Commentary: Fed Capital, Central Bank Solvency, and Budget Gimmickery

It's the last day of 2015,and the Fed transferred an additional 19 billion dollars to the US Treasury in accordance with a key funding provision of this year's Highway Bill.  Many commentators have called this move a "shakedown" or theft.  Some Fed officials, including Chair Yellen, are concerned that the move threatens the central bank's independence.  The latter may be closer to the truth.  In reality, this transfer has no economic significance whatsoever. 

Fed Profitability:

The Fed earns billions of dollars every year, most of which is remitted to the US Treasury.  The Fed creates money out of nothing and uses that money to purchase interest bearing securities.  Until recently, nearly all of the Fed's portfolio was US Treasury securities.  By purchasing these securities and earning interest on them the Fed is effectively saving the government interest costs.  By "paying" interest to Fed and having the money sent back to the Treasury, the US government is effectively borrowing money from the Fed for free.  Since the crisis, the Fed has also purchased bonds backed by mortgages. (Not subprime, but mostly conventional, 30 year fixed rate mortgages which performed very well during and since recession) Since the interest on these bonds is paid by homeowners, the earnings derived from these purchases can be thought of as a seigniorage tax.  As we shall see, the the exact nature of the transfer is not economically but politically significant.  While the expansion of the Fed's balance sheet was intended to jolt the economy by reducing long term borrowing rates, it had the side effect of raising nearly half a trillion dollars in revenue for the Treasury.  The fact that monetary policy can be profitable can spell trouble for central bank independence if the Federal Government were ever to pressure the Fed to put earnings ahead of economic stability.  

The Transfer: 

The 2015 Highway Bill orders the Fed to reduce the money in its Surplus Capital Account to 10 billion dollars, resulting in a 19 billion transfer to the Treasury. Crucially, the Fed will effectuate this transfer by selling securities it already holds in its existing portfolio.  This will reduce future Fed earnings and thus remittances to the Treasury.  Mechanically,  the Treasury will thus make interest and principal payments on these securities to private bond holders instead of the Fed. The net result is thus no different than if the Treasury itself had issued new bonds at one of its weekly auctions.  The only distinction is political, not economic. Since only bonds sold by the Treasury count against the official national debt under government accounting rules, Congress can make it appear as though the Highway Bill is deficit neutral.  

Fed Capital?: 

Budget games aside, the need for the Fed to hold capital is certainly a head scratcher that our own central bank seems to have acknowledged.  From a 2002 GAO report,  

Federal Reserve Board officals have noted that it can be argued that a central bank, including the Federal Reserve System, may not need to hold capital to absorb losses, mainly because a central bank can create additional domestic currency to meet any obligation denominated in that currency. 

The Fed also pointed out that its capital was largely symbolic.  From the same document as above, 

[Fed credibility...] could be fall if large losses wiped out the Federal Reserve's capital accounts, giving the misimpression that the Federal Reserve was insolvent. 

In other words, the unlike a commercial bank, Fed does not need to hold capital to maintain solvency or cover its losses because it liabilities all denominated solely in US dollars which it alone can print.  Alas, everything it not all hunkey dory.  Although in a technical sense the Fed can never face financial ruin or go bankrupt, it still faces constraints so long as it is committed to achieving its objective of price stability. 

Policy Insolvency: 

One danger is that of so called policy insolvency, where the Fed (or any central bank) remains solvent only by abandoning its policy objectives.  One scenario could include a rapid normalization of monetary.  If inflationary pressures picked up and the Fed wanted to accelerate the pace of interest rate hikes, it would be very difficult for the Fed to raise short term rates above the aggregate interest rate it earns on the securities in its portfolio.  Because the Fed is controlling interest rates by setting a price floor, it has committed to pay interest on the trillions of dollars of reserves it created to finance the expansion of its balance sheet.  With most of its security holdings yielding on average about 3 percent, the Fed could experience negative earnings if it set short term interest rates north of 300 basis points in the medium term. It could make up the difference by selling some of its securities, but it would realize losses because bond prices fall as interest rates rise. The Fed could also just pay interest by creating more reserves.  Unfortunately, both of these options both entail  a permanent increase in the monetary base.This may have implications for price stability. Additionally, the Fed could avoid this scenario by keeping the Federal Funds rate below the rate of interest it earns on its securities.  The Fed would be putting earnings ahead of price stability, essentially abandoning its objectives.   To avoid expanding the monetary base, the Fed could of course ask the Treasury for money to cover its shortfall.  However, the politics of such a move would be treacherous and currently the political will does not exist to enact such a program if it were necessary.     

All About that Base: 

However, the dangers described above rest the very shaky assumption that only the monetary policy variable is the size of the monetary base.  Followers of this extreme form of monetarism predicted (wrongly) that QE would result in hyperinflation.  What Ben Bernanke and many other economists understood perfectly well in 2008 and before was that the monetary base is not a constraint on bank lending and thus a poor forward indicator of inflation.  Crucially, because the Fed (and most other central banks) have explicit interest rate targets, they are committed to supplying such reserves as are necessary to meet that target.  Thus, central banks expand the monetary base to meet demand on a daily basis.  The real "printing press" is thus the banks themselves as they create credit and borrow reserves to fund new loans.  All about that base might be a catchy pop song, but it is an inadequate description of monetary policy or the process of money creation.      


Conclusion: 

In sum,  concerns about Fed solvency rest on faulty assumptions regarding the true constraints on bank lending and money creation.  Congress's latest move is more about political dysfunction than economics.  The real question is whether or not a sudden burst of inflation would find the Fed under political pressure to keep rates low in order to maintain positive earnings to both keep remittances high and thus avoid the need to fund expenditures with taxes or Treasury bond issuances. This lack of transparency is no way to run a country, let alone a superpower.  In the end, it's not at all reassuring that while the Fed will not have to choose between solvency and price stability, in Congress political gamemanship reigns supreme.   

 
 

Commentary: First Week Under the New Monetary Regime

It's the week of Christmas, but it's also the first week of a very new monetary framework in the United States.  When Federal Reserve hiked interest rates last week, it implemented it's policy change in a very unique manner.  Rather than selling Treasury securities into the market to drain liquidity out of the financial system, the Fed raised interest rates it pays on reserves. The Fed will pay 25 basis points to institutions which engage in reverse repurchase agreements (RRP) with the central bank, and 50 basis points on excess reserves. The idea is that the Fed is trying to set an effective price floor in the 25-50 basis point range.  The Fed is taking this new approach because the system is so awash in liquidity that it would need to unload trillions of securities in order to get short term interest rates up.  This would risk destabilizing the bond markets and send longer term interest rates soaring. 


In assessing the effectiveness of the Fed's new policy, it is critical examine the behavior of short term interest rates.  This will allow us to gauge the firmness of the Fed's newly constructed price floor.


Libor and Effective Fed Funds Rates have Fixed Higher:


Both libor for USD and the effective Fed funds rates have fixed around 36 basis points since the Fed moved.  However, it is dangerous to put to much stock in these figures, since again, given that the system is still full of liquidity from  QE, banks have no need to trade Federal Funds anymore.  Volumes on this market are therefore miniscule, and not reflective of actual overnight rates.


Overnight Repo Rates are also Higher:


According the DTCC Overnight Repo Index , repo rates for Treasurys and Agency MBS/debentures have go up in the past week to settled around 30 basis points.  Volumes on this market are much higher (about 150 billion daily), and thus a more accurate measure overnight rates.  Earlier this year, most repos were trading around 15 basis points. The Fed seems to have succeeded in getting this interest rate, which financial institutions actually borrow at, to rise slightly. 
Oddly, Short-Term Treasury Rates Haven't Budged:
The US Treasury auctioned off 4-week bills at a 19 basis point yield on Tuesday, a basis point lower than a week ago, and well below the Fed's 25 basis point RRP floor.  While traditionally the US government has been able to borrow below short term money market rates, this has long been assumed to be a reflection of the small amount of counter-party risk entailed in overnight lending.  Indeed, lending the fact that parking your money with Uncle Sam is safer than investing it in a money market mutual fund was all to evident seven years ago.  However, this time, the counter party for the new RRP is the Federal Reserve System, a branch of the US Government itself.  The only explanation can be that firms with money to invest cannot access the RRP and are thus forced to invest in short term Treasurys.  


In sum, the Fed has gotten money market rates up a bit, but holes exist in the rate corridor it has built.  A much, much cleaner solution would be for Congress to grant the Fed authority to pay interest on reserves to any and all takers (not just banks).  This would allow the Fed to set a unified, and single rate which would act as a much firmer price floor on the money markets than today's two tiered system.    

Commentary: An Easy Fix For Puerto Rico

Puerto Rico, a political subdivision of the United States, is mired in an economic crisis and the Federal government is doing nothing.  That's very odd, considering that the economic performance of the US mainland is among the strongest in the developed world.  But even stranger is the fact that the strongest, most technically capable nation on earth is simply sitting back while 3.5 million of its citizens face economic depression and stagnation.  The decisive actions of the Federal Reserve and the Administration to address the economic crisis in 2008 are to be lauded and praised.  They were the actions of the great power, and helped pave the way for the strongest recovery from the recession among the advanced economies.  Today, the President Obama must summon the political will to act again to ensure a prosperous economy for ALL US citizens living both on and off the mainland. 

The problems facing Puerto Rico are simultaneously simple and complex.  Today, Puerto Rico faces a debt burden roughly 72 billion dollars, about 70 percent of the island's GDP.  Some of that debt is municipal debt owed by the Commonwealth government.  A large chunk of it is debt owed by state owned utility companies.  On January 1st, Puerto Rico must make interest payments of 957 million dollars.  Governor Garcia Padilla has announced his intention to default on this payment because it is impossible to pay creditors and continue to provide essential services.  

What got Puerto Rico in trouble fundamentally comes down to the loss of economic competitiveness, misguided economic policy, and bad luck.  Puerto Rico lost a key tax advantage in 2006. (companies could book profits in Puerto Rico and send them to the mainland tax free) This was the ultimate death knell for the manufacturing sector.  The Island government then tried to heavily subsidize electricity and energy to convince manufacturing firms to stay.  Ultimately, however, these subsidies failed to prop up manufacturing because of the huge pool of cheap labor which was mobilized around the world by the forces of globalization.  In the end, these subsidies only further indebted the Island government and the public power company.  Finally, a bit of bad luck brought on crisis. The global recession killed the tourism sector, and the island has never recovered.  Per capital income is down nearly five thousand US dollars in PPP terms since 2006. 

Puerto Rico is currently barred from declaring bankruptcy, since it is an unincorporated territory.  This prevents the island from restructuring its debt in the courts.  Therefore, Puerto Rico is in the unenviable position of begging for mercy from its creditors or going hat in hand to international lenders like the IMF or World Bank.  This inevitability is beneath the dignity of the United States.  The strings attached from an IMF loan would essentially give a foreign entity significant leverage over a US territory.  It would also signal to the world that the United States lacks the political will to stand up for its own citizens. 

Fortunately, the United States is not caught in an economic straight jacket despite political dysfunction.  The Exchange Stabilization Fund, a special Treasury account that the President can use without the authorization of Congress, must be mobilized to aid Puerto Rico.  Presidents of both parties have used the ESF to stabilize the economy at home and abroad when Congress has failed to act.  President Clinton used to the ESF to lend 20 billion dollars to Mexico in 1994 after Congress refused to pass the Mexican Stabilization Act. (Mexico repaid the loans early with interest) President Bush tapped the ESF to guarantee the solvency of key money market mutual funds during the 2008 financial crisis.  

 Since it is unlikely that Puerto Rico can reach a timely deal with its creditors, the United States should offer the holders of Puerto Rico's debt the following deal.  The United States will pay 70 cents on the dollar to all of the island's bond holders.  Most of the bond holders would gladly except this offer, given it is highly uncertain when, how much, or if even investors will be paid without intervention from the Federal government.  Next, by imposing some losses, we can address the moral hazard problem.  However, by quickly resolving the question of the debt, Puerto Rico will gain the space to reform its economy and keep the government open.  This is essential, especially given the depressed state of the Puerto Rican economy.  

Finally, Puerto Rico would still owe money back to the US Treasury, again stopping the moral hazard issue and giving the island ownership over an economic reform package (ending fuel and electricity subsidies, modernization of infrastructure, and ending the "tax haven" culture and focusing on building up real economic advantages such as an educated workforce would be high on the agenda) which could be implemented in partnership with the Federal government.       

Puerto Ricans, like all Americans, deserve and equal shot, and equal shake, and chance at the American dream.  The Federal government has a duty to all of its citizens, not just those living on the mainland.  In sum, it's high time that the Federal government get its act together and underwrite a credible debt restructuring plan for the Commonwealth of Puerto Rico. 

Commentary: A Quick Note on the Doom Loop

The European Crisis has rekindled interest among economists in the possibility of a negative feedback loop between bank solvency and sovereign fiscal capacity.  The idea is a simple one.  Many sovereigns have implicitly or explicitly guaranteed the financial liabilities of their banking sectors.  In most advanced economies, and many emerging markets, bank deposits are insured by the central government.  Some have posited therefore that a string of bank failures could therefore bankrupt the state. 

The evidence for theory at first appears compelling.  Spain and Ireland entered the financial crisis with relatively low public debt loads. (36.1 and 25 of GDP respectively).  But the implosion of the banks in both nations and the ensuing bailouts made markets jittery.  Both countries saw their borrowing costs skyrocket in the wake of crisis, and were forced to turn to international lenders for assistance. (ECB inaction in 2010 and 2011 didn't help either)

Given these cautionary tales, it's not surprising that some have called for radical reform.  Laurence Kotlikoff has essentially proposed the abolition of deposit banking in the United States.  Instead, banks would split into two separate businesses.  Some banks would become payment banks.  They would take deposits, hold the cash for safe keeping, and effectuate payments, but make no loans.  Other banks would also take deposits and lend money, but they would be uninsured.  Consumers could choose where to keep their money;  'safe' payment banks that paid zero interest, or risky, uninsured lending banks which offered higher returns.  Proponents of this plan claim that in eliminates the need for deposit insurance. 

Sadly, ideas of so called 'limited purpose banking' fail to address what money actually is in a modern economy.  A bank deposit is nothing more than a spendable promise.  The bank promises to convert your deposits to physical cash on demand, or to allow you to transfer your deposits to other parties in payment.  In the United States, the Federal Deposit Insurance Corporation insures the deposit liabilities of the banks.  If the bank can't pay you your money when you ask for it, Uncle Sam will.  However, here it is crucial to remember that bank deposits themselves are money, because they can be used as payment.  In fact, 97 percent of the money in the United States is in the form of bank deposits and not Federal Reserve Notes.  

The promise that the United States makes, that bank deposits can always be exchanged for physical cash has nothing to do with state solvency.  The government is merely making the guarantee that bank deposits will always be convertible to small green pieces of paper we call dollars.  Because the US Government has the sole authority to print US dollars, it is impossible, for economic reasons, for the United States to default on this guarantee.  Nor would massive bank runs and a firing up of the printing press risk hyper-inflation, because the quantity of money would be essentially unchanged.  Rather one form of money (bank deposits) would merely be converted another(cash).  

Tragically, countries like Spain and Ireland gave up their ability to make this kind of ironclad promise when they abdicated their right to print their own money. Neither Spain nor Ireland have the right to produce Euros. The markets quickly imposed harsh discipline on these nations when it become apparent that massive financial bailouts were necessary to stave off economic disaster.  Of particular note, neither the US and UK faced sovereign debt crises despite of the fact that both nations had bigger deficits and debt levels going into the crisis, and implemented large, unprecedented bailouts.  This can only be explained by the fact that the US and UK borrow exclusively in their own currencies, and insure bank deposits denominated in those currencies.  And in sharp contrast to Spain and Ireland, public borrowing costs fell. Yields on US and UK government bonds plunged (despite huge increases in public debt) as the Federal Reserve and the Bank of England slashed interest rates.  

Financial regulation is important to prevent the boom and bust cycles and speculative bubbles that we get with lax underwriting standards.  Today, the FDIC and other deposit insurers play a key role in limiting the excesses of the banking sector and promoting financial and economic stability.  But, at least in nations which have prudently retained their monetary sovereignty, no bank failure could result in national bankruptcy.    

Canada's Disastrous Fiscal Policy

Canada is in recession.  It's central bank chief Steven Poloz made it official on July 15th, with his comments follwing this year's second rate cut.  Blame it on the price of oil.  That's Prime Minister Harper's line as he pursues fiscal austerity despite a weak economy.  Unfortunately, its the same tired, false equivalency between household and government finances, coupled with the myth that fiscal austerity will magically lead to prosperity.  In a demcracy, the people get the government they deserve, and old ideas die hard.  Canada's upcoming election is an opportunity for Canadians to reject the long dead idea that austerity is good for growth or that governments face the same kind of fiscal constraints as the private sector.  It's high time that government budgets are formulated with sound economics, not dysfunctional politics.  

Canadian Surpluses:

Government surpluses in Canada have been frequent occureneces over the past 50 years.  Politicians in Canada like to take credit, extolling the virtues of "balancing the books."  However, these surpluses are merely the result of the larger commodity cycle.  For example, when oil prices soared in 1974 as a result of the Arab embargo, the Canadian achieved a massive budget surplus of 8 percent of GDP.  When oil prices normalized in mid eighties and 90s, Canada ran mostly deficits.  The has repeated a few other times. By 1997, commodity prices were rising again, and would do so until the financial crisis.  For nearly all these years, Canada ran budget surpluses which again became huge deficits once oil prices crashed in late 2008.

It is also important to realize that the stance of Canada's fiscal policy is by definition tied to its external balance with the rest of the world.  Recall that:

Y = G + I + C + (X-M)

can be rewritten as

(S-I) = (G-T) + (X-M)

The above equations are well know macro economic accounting identities.  The term (S-I), or savings minus investment, can be thought of as the private sector's budget balance. 
(G-T), or government spending minus taxes, is the state's fiscal balance.  And finally, (X-M), or exports minus imports, is the external balance with the rest of the world. 

Thus, the private sector can only achieve a surplus if the government is in deficit or if the country has a positive trade balance.  Intuitively, this makes sense because private sector financial wealth is frequently cancelled out by private sector financial debt. Each time a credit card is swiped, new debt is created which on net cancels out the increased financial balances of those receiving credit card payments.  However, most private sector agents desire to increase their net financial wealth over time.  But again, this is impossible in aggregate without a government deficit or a trade surplus since one man's spending is another man's income.

In 2015, the Canadian economy is receiving twin shocks. Prices for its exports have fallen, which has resulted in a current account deficit.  At the same time, the Government is mindlessly insisting on balancing the Federal budget.  This only further squeezes the private sector's balance sheet. In other words, since the Government is running a nearly balanced budget, and the current account deficit is about three percent of GDP, the Canadian private sector by definition must be in deficit. And finally, the natural reaction to drop in income is to reduce spending.  Both the Canadian household and corporate sector are rolling back their spending plans, further depressing economic activity.

Bank of Canada:

With fiscal policy makers hard at work to slow the economy, despite a renaissance south of the border, the Bank of Canada has come under enormous pressure to cut interest rates to keep the economy chugging along.  Furthermore, divergence in the respective monetary policies of the Bank of Canada vis-a-vi the Federal Reserve has contributed to a large depreciation of the Canadian Dollar.  In recent months, the Loonie has even performed worse than the Euro and Japanese Yen, whose respective central banks are in the midsts of implementing unprecedented easing programs. 

The BoC has clearly indicated in its communications that it hopes a weaker CAD will boost manufacturing exports and help close Canada's trade gap.  That would shore up the Canadian prviate sector's balance sheet as aggregate earnings from abroad came into balance with money spent on imports.  However, a weak dollar policy is a rather crude mechanism for fixing the private sector's balance sheet problem.  With oil prices falling faster than the CAD, it would take substantially more weakness in the Loonie to actually close Canada's trade gap. 

Other dynamics are also at play, such as the price elasticity of demand for Canada's non-oil exports (since a weaker CAD makes Canadian exports cheaper abroad).  In any event, it is uncertain if a weaker CAD can by itself rebalance the Canadian economy. And even if it could, the process could lasts years. 

The primary mechanism by which monetary stimulates the economy is via reducing the cost of credit.  However, Canada's problem is not a lack of private sector borrowing, but too much of it.  Canada has one of the most indebted household sector's in the developed world.  History shows that it is large secular increases in private sector leverage, not public debt, which portend crisis.  In both the 1920s and 2000s, the rate of credit growth accelerated to unprecedented levels.  Furthermore, 1929 and 2008 both saw all time highs in private debt as a percentage of GDP.  Those years also share something else in common, namely, specutarly declines in asset prices and financial crisis.  A similar phenomenon occurred in Japan in the early 90s, and Sweden in 1992.  A massive build up of private sector debt led to the bursting of the credit bubble and then to financial sector and household insolvency. 

Fiscal Policy: 

The response of the US corporate and household sectors to massive reductions in borrowing costs in the wake of the financial crisis was largely predictable.  Rather than take on new debts in the face of a deep recession, most people preferred to shed excessive debts and repair their balance sheets.  Despite record low interest rates, credit growth in the US was basically flat until 2014, a full five years after the official end of the Great Recession. 

A key lesson from the financial crisis, and the Japanese malaise, is that interest rate reductions are not the answer private sector indebtedness.  Government deficit are.  When the government spends more than it taxes, the net income it provides to the private sector allows households and firms to earn their way back to solvency, allowing for private investment and consumption to return to prerecession levels.  Today, Canada is using the wrong tool solve its problems. 

Harper's Gambit:

The hallmark of Stephen Harper's reelection pitch has been achieving a balanced budget.  This rather folksy, austere message is meant to appeal to misguided voters who believe government budgets are like household budgets.  This idea is a dangerous myth.  Governments can print money and tax.  Countries like Canada which issue debt in their own currencies also control the interest rate at which they borrow via their own central banks. There can be no issue of debt sustainability or state solvency.  While it is indisputable that excessive money creation via deficit spending can be inflationary, that is unlikely to occur during recessions when large output gaps exist. Big deficits in the US and the UK, accompanied by full blow QE, failed to produce meaningful inflation in either nation precisely because so much excess capacity existed in the wake of the crisis. There wasn't the classic case of "too much money chasing after too few goods."  Rather, firms responded to what little new spending there was by ramping up capacity, not raising prices.    
Nobody disputes that it is a good idea for households to save money.  However, the aggregate household sector cannot save without a trade surplus or a government deficit.  At a time when Canadians are desperately trying to reduce their debts and increase their savings after years of heavy borrowing, and when the trade deficit will widen because of low oil prices, it is madness for the Government to pursue contractionary fiscal policies.

Harper demeans potential stimulus as short-sighted and irresponsible.  History and facts about government spending under sovereign currencies refute this assertion.  There is nothing responsible about keeping people out of work  or reducing economic output with restrictive fiscal policy. 

Sadly, Harper's gambit may pay off.  Should commodity prices rebound and he somehow pulls out a relection win, he will no doubt brag that fiscal austerity works.  But something as important as jobs and the vitality of the economy ought not be the purview of politics, or of politicians trying to appeal to far-right constituencies.  Canadians (and Americans) would do well to remember this as the head to the polls this October.

Conclusion:

Meanwhile, the United States continues to outperform the other advanced economies, and that its includes its northern neighbor, the nation of Canada. Given the integration of the US and Canadian economies, the consensus from a few years ago was that US would pull up all of North America. To be sure, most of that thinking was developed before the crash in oil prices. Nonetheless, Canada's pro-cyclical fiscal policy, in contrast to the flexible and counter-cyclical fiscal policy of the United States, largely explains much of the two nations' divergence in economic performance. Excessive fiscal tightening, and the over reliance on monetary policy is worsening Canada's downturn. Canada would do well to learn from the lessons of history and recent experience. Austerity didn't work in 1930, it didn't work in Europe in 2011. And it won't work in Canada.

Why We Don't Need GSE Reform, Or How I Learned to Stop Worrying and Love Fannie and Freddie

It was 2005 and my Uncle was deeply bearish. The housing market was booming but he thought everything was overpriced.  Worse still, Fannie Mae and Freddie Mac had insured over five trillion dollars of US mortgages, and should housing prices descend from there stratospheric levels, the US taxpayer was potentially on the hook.  

"But aren't Fannie and Freddie private companies?" I asked as a bright-eyed seventeen-year-old while my dad flipped burgers on the grill.  

"Yes."  He replied.  

"And no. Investors have always assumed that since both companies were chartered by Congress, the Federal government would rescue them if they got into trouble." 

Back then I knew nothing about funding advantages, interest rate risk, fully sovereign currencies, or retained portfolios.  But three summers later, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation were placed into "conservatorship" by then US Treasury Secretary Henry Paulson.  At the time, I didn't understand the implications of this bold but necessary move.  Today, I realize that conservatorship were the best thing to ever happen to the GSEs, and that seven years later, in 2015, we don't need GSE reform so much as a formalization of legal arrangements which preserve the current status quo.  

Nominally Private:

In testimony before the Financial Crisis Inquiry Comission, former Fed Chairman Ben Bernanke descibed Fannie and Freddie as 'nominally private.'  Specifically: 

Fannie and Freddie were nominally private corporations, but they enjoyed cost advantages from the implicit federal guarantee on their liabilities; these cost advantages allowed them to act as a duopoly in a number of businesses [....] Fannie and Freddie were permitted to operate with capital that was both of low quality and of inadequate size to buffer the risks in their portfolios. In addition, their balance sheets were allowed to grow rapidly.  

While Bernanke does not explicitly draw the connection, much of the growth of the balance sheets at the GSEs was specifically because of the strong market demand for their guarantees, a fact not lost of GSE executives.  In fact, so confident were the GSEs that they could access the money markets that they frequently began the business day with a negative cash balance which was made up by intraday borrowing.  Only a government entity could ever expect to have such seamless access to the money market.  

The truth of the matter is, both GSEs could never has grown as large or operated with the levels of margin that they did without government involvement.  However, under the system of allowing the GSEs to issue publicly traded shares and operate largely as normal corporations, we ended up with the worst of both worlds.  In essence, Freddie and Fannie were forced to serve two masters.  They were compelled to make as much money as possible for shareholders, which meant exploiting their government granted privileges to the fullest.  While their implicit government backing meant that profits would be privatized and losses would be socialized. 

Monetary Policy:

But even more bizarrely, both GSEs even gained the power to engage in de facto monetary policy. With the ability to borrow large sums on the short term money market at the same rate as the government, both GSEs were able to finance gigantic retained portfolios which at their height had notional values in the trillions. Again, because investors believed Agency debt to be as good as US Treasury debt, there was practically no limit to the amount the GSEs could borrow in order to finance mortgage investments. In essence, the GSEs were swapping short term liabilities (Agency debt) for long term assets (mortgage bonds). This is very similar to quantitative easing, whereby the central bank removes long term government debt from the market place and replaces it with short term assets (usually reserves). The effect of both policies was to markedly reduce long term borrowing costs. In fact, a 2006 report written by the CEOs of both Freddie and Fannie openly brags that large retained portfolios were materially reducing long term interest rates by keeping bond prices high.

Monetary policy ought to be the purview of the Fed, and should be conducted with the goals of economic stability, not profit. Nothing stops the Fed from running up its balance sheet as much as it wants to increase its earnings. And maybe if the Fed had shareholders to answer to, it might let its balance sheet balloon to the tens of trillions. But if Congress ever had the bright idea to make the Fed list on the NYSE, we would have nobody to blame but ourselves if when inflation got too high, the Fed put earnings ahead of price stability.

Instead of feigning outrage or surprise at the over-leverage and gigantic balance sheets at both GSEs prior to the crisis, policy makers should take note that both Freddie and Fannie responded in a highly predictable way to the incentives that they were provided. Their mandate was not to stabilize the housing or mortgage markest, rather, it was to maximize mortgage originiations and securitization to boost profits as their balance sheets, both in terms of direct mortgage investments and insuranced mortgages, grew to truly epic proportions.   

Dual Roles: 

Perhaps a bit of history is important.  In 2008 it was easy to say that Freddie and Fannie never should have been chartered.  A more insightful line of inquiry would be to examine why the government ever got involved in the mortgage business in the first place.

Mortgage lending is tricky for traditional underwritiers mainly because of interest rate risk.  Since banks finance the majority of their assets with demand deposits, writing long term mortgages can result in large amounts of asset liability mismatch.  In layman's terms, it's pretty risk to lend money to borrowers for 30 years while you might need to payback your depositors at moment's notice.  The beauty of securitiziation is that it allows traditional underwriters such as banks to make mortgage loans and then sell off the interest rate risk to investors in mortgage backed securities.  In fact, most so-called portfolio lenders, or those which both originate and retain mortgage loans, offer mainly adjustable rate mortgages.  They don't have the capacity to bear the interest rate risk. Without securitization, and without the GSEs, the 30 year fixed rate mortgage would not exist. 

On the other hand, most MBS investors are large pension funds, life insurance companies, or sovereign wealth funds.  These investors usually have long term liabilities. Most life insurance holders won't die for a long time, and most people involved in a pension scheme won't retire for decades.  These investors are therefore perfectly happy to invest in long dated assets.  

The GSEs are a fairly basic arrangment.  Traditional underwriters originate the loans, but again, since they can't take interest rate risk, they sell the loans off to investors.  The GSEs underwrite the process and also insure against the credit risk.  The result is that borrowers have access to long term (30 years) mortgage financing.  In theory, this same set up could be used to create a market for 30 year car loans, or 30 year personal loans, or 30 year loans to buy dishwashers.  Because the credit risk is stripped away, the investors who bear the interest rate risk will be indifferent to the to underlying colateral.

Therefore, because of the implicit government guarantee, Agency MBS have evolved into gross substitutes for US Treasury bonds.  The GSEs serve dual roles for different groups.  They help home buyers by providing long term fixed rate financing.  But they also help satisfy investor demand for long term government liabilities by effectively enlarging the size of the Treasury market. Indeed, after Treasurys, the Agency MBS market is the biggest and most liquid bond market in the world. 

The dual role of the GSEs can only be achieved with government involvement.  No entity other than the US Treasury itself on Agencies explicitly backed by it can provide risk free dollar denominated securities to worldwide investors.  Similarly, satiating this strong investor demand while simultaneously achieving the socially desirable goal of providing flexible borrowing terms to homeowners is a feat of financial engineering that the private sector would never provide.  In no other market do 30 year fixed rate mortgages exist.  Even in the UK, which has one of the most developed financial sectors in the world, mortgage loans typically have balloon payments after three to five years precisely because the British government is not involved in the making of mortgage loans.

Conservatorship:

Many believe that perpetual conservatorship is a step backwards for the GSEs, but in reality, conservatorship merely formalized an implicit structure which was crucial to achieving both of the their dual roles.  As effective public monopolies and quasi-sovereign securities issuers, it was incredibly misguided to involve the private market at all with either Fannie or Freddie.  Neither should have been publicly listed on stock exchanges.  The inevitable result was that both enterprises would put profits ahead of financial stability, and would exploit there public monopolies not to achieve the public purpose of providing safe investment vehicles and access to mortgage credit, but to make money for investors.  

In fact, in the heyday of Fannie and Freddie, both became more and more involved in riskier lending products which in hindsight destabilized the mortgage market and did not benefit borrowers.  Their securities issuance business was soon accompanied by highly leveraged trading operations which traded MBS on the GSEs' own account rather than on the behalf of clients.  That's right, Freddie and Fannie engaged in so called proprietary trading, a practice thought to have contributed greatly to the systemic risk which built up in the financial sector prior to the crisis. 

Going forward, conservatorship provides a perfect model for both GSEs.  Most importantly, it removes the perverse incentives and conflicting goals that the GSEs had before the crisis, namely, the need to please shareholders but also to responsibly use their government granted priviledges for public purpose and not short term profit.  

Conservatorship also provided stability to the credit markets.  Mortgage markets did not stop working in 2009.  In fact, the GSEs have securitized trillions of loans since the crisis.  Had the mortgage market been left the private sector, it would have essentially ceased to exist after the fallout from the crisis.  This in turn would have made the economic downturn even worse.  Given the primacy of housing in the economy, it is nothing short of reckless to leave the goals of homeownership and the financing necessary to achieve it to the vagaries of the market. 

If the GSEs were made explicit agencies of the US government, the risk to the taxpayer would be essentially zero.  This is because the all mortgage debt in the US is denominated in US dollars, of which the US government is the issuer.  Specifically, the cost of government spending is an opportunity cost.  Real resources marshalled for public purpose cannot be put to private use.  However, goverment spending to make financial transactions, such as paying off bond holders, involve no such relagation of private sector wealth to the state.  Therefore, even massive purchases of securities of by the government, even when financed by money creation, is unlikely to cause inflation.  Indeed, after nearly four trillion dollars of quantitative easing inflation is still at historic lows.  To put things in perpsective, the GSEs drew a combined 187 billion dollars from the Treasury.  This event occured after the worse economic downturn since the great depression and on a combined balance sheet of over five trillion dollars of mortgage assets.  Furthermore, all of the money and then some has been paid back to the Treasury.  And even if the losses had been more severe, nothing would have stopped the government from simply creating the dollars necessary to pay the bond holders with little risk of inflation. So much for risk to the taxpayer.

Lastly, an explicitly public model of mortgage insurance would greatly aid the government's ability to engage in counter cyclical credit policies and implement macro-prudential regulation.  Currently, both GSEs collect a fee for insuring mortgage loans.  However, since the government isn't required to turn a profit, this fee could be adjusted to run counter to the business and credit cycle.  In frothy housing markets, the fee could be increased to effectively raise the cost of mortgage financing and stop bubbles before they get started.  In a depressed housing market, the fee could be reduced or even eliminated to help spur recovery.  In any event, counter cyclical credit policies to smooth out the business cycle merit further attention, especially in light of the reactionary and counter-productive cutting off of traditional mortgage credit to qualified borrowers since the crisis.  Such actions arguably slowed the recovery in both housing and the broader economy. 

In sum, had the status quo existed before the crisis, Fannie and Freddie never would have gotten into trouble in the first place, and the government would have been better equipped to fight the ensuing recession.  Furthermore, private shareholders would never have been unfairly enriched by exploiting government granted advantages.  And finally, without Fannie and Freddie, the mortgage market would have completely collapsed in the wake of the crisis which would only accelerated and prolonged the downturn.  I'm all for private markets and private industry, but eliminating the GSEs or reprivatizing them is just nuts. 

  







 

Introducing Fellman Economics

Every one needs a change of pace once and again, and your humble correspondent is no expeception.  After nearly three years of sucessful blogging and FX trading, I have decided to rebrand my blog to reflect its new more broad direction. 

Attentive readers will note that I have branched out in many different areas, covering the broader capital markets, the US budget process, and even immigration reform.  This rebranding will reflect this new direction.  FX Fusion is now Fellman Economics!

To be sure, there will still be lots of coverage of currencies and exchange rates. But over the years, and especially after picking up my Master's degree in economics, this blog has evolved into a more general source of news and commentary about the economy.  My aim here is to acknowledge this natural evolution for me as an economist, writer, and investor. So sit back and relax.  More great content to come! 

Commetary: CBO Still Dead Wrong on the Budget

CBO has released another one of its long term budget outlooks.  It’s a 132 page document choke full of graphs and figures to help Congress make fiscal policy.  A lot more is going on ‘under the hood.’  Thousands of man hours went into developing the methodologies to make the projections.  I neither endorse nor dispute the quality of these projections.  Sadly, it’s not necessary.  That’s because CBO lays out its basic assumptions and framework through which it views the task of fiscal policy makers.  It’s a laughably incomplete and obsolete set of principles which still sees the world on a gold standard, propagates myths about the banking system, and ignores history. 

The best way to dispatch this whopper of a report is simply focus on exactly what CBO says.  Specifically, three bullet points early in the document lay out why Congress should care about the long term path of the debt and the deficit.  We’ll cover them in order:

“The large amount of federal borrowing would draw money away from private investment in productive capital over the long term, because the portion of people’s savings used to buy government securities would not be available to finance private investment. The result would be a smaller stock of capital, and therefore lower output and income, than would otherwise have been the case, all else being equal.” 

 

Again, here we see the tired long refuted idea that banks act as intermediaries between borrowers and savers.  In reality, because modern central banks play an accommodative role in providing sufficient reserve balances to the financial system, banks create new purchasing power ex nihilo.  Indeed, the old model of banking described in the textbooks is mythological. 

 

It is true that the sale of government securities does indeed reduce the aggregate reserve balance of the banking sector, but the Federal Reserve can and does act to ensure that Treasury Auctions do not interfere with monetary policy.  Usually, this means engaging in defensive purchases of existing Treasury assets to ensure that the reserve drainage caused by Treasury Auctions does not disrupt the banking system by making short term interest rates rise. 

 

Furthermore, although the Treasury is selling assets and the Fed is buying them, the consolidated government is really just executing offsetting open market operations.  Thus, both short term interest rates and therefore the cost of credit creation are not affected.  

 

So long as the Fed has an accommodative policy in terms of providing such reserves as are necessary to allow the banking sector to both settle payments and create credit at the stipulated cost (the Fed Funds Rate), no amount of government spending or debt could ever crowd out private sector borrowing or investment.

 

“Federal spending on interest payments would rise ,thus requiring the government to raise taxes, reduce spending for benefits and services, or both to achieve any targets that it might choose for budget deficits and debt.”

 

No. The government does not face a tradeoff between making interest payments and paying public benefits.  Because the US government spends in its own currency, no binding constraint exists on nominal spending.  The cost of government spending is an opportunity cost.  The real resources (man power, output) assigned to the government for public purpose cannot be put to private use.  However, government payments to purchase financial assets or pay interest do not remove any real wealth from the private sector.  The first order effect of these transactions is therefore not to raise the price level in the real economy.  Nothing stops the US Treasury from continuing to paying interest by issuing more securities, just like the Fed is currently paying interest on reserves by issuing more reserves!  Yet again, the CBO makes lazy assumptions, seeing all government payments as equal both in terms of their inflationary effects and therefore assumes that all spending must ultimately be financed with taxes.

 

“The large amount of debt would restrict policymakers’ability to use tax and spending policies to respond to unexpected challenges, such as economic downturns or financial crises. As a result, those challenges would tend to have larger negative effects on the economy and on people’s well-being than they would otherwise.The large amount of debt could also compromise national security by constraining defense spending in times of international crisis or by limiting the country’s ability to prepare for such a crisis.”

 

This last point has been made before by the CBO, and it’s still a pot-pourri of partisan hat tipping.  It’s painfully obvious that the words ‘people’s well-being’ are aimed directly and Democrats while reference to national defense is geared towards Republicans.  In any case, if we ever let the national debt constrain the war fighting capacity of the country, we might as well give Texas and California back to Mexico and then surrender to the Russians.   In a stunning rewriting of history, CBO believes that the US government, or any government for that matter, has ‘constrained’ its spending during wartime.  In reality, every major war fought by the United States has been financed by the printing press. 

 

The Continental Congress printed up Continental dollars to finance the revolution.  Abraham Lincoln established the Office of the Comptroller of the Currency to print the dollars necessary to finance the Civil War.  By the Second World War, things had gotten a bit more sophisticated.  The Federal Reserve pegged Treasury rates at 0.375 percent  via massive bond purchases, which were financed by crediting bank accounts with dollars created by an accountant’s pen.  In sum, the power of money creation means that the nominal spending of monetary sovereigns is never constrained.  While it is true that periods of very high to severe inflation followed each of the above episodes, the extent to which the inflation was caused by money creation is unclear.  Surely, the removal of productive capacity from the economy to help with the war effort only exacerbated the inflationary pressure on the economy.  

 

In any event, neither potential inflation nor the national debt could ever prevent the US government from marshalling enough forces to fight a war or defend the nation.   Rest assured, if the Canadian Mounties ever occupied my native Minneapolis, the United States would have the real military assets to dislodge them, regardless of government finances.

 

While the CBO is supposedly highly respected by both sides of Congress, that says more about the sorrow state of political discourse and economic thinking in the twenty first century.  The CBO’s tired and outdated mode of thinking is only adding to the noise and confusion surrounding important issues that face the country when it comes to fiscal and economic policy.

Essay: How QE Actually Affects the Economy

To virtually nobody's surprise, the ECB announced a 60 billion Euro a month asset purchase program.  Queue the peanut gallery. 60 billion isn't enough.  60 billion is too much. Europe's economy is saved.  Hyper-inflation is around the corner.  The ECB is causing a bubble in stocks.  The ECB is causing a bubble in bonds.  The responses ran the gamut and pretty much aligned one-for-one with the political predilictions of the commentators. But perhaps some of the most confused people in the room were economists themselves.  When the story hit the newswires, all the reporters called up their economist sources to give them one liners they could quote.  There was lots of quotes about liquidity, money creation, and interest rates. But most of it was muddled and simply decreased the signal to noise ratio.  The purpose of this essay to speak with authority and clarity on how QE actually affects the real economy.

QE Shifts Portfolio Preferences and Investment Behavior

People seems to have an infatuation with incomprehensibly large numbers so its not surprising that news sources like to use them a lot in headlines.  The number 60 billion and 1.1 trillion littered the front pages of the financial press this morning. No doubt, editors secretly hoped that readers would see the headlines, imagine 1.1 trillion euros being pumped into the financial sector, and wonder how they could get a piece of the action.  Sadly, this is not remotely close to how QE works.  In fact, the ECB is not pumping any 'money' per se into the financial sector at all.  Rather, it removing certain assets from the market place in an attempt to shift portfolio preferences.  The idea is actually very simple.  When the ECB (or the Fed or the Bank of Japan) purchases government bonds, it removes interest bearing assets from the market.  This reduction in supply raises the price of bonds because investors are now forced to compete over fewer outlets to earn interest.  The result is higher bond prices and lower yields.  Inevitably, some investors who were satisfied earning some rate of interest which was available to them before QE happened are now disatisfied with current yields, and thus shift into riskier assets such as stocks or lower grade bonds.  With more investors fighting over the same number of stocks, stock prices rise.  The same is true for corporate debt all the way down the credit quality spectrum. Therefore, by lowering government bond yields, the central bank is able to affect the kind of investments that get made.  Investments in riskier assets is stimulative to the real economy via a variety of factors. Namely, firms are now able to issue debt more cheaply, which makes expanding operations more attractive.  The required returns for capital investments is now lower as well.  For example, say a widget company is thinking about building a new factory and reckons it will earn a 10 percent return on its investment.  If government bonds are yielding 10 percent risk free, you can bet the corporate treasurer of the widget company will advocate that the firm simply invest its retained earnings in government bonds.  But if the government could lower the yield on its debt to say 4 percent, that factory may well get built, and thousands of jobs could be created.  Some have also speculated that there is a 'wealth effect' whereby higher securities prices stimulate the consumption of other investors because they 'feel' richer.

QE is not about Liquidity

But wait a minute, don't interest rates fall beacuse the banks are now awash in 'free' money?  No. TThe reserves created by QE are not an important part of the transmission mechanism.   The banks are not able to lend more than they could before QE.  This is because QE typically, though not necessarily, occurs when the short term interest rates are already at zero.  The policy rate, or short rate, through which most modern central banks traditionally implement monetary policy is the effective price of reserves that banks must pay to meet the reserve requirement.  And the central bank can only credibly implement monetary policy if it stands ready and willing to supply these reserves at the stipulated price.  The cost of meeting this reserve requirment is the true constraint on bank lending. Bank credit is thus constrained by the price of reserves, not the quantity of reserves.

The failure of QE to spark a credit explosion in the United States should thus ultimately be the deathknell for the so called money multiplier model of money creation, as well as the so called loanable funds market. On loanable funds, reserves can never be 'used up' because banks lend by crediting the checking accounts of borrowers.  When the newly created checking deposits are spent by the borrower, reserves are transferred from the borrower's bank account to the bank account of whoever the borrower purchased goods or services from. The total amount of reserves held by the banking sector is unchanged. The bank of the payee now invests those reserves at the policy rate.  There is no limit to the number of time these reserves can be lent and re-lent.  The so called 'loanable funds market' does not exist. 

But what about the reserve requirment everybody learns about in Econ 101?  Actually, most advanced economies have no practical reserve requirment.  The US technically has a 10 percent reserve requirement, but that only needs to be met during the so called 'reserve matenence period,' which consists of a day or two every three weeks. The effective reserve requirment in the United States is really only 2 percent.  Canada, Austrailia and New Zealand have formally abolished their reserve requirements.  But even under a reserve requirement, banks can never 'use up' the reserves of the banking system.  This is beacuse in modern times, the central bank is the sole issuer of bank reserves and can create them at will.  Thus if lending ever picks up and the demand for reserves increases, again solely to meet a statutory reserve requirement, the central bank simply issues more reserves such that the price of reserves remains constant.  In essence, the central bank allows the quantity of reserves to float, and fixes the price.  Thus, even under a reserve requirement, the quantity of reserves is never a constraint on bank credit.  The constraint is the price of reserves.  Banks must find willing, credit worthy customers who will take loans at a high enough interest rate to cover the costs of meeting the reserve requirement.  Reserves are thus analogs to tradeable pollution permits.  There have value and a price only because they are required by the government to be obtained in order to engage in some economic activity. 

The quantity of reserves in the banking system is irrelavent, but it is especially irelavent when the price of reserves is zero.  Reserves are only necessary for meeting the imposed reserve requirement.  Returning to the tradeable pollution permti analogy, suppose for second a cap and trade system was fully implemented in the United States and that carbon emission permits traded on open exchanges.  Now consider the economic implications of a price of zero for emission permits.  This would entail that all emittors already held the necessary permits to perform their economic activity of choice, and that there was no bidder for the permits, eg, no one new wanted to engage in economic activity which required carbon emssion.  Now, say the economy is deeply depressed, and the government actually wants to encourage economic activity which results in carbon emission (Eg,factories, taxi cab fleets, ect.)  Would issuing more permits result in more emissions?  No. Again, even at a price of zero, nobody wants to emit more.  Thus, the extra permits will simply go unused, sitting idle and in excess.  A similar situation has been going on in the banking sectors of countries where QE has been implemented.  The price of reserves was already zero. Thus, the demand for reserves was already met, and no bidder existed for reserves.  Therefore, creating more reserves has no effect on credit creation. Banks could obtain reserves at a price of zero before QE, and can obtain reserves at zero after QE.  QE created more reserves, but the banks are price constrained, not reserve constrained.        

QE is never inflationary

Perhaps never is too strong a word.  But nonetheless, QE is very unlikely to ever be inflationary. Again, we all learn PQ=MV in Economics 101.  That is, the price level times the quantity of goods produced is equal to the money supply time velocity of money.  The obsession of human beings with big numbers is rearing its ugly head again. Surely massive injections of reserves must lead to hyper-inflation. However, as we have discussed at length, the banks are not able to do anything after QE they could not do before QE.   

Outside risks to inflation do exist if the private sector responds strongly to lower interest rates and the credit cycle quickly restarts.  But recent experience has shown us that this is unlikely in a depressed economy.  In the United States, bank lending did not begin to grow again until 2014, nearly six years after QE started and ironically the same year it ended.  QE it seems does not lead to credit creation precisely because the quantity of reserves is not a constraint on the banking system. 

A major source of the confusion is that before modern central banking, the quantity of reserves was a constraint on the banks.  Under the gold standard, banks held reserves of gold against their note issues and created loans by printing notes and giving them to the borrower. (In an analogous fashion by which modern banks simply credit the checking accounts of borrowers, essentially issuing 'bank money' or M1) Since notes were backed by some fractional reserve of gold, gold reserves did act as a real constraint on credit creation.  Thus, when credit was tight in the United Kingdom, the Bank of England would ironically raise the rate of interest paid on gold.  This would attract gold from abroad, which would allow the banks to issue more notes and thus fund more loans.  In contrast to today, central banks supply reserves at will, on demand, and at a stipulated price.  Thus, the quantity of reserves is again never at issue, especially when the price of reserves is zero. 

QE does not entail ZIRP

Mario Draghi was one for two at his press conference when talking about the transmission mechanism by which QE affects the real economy. He touched on the portfolio balance channel, but also mentioned the mysterious signalling channel by which QE reassures the banks that interest rates will remain at super low level for a long time, thus reducing the interest rate risk born by the banks.  While any central bank is certainly free to pledge to keep rates low forever, QE does not tie the hands of central bankers when it comes to short term interest rates.  This is because most central banks have the authority to pay interest on reserves.  Therefore, nothing stops the Fed, the ECB, or the Bank of Japan, from simply buying up tons of long term assets financed with reserve creation, and then simply setting a price floor on reserves by paying interst on them.  The result would be a flatter yield curve.  The supply of long term assets would fall, reducing long term bond yields.  At the same time, the short rate would stay constant because of rate of interest paid on reserves kept at the central bank. 

A flatter yield curve may be a legitimate policy goal.  In the 1960s, the monetary autorities in the United States wanted to increase short term interest rates but lower long term rates.  The government had dual objectives.  It wanted to raise short term interest rates to support the dollar, which had come under pressure because of the US balance of payments deficit.  But it also wanted to stimulate long term investment.  Thus, the US Treasury hatched a plan whereby it would issue more short term Treasury bills and fewer long term Treasury bonds.  The result was an increase in short rates by about 10 basis points, but a sharp reduction in very long term rates (30 year) by about 47 basis points.  As discussed in the previous post, funding the government with more bills and fewer bonds is the economic equivalent of QE.  This early monetary experiment shows that QE does not entail ZIRP.  In fact, QE even allows for an increase in short term interest rates! 

Conclusion

We have explored QE and its various flavors in the context of the modern monetary system.  I have shown that QE acts via a portfolio balance channel.  I have also demonstrated that it does not increase liquidity in the financial sector nor does it represent 'free money' for the banks. I discussed why QE is very unlikely to be inflationary, though it is not impossible for QE to cause inflation.  Finally, I used a historical example to show why QE does not entail a zero interest rate at the short end of the term structure.  

In sum, the implementation of QE around the world has generated much hype, hysteria, and conspriracy theories and confuses even seasoned economists.  While I cringe every time I hear an economist talk about how QE is important because it 'expands the money supply' I hope this essay will serve as useful guide to both expert and layman alike when they try to wrap their heads around the opaque world of unconventional monetary policy.     
  

Commentary: Falling US Yields Do Not Portend Disaster

In 2014, the biggest economic story was the dramatic collapse of oil prices.  But perhaps more surprising to both economists and bond traders has been the dramatic fall in US yields despite clear signaling from the Fed that rate hikes are coming in 2015. However, cutting edge research from the Bank for International Settlements suggests that the drop in long term yields in the US, and also notably in Australia and New Zealand is not a mystery at all. On the face of it, this research is simple in premise. Just like any other security or commodity, the price of long term assets (and thus yields) are driven by supply and demand, not a "stacking up" of shorter term interest rates.  Thus, the dramatic fall in the supply of long term assets relative to demand, in most cases due to large scale asset purchases by central banks, explains the fall in yields even in the face of rising short rates. 
 
Bernanke’s “Global Savings Glut”
In 2005, the future Fed Chairman Bernanke delivered highly influential lecture on bond yields which sought to explain the so-called “Greenspan Conundrum” whereby aggressive hikes in the Fed Funds Rate beginning in 2004 failed to increase long term bond yields (or mortgage rates).  Bernanke believe that a global glut of dollar reserves from abroad, mainly the result of large US current account deficits, were being recycled back to the US as foreign investors piled into US Treasuries and Agency debt.  While Bernanke made many insightful observations about why high savings rates abroad might contribute to low long term interest rates, he completely ignored the supply side of the equation. A glut of savers could equally be seen as a dearth of borrowers and/or long dated assets.  A key factor missed by both the Treasury and the Federal Reserve was that the supply on long term investment outlets was falling rapidly, and this was the direct result of government policy. Beginning in 2002, the US Treasury department radically shifted course by issuing a large number of short term bills relative to longer term bonds.  In 2006, right before the yield curve inverted, the average weighted maturity on US Treasury securities held by the public stood at a historic low of 43 months. The net supply of new long term Treasury bonds being supplied to the market was falling, and falling fast.
 
Fundamentally, what Bernanke failed to grasp was that there is and will always be a strong demand for long dated Treasury securities.  Regulatory and institutional features are the main drivers of this highly price inelastic demand.  In general, banks are required to hold zero capital against US Treasuries because they are correctly judged as risk free.  Insurance companies, which have many long term liabilities and thus match them with long term assets, are required to hold large percentages of their portfolios’ in government bonds.  Liquidity requirements also play a role. Large financial institutions are required to hold a certain amount of highly liquid assets, and the most liquid bond on the planet is the US Treasury. 
 
Supply Effects Persist
 
Later, Dr. Bernanke would become Fed Chairman, and would exploit supply effects in the Treasury and Agency MBS markets to push down long term interest rates.   The reserve creation brought on by the various rounds of QE was meaningless because the price of reserves was already zero. In contrast, QE removed long dated assets from the private marketplace.  This is the economic equivalent of the Treasury funding itself with more bills rather than bonds.  In sum, QE caused investors already starved for yield to compete for even fewer Treasury bonds, which bid down yields even further. 
Something else happened in 2009.  The deficit exploded because of collapsing tax receipts, and the US Treasury faced a humongous financing task.  However, in what now is recognized to be a highly unproductive course, the Treasury decided to finance the deficit with mostly long term bonds rather than bills.  This may or may not have been consistent with the Treasury’s mandate to achieve the lowest possible borrowing costs for the taxpayer. (A mandate that should be reconsidered) But there is no doubt that it was highly disruptive to the implementation of monetary policy.  Just as the Fed’s was desperately trying to remove long dated assets from the market, the Treasury was boosting the supply of them.  2010 minutes of the Treasury Borrowing Advisory Committee reveal that the Treasury is loathe to acknowledge Fed actions when making borrowing decisions, viewing that as nothing more than another “large investor.”  Strikingly, the supply effect was also noted yet dismissed, 


At this point, a member asked about the impact of the Fed's potential quantitative easing (QE2), expected to be announced at the November 2010 FOMC meeting.  The question arose regarding whether the Fed and the Treasury were working at cross purposes, given that Treasury is extending the average maturity of the portfolio while the Fed is expected to purchase longer-dated securities.  The member noted that from an economic perspective, the Fed's purchase of longer-dated coupons via increasing reserves was economically equivalent to Treasury reducing longer-dated coupons and issuing more bills.
 

The same minutes even openly acknowledged that the Fed and Treasury are “independent institutions whose objectives may at times appear to come into conflict.” The Treasury's insistence on changing its funding strategy even when it disrupted the implementation of monetary policy calls for a re-examination of the Fed-Treasury relationship.  Specifically, two institutions control the aggregate supply of US Treasuries, the Fed and the Treasury itself.  And, if the supply of US Treasuries is major determinant of long term interest rates and thus a monetary policy variable, coordination, not independence or mutual ambivalence, is required to implement policy objectives.  

Today's Environment

In October 2014, Fed purchases of Treasury bonds finally ended, but Treasury rates have kept falling.  However, yet again a simple supply story can explain this drop. Indeed, in 2010 when the deficit peaked at 10 percent of GDP, net issuance of long term Treasuries topped out 1.2 trillion dollars. Net issuance in 2013 of Treasury notes was 644 billion dollars, while in 2014 this figure fell to 576 billion dollars, a drop of 70 billion.  This dramatic reduction in net issuance is exclusively the result in the shrinking deficit, itself a product of the improving economy.  Therefore, the Treasury began supplying less long dated Treasuries to the market precisely as the Fed has phased out its purchases of Treasury assets.  The net economic result is that the private market is being supplid with less Treasuries, which causes the prices of these very securities to be bid up. 

The fall in Treasury yields is not the bond market's way of pricing in disaster.  Rather, it is simply a reflection of the sharp reduction in the supply of new Treasuries over the past few years. Should the Fed move to raise rates on the short end of the curve, the result will be a flattening of the term structure, not a parallel shift in long term rates.  In fact, we already have a test case for this. The Reserve Bank of New Zealand hiked the overnight rate by 150 basis points in 2014, while at the same time public debt in New Zealand is very low.  This created a scarcity of long dated NZD denominated assets, which many investors are required to hold for regulatory reasons.  The result has been (unsurprisingly) an inversion of the NZD yield curve.  Fixed income investors can rest easy. A shrinking deficit all but ensures a greater scarcity of Treasury notes and bonds.  Flatter yield curve here we come.