Fufill its role

The Federal Reserve came out with a press release today at 4pm.  The long version is linked here.  The short version is: If you are a large U.S. financial institution you will not be able to pay back the government capital until the system is working.  This is great news.  The Federal Reserve Board gave themselves a lot of subjective wiggle room to prevent banks from paying them back.  “Whether a BHC (bank holding company) can redeem its Treasury capital and remain in a position to continue to fulfill its role as an intermediary that facilitates lending to creditworthy households and businesses”  It seems fair to assume that the banks, besides Citi and Bank of America, could pay back that capital with some combination of public capital raising and balance sheet contraction.  This means that there is demand to shrink the capital base of the banking system and the Federal Reserve has it hands on the nozzle controlling that force.  Wha la! A new monetary policy tool, a capital escape value.  Although that was not the point (the point being they didn’t want the banks shrinking there balance sheets and thus induce a deflationary depression just to get out from of the burning wrath of congress) it doesn’t change the reality that is what happened.  And as I’m a big proponent of dealing with reality instead of what you would like to had happen.  I’m inclined to argue that it (the faucet of capital) needs to tended with care.  The Fed should think more about system level capital (in addition to the bank level capital).  This is what should have been done (and quite possibly was done) with the stress test program. Also the Fed should avoid shocking the system by having it all paid back at once.  They may also want to consider unwinding their own interactions with the financial system before letting the traditional banking sector back away from the table.

Cash is Risky

You can’t get away from risk unless you are dead, which is fairly high price to pay for eliminating risk.  A portfolio of cash just has different risk exposures than a portfolio of other assets.  Cash as a component of a portfolio makes all the sense  in the world.  It increases robustness and allows you to take advantage of situations as they arise but if you think because you hold a boat load of cash (or deposits or t-bills) that you are risk free; you are wrong.  Consider the following picture, it shows the real value (inflation adjusted) draw-down (or value relative to its previous peak) of a T-bill portfolio.

What does this mean?  We’ll for most of our lives T-bill have been fairly safe investments but in the early 1940s they were terrible and although you didn’t lose the nominal (number value) of the investment you did lose it purchasing power as inflation ate away at what you could buy. You can see this illustrated by the next chart which shows year over year inflation and T-bill rates.

Maybe you now believe me that cash is risky and I have not even illustrated the real risky case studies for fiat cash holding: Currency collapses.  Think Germany after WWI or Argentina a few years ago or Russia or (this is a long list).  Investors who held thier wealth exclusively in cash were devistated. 

Thus I repeat my intro, you can’t get away from risk, you can only manage it.  Sensible risk based diversification is the means to do this.

Debt Bubble II or Not?

One chart that is commonly use to explain the challenges we are having is the amount of Debt to GDP.  At a first glance it seems to suggests two things (1) we have a debt bubble just like the great depression and (2) that the aggregate level of debt is drowning us (who could support a debt 3.5x the size of their annual income). 

Part of this intuition is right.  Higher levels of debt exposure mean that the leveraged entity is exposed to a higher level of risk (call it survival or crisis risk).  But I think a closer look is warranted.  First, the ‘debt bubble’ that started in 1929 was – from my back of the envolope calculations – driven by the denominator not increased in nominal debt levels.  Nominal GDP collapsed  – both because of falls in real GDP and massive deflation.  The total debt to GDP increased by about 30% (in a X1-Xo sense) in each year between 1929 and 1933.  The below chart show where the increase is coming from.  It wasn’t an increase in debt that sunk the country but debt failures due in large part to deflation (yes, it was the Fed’s fault….Damn it; why did Ben Strong die….please don’t die Bernanke) as well as an economic collapse. 

If we can avoid deflation, the delevering process is much much easier (and if we have some inflation its even easier…although this is like playing with fire). 

My next complaint is that including finanicaldebt in the debt burden is odd.  This large increase show how much more interconnected the financial system and the degree of counterparty risk but it does not suggest an increase in real debt burdens.  If you take out the non financial debt then it looks like:

Yes debt has increased across the sectors, particularly in households, over the past 20 years but if you compare this level to the 1929 (before the deflation driven spike) its very similar.  I have a very hard time believing people who say that what has happened was inevitable.  Think about the debt level as the speed you are driving your car.  If you drive 80 it is risky, if you drive 100 it is even riskier, and if your drive 120 even riskier but you could die driven at 80 and you could live driving at 120 under the right circumstances (and the car – which in this story is the structure of your economy).  Typically you (the driver or economy) only die if there is a sudden stop or shock….which is what happen this time around (to a degree) after Lehman. 

So what does this mean going forward.  Don’t know for sure but I think low growth is obtainable and a depression avoidable.  If deleverging is done in the context of new capital and increasing money/balance sheet capacity (not deflationary) instead of shirking balance sheets, we are not in for a depression.  If deleverging is done in the context of a paradox of thrift and deflation balance sheet contraction then we are in for a rough ride.

Inflation is Your Friend!?

Inflation is a dirty word which – if you wish to increase your credibility – you will only say bad thing about it.  Here’s a small sample:

The best way to destroy the capitalist system is to debauch the currency.  By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.  – JM Keynes.

The first panacea for a mismanaged nation is inflation of the currency; the second is war.  -E Hemingway

Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man. – R Reagan

Althought these statements are fairly rhetorical, they are also reasonably true.  But, why is inflation bad?  (1) It can breakdown the price mechanism which is how resources are allocated and thus – in a sense – randomize the production system and (2) it can create transitional problem between nominal (money) and real prices which can destabilize society.  These problems emerge from having too low inflation (deflation debt spiral), or having a large change in inflation over a short period of time, or having a high (>8% annual inflation).  So the ideal of low stable inflation – which is what we shoot for – is a good middle ground. 

So why is the title of this post, ‘inflation is your friend.’  We’ll I could mean that inflation could help us get out of the real debt burden on the economy by increasing the nominal (money) price of the assets and thus decreasing leverage but what I am thinking about is inflation as a political buffer.  Consider that a large chunk of the most recent IMF recapitalization is going to go to Eastern Europe.  Why not just have Western European countries bail them out directly instead of through the IMF.  The IMF gives Western Europe political cover; the elected official in the West don’t have to answer to voters that they are bailing out Eastern Europe (which is what they are doing) instead they are sending money to the IMF.  Inflation can fill that role when it comes to the real size of government.  As long as spending grows slower than inflation (or slower than inflation and the growth of the economy) the real value (or % of GDP) value of government spending will decrease (in real terms).  Given it is pretty clear that we are incapable of shrinking (nominal) spending (would be nice but doesn’t appear that it will ever happen) because politicians view it as political suicide, inflation is our political cover. 

I’m not suggesting that we should target 10% inflation (playing with fire) but maybe we ultimately want 4/5% instead of 2%.  (There are also leverage discouraging side effect of this that may be beneficial). 

Revisit Monetary Policy Tools

I recently had a conversation about the problem of zero interest rates and it made we want to revisit the topic of the tools of the monetary policy.  (In the United States this would be the federal reserve)  Typically the monetary authorities around the world try to manage their economies through the use of interest rates.  If they are trying to stimulate the economy they will lower the interbank rate thus pulling down the rate that banks lend to each other which flow through both deeper in the credit markets (pulls down the higher risk credit – because they are priced on spread) as well as pulling down longer term rates (because of the term structure of interest rates).  When this rates drop to zero it is true they can not lower the rate any more but they are not without tools. 

In theory they can change the money supply which can facilitate lending (and push up inflation, which will push down the real rate).  This changing of the money supply can happening through liquidity provision, credit inter-mediation (credit easing) or quantitative easing (increasing the money supply).  Providing liquidity gives the banking system assurances that they will not have a problematic run on their funding thus encouraging lending (the fed is doing this happening).  Credit inter-mediation is when the central bank takes on credit risk itself (it take on the role of the banking system – we are doing this as well).  Lastly quantitative easing is when the money supply is increased.  I interpret this to mean that the central bank would buy assets without funding the purchases (meaning they don’t borrow to buy assets which they are currently doing, but they simply buy the assets).  Up till now they have been funding the purchases via reserve creation (or t-bill issuance via the treasury), unless those reserves increase lending that is going on (are used to credit credit); then I would argue that new money has not been created.  The fed is trying to push out new money but is challenged by a dis-functional banking sector (which is why they are doing some inter-mediation themselves).  The big challenge is that if and when the banking system feels more comfortable and starts to use it excess reserves will the fed be able to walk along the tightrope they have created for themselves without (a) pulling back to much on liquidity and starting a new problem or (b) not pulling back enough and starting a inflation fire (and plausibly a currency problem – although I think the Fed has some ability to fight that with the FX swap lines at the moment). 

Now it is important to note that we don’t have a lot of experience with these tools and thus it is hard to have a lot of confidence in the handling.  In fact I would argue that we (economist) don’t have a precise tool set when working with the concept of money (which I ranted about before).  I think it would be fair to say that we are in a large economic experiment. 

One major risk is that of the political system interfering with independence of the fed; although I think it is still unlikely it is much more likely that at anytime during my life.

Independant Central Bank

Creating rules of the game such that the game ends up playing out the way that you want is something I tend to repeatedly harp on.  The political independence of a central bank is well recognized as a beneficial thing and the U.S. Federal Reserve is set up to protect its independence.  It is self financing and each year send back to the treasury a health check of excess profits; 34.9 billion in 2009.  This ‘profitablitiy’ - admittedly most of it is coming from interest on treasury bonds – will be weakened because the the fed is now paying interest on reserve; although I don’t think this will risk needing congressional financing.  What may risk the need for legislative financing is massive losses on its investment…in this arena we are in a wait and see place.  The structure as the board is also designed to prevent any administration from being able to dominate it.  There are seven members on the board, there terms are 14 years and the terms begin every two years.  This seems like it would keep the Fed Board insulated….but the board currently only have 4 members and Kroszner has announced his retirement.  Thus if the president can get his appointment through the legislature (seems likely) he would have a board that could be in his pocket.  Not what one would hope for.  With this structural risk in mind it is encouraging to note that Obama approach to appointments doesn’t seem dogmatic and Paul V. has his ear.  Its hard to imagine him being any where near a politicization of the Fed Board.

Printing Money or PRINTING MONEY.

People throw around that phrase that the Federal Reserve is printing money and many people are implicitly suggesting that we should exchange our dollars for gold, guns, and farm land.  In a way I agree with these folks (a farm could be very peaceful), but I have a complaint about the loose way that people throw away the ‘printing money’ phrase.  It’s a multi-dimensional problem. 

Yes (excess) banking reserves have exploded recently:  797 Billion as of 12/17 up from 12 Billion  as of 8/27.  If this is looked at by itself it seems as if the banking system has exploded but the evolution is slightly more complicated.  The Federal Reserve has been using its balance sheet to hold the banking system (and I think its fair to say the Fed has become the banking system; consider that the Fed’s balance sheet is 2.35 trillion and the entire FDIC insured banking system is 13.5 trillion) since early 2008 when it started the term auction credit program (and its balance sheet was still under 1 trillion).  The operative question is how are these operations being funded? 

Is the money unfunded/unsterailized (increase in notes/capital) or it is being funded?  Basically it has all been funded (yes currency has increased by 55 billion but less than the increased due to the Y2K scare so I don’t view this as out side of normal given the increased level of fear…how much went under the mattresses?).   At first it was self funded through the selling of t-bill and bonds (some bonds are still on the balance sheet to facility the repo operation meant to have the treasury market function well).  Once they ran through the assets they started to fund through the treasury’s supplementary financing account, this is now being unwound and the fed is funding its interventions via reserve growth (and the fed many start issuing it own debt- this is smart, we don’t want a conflict between treasury and fed or politics breaking the banking system).  All of this intervention is funded, so is it printing money?  Ahhhhh sort of.  Credit extension and maturity transformation is transforming money but it not pure printing.  If they start buying assets without somewhere pulling cash out of the system it is pure printing. 

Sterilized printing can do the job and is not nearly as scary as unsterilized printing either from the Dollar perspective or the inflation front.  For now the fed has simply taken over the banking system role (they are desperately trying to get the banks to do it, so desperate in fact they are now – smartly in my view – extending credit to hedge funds); Unwinding this intermediation will be a story for some time to come.

Ten Years of Uncertainty

Today’s FOMC releasediscussed the Fed’s decision to continue the quantitative and qualitative easing programs which have allowed the Fed to play the role of the banking system-performing credit and maturity transformations-while ensuring that the money supply doesn’t collapse.  The release also mentioned that the Committee was “evaluating the potential benefits of purchasing longer-term Treasury securities.”  That may have triggered the large rally in treasuries that pushed the 10-year yield down to 2.27% (down 25 bps). With this in mind, I’d like to expand on yesterday’s post.

First, consider that an arbitrage relationship exists between a 10-year rate and 40 sequential 3-month rates.  You could finance the purchase of a 10-year bond with funding from the next 40 3-month rates.  Next, imagine that market expectations are that the 3-month rate will be 25 bps (the high end of the new fed funds target range) over the next 10 years.  If the market were certain, then the ten-year rate would be 25 bps as well, but the situation changes when those expectations are uncertain.  Let’s say that market expectations are normally distributed with annual volatility of N (a stylized assumption to illustrate a point).  As the range of plausible 3-mth rates expands, the bottom of the distribution is cut off by a certainty, the zero nominal rate.  The market 10-year rate ends up being a value based on the weighted average of the expected rates. The truncated distribution thus moves the expected rate away from the first guess (25bps).  This can be thought of just like an option (selling the bond has limited downside in a nominal sense).

You can now see how uncertainty affects rates.  How much does this upward pressure on rates matter? The soft floor on the 10-year rate will be a function of the uncertainty about the future path of the 3-mth rate, as illustrated by the following chart.  The open question is what you think the proper degree of uncertainty is for the 3-mth rates.

 

Update: It is worth nothing that Japanese 10-yr rates fell below 1% (although they’re usually in the high 1% range).  One plausible explanation for this is that in a deflationary environment (inflation is running at -5%) where the nominal short rate is 0% but in real terms it is higher at 5%, it is hard to imagine the monetary authority actually wanting a tight monetary policy.  This may give you a large degree of confidence that the nominal rate will not increase, meaning that the distribution contracts and thus the 10-year rate is able to fall.

Federal Reserve Challenge: When normal just doesn’t cut it.

When the economy slows, the first responder is the Federal Reserve. It eases monetary policy by lowering the bank reserve rates (it is often tight monetary policy which triggers the slowdown in the first place).  This time around, the Federal Reserve responded more aggressively than usual, but they quickly realized that in this cycle problems would not be solved by decreasing the interest rate paid on loaned reserves.  As the reserve rate was cut, the rates that were paid by consumers and businesses did not drop-in some cases they even increased because spreads increased faster than rates fell.  The Fed’s efforts were ineffective.  Now the rate is approaching the 0% nominal floor, which means that this type of intervention (in a nominal sense) is about to run out of bullets. 

 But the Fed did not settle for the standard policy tools; it has gone well beyond what is normally done to stimulate the economy.  One means to stimulate credit is to guarantee bankers access to liquidity, so bankers need not worry about liquidity risk when doing maturity transformations (borrowing short and lending long).  With this in mind, and a focus on preventing widespread banking failures, the Fed started to push out liquidity to banks through programs such as the Term Auction Credit program (after discovering that no one would use the discount window).  This program was useful in that it held the system together (we would be a lot worse off without it), but for the past few months the Fed hasn’t been able to push money out the door. This means that for every 100 dollars it auctions, only a fraction, say 60 dollars, is bid on.  Banks are so focused on deleveraging that they have no interest in doing maturity transformations even with cheap Fed money. 

 As things continued to fall apart, certain markets, such as commercial paper, were on the verge of collapse. The Fed’s response was to set up a program to provide liquidity so that bankers could buy the CP, but it quickly realized that it wouldn’t work because bankers were not interested in expanding their balance sheets.  The Fed then set up a program to take the CP on its own balance sheet.  We have now reached the stage where the Fed has taken on the maturity and credit transformation responsibilities which were once the role of the banking system.  Examples of this include the money market investor facility, the commercial paper facilities, and the new GSE purchase facility (and possibly a program to buy long term government debt).  In addition, the Fed has held together the fragile banking system by facilitating the JPM-Bear Stearns deal and providing ‘liquidity’ to AIG. 

 Now that I’ve gone over what the Fed has done so far (and how unconventional its actions have been), a fair question would be ‘what else could the Fed possibly do during its meeting on Dec 15/16?’  It could expand the existing programs and commit to buying more risky assets (thereby committing to do more maturity and credit transformation).  Even though this seems like more of the same, it would be beneficial.  I think the Fed should also provide transparency to the market on the duration of these programs.  While this would require the Fed to keep these programs in place or interest rates low for a certain period of time, which bears some risk, it would also allow the market to start pricing in the continuation of these programs and possibly encourage bankers to take advantage of the subsidies provided.

 To show the effect that future assurances could have, look at the forward interest rate picture.  The most likely path as imputed from Fed Futures (financial instruments used to transact on future rates) is that rates will fall to 25 bps (0.25%) and stay there throughout 2009.  But the futures curve for the same interest rates has them priced at around 80bps (0.80%) at the end of next year.  Why the difference?  Because as time increases, so does the uncertainty surrounding the expected rate.  If you look at the -1 SD (standard deviation) and +1 SD line, you’ll see a plausible distribution for future rates.  Think about it this way as the prediction is about a further point in the future you become increasingly uncertain about the prediction.  The expected rate ends up being the average of this distribution of rates. The problem is that the low side is truncated at zero so even if one does not expect rates to increase, the fact that your uncertainty increases as the duration of your prediction increases means that the forward curve prices in higher rates.  If the promise were made to hold down the rate at 25bps through 2009, then the forward curve would drop because the +1 SD deviations would drop (based on our confidence in the Fed’s statement).

 

Remember flatting out the short rate curve will pull down long rates.

Free Money: Not What Hamilton Had in Mind

Alexander Hamilton, the United States’ first and even now most influential Treasury Secretary, said ‘a national debt, if it is not excessive, will be to us a national blessing.’ Well today, for the first time in our history (I believe it has already happened in Japan), the United States government was paid, in nominal terms, to borrow money. Simply put, the interest rate on 3-month T-bills was negative. Now I greatly doubt that Hamilton was arguing that we should have a national debt because we would one day get paid. I believe his point was twofold: (1) having debt would help establish the creditability of the government and empower a federal bureaucracy (although not to the degree we have now), which would strengthen the Union, and (2) it would ensure that the government would have the infrastructure and credibility to access capital markets when it needed to (essential for the purpose of national defense).

The question of why the rates are negative remains. Why not hold on to the money yourself? A few parties do have an incentive to bid t-bills down below zero: corporate treasuries and central banks that are charged with managing liquidity rather than making money. They have too much cash to fit under the FDIC insurance levels at banks, meaning these deposits would carry bank credit risk; if they move out on the curve they have more duration risk, if they move to other instruments they have credit risk, and so on. T-bills are risk-free (or so the markets claim, what is meant is that they are less risky than anything else). Why not just take the cash? The physicality of this is a problem. I assume it is not simple to take billions of dollars in cash (you’d have to store it, risking theft or damage). Thus the negative rate could be considered a service fee. That said, I doubt it could remain significantly negative (roughly more than 10bps) for any period of time because these entities will start looking into other options.

This event is in part caused by the upcoming year-end marking period when corporations, particularly financial firms, will try to clean up their balance sheets. It would not surprise me if we see negative rates off and on until after the New Year.

Note: This doesn’t eliminate the zero rate ‘problem’ for monetary policy (more on this later).