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Forex Blog - Fed Should Go to ZIRP (zero interest rate policy or quantitative easing) Next Wednesday

Fed Should Go to ZIRP (zero interest rate policy or quantitative easing) Next Wednesday


How about this for a novel idea…use taxpayer money to invest in bank stocks to boost Tier 1 capital and voila watch banks get back to the business of banking – lending.  Well after $290bln of investing in banks and some $40bln invested in AIG, banks and near banks are not doing much lending beyond buying US government debt…sometimes when yields are at or near zero…today’s $30bln 1-month T-bill auction went off with zero yield and it was four times oversubscribed. 


Washington claims the credit market is thawing noting spreads are coming in and LIBOR is falling.  But T-bills and the repo market failures suggest banks are still all gummed up.  TARP money was used to white out large writedowns from toxic securities…no credit creation from this credit creation intended use of taxpayer money (why are there no hearings with Paulson and Bernanke on this?).  Failure to deliver (T-bills…now the currency of acceptable collateral…are in short supply as banks hoard the precious near zero-yielding assets) collateral in repo transactions is now the rule rather than the exception…there are no real penalties for not delivering and no one wants to hand bills away fearing may not get them back. 


If the credit market was anywhere close to thawing, these behaviors would not be worth mentioning.  A condition for a Keynesian liquidity trap is when cash and government bills are perfect substitutes (zero yields).   Well we have met this condition and yet the Fed is operating as if the Fed funds target is the focus of monetary policy.  Sure we have heard much in the last month from Fed officials about the expansion of the Fed’s balance sheet (nearly tripled to $2.1trln since August), the start of outright buying of securities and the low effective Fed funds rate.  But quantitative easing starts with a new target for monetary policy to replace Fed funds that are at or near zero and this target has yet to be introduced.  Having elements of QE is not the same as adopting QE. 


Which gets me to next week’s FOMC meeting (extended to a 2-day meeting a few weeks back presumably because there is much to discuss on QE and much convincing to do for the consensus-oriented Chairman Bernanke) when I think the Fed should move directly to a zero funds rate target and the immediate launch of QE with a new explicit target to guide Fed liquidity operations.  Cut 100bps  to a zero Fed funds rate “target” (Fed funds futures are fully priced for 75bps and arguably 25bps Fed funds rate is essentially close enough to zero to get QE formally started) and get on with it. 


It seems to me that fiscal policy guns could be aligned with monetary might.  Paulson and Congress (Democratic leadership with implicit support from President-elect Obama…the odd couple…Congressional Republicans are sprinting away from President Bush and his Treasury Secretary savant) should announce Wednesday a plan to use the remaining $350bln in TARP funds to support the housing market (some aimed at checking foreclosures though re-default rates make this approach iffy, some aimed at driving mortgage rates down and perhaps some aimed at reducing principle which would address negative equity).  Obama’s economic transition team could go more explicit on its planned fiscal stimulus shock and awe campaign after the inauguration…give us a number over $600bln. 


My bet is stocks would rally 1000 points (DJIA), bill and cash hoarding might look less attractive and banks may start to feel enough internal and external pressure to begin lending.  Indeed it would aid risk assets and risk currencies and start the dollar on a much necessary run lower.


What will the Fed do?  It will probably delay formal adoption of QE and instead discuss more (in the statement) what ZIRP might look like while assuring rates would remain low for an indefinite (lengthy) period of time and then go on an education campaign to prepare markets for QE roll out January 28.


David Gilmore



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