Thursday, December 18, 2014

FMOC Statement

David Merkel of the Aleph Blog publishes a redacted FMOC statement with his own commentary after every meeting.

It is required reading at the Strategic Investor.

David, I think it is fair to say, is sceptical of the wisdom of committees of academic central bankers.  He is also a critic of the wordiness of the Fed Statement.  He believes (rightly, in my view) that in the effort to be clearer, the Fed has introduced lots of commentary on current conditions and the effect has been to reduce clarity, because the economy is a complex system about which it is difficult to make conclusive judgments.  Thus, the Fed highlights various uncertainties and often confuses the public.  A growth in 24/7 financial media which desperately needs something to talk about multiplies this as they attempt to parse every word.  I digress.

While I share much of that scepticism, I think that the narratives have become too rutted and categorical - as in - QE is great, the only problem is there  hasn't been enough and QE is bad, inflation is coming.

I think there are some other views of QE that should be expressed, and so I sent David an email, which I reproduce hereafter.

Broadly, I think that in terms of unemployment and combating deflation, QE has largely been ineffective.  This is by design.  Let me say it clearly, I do not believe that the underlying logic of QE is the dual mandate of the FOMC, but rather serves the regulatory function of the Federal Reserve, ensuring that sound institutions are able to operate.  QE hasn't obviously helped employment much - while employment has been rising, this has not been due to large amounts of credit expansion.   Moreover, it has not led to inflation.  This should not surprise us, as the Central Bank went to Congress at the outset of QE I and asked for permission to pay interest on reserve balances at the bank, which enabled the Fed to sterilize its new "money" by ensuring that the banks would keep it all at the Fed and not relend it.

What QE has done are two things - first, it has reduced the interdependency of the banks and banks' dependency on the money markets to provide short term liquidity.  This means that for the time being, there are likely to be fewer credit shocks that threaten any bank of size and that even if one bank is hurt, that the others are well insulated.  Thus QE allows the Fed to support the banks and protect the banking system while the banks build capital required in 2019 under Dodd-Frank.  It does so in a way that voters and perhaps Congress don't see, so it doesn't get labelled a "bank bailout".

The other thing that QE has enabled is for the Federal Government to run large (temporary) deficits without raising interest rates.  This might have been a problem over the period 2010-2012.  But should be be surprised that as the deficit has declined by $600bn per year since 2013, that the Fed has reduced its purchase of Treasuries ($45bn / month) by about the same amount?  The effect has been to bridge the government while the "core" buyers of treasuries, who were prepared to snap up $500bn of the things at "low rates" while the Fed was exercising QE are similarly prepared to accept similar rates for a similar volume of bonds today?  This is the real reason rates haven't risen.

Quite frankly, I think the Fed executed this move far better than anyone imagined.

Given that, I expect that in spite of short term volatility driven by Fed comments, that the economy will continue on about the same course for the forseeable future.

Below my letter to David, and hopefully a response from him.

I can understand if you are sceptical about Central Banks.  They are human constructs, and as such make mistakes.  But quite frankly, none of the doomsday scenarios appears to have occurred (I realize that fear that developing markets will experience a credit shock as a result of Fed tightening is possible).

Your specific criticisms have generally been of two sorts: first, that the Fed can’t really do anything about employment and therefore that we should expect no impact, and second, as today, to decry that the Fed’s policy hasn’t fixed anything and that unemployment is still horrible.  It seems to me you are trying to have it both ways - blaming them for taking action AND blaming them for not fixing the problem.  Which is it?  Or do you simply believe that the economy would have recovered faster without QE?  I think there is a case to be made here, but then make a case that QE has been harmful, not simply ineffective.

(FWIW, the case to be made is that to the extent that in a debt deflation savers are the consumers with the highest marginal propensity to spend, so don’t cut their income, because borrowers - who are largely overleveraged - cannot offset the belt-tightening by savers who find the yield on their savings cut).  Not really sure if it is true, but it seems possible.

I tend to lean in the direction of your first criticism - that the policy has largely been ineffective, at least by the metrics outlined in the FOMC.  Unemployment AND inflation are impacted most heavily by an aging society.  Retirees like low prices, tend not to spend and don’t like to work.  That the participation rate would decline after 2008, as demographic Boomers started being able to collect social security and tap into retirement plans is unsurprising.  In fact, to the extent that asset prices have risen (we can debate the extent to which the FOMC is responsible; I am a sceptic) we are ENCOURAGING lower workforce participation, as near retirees and those over 62 see a recovery in their nest eggs.

In other words, the Fed is getting the blame for a demographic challenge known since the late 1970s and quite frankly, one global in nature as fertility falls worldwide.

My own view, as I have stated before, is that QE is actually a bridge to Dodd-Frank.  What I mean by that is that banks have to build capital buffers to prevent insolvency, but they have until 2019 to do so.  In the meantime there is more than a bit of risk that a credit crunch could, through counterparty interconnectedness, lead to another infection of the banking system.  To avoid this, the Fed has built up massive Federal Funds at the banks which enable them to have a ready source of “safe” assets to trade with the other banks, and they can avoid resorting to commercial paper and other forms of short term financing.

After all, if the intent of QE were to actually flood the economy with cash, as many believe, the Fed would not have gone through the process of securing Congressional approval to pay interest on the reserves (thereby sterilizing them and preventing them from being fuel for new credit).  This also explains somewhat why the impat has been muted.

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