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Pragmatic Capitalism

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Q&A – The Answers

Okay, I am going to have to apologize in advance here if I can’t answer all the questions immediately.  There are 90 comments in the Q&A which is quite a few more than we usually get in these Q&A’s.  I’ll probably be doing this in 2 or 3 parts so if your question doesn’t get answered this week then please ask it again in the permanent Q&A section and I will get around to it in the next few weeks.   Thanks and sorry for the inconvenience.  Here goes nothing:

Barak – I’ll reiterate my question from yesterday since it wasn’t answered: Hussman suggested this week that if the fed records losses on his balance sheet, and considering the level of treasuries and MBS that is not unlikely, it would force the treasury to inject it with money since it is leveraged now 55:1 (and much more ahead) and the losses will wipe out its capital completely. this would mean the fed forced fiscal policy, and would violate its mandate. can you elaborate on the mechanism of what happens if a CB goes broke in a fiat world.

 CR – The Fed can’t “run out of money” or have anyone except the Congress determine that it can’t operate as a solvent bank can.  There is no FDIC to come into the Fed and determine them inoperable.  The Fed operates like a bank except it has a unique difference – the only thing that really constrains the Fed’s ability to issue money is the US Congress and what MR calls quantity value.  It is not capital constrained or any of the standard constraints that apply to normal banks (like having the FDIC walk in on a Friday night and say “well, that was fun, where are the keys to your vault and books?”.  There is no such thing as the Fed becoming insolvent or bankrupt because it creates money by changing numbers in computers.  The only form of insolvency is if Congress determines it is insolvent or the currency is unraveling in such a manner that no one wants to accept the Fed’s money.  This could occur in a hyperinflation, for instance, if the banks were to stop performing their required actions as the Fed’s Dealers, but as I’ve often explained (see the hyperinflation section here), this is a highly unique situation and a very different type of environment than the one we’re currently in.  The more worrisome impact of Fed purchases is moral hazard and the way this sort of permanent “put” under the private sector impacts the future actions of the private sector….

Bernie – The Fed committed to buying mortgage-backed securities, are these left over from the bubble or are the banks still making more? How long can they continue to buy these (what is the amount of MBS available for them to purchase at a 40B/month rate)?

CR – The Fed will be buying over half of all agency MBS issued which is estimated to be about 100B-120B per month.  George offered a very nice summary in the original comments so thanks, George!

Reader “Brick” asked 5 different questions:

Brick – Q1) The Fed suggests part of the reason it acted was due to continued strains in global financial markets. Do you think the Fed perceives a threat to financial markets which the market may not yet have noticed perhaps through food inflation affecting the political stability in the world and global GDP or a Chinese downturn?

CR – It’s impossible to know what the Fed “sees” that might be disturbing them, but they obviously felt the economy was weak enough and the financial system at risk enough to implement a new round of QE….Personally, I wouldn’t read into all that too much though.  

Brick – Q2) By swapping MBS for cash do you think the FED will really affect the cost of mortgages, since low interest rates are starting to spark rises in mortgage fees and costs as banks try to make money, possibly negating the effect. You also have the risk that tax relief may be curtailed for mortgages next year. So the question is will the buying be big enough to affect house prices?

CR – One of my big issues with QE is that it really leaves the pricing power in the hands of the market.  That is, monetary policy “works” by setting prices.  So, when they target the overnight rate they are effectively setting the rate.  With QE, they name a quantity and let the price float.  So the market sets price based on its perception of what it thinks rates will be at the long end.  If they really wanted to set long mortgage rates lower they’d be better off naming the price precisely and defending it.  Instead, they implement QE without naming price and so the price floats to where the markets think it should be.  

Brick – Q3) MBS convexity hedging with treasuries as MBS yields fall could push down further on treasury yields. Does this affect bank profitability/mortgage fees and make exit strategies complicated? Will the search for yield as a result cause commodity price inflation ?

CR – You touch on an important point.  By reducing the yield income the banks earn by replacing high yielding assets with reserves, they are having a negative impact on bank balance sheets.  Unlike the disaster scenario in 2008, I’d argue that this is currently counterproductive.  Especially since adding reserves doesn’t give banks more fuel with which to lend.  

On the commodity front – I think we see near-term price distortions in many markets as a result of the misunderstandings from QE.  If you recall QE2 there were Chinese farmers hoarding cotton in their kitchens because they thought they were bound to be impacted by the inflationary impact of QE2.  Extreme example, but we’ve seen this in each of the QE’s.  The markets still have no idea how it actually impacts markets and so prices adjust based on many myths that haven’t panned out.  

Brick – Q4) Housing construction picking up would make a difference to employment, but the link between this and house prices is complicated. With a marked recovery in house rents is there a risk shorter term that house price inflation could accelerate rental costs more than buying, leading to less consumer discretionary spending ? Could you get a buy to rent housing bubble squeezing out first time buyers, much like the UK housing boom was ?

CR – Lots of speculation in answering this question.  The honest answer is I don’t really know.  Robert Shiller has previously found that there is a quantifiable wealth effect from real estate price gains.  I’d argue this largely gets the cause and effect wrong since housing is very directly tied to incomes, as is the rate of inflation.  So a sustainable increase in real estate prices without a large increase in incomes is unlikely.  But that doesn’t mean it can’t happen in the near-term due to distortions (as we saw in 2002-2007).  

Brick – Q5) Perception rather than reality will be that the FED is printing. Exuberance and portfolio re-balancing could cause inflation in unexpected places like oil prices, where if anywhere do you think this might occur?

CR – The most notable place is equity prices.  But we also see the impact in commodities.  Gold and silver have already rallied 10-20% on the QE expectations.  Inflation expectations have surged.  Of course, QE doesn’t cause inflation because there is no real transmission mechanism, but the market can stay irrational longer than we can stay solvent.  

Brick – Q6) Fannie and Freddie may become more exposed to higher interest rates(long time in the future ) and see lower margins. How does this complicated any resolution of what to do with the Agencies ?

CR – The agencies have become nationalized for all practical purposes.  I don’t think there’s much reason to worry about them for now.  

Bob Brogan – If the Trillions of dollar denominated securieies held by the Federal Reserve (private bank) are paid for by the US Treasury as an electronic transfer, can the transfer be reversed by the U.S.Treas. and in so doing extinuished the IOU by an accounting transfer?

CR – The securities are paid for by the Fed who will almost certainly hold them to maturity.  But there is a chance the transactions could be reversed with the Fed selling them back to the banks.  But this is unlikely in my opinion.  It would only occur if the economy were really booming.  Besides, part of the reason we’re paying IOER is so the Fed doesn’t have to sell anything back to the market to change the overnight rate if it needs to.  Many people arguing for lower IOER don’t seem to understand this.  

DWilliams – 1. How long do you see this accomodative policy needing to be pursued?

2. Since you think that QE offers little to stimulate the real economy, will the eventual unwinding of policy have a similarly small drag?

CR – I hope that’s Billy Dee Williams using a shortened name.  Most people loved you for your role in Star Wars, but they forget the impact you had on many Americans when you issued your rules for having a good time: Rule #1 – never run out of Colt 45.  And rule #2 – never forget rule #1.  I don’t know if Buffet issued his similar rules before or after that and I don’t care.  Both are brilliant.  

Regarding your questions – The Fed has said they’ll remain accommodative until at least mid 2015.  And on part 2 – Yes, the drag should be negligible since the stimulative impact is negligible. 

CharlesM – Draghi bazooka makes the euro go up. Bernanke bazooka makes the dollar go down. What is the logic behind these opposed consequences of accomodative policies?

CR – Good question.  The USD actually rose through QE1.  Frankly, I think the currency moves are based in large on on misunderstandings and irrational responses.  So we impulse reactions on the announcements based on the perception that the ECB’s actions are not inflationary and the Fed’s actions are.  The market really has no idea what the impact is.  The traders selling USD on QE are like chickens running around with their heads cut off trying to guess where the exit to the farm is….None of them know and better than the others it seems.

Debtneutrality -To make matters more complex, isn’t what really drives the economy how much consumer debt there is? Not only have americans lost from 7 to 10 trillion dollars in equity since 2006 (according to a Chase Bank investment prospectus), wages are flat while consumer debt continues to rise.

Until consumers can pay down their debts at zero percent interest, there is no real way to “fix” the economy, no?

CR – Well, one of the main things we learn from Monetary Realism is that credit is the dominant form of money in the economy.  So an economy that is saddled with an inability to service its credit will lag.  Growth in credit is consistent with growth in investment and growth in the private economy.  So when you don’t have a private sector that can afford to expand credit then you have trouble generating growth.  So I’ve said QE is a deficient policy in a balance sheet recession because consumers are paying down debt and not expanding their balance sheets.  This means monetary policies primary transmission mechanism (the credit markets) is broken.  

Cheng – Are the markets too high to be true? Will there be a crash by end of this year or Q1 of next year?

CR – Are the markets “too high”?  That reminds me of Major League when the Yankees hit the home run off Charlie Sheen and the guy in the Indians outfit says “no way, too high, too high” and his friend looks at him and says “too high?  What does that mean – too high?”  I used this joke all the time when someone does something great and no one ever picks up on it.  But it makes me laugh and since I’m the only one who thinks I am funny I keep saying “too high” all the time.  

Anyhow, I’m not sure “too high” is the right description.  I’d say the markets tend to become distorted by QE and the perceived inflation that will result.  But again, the markets can remain irrational longer than you or I can remain solvent.

What’sgoinon asked 3 questions:

What’sgoinon – 1. What is your outlook on treasury bonds and do you have a interest rate forecast?

CR –  Well, the Fed just told us rates are going to be low until 2015 or so.  So I’d say there’s your forecast.  I wouldn’t go piling all of your money into T-bonds right now, but you can pretty much eliminate the risk of a substantial price decline between now and 2015.  Dollar cost averaging into a bond position or laddering should serve investors well in the coming years.   But again, you need to consult your financial advisor as I am not here on Pragcap to issue you specific investment advice.  

What’sgoinon – 2. Of the debt (Treasury, MBS/mortgage, education, consumer/credit card, corporate, junk) the Fed could target with a QE program which would have the greatest impact on unemployment?

CR – I’ve repeatedly said that the Fed could pin the 30 year bond at 0.5% and it would dramatically reduce borrowing costs across the entire debt spectrum.  I don’t endorse that policy, but it’s a clear option.  

What’sgoinon – 3. If I understand correctly, after twist runs out (in December I believe) the Fed is limited to purchasing MBS of $40B/month only. The unlimited refers to no end of this program until employment improves. The question than is the Fed limited to the purchase of MBS only and $40B per month? And if they want to purchase treasuries or increase the amount they purchase this requires a different program?

CR – The Fed can alter the program however they want.  

Kobayachi – Bernanke told us that the reason for the next round of easing is to improve the labor market. How can anyone connect the buying of MBS with the labor market?  Isn’t that pushing on a string? Rates are already very low and that didn’t help the “real” economy.

CR – Right.  Well, the idea is multi-faceted.  The first is that it can push rates down.  As previously explained, this is a sub-optimal rate targeting approach.  The other transmission mechanism are communications and portfolio rebalancing.  Communications supposedly give the private sector the confidence to make decisions because the uncertainty is reduced.  But I am not so sure.  If you tell me rates are guaranteed to be low until 2015 then there is no urgency for me to act.  I have 3 years left to do whatever it is you’re hoping I’ll do.  Further, this just distorts intertemporal supply/demand.  As we saw during the housing tax credits, this sort of govt policy front-loads demand and then it falls off later.  And lastly, there is the supposed wealth effect from the portfolio rebalancing.  The basic idea is to make people feel wealthier by jamming asset prices higher.  As I explained on Friday, this puts the cart before the horse.  So the bottom line is, the transmission mechanism here is deficient.  

Cowpoke – Why is the 10 Year going UP???  QE is influencing it in the wrong direction.  

CR – Well, the market thinks inflation will rise as a result of QE.  So bond traders sell on QE because they’re worried about purchasing power.  Whether this is right or wrong is dependent on how well you believe a bunch of chickens with their heads cut off can predict the impact of a policy that no one seems to understand.  

Old Dog – How does the Fed buying MBS reduce the private sector debt load other than lowering the interest rates on those who refinance their mortgages?

To the extent that homeowners refinance investors in those MBS lose equivalent amounts of income. Net zero.

This action may increase housing transactions but it does nothing to reduce overall private sector indebtedness and it is that debt load that underlies the sluggish economy.

CR –  The hope is to reduce the burden on debtors by reducing rates while also getting new debtors to borrow.  It doesn’t reduce private debt.  It actually intends to increase it.  Which is why QE is deficient in a balance sheet recession.  The pvt sector doesn’t want more debt.  

Nepheric – By MR thinking is this QE actually deflationary?

Banks used ‘inside money’ to extend the mortgage loan and then packaged those loans to create the Mortgage Backed Securities. Now, the Fed is swapping that ‘inside money’ for their ‘outside money.’

The banks had an assest (MBS) that could be exchanged in the economy for inside money which could be used to extend more credit but now the banks just have more reserves that have no ‘inside’ use in the economy.

Wouldn’t removing $40B a month of ‘inside’ money be deflationary in practice? Banks will have less capital to extend as credit and less, not more, loans will be made. Have I got that right?

CR – No, the banks have the same capital position.  The reserves are an asset for the bank just like the MBS was an asset of the bank.  So it’s a clean swap.  No change in capital.  It might be marginally deflationary in that it reduces the interest the banks earn (high MBS rates swapped for low reserve rates).  But the Fed turns over all profits to Treasury anyhow so it’s really just that much less they feel the need to borrow.  And Federal spending is a redistribution so to some degree this is just money getting redistributed from the banks to the private sector in the form of government spending.  But since our government thinks there’s a solvency constraint on it, they see this as some great gain for the government that allows them to more quickly “pay down the debt” instead of boost the deficit during a balance sheet recession and give the middle class and indebted more cash to repair their balance sheets (which is what we really need here).  

Okay, that’s enough for tonight.  I’ll get back at it later in the week.  Sorry for the wait.  I’ll bookmark my stopping point. 

 

 

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