Ben’s new rabbit: Inflation expectations

Once again, we find ourselves holding our breath for a new fluffy rabbit coming out of Ben’s hat on November 2nd (the day of the next FOMC meeting). In previous pieces I have discussed the limitations of unconventional measures (QE in particular) in stimulating aggregate demand. Here, I want to revisit this discussion in light of Bernanke’s new magic trick: that of managing inflation expectations.

The starting point is the two principal factors restraining aggregate demand currently: First, the ongoing balance-sheet repair by a certain segment of households, corporates and banks; and second, the fact that economic agents that are cash-rich maintain a strong preference for liquidity. Put differently, those with little cash and lots of debt can’t spend; and those with lots of cash and little debt won’t spend.

So the question is: What tools does the Fed have available for addressing these two problems? Pre-empting my conclusion, Large-Scale Asset Purchases (or LSAPs) of US Treasuries are an ineffective—indeed, a counterproductive—tool for addressing any of the two problems above; the kind of LSAPs that would work are *not* available to the Fed in the current political climate. But there is certainly hope in the Fed’s intention to manage inflation expectations. The issue there is where exactly inflation expectations should be guided towards, and how best to achieve that.

Starting with balance-sheet repair... I have argued before that the Fed’s LSAPs of mortgage-backed securities (MBS) and US Treasuries (ie "QE 1.0") have not been an effective tool for tackling the problem. This is because, by design, they fail to target those segments of the economy undergoing balance sheet repair.

As an example, the drop in mortgage rates that followed the Fed’s MBS purchases helped prompt an increase in mortgage refinance activity. But the cash boon from lower mortgage payments only benefited people who could afford to refinance—ie those with jobs, income and positive equity in their home, instead of the cash-strapped households facing foreclosure. Meanwhile, foreclosures kept on rising as recently as September 2010.

Ditto for corporates: Large firms with access to capital markets benefited from higher investor demand for “safer” fixed-income assets such as high-grade corporate bonds (arguably triggered by the LSAPs). But small firms with no capital market access continue to face tight lending standards.

Against this backdrop, for any new LSAPs to work, the Fed would have to be far more adventurous in terms of the assets it purchases (for more on this see here and the comments on that piece). Unfortunately, in the current US political climate such an “adventurous” LSAP program is not an available policy tool—esp. since it would require the cooperation of the Treasury. So what’s left?

Come out the new rabbit—the guidance of inflation expectations. There are two issues here: First, how does the management of inflation expectations help stimulate aggregate demand? Second, what should “managing inflation expectations” mean at this juncture and how can the Fed best achieve it?

Starting from the first question, there are two ways in which the guidance of inflation expectations can help aggregate demand at this juncture. First, by preventing real interest rates from increasing to undesirable levels: with nominal interest rates at record lows, sustained declines in inflation expectations would translate into rising real interest rates—a rise that the Fed would be unable to “fight” by cutting the nominal interest rate further. Hence the need to work on the inflation-expectations front.

But the *appropriate* management of inflation expectations can go further in my view. It can help address the second problem I mentioned in the beginning—agents’ preference for liquidity.

Currently, with inflation (and inflation expectations) at low levels, holding cash is “cheap” because of the low opportunity cost. But an increase in inflation expectations would make holding cash expensive, provided it is accompanied by a Fed commitment to keep nominal short-term rates low even if inflation eventually exceeds the Fed’s medium-term “target”. Note that in the absence of such a commitment, agents would expect the Fed to raise short-term rates as inflation moves higher. This which would in turn preserve their real return on cash, eliminating the incentive to switch into less liquid investment instruments, consumption and/or hiring (in the case of corporates).

Put simply, in order to facilitate a switch away from cash, the Fed has to commit to allowing inflation to go above its medium-term projection. Now, before you accuse me of pushing the Fed into some treacherous territory, check out what Ben said on Friday:

Recognizing the interactions between the two parts of our mandate, the FOMC has found it useful to frame our dual mandate in terms of the longer-run sustainable rate of unemployment and the mandate-consistent inflation rate.

Repeat: “mandate-consistent.”

Later in that the same speech, Bernanke added that

“The longer-run inflation projections in the SEP indicate that FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below.”

Now that’s for the “longer-run”—i.e. beyond 2012. In my view (and that’s just *my* view), the “mandate-consistent” inflation in the nearer-term is above that level, precisely for the reason I mentioned above: Economic agents with lots of cash at hand need an incentive to part with their cash.

So much about the economic rationale. How about implementation? In my view, hints of such an approach were given by Bernanke on Friday:

A step the Committee could consider, if conditions called for it, would be to modify the language of the statement in some way that indicates that the Committee expects to keep the target for the federal funds rate low for longer than markets expect [my emphasis]. Such a change would presumably lower longer-term rates by an amount related to the revision in policy expectations.

The problem with Ben’s specification however is that “longer than markets expect” does not condition the period of low rates on the inflationary path. As such, it falls short of achieving the liquidity-preference objective I mentioned above.

But there is also a second problem (read “systemic risk”) with the Fed’s overall policy framework—one that brings me back to reiterating (for the nth time) my aversion to the LSAPs. This is the inconsistency between the Fed’s attempts to “force down” long-term yields to levels that are misaligned from the Fed’s own medium-term targets for inflation and growth!

Basically, it’s one thing to intervene in order to correct a misalignment of asset prices from fundamentals (like the Fed did with its liquidity interventions in 2008). It’s another thing to intervene in order to engineer a misalignment of asset prices away from fundamentals—the very fundamentals you (Fed) are trying hard to achieve! This latter is not only non-credible; it is also dangerous, as it creates bond-market bubbles that can unwind with potentially disruptive effects for the financial system (it’s no accident that the hot topic at the IMF meetings last weekend was when will the bond bubble burst).

So with all that in mind, my call to Ben would be “a little more inflation and a little less LSAPs please”. LSAPs of Treasuries or MBS have little power to stimulate aggregate demand but carry too many risks for the financial system. Instead, the FOMC should find the language to convince the world that a little more inflation in the near-term is the way to go.

Can this be for real?

I don’t know if it’s just me, but there is something disturbing about the recent market behavior. If one were to proxy the state of the (real) world with the stock market index, one would have to conclude that consumers, businesses and governments have turned into schizophrenics.

Surely, that’s not the case (though I’ll reserve my judgment about the latter group for later). News regarding the economic outlook has been by no means commensurate to the vertical moves we saw in the market last week. But since many have already thrown the “efficient market hypothesis” out of the window, here I’ll focus on a somewhat different question:

Is it possible to get a negative feedback loop, from volatile—or declining—markets to the real economy (and back to the markets) and turn the sudden shift in investor mood into a self-fulfilling “prophecy”?

To answer that, let’s first see what the possible channels of transmission are.

First, we have the good old wealth effects—declines in household wealth as a result of falling stock prices would tend to be associated with a drop in consumer demand. However, typical literature estimates for wealth effects are small, implying a tiny impact, unless we see the kind of drawdown we saw back in 2008/early-09.

Second, we have the “Tobin-q” link between stock prices and corporate investment, which conjectures that whenever the market value of a firm exceeds the replacement cost of its capital stock, firms will tend to invest more. Empirical support for this theory is very weak, however. One reason is that firms tend to view internally generated cashflow as the cheapest source of financing and equity as the most expensive one—so that cashflow is empirically more important in explaining investment than the equity cost of capital.

In addition, corporate investment is also tied to the outlook for final demand. Not only does a robust demand outlook generate new investment opportunities; demand also generates cashflow, which in turn means additional stocks of cheap corporate financing. This does not mean that equity capital is unimportant—only that the cost of issuance is sufficiently high that it usually is not the primary source of finance.

The same cannot be told of credit though, and here is where things can get tricky. Corporate spreads saw similarly vertical moves as equities last week, only upwards. Here it’s worth recalling Bernanke’s financial accelerator effect, whereby higher risk premia (due to higher volatility) lead to higher required rates of return, a deterioration in the perveiced health of borrowers balance sheet, and a drop in bank credit. On top of that, market indicators of stress in bank-funding markets (LIBOR-OIS, bank CDS spreads and so on) have also been moving in the wrong direction, raising concerns about a credit-crunch “encore” accentuated by poor bank funding conditions.

Starting from the former—the general carnage notwithstanding, credit markets were not exactly closed last week. Corporate issuance did go ahead in many cases, only that investors demanded higher yields and were more selective, depending on the name. In addition, much of the negative focus has been on financials: Indicatively, commercial paper funding for non-financial corporates has remained virtually flat throughout May (including last week), while that for financials (domestic, as well as foreign) has declined by $50 billlion—some 9% of the outstanding stock.

Turning to financials: Here I want to first make a distinction between cash and liquidity. Some have argued that, since financial institutions have tons of cash sitting at their respective central banks, surely funding problems can’t be the issue here. Even European institutions, which have been the focus of strains recently, can’t really be said to have funding problems, since the ECB has gone all the way in helping them: Not only with unlimited long-term refinancing operations at fixed rates, but also with purchases of “toxic” ClubMed bonds. All that is true. In other words, I would personally ignore the LIBOR-OIS spread, which became very fashionable during the 2008 crisis, as a signal of an impending credit crunch.

However... cash does not equal liquidity. As Pimco’s Paul McCulley said a few years back, liquidity is a state of mind. Banks’ holdings of large piles of cash reserves say little about their willingness to lend. One source where information about the latter can be found is the latest Senior Loan Officer Opinion Survey (SLOOS). This suggests that credit conditions remain tight for reasons including reduced tolerance for risk and a still uncertain macroeconomic outlook.

Importantly, the cash sitting around says little about demand for credit. Here, the SLOOS points to mostly unchanged conditions in the demand for credit for non-financial firms, with the balance towards a still weakening demand. In addition, only a fraction of reporting banks believed that, for those cases where credit did actually expand, the reason was a rise in investment.

The bottom line here is that, while market indicators may point to stress in the financial sector, (a) the stress is only theoretical, given the effective backstop by the ECB and the Fed; and (b) any spillovers to the real sector are limited. This is because, given the backstop, changes in the supply of credit have not been driven by banks’ theoretical ability to lend but by their tolerance for risk, a lukewarm credit demand and ongoing uncertainty about the economic outlook.

So unless the momentum of improvement of the global economy (especially that of private sector demand) turns negative, it will be difficult to see a spillover from the markets alone to the real sector. Note that this is what makes the current case different from 2008: At that time, there was a clear negative momentum underway in the real sector, starting from a collapsing housing market that fed through to labor markets, credit markets and, eventually, the global financial system.

Still—I said it will be difficult, but not impossible. The one channel of transmission I have not mentioned is confidence. I would have personally dismissed it as significant a while back, especially since at least one study that I’ve seen fails to find a significant impact of (transitory) bouts of market volatility on consumer confidence.

But I would say that 2008 changed the picture. The drawdowns we saw in labor markets or in consumer spending were considerably larger than what standard economic models of consumption or unemployment would have predicted. This tells me that we can not entirely discard the impact of sharp market drawdowns on the attitudes of households and businesses. And here, one can only hope that these guys have better things to do than checking their stocks, while the markets work through their schizophrenia—alone!


PS With the official beginning of the summer next Monday (Memorial Day), I will be taking time off Models & Agents for most of the summer (with occasional breaches, when I can’t help it!). This is to accommodate a heavy load of business and vacation-related travel ahead, and my customary use of my summer months to further building my capabilities as an economics nerd. Au revoier in the Fall!

The “E” and the “M” of the EMU

They say “do not believe anything until it’s been officially denied”. Just last Thursday, ECB President Jean-Claude Trichet categorically denied that the ECB had discussed buying government bonds of peripheral eurozone members.

A market sell-off and a hectic weekend later, it was time for a complete about-face… Per the ECB’s press release on Sunday night, “in view of the current exceptional circumstances prevailing in the market, the Governing Council decided [among other things]

To conduct interventions in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments which are dysfunctional. The objective of this programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism. […]

In making this decision we have taken note of the statement of the euro area governments that they “will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures” and of the precise additional commitments taken by some euro area governments to accelerate fiscal consolidation and ensure the sustainability of their public finances.”

The significance of this move is huge, as far as killing speculators goes, but here I want to focus on a key policy dilemma that has emerged since the subprime (and now the eurozone) crisis ever began: The need for a separation between monetary and fiscal policy—what Trichet referred to as the difference between the “E” and the “M” of the EMU (or Economic and Monetary Union) at the ECB’s press conference on May 6th.

In the US for example, this separation was all but blurred by the Fed’s decisions to put its own balance sheet at stake in the bailouts of Bear Stearns, Citi and AIG and, more bluntly, by its decision to buy US Treasuries, GSE debt and mortgage-backed securities. In the event, Congress’ disgruntlement with the AIG saga, monetarists’ concerns about “debt monetization” and valid criticisms about the Fed’s decision to favor a specific sector—housing—with cheap credit, have served to raise questions about the appropriate limits of the Fed’s independence.

Does the European/ECB approach offer an alternative/better(?) route? In my view yes, notwithstanding the latest decision to purchase government bonds.

Ignoring the bond purchases for the moment, recall first that, at the height of the financial crisis, all failed banks were “dealt with” by their corresponding national governments, without any participation from the ECB. To the extent that saving insolvent banks was deemed desirable form a social or financial-stability perspective, the burden was assumed by the elected governments, with ultimate responsibility going to the taxpayers (who voted for them).

Meanwhile, the ECB did not remain idle—on the contrary: It was the first central bank to flood financial institutions with liquidity right at the onset of the crisis in August 2007; and in June 2009, it decided to provide as much funding as demanded by European financial institutions at a low, fixed rate for a 12-month maturity (longer than the Fed’s liquidity operations). In other words, the ECB demonstrated full flexibility and creativity when it came to preserving financial stability and fulfilling its LoLR functions (to illiquid but solvent institutions).

Given the faithful delineation between fiscal and monetary responsibilities, Sunday's decision to step into the government bond market may be seen as an aberration—or worse: A betrayal to the spirit of its price-stability mandate, let alone an anathema to the Germans.

I actually don’t think so. First of all, the interventions are described as—effectively—liquidity operations, to improve the functioning of monetary transmission. This is not a b.s. excuse for back-door debt monetization. Repo transactions using peripheral-economy debt as collateral have been increasingly dysfunctional, undermining the ability of some European financial institutions to fund themselves in private markets.

Now, why is that so different from the Fed’s MBS purchases, which, ultimately, were also aimed to help improve conditions in financial markets? It is different in many ways. First, unlike the MBS purchases, the ECB’s operations will be sterilized—that is, the objective is not to loosen monetary policy further but to relax financial conditions from the currently tight levels by improving funding for financial institutions (and governments).

Importantly, the Fed’s MBS purchases were unconditional: No actions were demanded on the beneficiaries of these purchases (the mortgage borrowers). In contrast, the ECB *had* to extract commitments for further fiscal consolidation from the eurozone governments, so that it could claim that (by its own judgment, rather than the now discredited rating agencies) peripheral government bonds are “safe” enough for its portfolio. We yet have to see whether such pledges will be met, but they are at least a start.

Mind you, the point goes beyond the “narrow” objective of securing the safety of the ECB’s balance sheet. It is about securing a commitment by the eurozone governments that they still see the EMU as a desirable objective and one that is worth making sacrifices for: Namely, further fiscal measures in line with the spirit of the Stability and Growth Pact, and structural reforms to restore competitiveness.

Trichet’s tough talk on May 6th aimed at highlighting exactly that—the limits of monetary policy in preserving financial and economic stability, when the political will to do so is lacking:

“We cannot substitute for the governments. The governments have their decisions to take while we have our own role as an independent central bank, and of course we expect each authority to fulfill its own responsibilities.”

What are the lessons here, including for the U.S. of A.? The first is the realization that, unfortunately, politicians are unlikely to get their act together until things are at the brink of falling apart. And even then, political will may be hard to muster in the midst of the crisis. Trichet’s “bluff”(?) worked in finally stirring bold action. Bernanke had to step in and bail out the likes of AIG with Fed money. But once the emergency is over, any fiscal burdens must be transferred from the Fed’s books to of the US Treasury.

The second is that there was, in fact, an alternative to the MBS/Treasury purchases... which was to buy none! Instead, like the ECB, Fed operations could have focused solely on securing ample liquidity to the financial system, in line with its mandate of safeguarding financial stability. Indeed, as I argued here, the effectiveness of the so-called “portfolio balance” channel over and above the positive impact of the MBS purchases on bank liquidity is dubious. Let alone the hoped-for impact on inflation… has anybody seen the recent US inflation numbers?! (OK, OK, we can’t know the counterfactual!)

The third lesson is that monetary policy cannot be oblivious to fundamental imbalances in the economy, whether these take the form of fiscal imbalances, current account imbalances or large indebtedness in the household, corporate or financial sectors. This applies even to those central bankers fixated with (product price) stability. The reason is that the resolution of such imbalances is often “non-linear”—as in, abrupt and brutal and one that will tend to undermine the very price stability that the central bank claims to defend.

The eurozone came close to its "non-linear" experience by seeing the viability of the euro falling apart. The US (along with the rest of the world) felt it first hand, in the fourth quarter of 2008 and its ugly aftermath.

Both these instances suggest that Trichet may actually be wrong: The “M” and the “E” cannot be that separate after all.

Stopping the leakages in China

I’m increasingly convinced that there’s a bunch of algorithms out there with instructions to trade as soon as the word “hike” appears on a Bloomberg headline. Doesn’t matter who hikes or what they hike—milliseconds later, the market reaction is all but predictable: Stocks down, dollar up, commodities down, Treasuries sell off.

Take the Fed’s move to hike the discount rate: No matter that the Fed had warned about this; no matter that it made crystal clear this was neither meant to, nor expected to, affect financial conditions; the kneejerk reaction was all of the above (though, thankfully, actual people with brains stepped in subsequently to restore some sense).

Anyway, the lack of significance in the Fed’s move is too obvious to be worth discussing. What I want to dwell on here is another hike—that by China—where the implications (or lack thereof) are a touch less obvious.

So, you may recall that, at the end of last week, and right before the Chinese New Year holiday, China hiked banks’ reserve requirement ratio (RRR) for the second time this year. Both times, we got the all-predictable market reaction above—the rationale being that China is stepping on the brakes, prompting a slowdown in domestic investment (especially in infrastructure and real estate), commodity imports and global growth.

But as it happens, China’s RRR hikes have virtually zero impact on the country’s financial conditions. Indeed, as I’ll argue below, China has yet to show any signs that it is serious about avoiding overheating and asset bubbles in its economy in an effective and sustainable way.

I’ll start from the (non-)impact of the RRR hike first. In theory, a higher RRR can work to curtail credit growth in two ways: First (and most importantly), by affecting the price of lending—by reducing the average interest banks earn on their assets, it effectively forces them to raise lending rates to maintain their profitability. And second, by putting a ceiling on the quantity of funds/deposits available for lending.

However, in the case of China, both these channels are broken. Starting from the price, with interest rates prescribed "from above", lending rates have not budged since the end of 2008, when they were cut sharply to forestall an impending downturn. So no tightening there.

When it comes to the quantity of new loans, the authorities have set a target for new loans in 2010, at CNY 7.5 trillion. This is the second biggest ever (after last year’s CNY 9.6 trillion) and at least twice as high as in 2005-07, when GDP growth rates stood at double-digits. So, again, not exactly tightening.

Importantly, given the quantitative target for new loans, the hike in the RRR is in theory redundant: Once you have put a ceiling on new loan creation, what’s the point of trying to control quantities through hikes in the RRR?

In practice there may be a “point”... First, the authorities’ track record of enforcing their quantitative targets is less than stellar. For example, last year, new loans exceeded the target by almost 100%!

This year they’re trying harder: According to local press reports, regulators are closely monitoring new loan creation with a 30/40 rule, under which new loan creation in each quarter cannot exceed 30% of the whole year’s quota; and new loan creation in each month cannot exceed 40% of each quarter’s quota. Arguably, the hike in the RRR can provide an additional source of restraint in banks’ ability to lend…. But does it?

No. And here is why: What the RRR does is place an upper bound to the times a given amount of new deposits can be “multiplied” into new loans—all else equal, including interest rates, project riskiness, banks’ liquidity preferences, etc. In the case of a RRR of 15.5% (that’s the simple average of China’s 14.5% for small banks and 16.5% for large ones), this “multiplier” is equal to 5.5 times (=(1-RRR)/RRR).

That’s not really binding. Consider this: With the current RRR, it just takes a deposit “base” of CNY 1.3 trillion (or US$200 billion) to create new loans of CNY 7.5 trillion, China’s quantitative target for 2010. But the annual flow of new deposits is much higher than this, due to China’s commitment to a fixed exchange rate regime: Indeed, PBoC data show that some US$200 billion of (largely unsterilized) flows have entered the system in the six months to November 2009 alone (perhaps a little less, if one takes into account valuation effects).

Unless the inflows are either sterilized (which would require higher interest rates) or meaningfully reduced (via a CNY appreciation), “leakages” in new loan creation seem all but inevitable. Mind you, not just new loan creation.. excess liquidity can also be directed to the stock market or real estate assets at home or in Hong Kong, fuelling bubbles—already a concern for many investors and policymakers in Asia and elsewhere.

Bottom line, China’s recent measures fall way short of sending a signal that it’s serious about preventing overheating and asset bubbles. Quantitative and administrative measures can go only as far. The real McCoy would be a hike (or multiple hikes) in interest rates, and soon… much sooner than the Fed, which, in my humble opinion, is not moving on the rates front till next year, barring major surprises in inflation expectations or employment.

In turn, this means the exchange rate will have to give: Controls on capital inflows will fail to stop hot money from coming in, right as the tightening cycle is about to begin.

Is that the course of action the authorities envisage? Nobody knows. But in the meantime, the one advice I can give to all those algorithmic traders out there is that it may be time to expand your "vocabulary".

The good, the bad and the irrelevant

If I’m not mistaken, the Senate election last week was held not in Michigan, nor in Mississippi, but in Massachusetts: America’s highest-ranked state by health-insurance coverage and education, and the third-highest by per-capita income.

If I’m also not mistaken, the winning candidate lured voters not with his ruthless bank-bashing (on the contrary!), but by flagging himself as an “independent” with a (supposedly) fiscally conservative agenda.

Against this backdrop, the knee-jerk reaction that came out of the White House shortly after Tuesday’s results is not just bad (polarizing, desperate) politics; it’s also bad policy—irrelevant and potentially harmful policy.

Starting with irrelevant: The proposed “Volcker Rule”, which would prohibit banks “to own, invest or sponsor hedge funds [or] private equity funds” or engage in proprietary trading does exactly nada to address the causes of the financial crisis. These were:

(a) the inability of banks and their regulators to grasp, let alone contain, the level of systemic risk resulting from their highly leveraged operations;

(b) abundant liquidity, easy credit and the search for yield (call it greed if you like); and

(c) as a result of (a) and (b), too little capital to support the ballooning debt in the financial system and the real economy (esp. households).

Constructive initiatives to address systemic risk and capital adequacy are already underway, with high-level institutions like the Bank of International Settlements preparing proposals in these areas. These would include more effective and transparent rules for loss provisions, pro-cyclical capital buffers, a resolution framework for “too big to fail” institutions and stricter liquidity requirements.

What does the Volcker Rule add to this discussion? What… you said more protection to the taxpayer from the high risk takers?! Well, no.

Basically, the Volcker “rule” is grounded on an erroneous assumption: That only institutions that receive deposits from the man on the street are worth stabilizing with taxpayer money (e.g. through deposit guarantees) because of their special role in economic growth.

But this is clearly misplaced. Non-bank financial institutions such as money market funds, finance companies and securities lenders/dealers are absolutely instrumental for the flow of corporate finance and household credit. As such, they are very much “systemic” from an economic growth point of view. One can only recall the complete meltdown of the US and the global economy when Lehman was allowed to fail! Lehman was not a "bank"—yet it warranted an orderly resolution, which—at that stage—had to risk taxpayer money.

In light of this, the relevant policy response is not to --effectively-- force financial institutions to make a choice between their deposit-taking (ie banking) services and their "non-bank" activities. Instead, it is to recognize that what are seen as "non-bank" services are often very much "bank-like" and should be regulated approrpiately with the view of promoting sensible risk-taking across the balance sheet.

By "bank-like" I mean, first of all, maturity transformation. Take finance companies: They borrow short-term commercial paper to invest in instruments like mortgage-backed securities, which are backed by long-term assets. That's not far from plain vanilla banking. I also mean liquidity services: For example, securities dealers take deposits from their hedge fund customers, which are redeemable on demand, but then use the cash to fund their activities in credit market instruments whose liquidity can dry up instantly. This prompts funding uncertainties and a potential run on the dealers... and thus needs to be addressed.

Yet, rather than a targeted regulatory proposal, we get the Volcker rule--a waste of precious political capital and resources for a measure that is ultimately irrelevant!

Then you have the greed problem—and a problem it is! But containing it requires effective regulation, not populist one-off measures (which can backlash).

So what type of regulation can be effective in reining in greed in executive pay? Once again, some initiatives are already underway. The Federal Reserve for example has made a set of recommendations to better align incentive compensation with the risks undertaken by financial sector employees and also with their long-term performance.

But more may need to be done--if, for example, high executive pay turns out to be the by-product of an unduly monopolistic environment in the financial sector, which in turn leads to abnormally high earnings. Indeed, as I argued here back in November, a comprehensive assessment of the benefits and costs of the financial sector’s existing market structure and the identification of measures to improve it should be a top policy priority.

Yet, what we get is a bank tax! OK, may-be one can justify it by the extraordinary, government-backed recovery in financial markets and the, admittedly, business-as-usual attitude by some banks in the sphere of bonuses until it was too late. But it may also end up being harmful: If competition in the financial sector is limited, banks will have the market power to pass on the cost of business to their customers! And this can’t be good for lending nor for the economy more broadly.

Beyond the irrelevance of the proposals, what is far more disappointing is the new tone coming out of the leadership. Here you have the sober, Harvard-educated President, who excited many an independent voter with his intellectual approach to politics and policy back in 2008, employing an increasingly populist vocabulary.

Not only does this alienate independents further. It also raises the level of political risk for businesses and the markets, undermining the one visible achievement this Administration can claim credit for: The restoration of some sense of stability and order in financial markets and, with it, the recovery of a substantial amount of households’ financial wealth and confidence more broadly.

It would really be a shame if the (mis)reading of an electoral outcome ignited a policy agenda that is ill-focused, time-consuming and potentially unsettling. One can only hope it’s not too late to change tack.

Great Walls of Cash

With stock markets still shaking our nerves and rattling our brains, it has become fashionable to look at the piles of cash still parked in savings and time deposits and money market funds and argue it can only be bullish for stocks.

The argument goes that, as fear continues to recede, investors will put their excessive cash holdings back into higher-yielding assets, which is clearly good for equities. Indeed, some go as far as to contend that this excess liquidity alone can provide support to equities in the near-term, even if economic data fail to (positively) surprise us in the coming months.

I’m about to take issue with this argument, but let me say it’s not exactly on theoretical grounds… From a macroeconomic perspective, an excessive increase in liquidity should affect asset prices by driving up the demand for less liquid assets—be it stocks, bonds, real estate or a Rodin sculpture.

In fact, this portfolio-rebalancing channel is partly the theoretical rationale behind the Fed’s quantitative easing: Flood banks with cash to the point that they are so overwhelmed by it that they decide to give some of it up in exchange of less liquid, riskier assets—like loans to the private sector.

Here is the problem, however: It’s not exactly clear when liquidity is “excessive”. Most measures of “excess liquidity” have flaws that are likely to be exaggerated in the current environment.

For instance, some compare the current stock of M2 (or the subcomponent of M2 that comprises savings deposits, time deposits and retail money funds) with what M2 would have been, had it grown at the potential nominal GDP growth rate. This latter is the combined rate of potential real GDP growth and the Fed’s “target” inflation rate (that is consistent with price stability).

[Incidentally, the rationale behind such a comparison is the so-called “quantity theory of money”—the idea that money supply should only expand to reflect the expansion in the demand for goods and services (aka GDP), assuming a constant financial “technology” and stable inflation expectations.]

The problems with such a comparison are clear: The first has to do with the inevitable “ad hocness” of having to pick a base year. Another has to do with the sensitivities of the results to different assumptions of what is a reasonable potential GDP growth.

One way to bypass these problems is to look at the ratio of M2 (or your favorite broad monetary aggregate) to GDP, and whether it deviates from “trend”—with a positive deviation pointing to “excess” liquidity. (In the same spirit, some look at deviations of credit/GDP from trend). In fact, the current M2/GDP ratio appears to exceed its trend levels, suggesting(?) that cash holdings are excessive.

But this is not good either… First, the resulting deviation from trend is sensitive to the way we choose to specify the trend itself (linear, etc), as well as the period over which it’s specified. Second (and most important in my view), this approach relies on fairly naïve assumptions about the demand for money—namely, that money demand is solely determined by the demand for goods and services, while everything else is constant (technology, expectations, etc).

The obvious (and my preferred) way to correct this is to compare current monetary aggregates with a theoretical estimate of money demand that is based on a more sophisticated specification of money demand than the one suggested by the quantity theory.

But good luck with that! Not only would the resulting estimates be dependent on your chosen specification; the main problem is that, in the present environment, any model estimated on historic data will likely produce misleading results, given the huge shock on investors’ liquidity preference brought by the financial crisis.

So is there a way around this?

One way is to tackle the portfolio-rebalancing argument head on: By looking at “imbalances” in the composition of investors’ portfolios. The idea is that, if such an analysis finds that investors are, on aggregate, heavy on cash and short of equities, they will have to rebalance by selling cash and buying more equities.

In fact, in this spirit (I guess), one often quoted ratio is that of M2 (or just the sum of savings & time deposits plus money funds) to the market capitalization of the stock market. This ratio is currently still very high by historic standards, suggesting an imbalance (excess cash) that, it is argued, is bullish for stocks.

I actually think that this is a bogus ratio to look at. Investors’ portfolios do not comprise just cash and equities, but also bonds and other forms of wealth including real estate.

Importantly, the whole idea of portfolio rebalancing hinges upon the idea that there is a “benchmark” (optimal) allocation that the rebalancing will try to achieve. But what determines that benchmark?

Many analysts just eyeball the data, take the long-term average and claim that current levels are excessive compared to that average… ergo, rebalancing (out of cash and into equities) will have to occur.

But looking at the long-run average (i.e. a constant) for a benchmark is naïve: The benchmark is not static, but time-varying, depending on the expected risk and return on each asset class: equities, fixed income, cash and so on.

So what do we get when we take this into account? One of the big investment banks on Wall Street conducted the analysis recently, looking at a global portfolio of stocks, bonds and cash and taking into account the time-variation in the benchmarks.

Evidently, the results depend on one’s assumptions about the expected returns for each asset class, and notably for equities: Per their assumptions, a great deal of expected future stock returns is influenced by past stock returns over a given (long) period of time... which, these days, translates into relatively low expected returns for equities, in light of the two stock market busts that we’ve had in the course of 10 years.

Accordingly, despite their recent increase, global cash holdings actually come out to be in line with the “benchmark” allocation. The “overweight” asset class turns out to be bonds, with equities on the underweight side.

Obviously, changing the assumptions (e.g. positing higher equity returns based on, say, forward-looking assumptions) would change the outcome.

But if there is a conclusion here is that simply looking at those great walls of cash says very little about whether stocks are about to be set on fire!

Treasury myths

So that’s what it takes these days, huh? A few “bps” along the yield curve, scattered wobbles in the equity markets and a falling dollar for people to start prating about inflation scares, monetary debasement and what to do about it!

Big deal, I say. Headlines aside, the market moves we’ve seen in recent weeks are not only minute by inflation-scare standards but, actually, have little to do with inflation at all. Instead, they should be seen as part of the markets’ steady march towards normality.

Let me throw in some evidence:

The “sell-off” is global: First, the recent rise in long-term yields is not just an American phenomenon but a global one. Ten-year yields have gone up in countries like Germany, France or Canada, which haven’t yet embarked on quantitative easing (i.e. the purchase by the central bank of government bonds or other assets to reduce long-term yields and boost aggregate demand). Even Japan, which is already in deflation territory, has seen its long-term yields rise!

Sure, the rise in US yields has been larger than in those countries: Ten-year US yields have gone up 1.50% this year, i.e. more than twice the increase in European or Canadian yields.

But that’s from the absurdly low levels reached late last year, as the financial crisis deepened and investors rushed into the liquidity and “safety” of US Treasuries. So, effectively, US yields are now playing catch-up with foreign ones, as investors feel better about the health of the financial system and are beginning to look for higher returns elsewhere. The steady decline in corporate spreads, even as Treasury yields trod upwards, only confirms that view.

Misleading TIPS: Then you have the TIPS—the Treasury Inflation-Protected Securities. These are government bonds indexed for inflation. Analysts have historically looked at the difference between the yields of standard (or “nominal”) Treasuries and those of TIPS of the same maturity to derive an estimate of investors’ inflation expectations.

Since the beginning of the year, the difference between five-year nominal and real yields has “spiked” up by roughly 1.5%, prompting sounds of alert in some segments of the investor community.

But the analysis is misleading: The comparison of TIPS with nominal Treasuries is not an “apples to apples” one. There are two opposing forces affecting the yields of TIPS that make the comparison an art more than a science.

The first force is related to the uncertainty about the inflation outlook. When you invest in nominal Treasuries, the yield you require will be equal to the real interest rate plus your expected future inflation rate; but it will also include additional compensation for your (or the market’s) uncertainty about the inflation outlook. TIPS eliminate that uncertainty and therefore their yields will in theory be free of that inflation premium (i.e. lower).

The second force works the opposite way and is related to the relative liquidity of nominal Treasuries and TIPS. TIPS are less liquid that standard Treasuries and investors will therefore require additional compensation for holding on to them—a liquidity premium.

The bottom line here is that deriving the “true” inflation expectations from a comparison between TIPS and nominal yields requires disentangling these two effects—it’s not a simple act of subtraction.

If this disentanglement has been an art in the past, today it has moved well inside the borders of abstraction. The reason is that, as the crisis escalated last year, the relative liquidity advantage of nominal Treasuries became such a dominant factor that the yield investors demanded from TIPS moved above the yield of nominal Treasuries! In plain terms, not only were you getting inflation protection; you were also getting paid for it!

The decline in TIPS yields this year should therefore be seen in the context of normalization of liquidity conditions and risk appetite, rather than a “surge” in inflation expectations. Indeed, survey-based measures of inflation expectations such as the University of Michigan’s 5-year-ahead inflation expectations or the Conference Board’s 12-month-ahead number do not point to any measurable increase in expected inflation.

The dollar’s woes: The dollar’s broad-based sell-off is part of the same story: A story of normalization in liquidity conditions, appetite for risk and higher yields, and renewed investor focus on economic fundamentals. It has nothing to do with fears of monetary debasement.

The dollar surged at the height of the financial crisis for reasons largely unrelated to the health (or not) of the US economy relative to its peers: One reason was the flight to the safest and most liquid securities around, which are (still) the US Treasuries. Another was the tremendous funding pressures faced by banks.

Basically, as Lehmans collapsed, banks across the globe found themselves short of cash and, in particular, short of dollars—which had been the currency of choice for funding all the “exotic” stuff that originated in the US, like mortgage-backed securities, collateralized debt obligations and so on. Demand for dollars surged therefore, and so did the dollar’s exchange rate.

But funding pressures have been coming down. You can see that for example in the Fed’s balance sheet: Term auction credit to US banks has declined by $80 billion this year, while the Fed’s swap facilities set up to provide dollars to foreign central banks (which, in turn, lent them to their own banks so that they can meet their dollar needs) have shrunk by $370 billion.

Market indicators also point to the same direction: I’m about to get a bit nerdy here but you can look for example at the difference between the short-term interest-rate differentials between, say, the dollar and the euro as implied by exchange-rate forwards; and as implied by the LIBOR (interbank lending) market.

These should be almost equal in normal times due to arbitrage. But at the height of the crisis, as the LIBOR market shut down, investors turned to the FX markets for their dollar funding needs, creating a large spread between these two differentials that pointed to a huge premium for owning dollars. The spread has now come back to normal levels.

Given the widely known weaknesses of the American economy, and opportunities for higher returns elsewhere, it was only a matter of time before the dollar began to sell off. The gradual normalization in financial markets, together with perceptions that some foreign markets might be more resilient to the global slowdown than the US itself, prompted investors to seek to put their money at work elsewhere.

Indeed, as mutual funds data suggest, US investors have been net buyers of foreign equities for 11 consecutive weeks now. Clearly, this may not be a one-way street, and may reverse as the global economic outlook changes. But my point here is that the dollar’s recent sell-off is unrelated to putative concerns about monetary debasement.

I could keep going but I’ll stop here for brevity’s sake… with one additional point, especially for my friend Ben:

Credit conditions have been easing, even while Treasury yields are rising. Indeed, the increase in Treasury yields is partly the result of credit easing. Therefore, the case for the Fed’s Treasury purchase program, whose stated objective was “to improve overall conditions in private credit markets”, is now weaker than ever.

If Ben wants to expand the purchases beyond the original $300 billion, as some analysts have called for, he will have to find another reason. And, frankly, the only reason I can think of is “to avoid at all costs disappointing the markets”!

Never mind the gap

In case you were looking forward to my judicious insights on how to best get off the subway, you're about to be disappointed: It’s the output gap I’m gonna talk about—the difference between aggregate demand and an economy’s potential supply.

Some inflation hawks out there have taken the task of trashing the usefulness of the output gap as a guide for monetary policy decisions, in order to extrapolate scenaria of high inflation as a result of the Fed’s current money-printing enterprise.

But the argument is misplaced… Not because the possibility of high inflation is far too remote (I’ll come back to that in a minute); nor because the criticism re. the output gap is unfair (it isn’t). It’s just that the inadequacies of the output gap framework fail to provide a reason for casting Cassandra-isms on the inflation outlook.

But let me go a step back.. on the output gap... The concept has been used for years now by economists—including the Fed—as an important component of their modeling toolkit to forecast inflation and guide their monetary policy decisions.

The idea goes like this: When aggregate demand is higher than potential supply, inflation should be expected to go up—therefore the Fed should raise interest rates to prevent an undue acceleration of prices. The opposite holds when aggregate demand is lower than potential supply, which is believed to be the situation today.

The problem with this framework is that nobody has ever seen an output gap—the “potential output” of an economy is unobservable and has to be modeled for. As such, it is subject to a lot of uncertainty, given different model specifications and/or the frequent data revisions that occur as our information about the economy improves over time.

That may not be as big a deal for someone who wants to conduct a historical analysis. But it’s a serious issue when it comes to policy-making in real time, as has been frequently pointed out by renowned monetary economist Athanasios Orphanides (formerly at the Fed). Orphanides has found that the often inevitable mismeasurements of the output gap in real time could lead to inferior policy responses, even compared to policy responses that are guided by a simpler framework, e.g. one that uses past output growth instead.

That’s all solid and good. But is there any connection with the inflation omens of our times?

One supposed connection is the idea that we may be mismeasuring the output gap right now, by a significant amount. In other words, the Fed may be under the illusion that aggregate demand has fallen way short of potential output and, as a result, keep monetary policy too loose for too long.

The reason for the illusion could be that the economy’s potential supply has fallen beyond imagination: For example, the "equilibrium" unemployment may have risen as laid off workers need time to retrain in order to find new jobs; meanwhile, firms may shy away from putting new capital to work as they seek to repair their balance sheets a retool for a tougher financing environment.

While plausible, the drop in potential supply would have to be pretty severe to justify a high inflationary scenario based on the output-gap framework. It's like saying that the "natural" unemployment rate has gone up to 9-10% (ie near or above current levels). Not impossible, only that since nobody has perfect information about the current output gap, the conjecture is as inadequate for guiding the Fed's policy decisions as the argument of the opposing camp.

Then you have to think of the alternatives. I mean, fine, academic research has shown that the Fed’s output gap framework is not the holy grail of real-time inflation forecasting: Alternative models of future inflation could produce superior policy responses, e.g. models of inflation based on past inflation alone, or a combination of past inflation with past output growth.

But what would these models tell us today? With both inflation and output growth having gone downhill recently, even these “superior” models would still fall short of predicting a scary inflationary scenario.

So hawks need additional ammunition. And they find it in the Fed’s expansion of base money—the result of its credit/quantitative easing operations. But now things become flakier.

As I’ve argued in past posts, the usual monetarist argument that a large-scale expansion of money supply leads to inflation appears naïve at present, as it assumes a stable demand for money. But this has clearly not been the case, as people, banks, everyone rushed away from risky assets towards liquid alternatives (read “money”!).

So should we sleep in peace then?

Well no... I didn't say there has been no policy blunder. In my view there has been, though not in the choice of an inflation model, but in the effort to manage inflation expectations.

First by communication: The Fed has yet to be crystal clear about the hierarchy of its objectives in the case where inflation, growth or credit conditions start drifting in conflicting directions (e.g. inflation heading up while growth remains subpar).

Importantly (and I can’t say this enough), the Fed screwed up in my view by deciding to buy Treasuries. Apart from the very shaky empirical evidence on the effectiveness of Treasury-buying in bringing down long-term rates, the policy has spread confusion about the Fed’s intentions, fuelling suspicions about debt monetization at a time when the incentives to do so are pretty strong. (See here for more on this issue).

Indeed, one could conceive a spiraling scenario whereby large Treasury purchases end up undermining confidence in the Fed’s credibility and the US dollar, prompting a sell-off in the currency, leading to inflation, undermining the Fed’s credibility further and so on. We kind of saw tiny hints of this last week with the dollar sell-off gaining momentum.

I don’t want to sound like a Cassandra myself. Especially because economists have a very poor understanding of how agents form their inflation expectations and, importantly, how expectations react to different sets of policies.

So I could go on speculating that the Fed’s Treasury buying will fuel inflation via a collapse in the dollar, while you argue for the opposite by pointing to the various indicators of inflation expectations (TIPS, surveys to economic forecasters, wages, commodity prices, etc), which (still) remain fairly well-contained.

Perhaps if there is any conclusion to be drawn out of this is an admission that we are all pretty much clueless.

Time to ditch the PPIP

You know the world has changed when you go out for a drink with a banker (from the “legendary 19”) and he orders “anything without government in it”! Out of curiosity I seconded the order, and we both received a commiserating look and a vodka tonic.

Anyway, the topic du jour is the PPIP… Revisited after several rounds of thinking, as well as conversations I had with a (small) sample of eligible buyers and sellers. And I am convinced more than ever that the scheme has become useless.

I mean, literally. First of all, in the post-stress test era, I’m having trouble to understand why we need to subsidize investors with taxpayer money to bid up the prices of the banks’ legacy assets.

Think about it… IF (big IF) we were to take the results of the stress tests at face value, banks are fine (we are told), provided they can raise the amount of capital they were instructed to, privately or otherwise. This is because the stress tests have already taken into account the expected losses on banks’ assets (over 2 years), including the “legacy” ones, even under an extremely bad scenario.

But if that’s so, banks shouldn’t need additional help in the form of artificially high bids for their legacy assets. At best, they could sell them to the private market and fetch prices consistent with the government’s own analysis. At worst, they could keep them in their books for a couple of years, possibly more, and still be comfortably capitalized and ready to lend to businesses, mortgage borrowers, you and me. So, why PPIP?

One reason could be that the stress test results are a joke. But let’s not be so harsh… Even if the stress tests results are sound, the PPIP might still be useful if it could facilitate the process of “price discovery” for the legacy assets. But this is not the case.

The whole point of providing private investors with cheap government money is to encourage them to bid up the prices and help bridge the gap between what sellers would love to receive and what buyers would be prepared to pay in the current market conditions. (The idea is to avoid having sellers incur massive losses that could force the government to acquire unacceptably high equity stakes in banks and be accused of the N-word.)

But this is not “price discovery”. It’s a subsidized purchase. As such, it will do little to catalyze market activity in banks’ illiquid assets more broadly, since buyers will not risk bidding high for assets that are not covered by the government’s funding. It is even questionable whether investors would be willing to take the risk to buy securities with maturities longer than the government’s funding.

Ironically, price discovery is happening already in private markets, at least for some “legacy” assets. I am not in this field so what follows is anecdotal, but I understand that at least some “legacy” securities and even loans are being sold and bought as we speak.

Indeed, if you want to see price discovery, you might not have to go further than the sales of loans and securities conducted by the FDIC itself! These are asset sales on behalf of the numerous banks that have been going bust every other Friday or so and that the FDIC (shhh!!) nationalizes before turning them around and re-selling them to new private owners.

True, the prices fetched may not be prices that the FDIC (or the taxpayer, for that matter) likes. But the merit is a swift turnaround of the failed banks, which can then be run by new (better) owners and start lending again. At the same time, the “legacy” loans are passed on to investors with better expertise in distressed assets, loan work-outs and the like, who should be able to maximize the value of these assets (sure, for their own benefit, but also at their own risk!)

Then you also have the problem with the sellers. I mean, what’s in it for a seller? Oh, really? Higher prices? But take a look at the cost…

First, per my fellow drinker’s quote, eligible sellers loathe the idea of having anything with “government” in it. So that’s the starting point. The question is, is there anything that can incentivize them to participate anyway?

Well, one could be the government’s stick. But how strong is that stick? Post-stress tests (and related recapitalization), the government’s case for forcing banks to sell their illiquid assets has become weaker.

Beyond that, the incentives are few to none, especially in the absence of forced collective action. The reason is a big free-rider problem: An individual bank has every incentive not to sell anything, and wait (hope) instead that the participation of the other banks in the PPIP will improve financial market stability and lift asset prices more broadly. At which point, it will go ahead with its own sales, benefiting from the PPIP without having to bear the brunt of Congressional oversight or the public’s wrath for its taste for private jets.

So is there a solution?

Frankly, my preference has been, since time immemorial, for a fully government-owned vehicle to take over banks’ illiquid assets swiftly, at close to “market” prices (or at least prices consistent with a given probability distribution of economic scenaria).

The government could then manage these assets to maximize shareholder (taxpayer) value. Management would include, of course, selling these assets in an orderly fashion to private investors—only that taxpayers have all the upside (and the risk, of course, but they bear most of the risk now anyway).

This never happened because of concerns about heavy writedowns and concomitant bank nationalizations. Fine. But post stress-tests, the landscape has changed: The government’s case for a taxpayer subsidy to banks and investors is weak, especially as banks have been raising capital in private markets and trying to issue debt free of FDIC guarantees.

So maybe it's time to ditch the PPIP and let buyers and sellers sort things out privately, including bank recapitalization. If the latter becomes forbidding for some banks, the taxpayer can step in, with all the strings attached to maximize taxpayer value but also with the due arms-length approach to bank management that allows that value to flourish (something that is not happening right now in some cases).

Ultimately, you can't satisfy buyers, sellers and taxpayers all at once--something has to give. In my world, sellers are forced to take action (as in writedowns), but with the promise of a predictable, reliable and prosperous field ahead for private enterpreneurship (and bonuses!).

Because if there is anything all three groups agree on is the following: Nobody likes to have the government meddling in their affairs!

Ben's Shakespearean dilemma

Inflation or deflation? That is the question.

For all the increase in unemployment and excess capacity that this recession has brought (arguably, the perfect incubator for DEflation), there are people out there raising the INflation alarm.

Me thinks it’s the Fed’s fault. Not because of its aggressive expansion of (base) money. The usual monetarist argument that a large-scale expansion of money supply leads to inflation appears naïve at present, as it assumes a stable demand for money. But this has clearly not been the case: The financial crisis led to a sudden surge in the demand for money, as institutions and individuals fled riskier/less liquid assets in favor of liquid alternatives.

The problem has been communication. The Fed, with its actions, has created confusion about its priorities and objectives. Let me explain.

The “positives” first… Since September 2008, right before the “fireworks” began, the Fed’s balance sheet has expanded by $1.2 trillion. But almost half of that is the result of lending facilities (the TAF, CPFF, PDCF and ABCPMMMF) established to fill the funding gap that financial institutions faced, as counterparty risk skyrocketed and banks lost their traditional sources of funding. The corresponding expansion in money supply is therefore a response to a surge in the demand for liquid assets and, as such, it’s inflation-innocuous. Moreover, by design, these facilities are short-term and set to expire once the need for them is eliminated.

Secondly, in his communications Ben has been careful to subsume every single unconventional measure the Fed has taken under the “credit easing” sphere instead of “quantitative easing” (QE). In other words, the arch objective of these measures, we are told, is to help improve conditions in private credit markets (rather than to help create inflation, which was the case in Japan during 2001-06).

Very importantly, Ben has been talking time and again about the Fed’s menu of exit strategies, presumably with the view of addressing fears about inflation once financial conditions normalize.

But that’s where the clarity ends. Then come the (other) deeds.

Beginning with the Fed’s decision to purchase longer-term Treasuries. Not only are there theoretical reasons why they are likely to be ineffective in lowering long-term yields (I promise a post on this). Not only is there empirical evidence from Japan’s own QE suggesting that the so-called portfolio rebalancing channel through which it’s supposed to work had a small impact at best. Not only have long-term yields here in the US actually increased since the Fed’s announcement that it will start buying Treasuries on March 18th…

…Basically, not only are Treasury purchases a waste of money from a “credit easing” perspective; they are also a mistake, in so far as they breed concerns that the Fed is monetizing the government deficit and/or has inflation as an implicit objective.

This is not paranoia. We are in a world where the menu of unconventional central bank policies that Ben talked about in his famous “Deflation speech” are handicapped: The banking system is broke and thus incapable of fulfilling its role in the monetary transmission process (e.g. by lending out the cheap money the Fed is providing). Household and financial sector leverage is high, which means that, even if rates came down, the room for additional borrowing is limited. Importantly, the economy is in recession and the government is engaging in a massive fiscal expansion which, per CBO’s projections, would raise the government debt by a shocking 30% of GDP by 2012.

In other words, the Fed’s Treasury purchases were announced at a time when the Fed’s tools are impaired by a broke banking sector; and when high household debt and a huge fiscal deficit are creating strong incentives for inflating our way out. I mean, sorry, but this is the perfect setting for a “helicopter drop” of money—a measure proposed by Ben himself in that same “Deflation” speech. Combined with the dubious theoretical and empirical case for them, Treasury purchases can only confuse as to the Fed’s policy priorities and objectives.

Priorities, objectives… So here is a second source of confusion. The Fed has a LOT of objectives at the moment. Take a look at the March 18th FOMC statement:

The Fed “will employ all available tools to promote economic recovery and to preserve price stability.” The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities [..] and to increase its purchases of agency debt this year [..] to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses […].”

Everything but the kitchen sink! I should add of course the objective (me now) “to prevent a financial sector meltdown”, which has seen the Fed acting as lender of last resort to Bear Stearns, Citi and AIG; or (coming shortly) “to promote the orderly deleveraging of greedy financial institutions” through the Fed’s participation in the PPIP.

Luckily for Ben, for the moment all his objectives—stirring economic activity, credit easing and “price stability”—point in the same direction. That’s because “price stability” in this environment means avoiding deflation. But what happens if this alignment is broken? What would he do if the objectives become conflicting?

The answer looks unclear right now. On one hand, for the Fed to effectively bring long-term rates down, in the hope of stimulating aggregate demand, it has to credibly guide the private sector to expect that short-term rates will stay near-zero for a long time, even after economic recovery picks up. The Fed has indeed tried to do so, per the FOMC statement above (“conditions are likely to warrant [...] for an extended period”). Upward price stability would be a secondary objective, under this line of thinking.

On the other hand, Ben’s talk about exit strategies suggests that the Fed is very alert to the inflationary implications of the its current policies and stands ready to fight. Sounds reassuring but, if that’s so, it undermines the credibility of the Fed’s “promise” to keep rates low “for an extended period”.

There is no simple solution, obviously. But my preference would be (a) do away with the “try everything and see what happens” approach to policy-making; (b) do away with (or, at this point, contain) Treasury purchases; and (c) clarify that upward price stability will be *the* priority, if the environment warrants it, even if such clarity comes at the cost of a smaller “expectation effect” on the yield curve from the commitment to keep rates low for some time.

Ben is trudging through tough territory, I admit. But by dispelling “the question” about inflation once and for all, he might find he will not have to “suffer the slings and arrows of outrageous fortune”!

Ben's still dancing...

At first I thought I misheard… or that some charlatan journalist was trying to make headlines.

But no. Ben did say he's thinking of buying long-term Treasuries. His speech last Monday is crystal clear: “[T]he Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities […]”

Treasuries! Of all things! It’s like going to your favorite pastry shop, everything is at a discount, and you get a diet coke!

What’s wrong?

What is wrong is that this is the wrong solution to our problem, which is three-fold:

First, there is a huge hole in the balance sheets of banks, because a large amount of the assets in their books are either illiquid or junk or illiquid because they are junk.

Second, as a result of the first problem, there has been a brutal disruption in the availability of credit, as financial institutions hoard cash out of fear of each other, of nonbank firms and of their own ability to meet future obligations.

Third, the economy is on freefall, with the latest payroll numbers attesting to this (I’m looking for the superlative of “abysmal”).

So given these three aspects, what are the Fed’s priorities and objectives and what instruments will it use to achieve them?

Let’s start with the second, which is, ironically, the easiest part. By now, the Fed has established an entire infrastructure of facilities to address shortages of liquidity—the TAFs, CPFFs and ABCPMMMFs of this world. These are designed to be temporary, since the underlying assumption (and prayer) is that financial conditions will normalize.

That’s all good, only that along with praying, Ben’d better do something too. Like, deal with the first part of the problem, which is to plug the hole of the banks. What is he doing on that front?

It’s probably the Nth time I will argue “very little.” Yes, we had the use of part of the TARP (by the Treasury) to recapitalize some banks. Yes, we had the rescues of the selected few (AIG, Citi etc), partly with Fed money, to avoid a repeat of the Lehmans aftershocks. Yes, we had the announcement of the TALF, which was certainly a step in the right direction. But it has been very (very) patchy.

Take the rescue of Citi. It was last-minute. The modalities (fate of creditors, shareholders, etc) were a work in progress. No rationale was offered behind the amount of assets carved out of the bank (with the Fed's and the Treasury's help), including whether it would be sufficient.

Don’t get me wrong, it was the right “idea,” i.e. carving out assets on one hand, and plugging a potential hole with new capital on the other. But why not apply this approach uniformly and across the board of (systemically important) institutions, and clean up the system once and for all? And at the same time, prepare for the failure of institutions that (given our limited resources) we simply cannot rescue?

So let’s go back now to Ben’s idea of potentially buying long-term Treasuries. Clearly Treasuries are not really “toxic” (at least not yet!) and, as such, they’re not the kind of asset banks would like to see carved out of their books. So the purchases would do nothing to address problem #1 and, by extension, #2.

But then again, Ben really meant it as a potential means to address #3. Indeed, in his own words “This approach might influence the yields on these securities, thus helping to spur aggregate demand” (my emphasis).

Even here, this is not the most efficient use of Fed cash: First, long-term Treasury yields are super low already, so they don’t exactly need support.

Secondly, if there is any fear among investors that yields will go up in the future, that’s because of uncertainty over how inflationary of the Fed's easing is going to be—an uncertainty that is building fast, I should add, and which is not really dealt with by promising to, urh, print money to buy Treasuries!

Third, yields of, say, mortgages or loans to companies are high largely because banks currently demand a sizeable premium for liquidity (i.e. they’d rather hold cash or liquid Treasuries than lock their money on a long-term loan). This is not going to go away no matter how many Treasuries the Fed buys--unless the problems at banks get fixed.

So I’ll go back to my perennial call for the Fed to step in and buy a large chunk of the "troubled" assets in banks’ books. Like in the case of Citi, this should come in conjunction with a potential “refill” of bank capital, if the carve-out results in a new hole.

Buying toxic assets is better than buying Treasuries for another reason: IF the Fed is successful in revitalizing the economy, long-term Treasury yields are bound to go up (as growth expectations rise) and their prices would go down. This will translate into a large capital loss for the Fed.

On the other hand, if it buys the troubled stuff, success in rejuvenating financial markets will likely bring the yields of these securities down—at the very least because the "liquidity premium" will go down. Translation: The Fed could actually make a gain on at least some of these “toxic” assets.

Finally, let me throw another bombshell here--food for thought, you might say. This may be the time to revisit the desirability of an inflation-targeting regime for the Fed, of which Ben is a famous fan. Why?

Because uncertainty about future inflation is rising, as people get iffy about the expansion of the Fed’s balance sheet (which, by the way, is (still) non-inflationary for the reason I mentioned here). So this would be precisely the point where an explicit commitment by the Fed to a medium-term inflation target would help reign in inflation expectations.

Ultimately, what has been lacking all along is communication. Communication of the Fed's (and the Treasury's) accurate understanding of the size of the problem, their priorities and end-objectives, and the tools that will be employed to achieve them. We got one step forward last week, but Ben has now switched to foxtrot.

No offence, Ben, but it doesn’t look good! So why don’t you stick with the forward steps and let us do the dancing!


Glossary: troubled assets, cash hoarding, liquidity premium, communication, foxtrot.

The best is yet to come

In case you were deceived by the title into believing I’m about to offer my perspicacious insights on the future of the stock market, let me say you will be disappointed. In fact, I am about to disappoint you even more…

I will be temporarily cutting down on my weekly blogging activity, which I have (miraculously) managed to keep up for a year now, in order to embark on something, let’s say, bigger. I can see you’re about to be heartbroken so let me reiterate… this is not a “goodbye”, rather a less frequent “au revoir.”

So now, let me do give my penny’s worth of weekly insight, which comes after hearing numerous “voices” wondering whether it may be a good time to add on risk—“all these bargains out there,” “volatility is on its way down,” and “credit markets moving in the right direction, still not enough, but in the right direction.”

Perhaps. Indeed that’s exactly what you see if you look at a number of price-based indicators that market-pros are tracking these days. For example, the so-called “LIBOR-OIS spread”, that is the difference between the rates at which banks lend to each other and the Fed’s rates (as captured by the so-called “overnight indexed swap” rates) has been narrowing dramatically. Interest rates on commercial paper (used to finance companies’ day-to-day business) have been falling. So has the cost of insuring the debt of companies (CDS spreads), financials or other.

All suggesting perhaps that the painful dislocations we endured (and will always remember!) during September and October are thawing.

Or are they? I’m not convinced. You see, it would be marvelous if commercial paper rates were falling because the dawn is about to break, confidence is returning and banks are lending again. It would be splendid if LIBOR-OIS spreads had narrowed because interbank lending is truly rebooting. But I, not sure that’s the case.

My favorite indicators these days come from the Fed... The Fed’s balance sheet to be specific (and for the more cosmopolitan among you, you can also look at the balance sheets of the European Central Bank and the Bank of England). What we see is a pretty spectacular expansion of Fed lending—doubling since mid-September from less than a trillion dollars to two trillion last week. One trillion in a month!

What does this mean? First, that the Fed has effectively taken over financial intermediation. To put it in plain English, the Fed is right now the only functioning bank in this country—taking “deposits” by all the other banks, who cannot/will not lend, and lending it on to those banks who need it. So the decline in LIBOR-OIS spreads is to a large degree the result of the Fed’s (and the Treasury’s) backstop in the interbank market.

Ditto for lending to companies in the commercial paper market. For those relieved to see the issuance of commercial paper going up, let me point that this has been matched one-to-one by the Fed’s buying of that paper. In other words, the Fed has been the (only?) marginal buyer/lender.

Bottom line, financial markets are on a fibrillating mode, the Fed is the defibrillator, and as long as we don’t have a power cut of some sort, the game can keep going for a while, in the hope that the dawn will eventually break.

At least that’s what Ben is surely hoping, although I sense a whiff of despair and confusion in his quarters, with all that re-thinking of the AIG bailout, which has personally baffled me (hello? I though it was the Treasury that was in the bailout business, the Fed into the liquidity/ monetary policy business, and the Bear Stearns a “one-off.”)

ANYWAY. All this to end with a Frank Sinatra quote that encapsulates my mood of the day..

“The best is yet to come and won’t that be fine
You think you’ve seen the sun but you ain’t seen it shine”

The IMF as Global Fed

Is the world running out of balance sheets?

With banks “done”, investors terrified and corporates struggling to raise cash to keep business as usual, there was only one balance sheet left to (try to) resurrect the financial system: The government’s.

And so it went. Governments across the developed world stepped in with a joint $2 trillion-plus “rescue” package, while their respective central banks also injected hundreds of billions, determined to re-liquefy the system.

But now the crisis has entered a new Act: “Spillover to Emerging Markets”. Who’s gonna bail out those?

Enter the International Monetary Fund. The world’s designated financial firefighter, which, up till recently, was shunned as irrelevant by market participants swimming in an ocean of cheap credit. An institution vilified by many an erstwhile borrower for its stringent lending “conditionalities” and its perceived allegiance to west-style capitalism. A lender of truly-last resort; so truly-last that its acronym (“IMF”) was at times associated with the exclamation “I’M Finished!” (or the less eloquent “I’M F***ed!”).

No more. Countries from Iceland to Pakistan are lining up to negotiate their own rescue package, as the crisis spreads ferociously into their territory.

What has changed?

First, the Fund itself. Destitute and demoralized after years of inaction, the IMF is keen on putting its idle money to work and its army of economics PhDs on a business-class ticket to Reykjavik. So keen that it's considering sidestepping its (admittedly arteriosclerotic) lending guidelines in favor of more nimble packages—basically more (much more) money and fewer (if any) conditions.

Second, the stigma of IMF borrowing is arguably less of an issue than in years past. Why? Because, for once, emerging-market leaders can “market” their predicament as collateral damage from a major screw-up in the advanced world, rather than an obvious policy error at home.

While dubious under probing, the headlines are in their favor: Emerging Markets: Victims of a triple whammy of sharp declines in commodity prices (a key export for many); slowing world demand; and, crucially, a massive pull-out of foreign capital.

Now, emerging markets are special: The tools employed by advanced economies to deal with the crisis are not available to the likes of Hungary or Brazil.

For example, large government bailouts are not an option—emerging markets cannot borrow their way out of the crisis. Instead, the more they borrow, the bigger the fear they will default, and the larger the capital pull-out. Clearly, that’s not the case for advanced economies, not least America, whose debt (amazingly!) continues to be viewed as a safe haven by investors.

Unfair? Perhaps. But gets worse. As American or European banks cut their credit lines, emerging markets are left without money. Now this is not any money—it’s not their own Russian rubles or Hungarian forints their central banks can supply in unlimited amounts. It’s “hard” currencies they are short of—“hard” as in “respectable”, “sound”, “convertible” and “hard to find when foreigners are pulling out!” Dollars, euros, pounds, yen.

Once again, “rich” countries have an advantage: Their funding problems are (by and large) in their own currencies and, therefore, their central banks can be employed to provide the needed liquidity.

Gets even worse. While the Fed has established currency swap arrangements with its peers in the developed world, it does not (yet) have any such arrangements with central banks in the emerging universe. So if British banks, for example, are short of dollars, Bank of England can get dollars from the Fed to lend them on to its banks. Not so for the central banks of Brazil or Turkey, who will have to tap their own dollar reserves—reserves that, as we know, are depletable.

* * * * * *

So the IMF is back. But what can it do? I mean, its (much advertised) $200 billion-“strong” balance sheet is puny. Sure, it could provide some temporary help to the Latvias and Belaruses of this world, but what if Brazil or Russia were to go under? We’re not talking remote, idiosyncratic crises here, but a global disruption in liquidity. Mini-injections will hardly be of help.

What we need at this point is a global provider of liquidity… in hard currencies. A global version of the Fed. An institution that can “recycle” hard currencies from the cash-rich to the cash-strapped, until the bubble deflates, deleveraging subsides and investors come to their senses. The IMF could be that. Let me explain.

First, look at what the Fed is currently doing: Effectively, it has taken over financial intermediation in America: At a time when banks are reluctant to lend, hoarding cash instead, the Fed attracts this cash onto its balance sheet and lends it on to those who need it.

The Fund could play a similar role at a global level: Attract funds from the cash hoarders and lend it on to the cash-strapped. But who would give money to the Fund? Well, the Fed, the ECB, Bank of England, etc would be obvious providers of hard currency.

But here is another: China. As much as it enjoyed (and, indeed, fuelled) the global credit party while it lasted, China has been a silent observer of the demise of the global financial system. It’s about time it put a good chunk of it’s near $2 trillion of foreign exchange reserves into action.

So, were the IMF to garner the required funds, the question becomes: Who should it lend to? And under what conditions?

The “Who?” should not be difficult: Lend to countries that are illiquid, not insolvent. In fact, lend to insolvent too, provided they enter a program to restructure their debt. Let me say this is the IMF’s bread-and-butter expertise (the unfortunate instance of the 2003 program to Argentina notwithstanding!) so it shouldn’t be hard to dust off those crisis-resolution folders.

As to the conditions: Despair for action should not translate into an “anything you want” approach. Large-scale? Yes. Flexible? Absolutely. Nimble? Of course. But the programs should still aim at ensuring borrowers will be able to repay; and that IF(!) there was, indeed, some home-made screw-up, they use the opportunity to fix it.

Finally, let’s face it. The IMF is not the Fed. It can’t print its own money, nor can it rely on America’s taxpayers to cover up the hole. Moreover, unlike the Fed, there is no obvious collateral it could receive to make its lending more secure (Belarusian bonds? Russian vodka? Turkish kilims?) But then, who would bail out the Fund, if any of its borrowers were to default?

Ultimately, the IMF’s membership should stand ready to back up its balance sheet in the event it’s threatened. And they should unanimously reiterate the Fund’s preferred-creditor status, in letter and in spirit (no more Argentinas please!)

And if you think this is an ambitious, if not loony, idea, so be it. Just get ready to have another quarter like the one we’ve just had!


Glossary: IMF, emerging markets, global liquidity, conditionalities, preferred creditor, hard currencies, Turkish kilims.