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Friday November 21, 2008 - 16:53:38 GMT
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Forex Blog - No One Home at Treasury, Fed

No One Home at Treasury, Fed

Nero may have fiddled while Rome burned, but US Treasury Secretary Paulson and Fed Chairman Bernanke might as well be on their way to Disneyland in some phantasmagorical celebration of having successfully stabilized the financial system.  That is what both said to Congress in testimony earlier this week and what Paulson asserted in his farewell address at the Reagan Library Thursday.


What planet are they living on?  Even earlier in the week when testifying in Congress bank shares were sliding, CMBX and ABX were exploding and agency debt was imploding.  Yet all that seemed to matter to our top economic policy generals was the retreat of LIBOR rates which in their current form reflect rates at which banks won’t lend to each other.   One could imagine a banner behind Bernanke and Paulson in House Financial Services Committee reading Mission Accomplished.


Sorry to break the news to Hank and Ben but the financial system is not stable and much more needs to be done to stabilize it.  And who cares if the lame duck is quacking and waddling…this is no time to close up shop and await the next administration.  Okay this message is more aimed at Paulson than Bernanke.  And if the Treasury Secretary and the White House is more concerned about packing boxes then we need to see the inauguration moved up to December01 from January20.


But Bernanke is culpable too.  He prematurely indicated that monetary policy was largely used up and the next phase of fixes had to come from government.  Well that is partly true…the Fed should not have rested – when was the last new policy step announced from the Fed?  Bernanke has been as quiet as a church mouse.  Indeed the silent void he has left has been filled by half-cocked remarks from a host of other Fed officials including Stern, Kohn, Bullard and Fisher.  And we still don’t know if the Fed has definitively embarked on a new approach to monetary policy – quantitative easing.  Some officials have said it is in operation and others have indicated it is possible but not yet in place.  And what does Bernanke think?  Last time he addressed monetary policy in a zero bound environment (Fed funds at or near zero) in any detail was in November 2002, when the Fed was worried about the remote risk of deflation and building a firewall around it…that firewall was never built and deflation indeed proved to be so remote a risk that the near ZIRP (zero interest rate policy – 1.00% FF target) in part gave birth to an inflation run and asset bubble (and 425bps in tightening).


While there is no fixed rules for the road for what constitutes quantitative easing it is most often associated with a central bank that cuts its official targeted rate to zero and more monetary stimulus is needed.  QE does not make deflation a necessary condition before a central bank will engage in this policy approach.  Indeed disinflation in a deepening recession could get an official rate to zero and prompt the start of QE before the broad price level turns negative (year-over-year).  What makes QE QE?  A new target, like a market rate (government bill or note yield), excess reserves held at the Fed (what BOJ targeted in its QE period from 2003-2005 – BOJ’s “current account” target) or a broad monetary aggregate and no longer targets an interest rate.  So using my definition QE has yet to start.  But what has started is an element of a policy response normally associated with ZIRP – a rapid and significant expansion of the balance sheet (now around $2.2trln up from $880bln in August).  The expansion in the Fed’s balance sheet would normally begin with the implementation of QE – a stated new target for open market operations.  So at most we have begun a QE tactic without a formal start of QE target shift. 


I would also note that the Fed has two options for expanding the balance sheet – lending against collateral and buying assets outright from the market and this could include foreign assets which would leave dollars sold for foreign currency unsterilized.  The latter operation is monetization or a permanent increase in the money supply and would be a more aggressive attempt to achieve a QE target.  Buying assets outright would also be a more deliberate attempt to create inflation and inflation expectations.  Inflation would penalize banks, firms and households for holding cash or near cash (bills) as inflation erodes purchasing power and forces these financial actors out of cash to reach for yield and consumers and firms to spend before things cost even more.


We are not at the monetization stage, but increasingly closer to a formal announcement of QE and this may well be behind the Fed’s announcement Thursday  it was making the December16 FOMC meeting a two-day meeting starting December15.  I think everyone believes the Fed will cut rates 50bps December16 leaving the funds target at 0.50% and if this is the bottom for funds it will state that rates will remain low for an indeterminate period which would imply that additional policy stimulus will be in the form of QE.  Alternatively, in the spirit of greater transparency, the Fed could announce a new target – perhaps a bill yield and drop Fed funds rate as the policy anchor which would be a far more explicit start to QE.  Since the Fed funds target is already meaningless as the effective funds rate is close to zero, why not just announce a zero Fed funds rate (100bps cut) and go straight mast GO and get on with QE?  How about a press conference to go along with QE announcement and 100bps cut to explain what QE is and why the Fed is using it?


As far as US Treasury and White House response to the crises goes, there is no time for packing boxes or planning the next iteration of work and or leisure.    The collapse in asset prices in the last week have largely wiped out the capital infusion from the US government and so we are back to square one on banks needing capital (Citigroup obviously most, but who is to say it won’t be another institution next week?).  Paulson said he will not ask Congress to authorize more TARP funds for banks and leave this to an Obama Treasury Secretary (looking like Summers or Volcker with Geithner staying at NY Fed).  Much as Washington can’t and won’t wait for a GM bankruptcy filing Treasury can’t wait for January20 inauguration to put more capital into the major banks under the to big and too connected to fail principle.  That is what I found so infuriating this week – Paulson has the audacity to give a farewell address when the financial system is burning like a California wild fire on Santa Ana winds.  Hubris of the highest order.


Officials also need to address disorderly markets – every market is disorderly and this is reducing liquidity by the day – look at cable, euro/dollar…supposedly deep and liquid currencies.  Look at the 30-year bond.  Look at stocks.  Willem Buiter of the LSE and formerly with BOE MPC and EBRD argued back in August that central banks should switch from lender of last resort to market maker of last resort and at the very least Buiter makes the case for central banks making markets in illiquid assets that are the cornerstone of the financial system…buy (or sell) stock index futures, currencies, commodities and government bonds from the market.  Officials caught up with the financial problem in October but the problem has morphed into a sprint and US officials are waltzing out of office or walking at a leisurely pace at the problem.  Policy is again looking reactive and to conquer this one we need the Fed and Treasury to take down the gone fishing sign and become proactive. 


Obama will have a $700bln to $1trln fiscal stimulus in hand for January21…and there will be more.  But the financial system and real economy can’t wait that long. 


David Gilmore



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