The Fed Policy Conundrum, Irving Fisher, the Yield Curve and the Budget Deficit
Carlos M Pelaez
The view of the Fed is that the economy expanded at a rate of about 4 percent in the second half of 2009 but a substantial part of that growth is explained by reduction of inventories, which is temporary, and the fiscal stimulus is phasing at the end of the year such that private sector final demand for goods and services will be the driver of growth (http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ). The job market is not yet dynamic and over 40 percent of the unemployed have been without a job for six months or more. The central tendency of the forecast of the Federal Open Market Committee (FOMC) is for GDP growth in 2010 of 2.8 to 3.5 percent, accelerating to 3.4 to 4.5 percent in 2011 with long-term trend of 2.5 to 2.8 percent. The unemployment rate would remain at 9.5 to 9.7 percent in 2010 declining to 8.2 to 8.5 percent in 2011 and to 6.6 to 7.5 percent in 2012. PCE inflation would remain in the 1 to 2 percent range. There is significant uncertainty in economic forecasts especially turning points. In retrospect, the Fed finds that the coordinated efforts with Treasury and other authorities jointly with substantial stimulus by monetary and fiscal policies prevented sharper decline and “are supporting now a nascent economic recovery” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ). The FOMC finds that low utilization rates of resources, restrained current inflation and stable expectations of inflation “are likely to warrant exceptionally low levels of the federal funds rate for an extended period” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ).
To be sure, short-term indicators only provide specific snapshots of conditions in a given segment of economic activity and need not point to overall economic conditions. However, various indicators during the past two weeks have raised doubts in the views on the dynamism of the economy. The most comprehensive indicator is the annualized rate of growth of 5.9 percent of GDP in QIV2009 but the breakdown shows that the most important contribution in percentage points (pp) is the change in private inventories by 3.88 pp followed by 1.23 pp for personal consumption expenditures, 1.09 pp by equipment and software, 0.30 pp by net exports of goods and services and -0.23 pp by government (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Qtr&FirstYear=2007&LastYear=2009&3Place=N&Update=Update&JavaBox=no ). Strengthening of the dollar in a world of “beggar-my-neighbor remedies for unemployment” may close the avenue of growth by net exports (Joan Robinson in her Essays in the Theory of Employment, Macmillan 1937; for comprehensive review of the Great Depression see Pelaez and Pelaez, Regulation of Banks and Finance, 197-217, and for current trade issues Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars, 174-84, Globalization and the State, Vol. I, 157-206, and Globalization and the State, Vol. II. 205-13). The issue is whether the government has tools to increase private demand for goods and services without deteriorating further the precarious fiscal situation. The index of consumer confidence of the Conference Board declined sharply in Feb by 10 pp to 46.0 from 56.5 in Jan (http://www.conference-board.org/economics/ConsumerConfidence.cfm ). The US Census Bureau and Housing and Urban Development reported a decline in new residential sales of 11.2 percent in Jan 2010 relative to the revised annualized, seasonally adjusted rate for Dec 2009 of 348,000 units sold, corresponding to decline of 6.1 percent relative to the rate of 329,000 in Jan 2009. The supply of unsold residences corresponds to 9.1 months at the current sales rate (http://www.census.gov/const/newressales.pdf ). New orders for manufactured durable goods reached $175.7 billion in Jan, corresponding to an increase of $5.2 billion or 3 percent after an increase by 1.9 percent in December. However, excluding transportation, new orders decreased 0.6 percent and increased by 1.6 percent excluding defense (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf ). Authorizations for building permits of houses declined by 4.9 percent in Jan relative to Dec partly because of the upward revision for Dec but still were higher by 16.9 percent relative to Jan 2009; housing starts increased by 2.8 percent in Jan relative to Dec and by 21.1 percent relative to Jan 2009 (http://www.census.gov/const/newresconst.pdf ). Existing home sales declined by 7.2 percent in Jan relative to Dec but are still higher by 11.5 percent relative to Jan 2009 (http://www.realtor.org/press_room/news_releases/2010/02/ehs_january2010 ). Seasonally adjusted initial unemployment insurance claims reached 496,000 in the week ending on Feb 20 for an increase of 22,000 relative to the prior week with the four-week moving average increasing by 6000 to 473,500 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). The employment report will be released on Mar 5, the IMS manufacturing index on Mar 1 and personal income and outlays on Mar 1 in a week rich in economic reports.
There are two views about the timing and doses of interest rate increases analyzed by Kelly Evans in the Wall Street Journal (http://online.wsj.com/article/SB10001424052748703503804575083873402927544.html?KEYWORDS=Bernanke+%22Kelly+Evans%22 ). First, the market view anticipates increases in the policy rate perhaps even this year because of the possible signal in the discount window increase by 25 basis points and shortening of the term to overnight. The market view resuscitated by the Treasury debt management guidance of increasing the Supplementary Financing Program (SFP) from $5 billion to $200 billion, corresponding to the level during Feb-Sep 2009, by eight $25 billion auctions of 56-day SFP bills every Wednesday beginning Mar 24 (http://www.ustreas.gov/press/releases/tg560.htm ). The proceeds of $200 billion from the issue of SFP bills will be deposited at the Treasury account at the Fed (for the origin of the FSP and its use in quantitative easing see Pelaez and Pelaez, Regulation of Banks and Finance, 225-6, Financial Regulation after the Global Recession, 158-9). The objective could be increasing the three-month Treasury bill from its near zero current level while withdrawing excess reserves without using the open market operations by the desk of the FRBNY and/or recreating an alternative liability to excess reserve deposits matching the securities assets in the Fed’s balance sheet. Second, the view of economists is that employment conditions, financial markets and economic recovery must be strong for the Fed to move into a tightening mood. In the past two recessions, characterized by milder loss of output and jobs, the Fed waited 33 months on average before increasing the policy rate and financial indicators were much stronger than currently (http://online.wsj.com/article/SB10001424052748703503804575083873402927544.html?KEYWORDS=Bernanke+%22Kelly+Evans%22 ).
Stress tests of banks use parameters of the bond market crash in 1994, which started in the US by the tightening of the fed funds rate from 3.00 percent in Feb 1994 to 6.0 percent in Dec 1994 (Pelaez and Pelaez, International Financial Architecture, 114-5, The Global Recession Risk, 206-7). The yield of the US 30-year Treasury bond increased by 150 basis points, causing declines in bond prices because increases of yields of 100 basis points caused declines of prices of 13 percent, which were magnified by typical leverage of 10:1. There was an increase in 30-year mortgage rates of 200 basis points that caused the loss of most of the value in funds of asset-backed securities. Europe was lagging the business cycle in the US and bond strategies consisted of long positions in higher-yielding markets that eventually also turned sour. Traders with long leveraged fixed-income and derivatives exposures waited for decoupling of European bond prices that continued declining during 1994. The correlation of bond yields of the US, European Union and Japan was only 0.18 and that of equities 0.40. Available statistical models failed to capture the much higher fed-tightening event correlation of fixed income and equities used in subsequent stress tests much the same as changes in correlations and effectiveness of hedge ratios caused by flight out of risk during the Long Term Capital Management (LTCM) event in 1998, converting LTCM’s hedged position into a short naked option (Philippe Jorion cited in Pelaez and Pelaez, The Global Recession Risk, 12-3). The Mexican crisis of 1994 was significantly influenced by the flight from risk and duration caused by the doubling of the policy rate by the Fed in 11 months, causing shocks in Argentina and Brazil. The 1994 episode resembles the increase of the fed funds rate from 1 percent to 5.25 percent from Jun 2004 to Jun 2006 that had strong effects in the credit quality of mortgages. The strength of labor and financial markets and the real economy were not major factors of fed policy. In the increase of rates in 1994 the Fed was concerned with inflation originating in commodity price increases that failed to spread to general prices. In the increase after Jun 2004 the Fed was escaping the 1 percent interest rate and forward guidance after deflation also failed to materialize, which was an important determinant of the credit/dollar crisis and global recession (Pelaez and Pelaez, The Global Recession Risk, 207, 221-5, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The fed has been managing monetary policy with aggressive changes in interest rates based on the view of the economy and financial markets six months ahead. There may not be sufficient knowledge about central bank policy for controlling the effects of these wide swings in monetary policies (Pelaez and Pelaez, Regulation of Banks and Finance, 108-112, Financial Regulation after the Global Recession, 74, 84-6, International Financial Architecture, 230-7).
The major conundrum of monetary policy at the moment is not potential inflation as in 1994 or potential deflation as in 2003 but rather the probable impact of the budget deficit and national debt in shifting upwards and twisting the shape of the yield curve. At the close of markets on Feb 26, the yield of the 3-month Treasury bill was 0.124 percent per year, within the target of fed funds of 0 – ¼ percent, along a virtually flat yield curve short-dated segment, rising sharply with 0.816 percent for the 2-year note, 3.619 percent for the 10-year note and 4.560 percent for the 30-year bond in a sharply-sloped long-dated segment (http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3012 ). Using the central forecast of the Fed as proxy for inflationary expectations, the Irving Fisher real rate of interest, or the nominal rate discounted by inflationary expectations, is negative for the Treasury maturities below three years (The Theory of Interest, Macmillan 1930, http://www.econlib.org/library/YPDBooks/Fisher/fshToI19.html ). The Fed may wish to revive the short-dated end of the yield curve by raising the rates closer to its central forecast for inflation. A danger of this policy could be the unquantifiable, uncertain repetition of the 1994 bond market crash during an incipient or nascent recovery. The alternative of doing nothing is perpetuating a negative real rate of interest with potentially more adverse effects of its future adjustment. Combinations and sequences of the arsenal of Fed policy tools are not immune to high risk of disrupting again financial markets.
The long-dated end of the yield curve may prove to be more difficult to manage because of two restrictions. First, the Fed’s balance sheet, as of Feb 24, 2010, shows $1227 billion of reserve balances of member banks deposits at Federal Reserve Banks and $1907 billion of holdings of securities of which $709 billion in Treasury notes and bonds, $1032 billion in mortgage-backed securities and $166 billion in federal agency securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). There are no doubts on the number and effectiveness of tools: the Fed has five instruments of withdrawing reserves, the interest rate on excess reserves held by member banks at the Fed and now again the Treasury SFP that can be used in various combinations and sequences (http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20100127.pdf ). The uncertainty is whether the effects of withdrawing reserves and increasing rates on bond markets and financial institutions funding with short-dated funds will be smooth or turbulent as in 1994 and after 2004. For example, a minute policy impulse could have much stronger effects on financial markets and possibly even the real economy if it triggers risk flight out of duration in Treasuries notes and bonds and mortgage-backed securities. Second, the financing of the deficit and refinancing of maturing debt can cause rapidly rising yields of notes and bonds.
The environment of monetary and fiscal policy is complex and difficult to influence even with the arsenal of monetary policy tools and the Fed’s expertise. Budgetary deficits and the growing government debt take time for adjustment and sometimes the adjustment is forced by fire sales of debt and sharp increases in yields. Because of the easier control of monetary policy in the short-term, it is inopportune to engage in legislative exercises that weaken the Fed and its independence in technical conduct of monetary policy. National financial regulation efforts should follow global efforts that postpone implementation until full recovery of financial markets and economic activity. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Sunday, February 28, 2010
Sunday, February 21, 2010
Fed Exit, Discount Window, Policy Constraints and Orderly Adjustment
Carlos M Pelaez
The two most important interrelated issues of economic policy are (1) the orderly unwinding of the Fed stimulus in the form of fed funds rate target of 0 – ¼ percent while downsizing the Fed’s balance sheet, which as of Feb 17, 2010, shows $1200 billion of reserve balances of members banks deposits at Federal Reserve Banks and $1899 billion of holdings of securities of which $709 billion in Treasury notes and bonds, $1024 billion in mortgage-backed securities and $166 billion in federal agency securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ); and (2) reducing the budget deficit to reverse the perilous path of the debt/GDP ratio. The issue of world imbalances or current account and fiscal deficits of the United States and current account surplus of Asia is analyzed in technical literature as the threat of disorderly adjustment (Pelaez and Pelaez, The Global Recession Risk, 11, 19-55, 188-229). According to this view that was popular before the global recession, continuing US fiscal and current account deficits would find a tipping point at which risk premiums on US debt would cause crashing bond and stock markets, depreciation of the dollar and income contraction or global recession without which there would not be full adjustment of unsustainable internal and external deficits. The credit crisis was actually provoked by the Fed’s target of the fed funds rate at 1 percent between Jun 2003 and Jun 2004, the interruption of the auction of 30-year Treasury bonds between 2001 and 2005 to lower mortgage rates, the yearly housing subsidy of $221 billion and the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). These policies created an incentive to highly leveraged, excessively risky exposures with low liquidity and imprudent credit assessment. The threat of disorderly adjustment currently is posed by high interest rates resulting from the unwinding of the Fed stimulus and financing the trillion-dollar budget deficits and refinancing maturing debt. Increasing interest rates and taxation could flatten the growth path of the economy, prolonging the jobless recovery. US debt could become unsustainable at some point in the future forcing adjustment by tax increases and expenditure reductions.
The objective of this post is to analyze the policies of the Fed in unwinding the stimulus, the constraints of monetary policy, effects of the unwinding and the orderly adjustment of fiscal deficits and debt. The following sections discuss Fed policies, constraints and the orderly adjustment.
First, exit policies. On Feb 18 the Fed announced “modifications” of its discount window programs effective Feb 19 (http://www.federalreserve.gov/newsevents/press/monetary/20100218a.htm ). The changes are intended as part of continuing normalization of financial markets and not as a change in the accommodative policy stand, in particular, the 0 to ¼ percent target for fed funds. The main modification is the increase in the primary rate or discount window rate from ½ percent to ¾ percent. Primary credit loans are provided by the Federal Reserve Banks to depository institutions that are solvent but require funding. This is part of the Bagehot 1873 principle in his Lombard Street by which central banks lend to solvent but temporarily illiquid institutions with the guarantee of highest-rated securities at a punitive rate to discourage moral hazard, which consist of engaging in careless bank management because of the safety net of central bank loans (cited in Pelaez and Pelaez, International Financial Architecture, 175-8, 194). The Fed also modified the maximum maturity of primary credit loans to overnight, which had been extended during financial markets stress to longer terms. Because of the stigma of borrowing through the discount window, signaling difficulties in individual banks, the fed created the Term Auction Facility (TAF) among 11 emergency facilities (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1, Regulation of Banks and Finance, 224-6). The TAF rate was increased from ¼ percent to ½ percent and the Fed confirmed the final auction of TAF funds for Mar 8. As a result of the new measures the spread relative to the fed funds target of 0 to ¼ percent of the discount window rate changed to 0.5-0.75 and the spread of the TAF rate changed to 0.50-0.75 percent. The initial nervousness in financial markets was provoked by the remembrance that the first easing measure in the credit crisis was on Aug 17, 2007, when the Fed reduced the discount window rate from 1 percent to 0.75 percent also agreed in a telephone meeting with the members of the FOMC (http://www.federalreserve.gov/newsevents/press/monetary/monetary20071016a1.pdf ) and then lowered the fed funds rate from 5.25 percent to 4.75 percent in the following meeting of the FOMC on Sep 18, 2007 (http://www.federalreserve.gov/fomc/fundsrate.htm ). The Fed maintained during a prolonged period a spread of one percentage point between the discount window and fed funds rate, which is consistent with the Bagehot rule of punitive discount window lending rates by central banks. The doubt persists in spite of reassurances to the contrary by the Fed that the increase in the discount window is not only because of more normal credit market conditions but also to allow ample spread relative to the fed funds rate that would facilitate a tightening posture.
Information on the view of the Fed is available in the testimony to Congress on the exit strategy (http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm ) and in the minutes of the Federal Open Market Committee (FOMC) meeting on Jan 26-7 (http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20100127.pdf ). The documents are consistent with the announcement of the modifications of primary credit rates and terms on Feb 18 but the view is changing toward increases in interest rates and withdrawal of the stimulus at an unknown time in the future. There are three sets of information in the documents. (1) The view of the current economy by the staff of the Fed and the members of the FOMC coincides with that of many market participants. The economy of the US is expanding with the engine changing from a lower rate of inventory liquidation to growth of demand, industrial production and investment. The housing market remains sluggish while the employment situation is improving but not as desirable. Consumer price inflation is subdued. There are not restraints from financial markets on economic growth. The indicator of financial risk provided by the spread of LIBOR to the overnight indexed swap (OIS) or LIBOR/OIS spread remains low. Economic growth with significant resource slack still suggests accommodative monetary policy. The Fed has responsibilities in four areas: monetary policy, supervision and regulation, systemic risk and provision of financial services. There are three objectives of monetary policy: stable prices, maximum employment and moderate long-term interest rates, which have conflicted in the past (Pelaez and Pelaez, Financial Regulation after the Global Recession, 74). Balancing these objectives is a delicate art. (2) The exit strategy consists of the isolated use or combination of six tools: (i) increases in the interest on excess reserve balances (IOER); (ii) term reverse sales and repurchase agreements (RSRP) with primary dealers; (iii) RSRPs with market participants other than primary dealers; (iv) absorbing excess reserves with a term deposit facility (TDF); (v) redeeming without reinvesting of maturing and prepaid securities held by the Fed; and (vi) sale before maturity of securities held by the Fed. With the exception of increases in the IOER, all tools would reduce the excess reserves held by depository institutions at the Federal Reserve Banks. The Fed has expertise in managing all these tools. It is quite difficult to anticipate market reactions to the various alternatives of increasing interest rates and reducing excess reserves. (3) The central tendency of the forecast of the FOMC is for GDP growth in 2010 of 2.8 to 3.5 percent, accelerating to 3.4 to 4.5 percent in 2011 with long-term trend of 2.5 to 2.8 percent. The unemployment rate would remain at 9.5 to 9.7 percent in 2010 declining to 8.2 to 8.5 percent in 2011 and to 6.6 to 7.5 percent in 2012. PCE inflation would remain in the 1 to 2 percent range. There is significant uncertainty in forecasts of economists especially turning points. The critical question is whether maintaining low interest rates with growth of the economy accelerating toward 4 percent is consistent with targets of fed funds rates of 0 to ¼ percent. Zero interest rates induce the carry trade of short positions in dollars and long positions in commodities and emerging market stocks that cause wide oscillations in financial variables (Pelaez and Pelaez, Globalization and the State Vol. II, 203-4, Government Intervention in Globalization, 70-4). Zero interest rates also create incentives for high risk, excessive leverage exposures with low liquidity and careless credit risk assessment. The tradeoff for the Fed is whether increasing rates to reduce these distortions could cause an overshooting of interest rates and exchange rates, disrupting financial markets. Replacing or affecting the FOMC with a risk council of politically appointed members instead of the technical tradition of the Fed as in proposed financial regulation would deteriorate instead of improving the conduct of macroeconomic policy at an inopportune time.
Second, constraints of monetary policy. The golden period of central banking is called “the great moderation,” consisting of significant reduction in inflation with adequate growth rates of output and subdued volatility in both inflation and output but continuing oscillation of financial variables in the two decades preceding the current crisis (Kenneth Rogoff cited in Pelaez and Pelaez, Regulation of Banks and Finance, 221, Globalization and the State, Vol. II, 195). In the search for a new paradigm of macroeconomic policy, the IMF finds that using the interest rate to anchor inflation expectations suggests that monetary policy by central banks amortized shocks on the economy. The prevailing view before the crisis was that enhanced macroeconomic policy could attain sustained growth with price stability (http://www.imf.org/external/pubs/ft/spn/2010/spn1003.pdf ). Inflation targeting was considered the optimal process for central banking (Pelaez and Pelaez, Regulation of Banks and Finance, 108-112, Financial Regulation after the Global Recession, 74, 84-6, International Financial Architecture, 230-7). The credit crisis and global recession demonstrated the insufficient hard knowledge on the conduct of monetary policy and overall macroeconomic policy.
There are at least seven constraints in designing and implementing monetary policy. (1) There are major technical limitations in measuring and forecasting lags in effects of monetary policy on income and prices. The channels of effects of monetary policy on output are difficult to specify and verify. Macroeconomic policies may be improperly simulated and anticipations of policy could reverse intended effects (Pelaez and Pelaez, Regulation of Banks and Finance, 99-116). (2) Analyzing conditions of the current economy and financial markets is quite difficult. There is significant uncertainty in economic forecasting. The Fed bases its policy on the uncertain forecast of economic and financial conditions six months ahead of the current decision. (3) The increase in interest rates, or tighter monetary policy, is being processed in an environment of loose fiscal policy with rapidly growing expenditures, deficits and debt/GDP ratios. The intended increase of interest rates by monetary policy may be magnified by loose fiscal policy. It may be difficult for the Fed to find the desirable level of interest rates and the slope of the yield curve. (4) Tightening monetary policy departs from the current target of 0 to ¼ percent for fed funds rates. Low inflation may facilitate the task of the Fed in finding a positive real rate of interest that eliminates the distortions of zero policy interest rates. (5) Current economic conditions are characterized by moderate growth of the economy but continuing high unemployment rates. In this tough employment market, the Fed may be restricted by its objective of considering full employment, resulting in conflicts with other objectives. These conflicts exist in the objectives themselves. (6) Unwinding quantitative easing by sale of securities could raise long-term interest rates, steepening the yield curve. Term deposits at the Fed and reverse repos will find rising interest rates at maturity or refinancing. The weight of the huge balance sheet of the Fed exerts pressure on feasible monetary policy; and (7) the regulatory shock in the form of ambitious proposals in Congress could weaken the Fed at an inopportune time when its technical expertise and independence are most required. Increases in interest rates may deteriorate bank balance sheets to the extent that banks are borrowing short-dated funds and lending long-dated instruments and cause oscillations in exchange rates affecting currency mismatches (Pelaez and Pelaez, The Global Recession Risk, 174-87, provides an analysis of balance sheet effects and a practical stress case in reality). The Dow Jones US Bank Index has ranged between 82.61 and 241.0 in the past 52 weeks, declining 0.87 percent in the past three months (http://online.wsj.com/public/npage/industry_focus.html?bcind_sid=171501&bcind_ind=8300&symbol=8300 ). This is hardly the time to induce declines of bank stock prices by national regulation when proposals of global regulation by the Basel Committee on Banking Supervision call for increases in Tier 1 or common stock capital as percent of risk-weighted assets.
Third, disorderly adjustment. Research at the Fed and IMF has failed to find cases of extreme risks of disorderly adjustment in current account deficits (Pelaez and Pelaez, Globalization and the State, Vol. II, 185-90). The research over many centuries of experience by Carmen Reinhart and Kenneth Rogoff alerts about debt crises following credit crises (http://www.amazon.com/This-Time-Different-Centuries-Financial/dp/0691142165/ref=ntt_at_ep_dpi_1 ). An important adjustment barrier currently is the joint incidence of a zero central bank policy interest rate, trillion dollar deficits and rapidly growing debt/GDP ratio. The immediate risk is flattening the expansion curve of the economy, resulting in weak employment conditions.
The policy mix is a major restraint of effective macroeconomic policy. Tight monetary policy with loose fiscal policy remind past episodes of debt crises and stop-and-go volatile growth. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Carlos M Pelaez
The two most important interrelated issues of economic policy are (1) the orderly unwinding of the Fed stimulus in the form of fed funds rate target of 0 – ¼ percent while downsizing the Fed’s balance sheet, which as of Feb 17, 2010, shows $1200 billion of reserve balances of members banks deposits at Federal Reserve Banks and $1899 billion of holdings of securities of which $709 billion in Treasury notes and bonds, $1024 billion in mortgage-backed securities and $166 billion in federal agency securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ); and (2) reducing the budget deficit to reverse the perilous path of the debt/GDP ratio. The issue of world imbalances or current account and fiscal deficits of the United States and current account surplus of Asia is analyzed in technical literature as the threat of disorderly adjustment (Pelaez and Pelaez, The Global Recession Risk, 11, 19-55, 188-229). According to this view that was popular before the global recession, continuing US fiscal and current account deficits would find a tipping point at which risk premiums on US debt would cause crashing bond and stock markets, depreciation of the dollar and income contraction or global recession without which there would not be full adjustment of unsustainable internal and external deficits. The credit crisis was actually provoked by the Fed’s target of the fed funds rate at 1 percent between Jun 2003 and Jun 2004, the interruption of the auction of 30-year Treasury bonds between 2001 and 2005 to lower mortgage rates, the yearly housing subsidy of $221 billion and the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). These policies created an incentive to highly leveraged, excessively risky exposures with low liquidity and imprudent credit assessment. The threat of disorderly adjustment currently is posed by high interest rates resulting from the unwinding of the Fed stimulus and financing the trillion-dollar budget deficits and refinancing maturing debt. Increasing interest rates and taxation could flatten the growth path of the economy, prolonging the jobless recovery. US debt could become unsustainable at some point in the future forcing adjustment by tax increases and expenditure reductions.
The objective of this post is to analyze the policies of the Fed in unwinding the stimulus, the constraints of monetary policy, effects of the unwinding and the orderly adjustment of fiscal deficits and debt. The following sections discuss Fed policies, constraints and the orderly adjustment.
First, exit policies. On Feb 18 the Fed announced “modifications” of its discount window programs effective Feb 19 (http://www.federalreserve.gov/newsevents/press/monetary/20100218a.htm ). The changes are intended as part of continuing normalization of financial markets and not as a change in the accommodative policy stand, in particular, the 0 to ¼ percent target for fed funds. The main modification is the increase in the primary rate or discount window rate from ½ percent to ¾ percent. Primary credit loans are provided by the Federal Reserve Banks to depository institutions that are solvent but require funding. This is part of the Bagehot 1873 principle in his Lombard Street by which central banks lend to solvent but temporarily illiquid institutions with the guarantee of highest-rated securities at a punitive rate to discourage moral hazard, which consist of engaging in careless bank management because of the safety net of central bank loans (cited in Pelaez and Pelaez, International Financial Architecture, 175-8, 194). The Fed also modified the maximum maturity of primary credit loans to overnight, which had been extended during financial markets stress to longer terms. Because of the stigma of borrowing through the discount window, signaling difficulties in individual banks, the fed created the Term Auction Facility (TAF) among 11 emergency facilities (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1, Regulation of Banks and Finance, 224-6). The TAF rate was increased from ¼ percent to ½ percent and the Fed confirmed the final auction of TAF funds for Mar 8. As a result of the new measures the spread relative to the fed funds target of 0 to ¼ percent of the discount window rate changed to 0.5-0.75 and the spread of the TAF rate changed to 0.50-0.75 percent. The initial nervousness in financial markets was provoked by the remembrance that the first easing measure in the credit crisis was on Aug 17, 2007, when the Fed reduced the discount window rate from 1 percent to 0.75 percent also agreed in a telephone meeting with the members of the FOMC (http://www.federalreserve.gov/newsevents/press/monetary/monetary20071016a1.pdf ) and then lowered the fed funds rate from 5.25 percent to 4.75 percent in the following meeting of the FOMC on Sep 18, 2007 (http://www.federalreserve.gov/fomc/fundsrate.htm ). The Fed maintained during a prolonged period a spread of one percentage point between the discount window and fed funds rate, which is consistent with the Bagehot rule of punitive discount window lending rates by central banks. The doubt persists in spite of reassurances to the contrary by the Fed that the increase in the discount window is not only because of more normal credit market conditions but also to allow ample spread relative to the fed funds rate that would facilitate a tightening posture.
Information on the view of the Fed is available in the testimony to Congress on the exit strategy (http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm ) and in the minutes of the Federal Open Market Committee (FOMC) meeting on Jan 26-7 (http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20100127.pdf ). The documents are consistent with the announcement of the modifications of primary credit rates and terms on Feb 18 but the view is changing toward increases in interest rates and withdrawal of the stimulus at an unknown time in the future. There are three sets of information in the documents. (1) The view of the current economy by the staff of the Fed and the members of the FOMC coincides with that of many market participants. The economy of the US is expanding with the engine changing from a lower rate of inventory liquidation to growth of demand, industrial production and investment. The housing market remains sluggish while the employment situation is improving but not as desirable. Consumer price inflation is subdued. There are not restraints from financial markets on economic growth. The indicator of financial risk provided by the spread of LIBOR to the overnight indexed swap (OIS) or LIBOR/OIS spread remains low. Economic growth with significant resource slack still suggests accommodative monetary policy. The Fed has responsibilities in four areas: monetary policy, supervision and regulation, systemic risk and provision of financial services. There are three objectives of monetary policy: stable prices, maximum employment and moderate long-term interest rates, which have conflicted in the past (Pelaez and Pelaez, Financial Regulation after the Global Recession, 74). Balancing these objectives is a delicate art. (2) The exit strategy consists of the isolated use or combination of six tools: (i) increases in the interest on excess reserve balances (IOER); (ii) term reverse sales and repurchase agreements (RSRP) with primary dealers; (iii) RSRPs with market participants other than primary dealers; (iv) absorbing excess reserves with a term deposit facility (TDF); (v) redeeming without reinvesting of maturing and prepaid securities held by the Fed; and (vi) sale before maturity of securities held by the Fed. With the exception of increases in the IOER, all tools would reduce the excess reserves held by depository institutions at the Federal Reserve Banks. The Fed has expertise in managing all these tools. It is quite difficult to anticipate market reactions to the various alternatives of increasing interest rates and reducing excess reserves. (3) The central tendency of the forecast of the FOMC is for GDP growth in 2010 of 2.8 to 3.5 percent, accelerating to 3.4 to 4.5 percent in 2011 with long-term trend of 2.5 to 2.8 percent. The unemployment rate would remain at 9.5 to 9.7 percent in 2010 declining to 8.2 to 8.5 percent in 2011 and to 6.6 to 7.5 percent in 2012. PCE inflation would remain in the 1 to 2 percent range. There is significant uncertainty in forecasts of economists especially turning points. The critical question is whether maintaining low interest rates with growth of the economy accelerating toward 4 percent is consistent with targets of fed funds rates of 0 to ¼ percent. Zero interest rates induce the carry trade of short positions in dollars and long positions in commodities and emerging market stocks that cause wide oscillations in financial variables (Pelaez and Pelaez, Globalization and the State Vol. II, 203-4, Government Intervention in Globalization, 70-4). Zero interest rates also create incentives for high risk, excessive leverage exposures with low liquidity and careless credit risk assessment. The tradeoff for the Fed is whether increasing rates to reduce these distortions could cause an overshooting of interest rates and exchange rates, disrupting financial markets. Replacing or affecting the FOMC with a risk council of politically appointed members instead of the technical tradition of the Fed as in proposed financial regulation would deteriorate instead of improving the conduct of macroeconomic policy at an inopportune time.
Second, constraints of monetary policy. The golden period of central banking is called “the great moderation,” consisting of significant reduction in inflation with adequate growth rates of output and subdued volatility in both inflation and output but continuing oscillation of financial variables in the two decades preceding the current crisis (Kenneth Rogoff cited in Pelaez and Pelaez, Regulation of Banks and Finance, 221, Globalization and the State, Vol. II, 195). In the search for a new paradigm of macroeconomic policy, the IMF finds that using the interest rate to anchor inflation expectations suggests that monetary policy by central banks amortized shocks on the economy. The prevailing view before the crisis was that enhanced macroeconomic policy could attain sustained growth with price stability (http://www.imf.org/external/pubs/ft/spn/2010/spn1003.pdf ). Inflation targeting was considered the optimal process for central banking (Pelaez and Pelaez, Regulation of Banks and Finance, 108-112, Financial Regulation after the Global Recession, 74, 84-6, International Financial Architecture, 230-7). The credit crisis and global recession demonstrated the insufficient hard knowledge on the conduct of monetary policy and overall macroeconomic policy.
There are at least seven constraints in designing and implementing monetary policy. (1) There are major technical limitations in measuring and forecasting lags in effects of monetary policy on income and prices. The channels of effects of monetary policy on output are difficult to specify and verify. Macroeconomic policies may be improperly simulated and anticipations of policy could reverse intended effects (Pelaez and Pelaez, Regulation of Banks and Finance, 99-116). (2) Analyzing conditions of the current economy and financial markets is quite difficult. There is significant uncertainty in economic forecasting. The Fed bases its policy on the uncertain forecast of economic and financial conditions six months ahead of the current decision. (3) The increase in interest rates, or tighter monetary policy, is being processed in an environment of loose fiscal policy with rapidly growing expenditures, deficits and debt/GDP ratios. The intended increase of interest rates by monetary policy may be magnified by loose fiscal policy. It may be difficult for the Fed to find the desirable level of interest rates and the slope of the yield curve. (4) Tightening monetary policy departs from the current target of 0 to ¼ percent for fed funds rates. Low inflation may facilitate the task of the Fed in finding a positive real rate of interest that eliminates the distortions of zero policy interest rates. (5) Current economic conditions are characterized by moderate growth of the economy but continuing high unemployment rates. In this tough employment market, the Fed may be restricted by its objective of considering full employment, resulting in conflicts with other objectives. These conflicts exist in the objectives themselves. (6) Unwinding quantitative easing by sale of securities could raise long-term interest rates, steepening the yield curve. Term deposits at the Fed and reverse repos will find rising interest rates at maturity or refinancing. The weight of the huge balance sheet of the Fed exerts pressure on feasible monetary policy; and (7) the regulatory shock in the form of ambitious proposals in Congress could weaken the Fed at an inopportune time when its technical expertise and independence are most required. Increases in interest rates may deteriorate bank balance sheets to the extent that banks are borrowing short-dated funds and lending long-dated instruments and cause oscillations in exchange rates affecting currency mismatches (Pelaez and Pelaez, The Global Recession Risk, 174-87, provides an analysis of balance sheet effects and a practical stress case in reality). The Dow Jones US Bank Index has ranged between 82.61 and 241.0 in the past 52 weeks, declining 0.87 percent in the past three months (http://online.wsj.com/public/npage/industry_focus.html?bcind_sid=171501&bcind_ind=8300&symbol=8300 ). This is hardly the time to induce declines of bank stock prices by national regulation when proposals of global regulation by the Basel Committee on Banking Supervision call for increases in Tier 1 or common stock capital as percent of risk-weighted assets.
Third, disorderly adjustment. Research at the Fed and IMF has failed to find cases of extreme risks of disorderly adjustment in current account deficits (Pelaez and Pelaez, Globalization and the State, Vol. II, 185-90). The research over many centuries of experience by Carmen Reinhart and Kenneth Rogoff alerts about debt crises following credit crises (http://www.amazon.com/This-Time-Different-Centuries-Financial/dp/0691142165/ref=ntt_at_ep_dpi_1 ). An important adjustment barrier currently is the joint incidence of a zero central bank policy interest rate, trillion dollar deficits and rapidly growing debt/GDP ratio. The immediate risk is flattening the expansion curve of the economy, resulting in weak employment conditions.
The policy mix is a major restraint of effective macroeconomic policy. Tight monetary policy with loose fiscal policy remind past episodes of debt crises and stop-and-go volatile growth. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Sunday, February 14, 2010
Financial Regulation and the Fed Monetary Stimulus Exit Strategy
Carlos M Pelaez
The calculation of the government stimulus by Mark Pittman and Bob Ivry at Bloomberg declined from $12.8 trillion committed and $4.2 trillion used by March 2009 to $11.6 trillion committed and $3.0 trillion used by September 2009 (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ahys015DzWXc# see Pelaez and Pelaez, Regulation of Banks and Finance 224-7, Financial Regulation after the Global Recession, 157-70). The Federal Reserve total commitment by September 2009 was $5.9 trillion, or 50.8 percent of the total, and the use was $1.6 trillion, or 53 percent of the total. The deficits in the current budget proposal are staggering in trillions of current dollars: -1.4 in 2009, -1.6 in 2010 and -1.3 in 2011. Estimated outlays or expenditures increase in current dollars by 28.5 percent from 2008 to 2011 while revenues increase 1.7 percent after declining by 14.2 percent between 2008 and 2010. As percent of GDP the estimated expenditures are the highest since 24.8 in 1946: 24.7 in 2009, 25.4 in 2010 and 25.1 in 2011. The federal debt held by the public is now moving toward an estimated 77.2 percent of GDP in 2020 (http://www.whitehouse.gov/omb/budget/fy2011/assets/budget.pdf ). Long-term projections are subject to significant error and actions could occur before the debt touches 100 percent of GDP. There is significant threat of rising interest rates because of the unwinding of the stimulus by the Fed and the financing of record deficits and refinancing of maturing debt. Rapidly rising interest rates and taxes could flatten the expansion path of GDP, preventing full employment.
The Fed is facing one of the most difficult challenges of its existence. Financial regulation restructuring the Fed is inopportune when the institution deals with the critical unwinding of the monetary stimulus. Proposals to audit the monetary policy of the Fed could jeopardize the capacity of the institution to design and implement policy because of the specter that an audit could reverse ongoing policy before intended effects are realized. The traditional independence of policy and choice of highly qualified board members and staff could be eroded by public audits. The choice of regional Federal Reserve Bank presidents by central government could further politicize monetary policy. The Fed has relied on the information obtained in its supervisory functions to design and implement policy in a form of economies of scope (Ben Bernanke cited in Regulation of Banks and Finance, 100). Relocation of Fed supervision may weaken overall supervision, restricting the Fed from obtaining vital information for its policy decisions. Regulatory shocks on the Fed could actually translate into adverse effects on financial markets when financing is required for rapid economic growth that can create jobs. There should be a moratorium on financial regulation until the Fed has the time and independence to exit the monetary stimulus.
The Fed is increasingly providing information on the exit strategy from the monetary stimulus (http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm ). There are three areas of exit policies, interest rate adjustment, credit facilities and quantitative easing, which are discussed below in turn.
First, interest rate adjustment. The major instrument of Fed policy consists of targets of the fed funds rate. Fed funds consist of interbank loans of deposits of reserves by member banks at the Federal Reserve Bank in their region. The rate on fed funds is the cost of an additional dollar of funding that banks can use to lend. Increasing the fed funds rate increases the cost of borrowing money to lend by banks, likely causing an increase in the rate charged by banks on loans (Pelaez and Pelaez, Regulation of Banks and Finance, 99-116, Financial Regulation after the Global Recession, 69-90, Globalization and the State Vol. I, 30-43, Government Intervention in Globalization, 38-9). The increase in interest rates deteriorates the balance sheets of households because increasing interest payments lower the market value of assets that can be used as collateral in borrowing such as by home equity loans. The deterioration in the assets of households and business has adverse effects on the balance sheets of creditor banks that may reduce credit to their clients. There is resulting decline in nominal income or aggregate demand that lowers general prices (see credit channel and financial accelerator models by Ben Bernanke and Mark Gertler cited in Pelaez and Pelaez, Regulation of Banks and Finance, 103-8, The Global Recession Risk, 221-3). The converse process occurs after a shock that lowers interest rates. There are lags in the effect of monetary policy on prices, nominal income and economic activity. The Fed has to anticipate economic conditions in the future to set targets on fed funds rates.
The Fed has been aggressive and volatile in fixing the rate of fed funds or interbank loans of reserves deposited at the Fed, which is a proxy of the interest cost of an additional unit of bank lending. The Fed lowered the fed funds rate from 6.50 percent in May 2000 to 1.00 percent by June 2003 and left it at 1.00 percent until June 2004 when it increased it to 1.25 percent and then rapidly increased it to 5.25 percent by June 2005. In rollercoaster fashion the Fed lowered the rate to 4.25 percent by September 2007 rapidly lowering it to 0-0.25 percent by December 2008. The Fed lowered the fed funds rate by 525 basis points followed by an increase of 425 basis points and then by a decrease of 425 basis points in a time period of six years (http://www.federalreserve.gov/fomc/fundsrate.htm ). These policy impulses resemble traders who successfully shorted stocks reversing by going long in the same trading session to benefit from the undershooting during the 22 percent decline of the market on Black Monday, October 19, 1987. The central bank may not be as successful as the few traders who had that flexibility. The policy counterfactual posits that the credit crisis originated in four excessive types of stimuli in 2001-2004 (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between June 2003 and June 2004 with the implicit intention in the “forward guidance” of maintaining that rate indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings.
The exit strategy of the Fed includes the use of the interest rate on reserves deposited by member banks at the Fed as the policy rate instead of the rate on fed funds possibly supplemented with quantitative limits on reserves (http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm ). The fed funds market has diminished in volume and interest rates on reserve deposits may be more adequate as temporary policy rate. The interest rate on reserves can be construed as the cost of an extra dollar of money to lend and its increase could have the desired effect of increasing interest rates to avoid the undesirable effects of excessively low interest rates. Higher interest rates would also discourage the oscillation of financial variables caused by the carry trade of taking short positions on the dollars and simultaneous long positions in commodities and emerging market stocks.
Second, liquidity facilities. The Fed used about 11 facilities of monetary policy during the crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1). Lowering the fed funds rate was not as important in restoring normalcy in financial markets. Initial doubts on the potential default of mortgages bundled in structured products that were financed in sale and repurchase agreements (SRP) significantly increased perceptions of counterparty credit risk. Declines in prices of mortgage-backed and asset-backed securities in general and haircuts in SRPs reduced funding capital of traders, causing common liquidity effects and flight to quality in multiple market segments as analyzed by Markus Brunnermeier and Lasse Pedersen (cited in Pelaez and Pelaez, Regulation of Banks and Finance,223). The initial policy of the Fed was reducing the discount rate by 50 basis points on August 17, 2007 (http://www.federalreserve.gov/newsevents/press/monetary/20070817a.htm ). This was the first measure of providing financing for segments of financial markets of which the Term Auction Facility (TAF) providing short-term credit to depository institutions and the Term Asset-Backed Securities Loan Facility (TALF) were most important. TAF avoided the suspicion of credit problems by borrowing through the discount window while TALF alleviated counterparty credit risk problems in markets for asset-backed securities that provide financing for loans for autos, credit cards, small business and students. The Fed will phase out TAF on March 8 and TALF on March 31 with the exception of commercial mortgage-backed securities while most of the other facilities have been phased out. Commercial real estate loans continue to set pressure on bank balance sheets.
Third, quantitative easing. When policy interest rates are near zero, the central bank can manage its balance sheet by purchasing long-term securities. This quantitative easing can rebalance investment portfolios, causing increases in prices of long-term securities. The resulting decline in long-term interest rates could increase investment and stimulate economic recovery as analyzed by Ben Bernanke and Vincent Reinhart (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 224, The Global Recession Risk, 103-7). The Fed balance sheet in the week ending on February 10, 2010, shows holdings of long-term securities of $1844 billion, with individual holdings of $708 billion of treasuries notes and bonds, $971 billion of agency-guaranteed mortgage-backed securities and $165 billion of Federal agency debt securities; the major item of liabilities is $1154 billion of deposits at the Fed by depository institutions or banks (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). The Fed financed the balance sheet initially with deposits of banks remunerated with interest payments and Supplementary Financing or loan by Treasury that has virtually disappeared, being replaced with issue of notes (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27). The Fed is considering three tools to reduce large reserves of banks. (1) The Fed has been testing reverse repos in which securities in the balance sheet of the Fed can be sold with an agreement to repurchase them at contracted price, interest and date. The payment by the buyer withdraws reserves from the financial system. (2) The Fed is evaluating the issue of certificates of deposit similar to those offered by depository institutions to their clients that also withdraw funds. (3) The Fed can sell its portfolio of securities and allow securities to mature without new purchases (http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm ). The choice, doses and sequence of policy actions will depend on strengthening of the recovery.
There are no doubts about increases in taxes and interest rates. Dismantling the stimulus is a tough task full of pitfalls in an environment of little hard knowledge about current and future economic and financial conditions. Congress can continue its usual oversight of the Fed. The public, market participants, the media and academics can engage in constructive debate on Fed policy. Economic recovery and job creation depend on successful adjustment of the monetary stimulus. Regulatory shocks of the Fed and financial markets may disrupt the process with unknown adverse effects. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Carlos M Pelaez
The calculation of the government stimulus by Mark Pittman and Bob Ivry at Bloomberg declined from $12.8 trillion committed and $4.2 trillion used by March 2009 to $11.6 trillion committed and $3.0 trillion used by September 2009 (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ahys015DzWXc# see Pelaez and Pelaez, Regulation of Banks and Finance 224-7, Financial Regulation after the Global Recession, 157-70). The Federal Reserve total commitment by September 2009 was $5.9 trillion, or 50.8 percent of the total, and the use was $1.6 trillion, or 53 percent of the total. The deficits in the current budget proposal are staggering in trillions of current dollars: -1.4 in 2009, -1.6 in 2010 and -1.3 in 2011. Estimated outlays or expenditures increase in current dollars by 28.5 percent from 2008 to 2011 while revenues increase 1.7 percent after declining by 14.2 percent between 2008 and 2010. As percent of GDP the estimated expenditures are the highest since 24.8 in 1946: 24.7 in 2009, 25.4 in 2010 and 25.1 in 2011. The federal debt held by the public is now moving toward an estimated 77.2 percent of GDP in 2020 (http://www.whitehouse.gov/omb/budget/fy2011/assets/budget.pdf ). Long-term projections are subject to significant error and actions could occur before the debt touches 100 percent of GDP. There is significant threat of rising interest rates because of the unwinding of the stimulus by the Fed and the financing of record deficits and refinancing of maturing debt. Rapidly rising interest rates and taxes could flatten the expansion path of GDP, preventing full employment.
The Fed is facing one of the most difficult challenges of its existence. Financial regulation restructuring the Fed is inopportune when the institution deals with the critical unwinding of the monetary stimulus. Proposals to audit the monetary policy of the Fed could jeopardize the capacity of the institution to design and implement policy because of the specter that an audit could reverse ongoing policy before intended effects are realized. The traditional independence of policy and choice of highly qualified board members and staff could be eroded by public audits. The choice of regional Federal Reserve Bank presidents by central government could further politicize monetary policy. The Fed has relied on the information obtained in its supervisory functions to design and implement policy in a form of economies of scope (Ben Bernanke cited in Regulation of Banks and Finance, 100). Relocation of Fed supervision may weaken overall supervision, restricting the Fed from obtaining vital information for its policy decisions. Regulatory shocks on the Fed could actually translate into adverse effects on financial markets when financing is required for rapid economic growth that can create jobs. There should be a moratorium on financial regulation until the Fed has the time and independence to exit the monetary stimulus.
The Fed is increasingly providing information on the exit strategy from the monetary stimulus (http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm ). There are three areas of exit policies, interest rate adjustment, credit facilities and quantitative easing, which are discussed below in turn.
First, interest rate adjustment. The major instrument of Fed policy consists of targets of the fed funds rate. Fed funds consist of interbank loans of deposits of reserves by member banks at the Federal Reserve Bank in their region. The rate on fed funds is the cost of an additional dollar of funding that banks can use to lend. Increasing the fed funds rate increases the cost of borrowing money to lend by banks, likely causing an increase in the rate charged by banks on loans (Pelaez and Pelaez, Regulation of Banks and Finance, 99-116, Financial Regulation after the Global Recession, 69-90, Globalization and the State Vol. I, 30-43, Government Intervention in Globalization, 38-9). The increase in interest rates deteriorates the balance sheets of households because increasing interest payments lower the market value of assets that can be used as collateral in borrowing such as by home equity loans. The deterioration in the assets of households and business has adverse effects on the balance sheets of creditor banks that may reduce credit to their clients. There is resulting decline in nominal income or aggregate demand that lowers general prices (see credit channel and financial accelerator models by Ben Bernanke and Mark Gertler cited in Pelaez and Pelaez, Regulation of Banks and Finance, 103-8, The Global Recession Risk, 221-3). The converse process occurs after a shock that lowers interest rates. There are lags in the effect of monetary policy on prices, nominal income and economic activity. The Fed has to anticipate economic conditions in the future to set targets on fed funds rates.
The Fed has been aggressive and volatile in fixing the rate of fed funds or interbank loans of reserves deposited at the Fed, which is a proxy of the interest cost of an additional unit of bank lending. The Fed lowered the fed funds rate from 6.50 percent in May 2000 to 1.00 percent by June 2003 and left it at 1.00 percent until June 2004 when it increased it to 1.25 percent and then rapidly increased it to 5.25 percent by June 2005. In rollercoaster fashion the Fed lowered the rate to 4.25 percent by September 2007 rapidly lowering it to 0-0.25 percent by December 2008. The Fed lowered the fed funds rate by 525 basis points followed by an increase of 425 basis points and then by a decrease of 425 basis points in a time period of six years (http://www.federalreserve.gov/fomc/fundsrate.htm ). These policy impulses resemble traders who successfully shorted stocks reversing by going long in the same trading session to benefit from the undershooting during the 22 percent decline of the market on Black Monday, October 19, 1987. The central bank may not be as successful as the few traders who had that flexibility. The policy counterfactual posits that the credit crisis originated in four excessive types of stimuli in 2001-2004 (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between June 2003 and June 2004 with the implicit intention in the “forward guidance” of maintaining that rate indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings.
The exit strategy of the Fed includes the use of the interest rate on reserves deposited by member banks at the Fed as the policy rate instead of the rate on fed funds possibly supplemented with quantitative limits on reserves (http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm ). The fed funds market has diminished in volume and interest rates on reserve deposits may be more adequate as temporary policy rate. The interest rate on reserves can be construed as the cost of an extra dollar of money to lend and its increase could have the desired effect of increasing interest rates to avoid the undesirable effects of excessively low interest rates. Higher interest rates would also discourage the oscillation of financial variables caused by the carry trade of taking short positions on the dollars and simultaneous long positions in commodities and emerging market stocks.
Second, liquidity facilities. The Fed used about 11 facilities of monetary policy during the crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1). Lowering the fed funds rate was not as important in restoring normalcy in financial markets. Initial doubts on the potential default of mortgages bundled in structured products that were financed in sale and repurchase agreements (SRP) significantly increased perceptions of counterparty credit risk. Declines in prices of mortgage-backed and asset-backed securities in general and haircuts in SRPs reduced funding capital of traders, causing common liquidity effects and flight to quality in multiple market segments as analyzed by Markus Brunnermeier and Lasse Pedersen (cited in Pelaez and Pelaez, Regulation of Banks and Finance,223). The initial policy of the Fed was reducing the discount rate by 50 basis points on August 17, 2007 (http://www.federalreserve.gov/newsevents/press/monetary/20070817a.htm ). This was the first measure of providing financing for segments of financial markets of which the Term Auction Facility (TAF) providing short-term credit to depository institutions and the Term Asset-Backed Securities Loan Facility (TALF) were most important. TAF avoided the suspicion of credit problems by borrowing through the discount window while TALF alleviated counterparty credit risk problems in markets for asset-backed securities that provide financing for loans for autos, credit cards, small business and students. The Fed will phase out TAF on March 8 and TALF on March 31 with the exception of commercial mortgage-backed securities while most of the other facilities have been phased out. Commercial real estate loans continue to set pressure on bank balance sheets.
Third, quantitative easing. When policy interest rates are near zero, the central bank can manage its balance sheet by purchasing long-term securities. This quantitative easing can rebalance investment portfolios, causing increases in prices of long-term securities. The resulting decline in long-term interest rates could increase investment and stimulate economic recovery as analyzed by Ben Bernanke and Vincent Reinhart (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 224, The Global Recession Risk, 103-7). The Fed balance sheet in the week ending on February 10, 2010, shows holdings of long-term securities of $1844 billion, with individual holdings of $708 billion of treasuries notes and bonds, $971 billion of agency-guaranteed mortgage-backed securities and $165 billion of Federal agency debt securities; the major item of liabilities is $1154 billion of deposits at the Fed by depository institutions or banks (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). The Fed financed the balance sheet initially with deposits of banks remunerated with interest payments and Supplementary Financing or loan by Treasury that has virtually disappeared, being replaced with issue of notes (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27). The Fed is considering three tools to reduce large reserves of banks. (1) The Fed has been testing reverse repos in which securities in the balance sheet of the Fed can be sold with an agreement to repurchase them at contracted price, interest and date. The payment by the buyer withdraws reserves from the financial system. (2) The Fed is evaluating the issue of certificates of deposit similar to those offered by depository institutions to their clients that also withdraw funds. (3) The Fed can sell its portfolio of securities and allow securities to mature without new purchases (http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm ). The choice, doses and sequence of policy actions will depend on strengthening of the recovery.
There are no doubts about increases in taxes and interest rates. Dismantling the stimulus is a tough task full of pitfalls in an environment of little hard knowledge about current and future economic and financial conditions. Congress can continue its usual oversight of the Fed. The public, market participants, the media and academics can engage in constructive debate on Fed policy. Economic recovery and job creation depend on successful adjustment of the monetary stimulus. Regulatory shocks of the Fed and financial markets may disrupt the process with unknown adverse effects. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Sunday, February 7, 2010
Jobless Recovery, Policy Asset Put, Fiscal/Monetary Stimulus and Debt Crisis Fear
Carlos M Pelaez
The recession of 2001 was “shallow” with relatively low annual percentage rates of GDP contraction in only two quarters: -1.3 QI01, 2.6 QII01, -1.1 QIII01 and 1.4 QIV01. Economists, such as Paul Krugman, argue that recent recessions have been characterized by “jobless recovery” (http://krugman.blogs.nytimes.com/2008/01/22/deep-maybe-long-probably/ ). The peak of nonfarm payroll employment of 133,371,000 in November 2000 was only attained again with 134,058,000 in May 2005 and the annual average of 2000, 131,785,000, was only surpassed in 2006, 136,086,000 (http://data.bls.gov/PDQ/servlet/SurveyOutputServlet ). The unemployment rate as percent of the labor force was 4.0 in 2000, increasing steadily to 4.7 in 2001, 5.8 in 2002, peaking at 6.0 in 2003 and declining to 4.6 in 2006 (http://www.bls.gov/web/cpseea1.pdf ). The preliminary number of nonfarm payrolls in 2009 is 130,912,000 and the average yearly rate of unemployment 9.3 percent. The most important current issue of economic policy is creating incentives in attaining rapid quarterly annual rates of economic growth similar to those in the upswing of the 1980s: 5.1 QI83, 9.3 QII83, 8.1 QIII83, 8.5 QIV83, 8.0 QI84, 7.1 QII84 and thereafter at rates in excess of 3 percent. The rate of unemployment increased from 6.3 percent in January 1980 to a peak of 10.8 percent in December 1982, declining at year end to 8.3 percent in 1983, 7.3 percent in 1984 and 7.0 percent in 1985 (http://data.bls.gov/PDQ/servlet/SurveyOutputServlet ). The civilian labor force of the US was 153 million in January 2010 of which 14.8 million were unemployed equivalent to an unemployment rate of 9.7 percent and 8.3 million worked part-time because of economic conditions or could not find another job (http://www.bls.gov/news.release/pdf/empsit.pdf ). The data reveal a tough national event. Commonly considered policy options are (1) inducing high rates of growth by creating incentives for private sector job creation without significant expenditures or tax decreases; (2) increasing public expenditures in stimulus programs or reducing taxes selectively to increase aggregate demand for goods and services; and (3) a combination of (1) and (2). This writing provides background on the origin of the credit/dollar crisis and the fiscal/monetary stimulus followed by analysis of the current policy options in the light of current conditions in the world economy.
First, policy asset put. The credit/dollar crisis and global recession is officially attributed to an era of “irresponsibility” by finance professionals taking excessive risks to generate abnormal profits with which to receive billions of dollars in cash bonuses and other compensation. There is a competing interpretation. The financial system of securitization converts illiquid assets into immediate liquidity as in the banking theory of Douglas Diamond and Raghuram Rajan (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 37-44, 51-60, Financial Regulation after the Global Recession, 22-6, 30-42; see Globalization and the State Vol. II, 73-81, Government Intervention in Globalization, 128-31). A major part of credit is processed by securitization. Consider an example of mortgages that is valid for almost all credit such as credit cards, automobile loans, consumer loans and so on. The acquiring home owner receives cash to buy the home from an originating bank in exchange for a mortgage with the house as collateral and a loan agreement. Mortgages of similar credit rating and other characteristics are bundled into a security called mortgage-backed security (MBS) in which principal and interest are paid from the original mortgages. The MBS is acquired by investors and financed in short-term sale and repurchase agreements (SRP) in which the investor in the MBS or financed counterparty sells the MBS to a financing counterparty with an agreement to repurchase it at a contracted price plus interest for settlement at a specified short-term future date. The SRP converts the underlying illiquid home in the MBS into immediately available cash that can be construed as the funds that financed the purchase of the home. Securitization had worked for decades without a major crisis. The system was fractured when the financing counterparty decided not to renew the SRP in fear of defaulting mortgages underlying the MBS or asked for a deep discount in the contracted price in order to avoid losses if the financed counterparty did not repurchase the MBS because its market price collapsed. The financing counterparty would incur a loss equal to the difference between the depressed price received from selling the MBS used as collateral in the SRP and the value of the principal and interest defaulted by the financed counterparty. Some MBS were pooled in credit derivatives such as collateralized debt obligations (CDO) that were financed by issue of commercial paper of the structured investment vehicle (SIV), often related to banks, which was unable to roll over the SRPs of commercial paper because of defaults in mortgages underlying the CDOs (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). The critical event triggering the credit crisis was the default of mortgages in securitized instruments and derivatives.
The primary cause of the credit/dollar crisis and global recession was the fracturing of counterparty financing in SRPs of asset-backed securities and their derivatives. The most important function of finance professionals is protecting capital without which their institution disappears. Many finance professionals held most of their wealth in stock of the company where they worked. Many homeowners purchased their homes without premeditating or risking default and foreclosure that could ruin their lives. There is a more compelling alternative interpretation that the crisis was primarily caused by near zero interest rates, lowering of mortgage rates by interruption of the issue of 30-year Treasury bonds, housing subsidy of $221 billion per year and the purchase or guarantee of $1.6 trillion of nonprime MBS by Fannie Mae and Freddie Mac with leverage of 75:1 (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The target of the fed funds at 1 percent with forward guidance that it would be maintained low as long as required created an equivalent of a put option or floor on the prices of financial and real assets. The low interest rate policy was designed to prevent deflation and its adverse consequences, causing the unintended expectation that house prices and financial assets would increase indefinitely but never dropping below a price floor. There was upside potential without downside risk. Wealth, which includes financial and real assets and human capital, would also increase but never decline below a floor. Monetary policy encouraged high risk and leverage in the pursuit of higher returns to avoid near zero remuneration by interest rates that penalized holding liquid balances. The mirage was broken when the Fed raised targets on fed fund rates from 1 percent in June 2004 to 5.25 percent in June 2006 (http://www.federalreserve.gov/fomc/fundsrate.htm ). The increase in interest rates caused increases in monthly payments of adjustable rate mortgages (ARMS) that pushed many borrowers toward default. The increasing use of ARMS was based on the belief that rates would remain low forever. The collapse of house prices caused default of mortgages underlying the MBS financed in SRPs and other structured products. Counterparty financing risk perceptions catapulted, contracting the volume of SRP financing that paralyzed credit transactions throughout all segments of the financial system.
Second, monetary/fiscal stimulus. Research by Bloomberg finds that the US government and the Fed “spent, lent or committed $12.8 trillion” by March 2009 which was about the entire economic activity or GDP in 2008 (www.bloomberg.com cited in Pelaez and Pelaez, Regulation of Banks and Finance, 224). The amount disbursed or lent by March 2009 was about $4.2 trillion. The Fed used about 11 credit facilities during the crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1). The Fed also engaged in the policy of “quantitative easing” (Pelaez and Pelaez, Regulation of Banks and Finance, 224, see The Global Recession Risk, 83-107). As of the last statement on February 3, 2010, the Fed held $1.8 trillion of securities, consisting of $708 billion of Treasury notes and bonds, $164 billion of Federal agency securities and $970 billion of MBS (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). The retained portfolio of MBS by Fannie and Freddie was $1.6 trillion as of the third quarter of 2009 (http://www.fhfa.gov/Default.aspx?Page=70 ). The eventual sale of these portfolios of the Fed, Fannie and Freddie could exert significant pressure on interest rates. Since December 16, 2008, the target rate of fed funds has been 0-0.25 percent (http://www.federalreserve.gov/fomc/fundsrate.htm ). The zero target of the fed funds rate has played a significant role in the carry trade. The carry trade consists of shorting the currency of the country with low interest rates to take long positions in the currency of the country with high interest rates. These are high risk uncovered positions that can cause losses if the dollar appreciates and/or if commodity prices and stock markets lose value (Pelaez and Pelaez, Globalization and the State Vol. II, 203-4, Government Intervention in Globalization, 70-4). The carry trade has evolved into shorting the dollar and going long in commodity futures and emerging market stocks. The dollar depreciated to $1.59/euro by 7/14/08 with the DJ-UBS commodity index reaching 237.08 on 7/03/08 (http://online.wsj.com/mdc/public/page/mdc_commodities.html?mod=mdc_topnav_2_3000 ). The flight to the dollar because of the global recession caused dollar appreciation to $1.261/euro on 3/09/09 and decline of the DJ-UBS commodity index to 104.83. Renewed risk appetite resulted in $1.50/euro on 11/30/09 with the DJ-UBS commodity index at 136.49. The ongoing sovereign debt crisis resulted in appreciation to $1.368/euro on 2/05/10 and decline of the DJ-UBS commodity index to 126.558. The carry trade has been more cautious because of the threat of an increase in interest rates in the US that would appreciate the dollar, causing a loss in the short dollar leg.
Third, debt crisis fear. A few facts illustrate the deteriorating fiscal situation of the US. The largest recorded deficits of the US as percent of GDP occurred during World War II: -14.2 in 1942, -30.3 in 1943, -22.7 in 1944 and -25 in 1945. The deficit as percent of GDP declined to -7.2 in 1946 and turned into surplus of 1.7 percent in 1947 (http://www.whitehouse.gov/omb/budget/fy2011/assets/hist.pdf ). The highest deficit as percent of GDP since World War II occurred in 1983, -6, but no past budget is comparable to the estimated deficits as percent of GDP of -9.9 in 2009, -10.6 in 2010 and -8.3 in 2011. The deficits are staggering in trillions of current dollars: -1.4 in 2009, -1.6 in 2010 and -1.3 in 2011. Estimated outlays or expenditures increase in current dollars by 28.5 percent from 2008 to 2011 while revenues increase 1.7 percent after declining by 14.2 percent between 2008 and 2010. As percent of GDP the estimated expenditures are the highest since 24.8 in 1946: 24.7 in 2009, 25.4 in 2010 and 25.1 in 2011. The federal debt held by the public as percent of GDP peaked at 108.7 in 1946, declining to 52.0 in 1956 and never exceeding 50 until the current estimates: 53.0 in 2009, 63.6 in 2011, 70.8 in 2012 and above 70 during the remainder of the decade. In an essay presented at the meetings of the American Economic Association in 2004, Robert Rubin, Peter Orszag and Allen Sinai argued that the US federal budget was moving along an unsustainable path, accumulating over $5 trillion between 2004 and 2013 with the federal debt rising above 50 percent for the first time since the 1950s when the country was still paying for World War II. The deficit was rising toward the future time of collective retirement of the baby boom generation when multiple entitlements will sharply increase government expenditures (http://www.brookings.edu/~/media/Files/rc/papers/2004/0105budgetdeficit_orszag/20040105.pdf ). The federal debt held by the public is now moving toward an estimated 77.2 percent of GDP in 2020 (http://www.whitehouse.gov/omb/budget/fy2011/assets/budget.pdf ). Long-term projections are subject to significant error and actions could occur before the debt touches 100 percent of GDP.
Interest rate increases and higher taxes are inevitable in the next few years, restricting the rate of economic growth and the capacity of the private sector to create jobs. Further stimulus could deteriorate the fiscal situation. Sovereign debt fears that spooked financial markets last week, reversing carry trades with a flight to dollar assets, are less likely to cause similar events with US federal debt. The major problem with US debt is the trillions of dollars that must be financed because of the deficits or refinanced because of maturing debt. Excessive existing weight of Treasury securities in portfolios together with trillions of dollars of new debt issuance may trigger a premium on interest rates of Treasury securities. Managing the federal debt may become more difficult if markets anticipate rising rates that could cause capital losses. The Congressional Budget Office (CBO) defines an “unsustainable federal budget” as federal debt increasing at a much faster rate than the economy as a whole (http://www.cbo.gov/ftpdocs/102xx/doc10297/SummaryforWeb_LTBO.pdf ). Agendas of regulation, prodigal budgets and targeted taxation of segments of business and income brackets may be inferior to stimulating attitudes that foster confidence in business plans inducing job creation. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Carlos M Pelaez
The recession of 2001 was “shallow” with relatively low annual percentage rates of GDP contraction in only two quarters: -1.3 QI01, 2.6 QII01, -1.1 QIII01 and 1.4 QIV01. Economists, such as Paul Krugman, argue that recent recessions have been characterized by “jobless recovery” (http://krugman.blogs.nytimes.com/2008/01/22/deep-maybe-long-probably/ ). The peak of nonfarm payroll employment of 133,371,000 in November 2000 was only attained again with 134,058,000 in May 2005 and the annual average of 2000, 131,785,000, was only surpassed in 2006, 136,086,000 (http://data.bls.gov/PDQ/servlet/SurveyOutputServlet ). The unemployment rate as percent of the labor force was 4.0 in 2000, increasing steadily to 4.7 in 2001, 5.8 in 2002, peaking at 6.0 in 2003 and declining to 4.6 in 2006 (http://www.bls.gov/web/cpseea1.pdf ). The preliminary number of nonfarm payrolls in 2009 is 130,912,000 and the average yearly rate of unemployment 9.3 percent. The most important current issue of economic policy is creating incentives in attaining rapid quarterly annual rates of economic growth similar to those in the upswing of the 1980s: 5.1 QI83, 9.3 QII83, 8.1 QIII83, 8.5 QIV83, 8.0 QI84, 7.1 QII84 and thereafter at rates in excess of 3 percent. The rate of unemployment increased from 6.3 percent in January 1980 to a peak of 10.8 percent in December 1982, declining at year end to 8.3 percent in 1983, 7.3 percent in 1984 and 7.0 percent in 1985 (http://data.bls.gov/PDQ/servlet/SurveyOutputServlet ). The civilian labor force of the US was 153 million in January 2010 of which 14.8 million were unemployed equivalent to an unemployment rate of 9.7 percent and 8.3 million worked part-time because of economic conditions or could not find another job (http://www.bls.gov/news.release/pdf/empsit.pdf ). The data reveal a tough national event. Commonly considered policy options are (1) inducing high rates of growth by creating incentives for private sector job creation without significant expenditures or tax decreases; (2) increasing public expenditures in stimulus programs or reducing taxes selectively to increase aggregate demand for goods and services; and (3) a combination of (1) and (2). This writing provides background on the origin of the credit/dollar crisis and the fiscal/monetary stimulus followed by analysis of the current policy options in the light of current conditions in the world economy.
First, policy asset put. The credit/dollar crisis and global recession is officially attributed to an era of “irresponsibility” by finance professionals taking excessive risks to generate abnormal profits with which to receive billions of dollars in cash bonuses and other compensation. There is a competing interpretation. The financial system of securitization converts illiquid assets into immediate liquidity as in the banking theory of Douglas Diamond and Raghuram Rajan (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 37-44, 51-60, Financial Regulation after the Global Recession, 22-6, 30-42; see Globalization and the State Vol. II, 73-81, Government Intervention in Globalization, 128-31). A major part of credit is processed by securitization. Consider an example of mortgages that is valid for almost all credit such as credit cards, automobile loans, consumer loans and so on. The acquiring home owner receives cash to buy the home from an originating bank in exchange for a mortgage with the house as collateral and a loan agreement. Mortgages of similar credit rating and other characteristics are bundled into a security called mortgage-backed security (MBS) in which principal and interest are paid from the original mortgages. The MBS is acquired by investors and financed in short-term sale and repurchase agreements (SRP) in which the investor in the MBS or financed counterparty sells the MBS to a financing counterparty with an agreement to repurchase it at a contracted price plus interest for settlement at a specified short-term future date. The SRP converts the underlying illiquid home in the MBS into immediately available cash that can be construed as the funds that financed the purchase of the home. Securitization had worked for decades without a major crisis. The system was fractured when the financing counterparty decided not to renew the SRP in fear of defaulting mortgages underlying the MBS or asked for a deep discount in the contracted price in order to avoid losses if the financed counterparty did not repurchase the MBS because its market price collapsed. The financing counterparty would incur a loss equal to the difference between the depressed price received from selling the MBS used as collateral in the SRP and the value of the principal and interest defaulted by the financed counterparty. Some MBS were pooled in credit derivatives such as collateralized debt obligations (CDO) that were financed by issue of commercial paper of the structured investment vehicle (SIV), often related to banks, which was unable to roll over the SRPs of commercial paper because of defaults in mortgages underlying the CDOs (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). The critical event triggering the credit crisis was the default of mortgages in securitized instruments and derivatives.
The primary cause of the credit/dollar crisis and global recession was the fracturing of counterparty financing in SRPs of asset-backed securities and their derivatives. The most important function of finance professionals is protecting capital without which their institution disappears. Many finance professionals held most of their wealth in stock of the company where they worked. Many homeowners purchased their homes without premeditating or risking default and foreclosure that could ruin their lives. There is a more compelling alternative interpretation that the crisis was primarily caused by near zero interest rates, lowering of mortgage rates by interruption of the issue of 30-year Treasury bonds, housing subsidy of $221 billion per year and the purchase or guarantee of $1.6 trillion of nonprime MBS by Fannie Mae and Freddie Mac with leverage of 75:1 (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The target of the fed funds at 1 percent with forward guidance that it would be maintained low as long as required created an equivalent of a put option or floor on the prices of financial and real assets. The low interest rate policy was designed to prevent deflation and its adverse consequences, causing the unintended expectation that house prices and financial assets would increase indefinitely but never dropping below a price floor. There was upside potential without downside risk. Wealth, which includes financial and real assets and human capital, would also increase but never decline below a floor. Monetary policy encouraged high risk and leverage in the pursuit of higher returns to avoid near zero remuneration by interest rates that penalized holding liquid balances. The mirage was broken when the Fed raised targets on fed fund rates from 1 percent in June 2004 to 5.25 percent in June 2006 (http://www.federalreserve.gov/fomc/fundsrate.htm ). The increase in interest rates caused increases in monthly payments of adjustable rate mortgages (ARMS) that pushed many borrowers toward default. The increasing use of ARMS was based on the belief that rates would remain low forever. The collapse of house prices caused default of mortgages underlying the MBS financed in SRPs and other structured products. Counterparty financing risk perceptions catapulted, contracting the volume of SRP financing that paralyzed credit transactions throughout all segments of the financial system.
Second, monetary/fiscal stimulus. Research by Bloomberg finds that the US government and the Fed “spent, lent or committed $12.8 trillion” by March 2009 which was about the entire economic activity or GDP in 2008 (www.bloomberg.com cited in Pelaez and Pelaez, Regulation of Banks and Finance, 224). The amount disbursed or lent by March 2009 was about $4.2 trillion. The Fed used about 11 credit facilities during the crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1). The Fed also engaged in the policy of “quantitative easing” (Pelaez and Pelaez, Regulation of Banks and Finance, 224, see The Global Recession Risk, 83-107). As of the last statement on February 3, 2010, the Fed held $1.8 trillion of securities, consisting of $708 billion of Treasury notes and bonds, $164 billion of Federal agency securities and $970 billion of MBS (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). The retained portfolio of MBS by Fannie and Freddie was $1.6 trillion as of the third quarter of 2009 (http://www.fhfa.gov/Default.aspx?Page=70 ). The eventual sale of these portfolios of the Fed, Fannie and Freddie could exert significant pressure on interest rates. Since December 16, 2008, the target rate of fed funds has been 0-0.25 percent (http://www.federalreserve.gov/fomc/fundsrate.htm ). The zero target of the fed funds rate has played a significant role in the carry trade. The carry trade consists of shorting the currency of the country with low interest rates to take long positions in the currency of the country with high interest rates. These are high risk uncovered positions that can cause losses if the dollar appreciates and/or if commodity prices and stock markets lose value (Pelaez and Pelaez, Globalization and the State Vol. II, 203-4, Government Intervention in Globalization, 70-4). The carry trade has evolved into shorting the dollar and going long in commodity futures and emerging market stocks. The dollar depreciated to $1.59/euro by 7/14/08 with the DJ-UBS commodity index reaching 237.08 on 7/03/08 (http://online.wsj.com/mdc/public/page/mdc_commodities.html?mod=mdc_topnav_2_3000 ). The flight to the dollar because of the global recession caused dollar appreciation to $1.261/euro on 3/09/09 and decline of the DJ-UBS commodity index to 104.83. Renewed risk appetite resulted in $1.50/euro on 11/30/09 with the DJ-UBS commodity index at 136.49. The ongoing sovereign debt crisis resulted in appreciation to $1.368/euro on 2/05/10 and decline of the DJ-UBS commodity index to 126.558. The carry trade has been more cautious because of the threat of an increase in interest rates in the US that would appreciate the dollar, causing a loss in the short dollar leg.
Third, debt crisis fear. A few facts illustrate the deteriorating fiscal situation of the US. The largest recorded deficits of the US as percent of GDP occurred during World War II: -14.2 in 1942, -30.3 in 1943, -22.7 in 1944 and -25 in 1945. The deficit as percent of GDP declined to -7.2 in 1946 and turned into surplus of 1.7 percent in 1947 (http://www.whitehouse.gov/omb/budget/fy2011/assets/hist.pdf ). The highest deficit as percent of GDP since World War II occurred in 1983, -6, but no past budget is comparable to the estimated deficits as percent of GDP of -9.9 in 2009, -10.6 in 2010 and -8.3 in 2011. The deficits are staggering in trillions of current dollars: -1.4 in 2009, -1.6 in 2010 and -1.3 in 2011. Estimated outlays or expenditures increase in current dollars by 28.5 percent from 2008 to 2011 while revenues increase 1.7 percent after declining by 14.2 percent between 2008 and 2010. As percent of GDP the estimated expenditures are the highest since 24.8 in 1946: 24.7 in 2009, 25.4 in 2010 and 25.1 in 2011. The federal debt held by the public as percent of GDP peaked at 108.7 in 1946, declining to 52.0 in 1956 and never exceeding 50 until the current estimates: 53.0 in 2009, 63.6 in 2011, 70.8 in 2012 and above 70 during the remainder of the decade. In an essay presented at the meetings of the American Economic Association in 2004, Robert Rubin, Peter Orszag and Allen Sinai argued that the US federal budget was moving along an unsustainable path, accumulating over $5 trillion between 2004 and 2013 with the federal debt rising above 50 percent for the first time since the 1950s when the country was still paying for World War II. The deficit was rising toward the future time of collective retirement of the baby boom generation when multiple entitlements will sharply increase government expenditures (http://www.brookings.edu/~/media/Files/rc/papers/2004/0105budgetdeficit_orszag/20040105.pdf ). The federal debt held by the public is now moving toward an estimated 77.2 percent of GDP in 2020 (http://www.whitehouse.gov/omb/budget/fy2011/assets/budget.pdf ). Long-term projections are subject to significant error and actions could occur before the debt touches 100 percent of GDP.
Interest rate increases and higher taxes are inevitable in the next few years, restricting the rate of economic growth and the capacity of the private sector to create jobs. Further stimulus could deteriorate the fiscal situation. Sovereign debt fears that spooked financial markets last week, reversing carry trades with a flight to dollar assets, are less likely to cause similar events with US federal debt. The major problem with US debt is the trillions of dollars that must be financed because of the deficits or refinanced because of maturing debt. Excessive existing weight of Treasury securities in portfolios together with trillions of dollars of new debt issuance may trigger a premium on interest rates of Treasury securities. Managing the federal debt may become more difficult if markets anticipate rising rates that could cause capital losses. The Congressional Budget Office (CBO) defines an “unsustainable federal budget” as federal debt increasing at a much faster rate than the economy as a whole (http://www.cbo.gov/ftpdocs/102xx/doc10297/SummaryforWeb_LTBO.pdf ). Agendas of regulation, prodigal budgets and targeted taxation of segments of business and income brackets may be inferior to stimulating attitudes that foster confidence in business plans inducing job creation. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
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