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August 27, 2010
Today, Fed Chairman Ben Bernanke gave a speech regarding the recent weakness in economic data. Here is the link to the speech.
It isn’t too technical, so it might be worth reading the full 20 pages.
The market sold off immediately and honestly I cannot tell what was affecting the market’s reaction.
As I read the speech, he basically said nothing new. In fact, if anything, the speech further validated my belief that the Fed has limited options and it is worried about the use of those options. In other words, they really are low on bullets.
Essentially, Bernanke said the Fed has three tools that he’d consider using and one he won’t consider at this time.
First, they can print more money and use it to buy more securities in the open market.
Remember, they did this to the tune of $1.7 trillion for about a year. This policy ended in March 2010. Then, in early August, as the economy began to visibly weaken, they announced that they are going to restart the printing press – but only to replace the prepayments on their mortgage-backed securities portfolio. Well, in this speech, he identified the first tool as their ability to print a lot more and buy a lot more.
We’ve thought about this before. Money is printed by the Fed, money is used to buy assets in the secondary market, the sellers of those assets then have the cash and they decided to buy something with it. Possibly, the seller buys some more bonds with their cash – and they did this by buying mortgages and corporate bonds. And, yes, they also bought stocks and drove a rally from March ’09 to April ‘10.
Now, remember, they bought these assets from other investors and those investors in turn got the Fed’s printed cash. And, the cycle of buying and selling went on and on and one…until…the last guy with the cash finally just deposited it in his bank account somewhere…and then that bank - with nothing better to do with it - deposited in the form of “excess reserves” with the Fed. And, there it still sits.
Think of this money printing action – this is called “quantitative easing”, by the Fed – as money washing over and then through the system. It is a liquidity bath and it drives action for sure. It has an effect but it is, by definition, temporary.
Will it work a second time if the Fed decides to wash the system with a trillion or two more dollars? Will investors know that the cash will eventually find itself in a static resting place? We don’t know, but the reflex is that it is good for securities prices and as I write this, the market is now up.
Second, the Fed said they could simply tell the markets that they will maintain a zero short-term interest rates for more than just “an extended period”.
So, this tool is to change the wording of their monthly FOMC statement. This one can be characterized as a tool simply designed to manipulate investor behavior and their future expectations. I don’t get it, frankly. Japan has held low rates for a long, long time and it didn’t change the deflationary dynamic much.
Third, Bernanke said they could lower the interest they pay banks on their deposits of those “excess reserves” referred to above.
The whole point of paying interest on those excess reserves was to discourage banks from going ahead and lending their excess reserves some other bank that needs them to make a loan. Now, in this economy, that isn’t much of a problem with loan demand remaining quite weak. But, in a better economy, the fear is that the newly printed money turns into circulated money and sparks inflationary fears. In response to this fear, the Fed has sent the signal that they can just raise the rate that they pay on the excess reserves and stop this inflationary process in its tracks.
Now, in this speech, Bernanke mentions lowering the interest it pays on reserves as tool to encourage banks to lend to other banks who want to make loans. So, this is the tool and right now, the Fed only pays 0.25% on the excess reserves. I don’t think Bernanke actually believes that lowering the rate to 0% would spark much action by banks to lend the money out to businesses and consumers. Why? It is such a small change – from 0.25% to 0% - and at the end of the day, businesses and consumers aren’t all that interested in borrowing. In aggregate, they are actually de-leveraging.
Finally, the one tool that Bernanke said they could use - but won’t use now - is to just scare the market into believing that they’d be willing to tolerate much higher inflation rates than their stated goal of 1%-2% per year. In other words, if they sent the signal that 3% or 4% or 5% was okay, it would juice investors into borrowing money now on the cheap. In turn, this activity would spark nominal asset prices as well as nominal wages, etc. Nominal assets and wages up, debt levels stay the same and inflation fixes the problem of a deflationary trap. This is a method mentioned by Paul Krugman and others. Bernanke said that nobody at the Fed is going to promote this tool now – only if things got really slow and deflation was a real threat – which they don’t think it is today.
In summary, he didn’t say anything new. My main takeaway is that the Fed sees the slowdown that is afoot and they are uncertain about the effect of any of these policy tools. The future market reaction to any of these policies is not written in some textbook. Bernanke acknowledged this uncertainty. Personally, I don’t think we should be looking to the Fed as a saving grace for the economy. They’ve largely done their heavy lifting and it doesn’t appear to be working.
