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Wednesday August 11, 2010 - 00:37:15 GMT
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Fed Policy Inflexion Point - Balance Sheet is New Orientation (FXA)

Fed Policy Inflexion Point - Balance Sheet is New Orientation

 

Today is more about symbolism than economic recovery when it comes to sizing up the Fed’s decision to reinvest proceeds from maturing MBS, GSE debt ahead.  In case you forgot Hilsenrath said as much in his ex post well informed article he also said the move would be small in its significance but big for symbolism. 

 

Heck it is really big on this front – the Fed is no longer targeting a rate of interest (first), but is targeting the size of the balance sheet (remember the BOJ stopped targeting call rate and started targeting bank reserves held at the Bank?. 

 

Future policy easing will involve increasing the balance sheet from current target at $2.054trln.  Indeed future tightening will involve cutting the balance sheet target. 

 

The other part of the symbolism in this “modest” move is the inference that the Fed is in this for the long run.  Monetary policy impacts the real economy with long lags and indeterminate force.  All the Fed has done to date is kept zombie banking system alive and provided enough liquidity to drive up risk asset prices.  But we are learning that inventory-restocking blip in GDP is no recovery in the real economy and the Fed transmission mechanism to the real economy (bank credit creation) is not functioning.  Sadly we are also learning that the link between stock prices and consumption (wealth effect) are no longer as strong as they were back in the early part of the 2000’s and in 1987.  First of all the crash in stocks from the November 2007 high to the spring 2009 low saw many retail investors exit and they have yet to come back.  They did not experience the rebound in stocks through 2009 and 2010.

 

But more importantly households are stuffed full of debt and deflated assets (homes, boats, autos, RV’s, plasmas, granite counter tops…) and is in no position to drive a US recovery much more global recovery.  Businesses (not small- and medium-sized ones which are struggling to pay rent) are sitting on piles of cash because they do not see growth in orders and who in their right mind in corporate America would expand capacity when there is plenty of unused capacity?  Don’t believe for a minute the Kool-aid (politicized) explanation parroted on every TV report that Obama care, cap and trade, Bush tax cut expiration (always temporary) or gvt in businesses like GSEs and GM is behind corporate hesitance to spend.  If orders double and taxes go up quarter, you can bank on it that a firm will invest (and hire) well over the cost of the tax increase.

 

I am not sure the Fed can do much for the real economy.  Maybe if the banking system was nationalized and good banks spun out without toxic assets and shadow banking dominant propensities it might be different.  But this too ignores the need to deleverage.  This will take years.  No amount of Fed balance sheet expansion can change this process.  The only quick path to recovery is debt forgiveness – mortgage writedowns by banks, loan forgiveness including credit card, student and auto loans.  This is highly improbable politically and would do for households what TARP did for banks…drive home moral hazard…privatize upside (durable goods consumption) and socialize downside (debt forgiveness). 

 

The most the Fed can do is prevent a depression (along with WH and Congress).  But restoring a vibrant and growing economy will depend on some other part of the planet filling in for the US consumption engine…Europe, China, Brazil, India and Russia come to mind…about as probable as peace in the Middle East.

 

David Gilmore

 

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