Alan Blinder, a former Fed Vice Chairman says the Fed still has options if more monetary easing is needed.
Please consider Fed Is Running Low on Ammo by Alan S. Blinder.
Chairman Ben Bernanke has told the world that the Fed is not out of ammunition. It still has easing options, should it need to deploy them. The good news is that he’s right. The bad news is that the Fed has already spent its most powerful ammunition; only the weak stuff is left. Mr. Bernanke has mentioned three options in particular: expanding the Fed’s balance sheet again, changing the now-famous “extended period” language in its statement, and lowering the interest rate paid on bank reserves. Let’s examine each.
From exit to re-entry. The first easing option is to create even more bank reserves by purchasing even more assets—what everyone now calls “quantitative easing.”
When the Fed buys private-sector assets like MBS it is trying to shrink interest rate spreads over Treasurys—and thereby to lower private-sector borrowing rates such as home mortgage rates—by bidding up the prices of private assets, and so lowering their yields. Judged by this criterion, the MBS purchase program was pretty successful.
It is not at all clear the Fed was “successful”. Blinder is making an assumption that the Fed’s purchase of MBS is what drove rates lower. Is that really the case or did Congressional guarantees of unlimited bankrolling of Fannie and Freddie losses do it? Perhaps it is a combination. Remember, at best the Fed can enhance the primary trend, it cannot change it.
By what practical measure can Bernanke’s efforts be considered a success?
But when the Fed buys long-dated Treasury securities it is trying to flatten the yield curve instead—by bidding up the prices on long bonds. That effort also seems to have succeeded, perhaps surprisingly so given the vast size of the Treasury market. Now put the two together. By reducing its holdings of MBS and increasing its holdings of Treasurys, the Fed de-emphasizes shrinking risk spreads and emphasizes flattening the yield curve. That strikes me as a bad deal for the economy because the real problem has been high risk spreads, not high Treasury bond rates.
Once again, the question at hand is: Did Bernanke succeed and if so by how much?
Clearly yields are lower, but why? The answer is the economy is weakening rapidly in spite of heroic efforts by both the Fed and Congress. In simple terms, the Fed failed to stimulate either lending or the economy. Thus yields fell.
The goal was not to lower rates, the goal was to stimulate lending. Pray tell, how can a policy that failed to meet its objectives be construed a success?
If the FOMC is serious about re-entry into quantitative easing, it should buy private assets, not Treasurys. Which assets? The reflexive answer is: more MBS. But with mortgage rates already so low, how much further can they fall? And would slightly lower rates revive the lifeless housing market?
To give quantitative easing more punch, the Fed may have to devise imaginative ways to purchase diversified bundles of assets like corporate bonds, syndicated loans, small business loans and credit-card receivables. Serious technical difficulties beset any efforts to do so without favoring some private interests over others. And the political difficulties may be even more severe. So the Fed will go there only with great reluctance.
The last damn thing we need is for the Fed to get creative. Can the already distorted economy possibly take any more Fed creativity? Look at the failures of all the stimulus programs. Are we any better off? Are banks lending? Are consumers in any better shape?
In order, the answers are: No, No, No, No (not that the order makes any difference).
The FOMC has been telling us repeatedly since March 2009 that the federal-funds rate will remain between zero and 25 basis points “for an extended period.” This phrase is intended to nudge long rates lower by convincing markets that short rates will remain near zero for quite some time.
The Fed’s second option for easing is to adopt new language that implies an even longer-lasting commitment to a near-zero funds rate.
Frankly, I’m dubious there is much mileage here. What would the new language be? Hyperextended? Mr. Bernanke is a clever man; perhaps he can turn a better phrase. But market participants already interpret the “extended period” as lasting deep into 2011 or beyond. How much longer could any new language stretch that belief?
Blinder finally implied something that I totally agree with: jawboning by the Fed is virtually useless.
Interest on reserves. In October 2008, the Fed acquired the power to pay interest on the balances that banks hold on reserve at the Fed. It has been using that power ever since, with the interest rate on reserves now at 25 basis points. Puny, yes, but not compared to the yields on Treasury bills, federal funds, or checking accounts. And at that puny interest rate, banks are voluntarily holding about $1 trillion of excess reserves.
So the third easing option is to cut the interest rate on reserves in order to induce bankers to disgorge some of them. Unfortunately, going from 25 basis points to zero is not much. But why stop there? How about minus 25 basis points? That may sound crazy, but central bank balances can pay negative rates of interest. It’s happened.
Charging 25 basis points for storage should get banks sending money elsewhere. The question is where. If they just move money from their accounts at the Fed to the federal funds market, the funds rate will fall—but it can’t fall far. After all, it has averaged only 16 basis points since December 2008. If banks move the money into Treasury bills instead, the T-bill rate will fall. But even if it drops all the way to zero, that’s not a big change from its 12-month average of 11 basis points (for three-month bills). So charging 25 basis points is no panacea.
But suppose some fraction of the $1 trillion in excess reserves was to find its way into lending. Even if it’s only 10%, that would boost bank lending by 3%-4%. Better than nothing.
Blinder is correct to assume paying negative interest on reserves will not stimulate much lending. Moreover, it would be stupid to try, because forced lending will increase bank losses. How much additional pain can the FDIC take?
Blinder is also correct in stating the money will go somewhere. The “where” should be easy to spot although Blinder failed to mention it: longer dated treasuries. Should that indeed be the target, it would further suppress yields, which as Blinder says “strikes me as a bad deal for the economy because the real problem has been high risk spreads, not high Treasury bond rates”
The second place money might go is gold. That would not do the economy much good either.
There is a fourth weapon, which the Fed chairman has not mentioned: easing up on healthy banks that are willing to make loans. Given bank examiners’ record of prior laxity, it is understandable that they have now turned into stern disciplinarians, scowling at any banker who makes a loan that might lose a nickel. That tough attitude keeps the banks safe, but it also starves the economy of credit.
Well, quite a few of those bank examiners happen to work for the Fed. It would probably do some good, maybe even a lot, if word came down from on high that some modest loan losses are not sinful, but rather a normal part of the lending business.
So that’s the menu. The Fed had better study it carefully, for if the economy doesn’t perk up, it will soon be time to fire the weak ammunition.
By not making risky loans, banks are acting responsibly for the first time in a decade.
Now Blinder proposes more of what got us into this mess in the first place.
Assets at Banks whose ALLL Exceeds their Nonperforming Loans
The ALLL is a bank’s best estimate of the amount it will not be able to collect on its loans and leases based on current information and events. To fund the ALLL, the bank takes a periodic charge against earnings. Such a charge is called a provision for loan and lease losses.
One look at the above chart in light of an economy headed back into recession and a housing market already back in the toilet should be enough to convince anyone that banks already have insufficient loan loss provisions.
That is one of the reasons banks are reluctant to lend. Lack of creditworthy customers is a second. Quite frankly would be idiotic to force more lending in such an environment.
The one thing I completely agreed with Blinder about is that jawboning is useless. However that has not stopped others from recommending the tactic.
Jeannine Aversa, AP Economics Writer, claims Bernanke’s top tool now may be power of persuasion.
The economy appears to be stalling. Yet the Federal Reserve has run out of simple steps it can take to revive it. Short-term interest rates near zero have yet to rejuvenate the economy. The benefits of federal stimulus programs are fading, and Congress has declined to pass any major new economic aid. That puts increasing weight on Bernanke’s words.
But as Fed watchers like Alan Blinder, a former Fed vice chairman, have noted, the Fed has used up its most potent tools. And low rates, normally an elixir for a sluggish economy, have yet to stimulate much growth this time.
Ethan Harris, an economist at Bank of America Merrill Lynch, notes that several Fed bank presidents have sparked public uncertainty by pushing in conflicting directions. Some have expressed concerns about inflation, others about deflation — a prolonged drop in the prices of wages, goods and assets like homes and stocks.
“They’re hurting rather than helping confidence with their noisy public debate,” Harris says.
Bernanke needs “to give a sense of confidence there is someone with a steady hand on the tiller,” Harris says. “One decisive speech can quiet the noise.”
A speech from Bernanke would not quiet the noise, rather it would be noise, and nothing but noise.
“The challenge is for Bernanke to communicate to the world at large — to financial markets and the public — that monetary policy is currently contributing to the economic expansion, and we need to be patient, says William Poole, former president of the Federal Reserve Bank of St. Louis.
The Real Challenge
The real challenge for the Fed and President Obama is to admit neither the Fed’s policies nor Congressional policies are working, that there are no short-term cures or fixes, and that it is time to share the pain more equitably including huge concessions from public unions, a haircut by Fannie and Freddie bondholders, and a reduction in unsustainable spending, especially military spending.
Unfortunately, neither Bernanke, nor Obama is capable of saying what needs to be said, or doing what needs to be done. Unless and until they are, all the yapping by Obama and Bernanke will be as productive as giving a bullhorn to a bullfrog.
For demagogues and fools, It’s Not Practical To Tell The Truth.
I wrote that column on August 1, 2008.
Nothing has changed except banks and bondholders are better off at an enormous expense to ordinary taxpayers. Simply put, thanks to Obama and the Fed, the poor are bailing out the wealthy. No amount of bullhorn blowing can change that fact, and fortunately the public is starting to catch on.
Mike “Mish” Shedlock
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