoid the possibility of destructive volatility in bond markets, it should do away with the constructive(?) ambiguity in its policy message and come out with a clear communication about the sequencing of its exit strategy (and I’m not talking about pre-announcing rate decisions here).

Capital markets are still fragile and clarity in the Fed’s message will be key for a smooth transition process… Even more so, if the Fed truly has to deal with a market that is as “perceptive” as Robert Langdon!