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Wednesday October 14, 2009 - 20:19:52 GMT
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Forex Blog - Fed so Beyond Dovish, It's Pigeonish

Looking at the FOMC minutes, remarks from Kohn, Tarullo and even Bernanke in the last few days tells me there is no sign of a Warsh-led effort to engineer an early departure from ultra accommodative monetary policy.  And since when is Warsh a consensus builder?  He is the young Wall Street savvy Board member, not the tour de force capable of overriding Bernanke, Kohn, Dudley and the rest of the pigeon coop running the Fed.  Pigeon coop as in same phylum as a dove only bigger. 


Indeed not only did the minutes of the September 22-23 FOMC meeting not make any mention of the sooner, faster and larger option, but revealed instead that the FOMC pondered expanding the asset purchase program (MBS) while deciding on no change but leaving the question on the table with the full flexibility of doing more later.   Simply if the FOMC is leaving the door open to more quantitative easing in the form of asset purchases ahead, how on earth can the Fed be discussion the timing of an exit strategy with any precision?  I said at the time that Warsh was not taking issue with when to start removing accommodation, but rather was making a case for what the exit might look like when it becomes appropriate (and I also said track records at the Fed and Warsh’s human limitations make his contention that he knows what the recovery will look like to ascribe a pace and scale to the removal of accommodation as somewhat dismissible. 


Then there are the remarks from Vice Chairman Kohn who cooed about deflation risks, slack in the real economy and the need to stay accommodative.  Last week Bernanke said the Fed would tighten once the recovery took hold and many took this as a sign this was imminent.  Governor Tarullo’s remarks on the health of the banking system today were negative – yes the financial system is on firmer ground, but the banking system is still in a world of hurt staring down a serious problem in commercial real estate loans while bad residential real estate loans continue to be a problem. 


But make no mistake about it…the Fed still sees a need to end run the banking system where credit creation is not functioning at a level to support desirable levels of aggregate demand.  Hence conducting and contemplating expanding asset purchases is a de facto admission that a main transmission mechanism for monetary policy is the non-bank financial system or shadow banking system.


This was no better explained (shockingly honest for most central bank wonks) by BOE’s Bean in a speech on Tuesday.  Rather than summarize it, I have cut and pasted the key bit on what asset purchases are meant to do and as long as they are seen as possibly needed, there is no way in hell a central bank would begin raising rates (yes the BOE is also contemplating expanding asset purchases at future meetings even though this has not happened since the July meeting, and was voted down at the August meeting with Governor King and two other MPC members voting for a second increase and losing to the majority). 


Bean wrote:


Now obviously we would prefer that the money circulates more rapidly and that this is done through increased bank lending and deposit taking. In other words, we would like to see a further expansion of credit and broad money. Since the banks collectively are now awash with reserves, they should not be prevented from making additional loans because of any liquidity concerns. Banks are, though, constrained by a lack of capital and are looking to reduce leverage rather than increase it.


Fortunately, increased bank lending is not necessary for Quantitative Easing to work. Indeed, it was precisely because the Monetary Policy Committee expected the additional monetary injection not to stimulate bank lending directly at the current juncture, that the Asset Purchase Facility’s purchases were targeted at assets held primarily by the non-bank private sector1. So if the Asset Purchase Facility buys gilts from pension funds or asset managers, they will then have to look for another home for their money. As it is not very rewarding just to hold it on deposit, they are likely to look to put their money into other assets, including equities and corporate bonds. Thus not only does the price of gilts rise as a consequence of the Asset Purchase Facility’s initial purchases, but also the prices of a whole spectrum of other assets. That in turn lowers the cost of non-bank finance and encourages increased corporate issuance. Also the rise in asset prices increases wealth and improves balance sheets. In this way, Quantitative Easing helps to work around the blockage created by a banking system that is still undergoing a process of balance sheet repair.


That is exactly what we have seen since the Monetary Policy Committee started its asset purchase program. Gilt yields fell sharply, though they have subsequently risen and fallen again (Chart 2). But gilt yields can move for a variety of reasons, including changing expectations of future interest rates. If we control for that by comparing gilt yields with a measure of market expectations of the future level of Bank Rate (Overnight Indexed Swap rates for an equivalent maturity), we find that this spread has fallen by around ¾ percentage point (Chart 3). Moreover, no such movement is observed in either the United States or euro area, which strongly suggests that the movement may be related to our gilt purchases2. More importantly for the real economy, sterling investment-grade corporate bond spreads have fallen over three and a half percentage points since the start of Quantitative Easing (Chart 4). And equity prices have risen by almost a half, the fifth largest increase in a six-month period over the past three hundred years (Chart 5). Accompanying this, UK companies have issued over £60 billion worth of bonds and equities since January, compared with an annual average of around £40 billion in recent years (Chart 6). Moreover, the spread between the three-month interbank rate over expected Bank Rate, which had been unusually elevated during the crisis, particularly after the collapse of Lehman Brothers, has fallen by almost 1½ percentage points and is now more or less back to pre-crisis levels (Chart 7).


All this suggests that Quantitative Easing is having the expected effects on the economy.


All that Bean just said suggests to me that from day one the goal of unconventional monetary policy at the Fed and BOE was to arrest the decline in riskier asset prices (stocks) and the real economy will follow without kicking off a radical rise in market rates.  So far that strategy looks like it is working.    


If only the Fed was this frank markets would not take every mention of an exit strategy by a Fed official and turn it into a message about the timing of an exit strategy deployment.  Sadly the Fed operates on a different level of transparency than the BOE…call it “A Few Good Men” approach as in you (the markets) can’t handle the truth.  Not when it comes to the real dope on QE (or CE in Bernanke lingua franca) and also not in revealing the names of discount window borrowers, details on collateral posted and special facility customers (and amounts). 


Not only is the Fed’s power elite so dovish it is pigeonish, but when it comes to the language of choice for conveying policy to markets and the public at large, they speak pigeon too.


David Gilmore




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