Pragmatic Capitalism

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By now, we all know that QE2 wasn’t all that effective in helping the economy.   And after extraordinary measures, ZIRP, bank bailouts, endless loans, etc, some are saying that the Fed is completely out of bullets.  Still, like a group of masochists, we are looking to Jackson Hole and Bernanke’s speech to shed some light on what the Fed is going to do next to help get us out of this mess.

I’ve maintained for several years now that monetary policy was going to prove highly ineffective due to the uniqueness of our recession – a balance sheet recession.  Ineffective doesn’t mean useless, but the point is that there are more effective forms of government intervention than the tools the Fed has. In fact, one could argue that the Fed’s primary tool – credit expansion – is detrimental during a credit bubble.  Currently, fiscal policy in the form of a tax cut would be most beneficial given the political environment and the need for cash flow recovery during a balance sheet recession.  But since the Congress appears dead set on blocking any bill that might further “bankrupt” the USA we’re not likely to get any sort of fiscal measures that are going to generate any substantive results.  That leaves us with the Federal Reserve.  So, it might be helpful to review what options they’ve got left (emphasis on might).

What can the Fed do?

1)  Cutting the interest rate on reserves or cutting to a negative nominal rate.

What it means – The Fed would cut the overnight interest rate from 0.25% to 0% or effectively charge a tax on holding reserves or cash.

Will it work?   – As of last night the effective Fed Funds Rate was 0.07.  Cutting it to 0% is essentially meaningless as we’re already there for all intents and purposes.  Charging a fee by setting negative nominal rates would only act as a tax on consumers and/or banks.  Some economists have proposed charging a fee on consumer deposits in order to get them to spend.  But this misses the point.  Consumers aren’t spending because they’re overloaded with savings.  Just like businesses aren’t spending because they’re overloaded with savings.  Both consumers and businesses are suffering from a lack of consistent cash flows that gives them reason to reduce their savings relative to income.  Businesses are lacking revenues via demand and consumers are paying a disproportionate amount of incomes towards debt reduction. Charging a tax on savings is the exact wrong kind of solution for the current environment.  Not only would it reduce consumer spending, but it would filter through to lower corporate revenues.

Charging negative rates on reserves is equally misguided.  This would essentially serve as a bank tax with the idea that this might make banks more inclined to loan money.  But banks don’t lend reserves.  They are never reserve constrained so there’s no such thing as charging them a fee with the hopes that they will “lend their reserves”.  Banks lend when creditworthy customers enter their establishments.   Charging a fee on reserves would only reduce the net interest income to banks while having no impact on overall consumer credit demand.  Again, this would defeat the purpose of trying to boost aggregate demand.

2)  Language change.  

What it means – The Fed would alter market expectations through a change in their statement language.  This is essentially what they did at the most recent meeting when they altered “extended period” to a specific range (2013).

Will it work? – This is confidence fairy economics in my opinion.  I don’t know how this myth of “business uncertainty” has gained so much traction, but the bottom line is that businesses don’t hire because they’re feeling certain about what Fed policy is or isn’t.  They hire when they have higher revenues and an improved operating environment that gives them the certainty of knowing that leveraging their operation will result in a higher return on investment.  Altering the language in the Fed statements can change market expectations and it might even provide businesses with some clarity about the operating environment, but it’s unlikely to make a material impact in the real economy by increasing aggregate demand and ultimately business revenues.  Therefore, I see little reason to conclude that these sorts of language alterations do much more than alter short-term expectations.  Without a fundamental driver to help consumers during the balance sheet recession, this remains a weak policy tool at best.

3.  QE3.

What is means – The Fed would purchase more securities from the private sector.

Will it work?  – This depends on several factors.  There are a lot of different things the Fed could do at this point that would differentiate QE3 from QE1 and QE2.  They could alter duration, buy different assets, target rates, etc.

The one approach I have often discussed (and the primary reason why QE2 failed) is interest rate targeting.  This would involve the Fed setting the long bond rate explicitly.  The Fed would come out and directly say that the 10 year Treasury is 1% or whatever rate they desired.  They would then be a willing buyer of all bonds at that rate.  It would not be about size, but about price.  As I have said before, my fear, is that this would be viewed as pure monetization of the US government’s debt.  And while this view is not technically accurate, perception could have harmful effects via the speculative routes.  If $600B in “monetization” caused such rampant “money printing” fears then just imagine what will happen when the Fed announces that they will be a willing buyer of every single outstanding piece of US debt?  It could make the speculative ramp from QE2 look like child’s play.  Ultimately, I believe this would cause a further margin crunch on consumers as commodities price increases would lead to further cost push inflation.

The Fed could also repeat their actions during QE1.  This is what I initially believed the Fed would resort to during QE2 (because there appeared to be no other transmission mechanism that impacted the real economy).  This could include purchases of agency debt or MBS.  Given the fact that we are beginning to see strains in the credit markets again, this might be a more viable option and could actually be a good proactive move.  But we should be clear.  Like QE1, this would serve only to shore up credit markets and would not necessarily help the economic recovery via improving the state of the US consumer.  So this should be viewed as more of a downside buffer and not a stimulative response.

As I’ve discussed before, the Fed is legally permitted to purchase municipal bonds.  But again, I not only think is unnecessary as the states don’t require aid from the Fed at this juncture, but it would also be viewed as the Fed playing a fiscal role by “funding” the state governments.  Again, I do not think this is political territory that the Fed wants to enter.

The Fed is not legally permitted to purchase equities or corporate bonds at this juncture.  Doing so would require direct aid from the primary dealers or the arrangement of some sort of special purpose vehicle.  I am not sure the Fed is going to begin dabbling in such measures which would cause a political mess and could cause Congress to question the legality of the Fed’s actions.   Under the exigent circumstances clause of the Federal Reserve Act, the Fed could intervene in markets if the downturn were to deteriorate substantially.  But I don’t think we’re at a point where such Fed action would be justified.

The Fed can technically purchase foreign government debt, but is not permitted to bail out a foreign government.  In terms of the Euro crisis, I think the Fed is likely capped at its swap lines.  Again, buying foreign debt would be a messy political environment and the Fed is not in the business of politics.

4.  Making loans directly to banks and businesses.

What it means – Much like the many funding facilities used during the financial crisis, the Fed could re-implement some of the programs to help improve credit access.

Will it work – Again, we’re no longer in a credit crisis, but establishing some of these programs could be a wise proactive measures given the recent flare up in the European banking crisis.  It won’t necessarily prove stimulative, but it could provide downside buffer.  That would be an economic positive as it would remove a substantial downside risk.

5.  Prompting Congress to provide more fiscal aid.

What it means – When Ben Bernanke implemented QE2 last year he petitioned Congress for more fiscal aid.  He could again tell Congress that we are in an unusual predicament, we are not bankrupt, we cannot “run out of money” and we can afford to spend more money to aid our citizens.

Will it work?   Prospects look grim.  A push for a payroll tax cut by Bernanke could gain some traction, but I am not getting my hopes up.*  And unfortunately, I think Dr. Bernanke believes QE is needed to help “fund” this new spending so this idea could be a moot point if he petitions Congress for new fiscal aid and then implements a QE3 programs that sparks a market response that offsets the stimulative effects via cost push inflation.

The bottom line – The Fed has options here though their toolkit is looking depleted.  They certainly have options that could prove proactive in stopping some potential hemorrhaging from any European credit contagion.  But we should be clear.  The Fed’s options in terms of stimulating the economy at this point are extremely limited.  But that doesn’t mean it doesn’t have tools in its kit that could prevent a potential recession from turning into a repeat of 2008.

Dr. Bernanke has to announce some sort of change in policy response this Friday.  The markets are all banking on it now and he has proven time and time again that he’s a believer in the misguided idea that the markets can lead real economic growth.  I don’t believe he can announce anything that will substantially alter the economic landscape, but he’s proven more creative than he usually gets credit for.  Unfortunately, at this juncture, his toolkit is looking pretty limited on the stimulative side.  We’ll reassess his decisions when they’re in writing.

* Edited to correct payroll tax “cut”

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