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
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 wonâ€™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
waddlingâ€¦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
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 trueâ€¦the Fed should not have rested â€“ 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 donâ€™t know if the Fed has definitively embarked on a
new approach to monetary policy â€“ 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 itâ€¦that firewall was never built and
deflation indeed proved to be so remote a risk that the near ZIRP (zero
interest rate policy â€“ 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 â€“ BOJâ€™s â€ścurrent accountâ€ť 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 â€“ a rapid and significant
expansion of the balance sheet (now around $2.2trln up from $880bln in August).
The expansion in the Fedâ€™s balance sheet would normally begin with the
implementation of QE â€“ a stated new target for open market operations. So
at most we have begun a QE tactic without a formal start of QE target
I would also note that the
Fed has two options for expanding the balance sheet â€“ 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
We are not at the
monetization stage, but increasingly closer to a formal announcement of QE and
this may well be behind the Fedâ€™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 â€“ 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 wonâ€™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 canâ€™t and wonâ€™t wait for a GM bankruptcy filing
Treasury canâ€™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 â€“ 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 â€“ every market is disorderly and this is reducing
liquidity by the day â€“ look at cable, euro/dollarâ€¦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 http://maverecon.blogspot.com/2007/08/central-bank-as-market-maker-of-last.htmland at the very least
Buiter makes the case for central banks making markets in illiquid assets that
are the cornerstone of the financial systemâ€¦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 January21â€¦and there will be
more. But the financial system and real economy canâ€™t wait that
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