New York Fed President Bill Dudley

Dudley, a former Goldman Sachs economist, also rejected the widely held view that the Fed is really printing money. “What we’re doing is, when we buy Treasury securities, we are increasing the amount of reserves in the banking system.

Promising!

For those reserves to actually create money, the banks actually have to lend those reserves out.

:(

The problem with the U.S. economy now is that there is insufficient lending and he doesn’t expect the Fed’s purchase program to solve that problem because there are ample reserves in the system. He expects the current program to help the economy by lowering interest rates for businesses and consumers.

Ok, he mostly gets it. Like when one of the slow kids in class gets something close enough to right and gets a passing grade.

(If anyone reading this knows him personally, try sending him a copy of my book, thanks)

risk off Friday

Looks like a big ‘risk off’ day coming up.

The authorities are embodying uncertainty at a time when it’s ‘their move’

Where things go is not about market forces, but about what politicians and their appointees do next.

The competence of the G20 is looking much like that of the FOMC, and it’s not a pretty sight.

We can do nothing but ‘wait and see.’

For example, will they or won’t the fund the euro members?
The mixed message is both no, and they will do what it takes to ensure solvency.
And taxpayers don’t want to pay for it, whatever that means.

And the same time the US authorities are being exposed as, to be kind, being on the sidelines.

President Obama has both nothing of substance to add to the debate, either in the euro zone or domestically.

The Fed itself said QE does nothing but modestly lower rates (Bernanke speech, Carpenter paper) which hopefully boosts asset prices which hopefully adds to aggregate demand. Hasn’t worked in Japan, (even with the net exports we also aspire to) but hopefully here. And skeptical markets that fear the Fed is engaged in ‘irresponsible money printing’ are coming around to the reality.

The sustainability commission has reported and recommended ways to reduce the deficit and ensure unemployment rises and our standard of living falls.

The theme continues- by fearing we are the next Greece, we are turning ourselves into the next Japan. Including burdening ourselves with an export driven economy.

So on an otherwise quiet post holiday Friday I look for a risk off rush to the sidelines, and a continuation of illiquidity in general.

QE question

>   
>   (email exchange)
>   
>   On Wed, Nov 10, 2010 at 10:29 PM, Mark wrote:
>   
>   One more thing I dont get. You say there isn’t more money
>   in the system, but there is more “cash”. For instance, If
>   I have $10 in t-bonds before QE and you have $10 in cash
>   and the government comes and buys my bond from me then we
>   both have $20 in cash combined.
>   

Right, because as an investor, yields are such where you now favor cash over t bonds.

>   
>   If we both want to buy a pair of socks the next day we will
>   bid up the price of those socks because now there is more
>   cash in the system, right? Before I couldn’t buy the socks
>   because I owned a bond. Is that wrong?
>   

Not wrong, but probably not realistic.

If you wanted socks you could have sold your t bonds the day before, just at a slightly higher yield/lower price.

QE is predominately about yields adjusting to levels where investors in aggregate make investment decisions decide to hold cash rather than longer term securities.

To your point, the question is whether lower rates in general cause what were investors to become consumers.

There isn’t much evidence of this happening anywhere, including Japan, so the next question is why not.

My guess is the interest income channel- lower rates mean less income for the economy in general because the govt sector is a net payer of interest. And QE directly reduces govt interest payments as the Fed earns the interest on the securities it buys, rather than the private sector.

So rates are lower, which might encourage consumption, and might encourage borrowing to consume, but income over all is lower as well.

And, of course, without real asset prices rising lenders are less inclined to lend as they don’t have rising collateral values to bail them out. A 70,000 mtg on a 100,000 condo or house can easily turn into a loss if the borrower defaults, for example, just from fees, commissions, closing costs, depreciation due to neglect.

Zoellick Sees ‘Elephant,’ Not Endorsing Gold Standard

Back pedaling from yesterday’s remarks, but just getting the fish hook in deeper.

Gold is a non financial asset,not an ‘alternative monetary asset’

Starting to look like the QE fairy dust is wearing off.
The dollar selling was the focus of the ‘risk on’ hysteria, and it looks like the dollar may have stopped going down.

From what I see, the risk positions mostly look like short dollar bets, including long gold, commodities, and commodity currencies, etc. And long equity trades have had support from weak dollar assumptions as well.

I’ve yet to see any fundamental reason for the dollar weakness apart from misunderstanding QE. In fact, the firming US economy continues to lower the US budget deficit modestly, which tightens things up a bit, and also attracts foreign direct investment and financial investment. (I recall in the late 90’s reading that US FDI was the highest in the world, and it sure wasn’t due to cheap labor.)

So I’m watching for what’s potentially a dramatic dollar reversal here and all the other reversals that will come with it.

Zoellick Sees ‘Elephant,’ Not Endorsing Gold Standard

By Robin Knight

November 10 (Bloomberg) — Gold is the “elephant in the room” that must be addressed by policymakers, as it’s being used as an alternative monetary asset because of unease about the strength of developed economies, Robert Zoellick, president of the World Bank, told CNBC Wednesday.

What “the price of gold has been telling people is that there is a lack of confidence in some of the fundamentals growth policies,” Zoellick said.

“The golden elephant in the room, whether people recognize it or not, is being used as an alternative monetary asset,” he said.

QE still driving portfolio shifting

When Japan First Did QE, Stocks Shot Up And Then Quickly Cratered Massively

Pragmatic Capitalist

November 4 — There appears to be some confusion over the response of equity markets to quantitative easing. Of course, the Fed is hoping that they can ignite a “wealth effect” by driving stocks higher. But as we saw in Japan this failed to materialize. In fact, anyone buying in front of the QE announcement in Japan ultimately got crushed in the ensuing few months and years. When the BOJ initially announced the program in March 2001 the equity market rallied ~16%.

But the euphoria over the program didn’t last long. In fact, within 6 weeks of the announcement the Nikkei began to crater almost 30% over the course of several months. In the ensuing two years the Japanese stock market fell a staggering 43%! It wasn’t until the global economic recovery in 2003 that Japanese equities finally bottomed and went on a tear. Ultimately, the BOJ ended the program in March 2006 and deemed it a failure.

QE and the wealth effect

>   
>   (email exchange)
>   
>   On Thu, Nov 4, 2010 at 11:26 PM, wrote:
>   
>   Do you have any thoughts on this supposed wealth effect?
>   

There is one but I see it as coming from deficit spending, and probably not QE.

Federal deficits support income and add to net financial assets,
which is the financial equity and income that supports the credit structure.

The question is whether QE net adds to nominal wealth via the equity price channel, via ‘valuation’ due to lower long term risk free rates/higher pe’s.

First, the evidence isn’t clear that QE results in higher equity prices, with Japan as the leading example.

Second, there’s the question of whether the maybe 75 billion of annual income- about 1/2% of gdp removed from the private sector- is a stronger force than the valuation benefits of the lower discount rates.

Third, let me suggest that by doing QE on a quantity basis rather than targeting a rate, the change in rates on a ‘bang for the buck’ basis could be a lot lower than if the rate was directly targeted.

Let me give a possible example. Let’s say the Fed simply targeted the 10 year tsy at 2.25%. They would have a bid at that level and buy all the secs the market didn’t want to buy at that level. They may in fact buy a lot or a very few, and possibly none at all, depending on tsy issuance, investor demand, and market expectations. But let’s say for this example they did that and bought a total of $1 T 10 year notes defending the 2.25% level.

Now let’s say that instead, the FOMC had limited the Fed to buying $900 billion. The question then is how high would 10 year notes trade with that $100 billion free to trade at market levels?

What I’m saying is it could be at much higher yields, as the market expectation component of demand does its thing. The yield would simply be the same as if the Tsy had issued $900 billion fewer 10 year notes.

Note that we went for years with no issuance of 30 year t bonds, and 30 years t bond rates on the outstanding bonds did not fall to 0.

Yes, the curve flattened maybe 50 basis points, and steepened again when issuance resumed, but in the scheme of things it was a factor for the macro economy.

In other words, qe, without a rate target, qe might actually reduce rates very little.

It’s all about how much net govt issuance alters the term structure of rates.

So is there a wealth effect?

Yes, but in both directions- removing income lowers it and valuations help it.

And, recognizing QW when done the way they are doing it probably doesn’t reduce rates all that much, the cost of QE in lost income is more likely to be higher than the valuation gains.

Hope this helps!

Also:

Looks like it was buy the rumor and then double up on the news.

Either it all sticks or it all unwinds that much more intensely.

Still looks like the latter to me as the notion that QE doesn’t work sinks in. The mood now is there will be QE 3,4,5 or whatever it takes until it does work.

Like the kid in his car seat who keeps turning his toy steering wheel as much as it takes to turn the car.

QE still driving portfolio shifting

I’ve been watching for a ‘buy the rumor sell the news’ ‘risk off’ reversal, but it happened at best only momentarily after the Fed announcement, when the 10 year tsy note dipped to maybe 2.62 very briefly, stocks dipped, the dollar sort of held, gold was off a touch, etc. But now it looks like it’s ‘risk back on’ with a vengeance as both believers in QE and those who believe others believe in QE are piling on.

The fact remains that QE does nothing apart from alter the term structure of rates.

There are no ‘quantity’ effects, though from the following article and market reactions much of the world still believes there are substantial quantity effects.

And what we are seeing are the effects of ongoing portfolio shifting and trading based on the false notions about QE.

To review,

QE is not ‘money printing’ of any consequence. It just alters the duration of outstanding govt liabilities which alters the term structure of risk free rates.

QE removes some interest income from the economy which the Fed turns over to the Tsy. This works against ‘earnings’ in general.

QE alters the discount rates that price assets, helping valuations.

Japan has done enough QE to keep 10 year jgb’s below 1%, without triggering inflation or supporting aggregate demand in any meaningful way. Japan’s economy remains relatively flat, even with substantial net exports, which help domestic demand, a policy to which we are now aspiring.

QE does not increase commodity consumption or oil consumption.

QE does not provide liquidity for the rest of the world.

QE does cause a lot of portfolio shifting which one way or another is functionally ‘getting short the dollar’

This is much like what happened when panicked money paid up to move out of the euro, driving it briefly down to 118, if I recall correctly.

No telling how long this QE ride will last.

What’s reasonably certain is the Fed will do what it can to keep rates low until it looks like it’s meeting at least one of its dual mandates.

Asians Gird for Bubble Threat, Criticize Fed Move

By Michael Heath

November 4 Bloomberg) — Asia-Pacific officials are preparing
for stronger currencies and asset-price inflation as they blamed
the U.S. Federal Reserve’s expanded monetary stimulus for
threatening to escalate an inflow of capital into the region.

Chinese central bank adviser Xia Bin said Fed quantitative
easing is “uncontrolled” money printing,
and Japan’s Prime
Minister Naoto Kan cited the U.S. pursuing a “weak-dollar
policy.”
The Hong Kong Monetary Authority warned the city’s
property prices could surge and Malaysia’s central bank chief
said nations are prepared to act jointly on capital flows.

“Extra liquidity due to quantitative easing will spill
into Asian markets,”
said Patrick Bennett, a Hong Kong-based
strategist at Standard Bank Group Ltd. “It will put increased
pressure on all currencies to appreciate, the yuan in particular

has been appreciating at a slower rate than others.”

The International Monetary Fund last month urged Asia-
Pacific nations to withdraw policy stimulus to head off asset-
price pressures, as their world-leading economies draw capital
because of low interest rates in the U.S. and other advanced
countries. Today’s reactions of regional policy makers reflect
the international ramifications of the Fed’s decision yesterday
to inject $600 billion into the U.S. economy.

QE providing the ‘cover’ for foreign dollar buying?

Japan has already begun the resumption of dollar buying.
Now looking like QE is may be opening the door for a lot more?

Emerging Market Policymakers Vow to Combat Fed’s Easing

November 4 (Bloomberg) — Policymakers from Brazil to South Korea and China on Thursday pledged to come up with fresh measures to curb capital inflows after the U.S. Federal Reserve said it would print billions of dollars to rescue the economy.

The frosty reaction from emerging economies makes any substantive deal on global imbalances and currencies at next week’s Group of 20 meeting that Seoul is hosting even less likely.

South Korea’s Ministry of Finance and Strategy sent “a message to the markets”on Thursday saying it would “aggressively” consider controls on capital flows while Brazil’s Foreign Trade Secretary said the Fed’s move could cause “retaliatory measures.”

Bernanke Op-Ed

What the Fed did and why: supporting the recovery and sustaining price stability

By Ben S. Bernanke

November 4 (Washington Post) — Two years have passed since the worst financial crisis since the 1930s dealt a body blow to the world economy.

Only because policy makers failed to respond with an appropriate fiscal adjustment.

And, worse, they continue to fail to recognize this policy blunder.

Working with policymakers at home and abroad, the Federal Reserve responded with strong and creative measures to help stabilize the financial system and the economy. Among the Fed’s responses was a dramatic easing of monetary policy – reducing short-term interest rates nearly to zero. The Fed also purchased more than a trillion dollars’ worth of Treasury securities and U.S.-backed mortgage-related securities, which helped reduce longer-term interest rates, such as those for mortgages and corporate bonds. These steps helped end the economic free fall and set the stage for a resumption of economic growth in mid-2009.

In Q3 08 the Fed failed to provide sufficient routine bank liquidity for several critical months while it experimented with a variety of poorly thought out open market operations that progressively accepted more and more bank collateral until they eventually did what they should have all along- lend to member banks at their target rate on a continuous, as needed basis. Yet even now they fail to do this to the smaller community banks, whose cost of funds remains at least 1% over the fed funds rate.

They also continue to fail to recognize that their role is setting the term structure of risk free rates, which can be done directly.
By simply offering to buy tsy securities at their target rates in unlimited quantities.
However, they have yet to fully appreciate that it’s the resulting interest rates and not the quantities they purchase that are of further economic consequence. And if they wish to specifically target mortgage rates, this is readily done by lending to their member banks specifically for this purpose at the Fed’s desired target for mortgage rates, with the Fed assuming the ‘convexity’ risk.

Additionally, while the Fed did address the ‘market functioning’ issues that were caused by the Fed’s own initial lack of liquidity provision, they failed to recognize that monetary policy was not going to restore aggregate demand. In fact, they were all but certain it would, as evidenced by their concern their policies carried the risk of generating ‘inflation, etc.’ this led other policy makers to take a ‘wait and see’ attitude which has been monumentally costly with regards to lost real output and all the real costs of unemployment.

Notwithstanding the progress that has been made,

After more than two years the output gap in general remains at near record levels.

when the Fed’s monetary policymaking committee – the Federal Open Market Committee (FOMC) – met this week to review the economic situation, we could hardly be satisfied. The Federal Reserve’s objectives – its dual mandate, set by Congress – are to promote a high level of employment and low, stable inflation. Unfortunately, the job market remains quite weak; the national unemployment rate is nearly 10 percent, a large number of people can find only part-time work, and a substantial fraction of the unemployed have been out of work six months or longer. The heavy costs of unemployment include intense strains on family finances, more foreclosures and the loss of job skills.

The fed’s responsibility for this is largely that of its failure to do its job of providing continuous and unlimited liquidity to its member banks and to not recognize that monetary policy was not capable of restoring the aggregate demand necessary to support full employment.

Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. Although low inflation is generally good, inflation that is too low can pose risks to the economy – especially when the economy is struggling. In the most extreme case, very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation.

Morph? Inflation deteriorates to unwelcome deflation with a lack of aggregate demand. There is no mystery here.

Even absent such risks, low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating.

Note the continued failure to recognize monetary policy has no tools to support demand at desired levels.

The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

These are all very weak channels at best.

What is hoped for is that lower interest rates encourage private credit expansion, where consumers return to borrowing to spend. And while this can happen, and may already be happening to a small degree, there is no reason to believe that QE will promote this outcome.

What the chairman knows and fails to discuss are the interest income channels, which he wrote about in a published paper in 2004. Lower rates cause the treasury to pay less interest on its treasury securities, and the interest the Fed earns on its newly purchased securities is interest no longer earned by the economy which previously held those securities. This reduced interest income paid by govt to the non govt sectors is much like a tax increase that to some degree neutralizes the modest positive effects the Fed is hoping for.

Also ignored is the fact that Japan has had near 0 rates and much lower long rates than the US, also helped by massive QE, and has also had very large net exports helping to support GDP, something the Fed and the US administration aspires to as well, yet has failed to restore desired aggregate demand, growth, and employment.

While they have been used successfully in the United States and elsewhere, purchases of longer-term securities are a less familiar monetary policy tool than cutting short-term interest rates. That is one reason the FOMC has been cautious, balancing the costs and benefits before acting.

Costs?

As monopoly provider of net clearing balances (reserves) for the payments system, the Fed is necessarily ‘price setter’ of the term structure of risk free rates. Their notion of ‘cost’ is inapplicable. And all QE does is alter the duration of total govt liabilities. It doesn’t change the quantity of non govt net financial assets.

We will review the purchase program regularly to ensure it is working as intended and to assess whether adjustments are needed as economic conditions change.

Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.

Agreed! Yet their expressed motivation all along is to prevent deflation, which is the same as ‘causing inflation.’

A problem here is they believe that inflation is caused by rising inflation expectations, and not aggregate demand per se. That is, rising demand per se doesn’t cause inflation until that demand starts to drive inflation expectations.

Until this confused theory of inflation is discarded policy will continue to be confused as well.

Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation.

Correct, which also means the policy failed to generate the desired results.

We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.

Agreed.

The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.

The Federal Reserve cannot solve all the economy’s problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability. Steps taken this week should help us fulfill that obligation.

How about an obligation to support a sufficient fiscal adjustment to eliminate the output gap rather than supporting deficit reduction?

FOMC


Karim writes:

  • Statement dropped reference to bank credit contracting
  • Several references to inflation being too low; 2nd paragraph completely overhauled to specify that Fed is missing both parts of the dual mandate and also characterizes progress towards objectives as ‘disappointingly slow’
  • Buying 600bn thru end of Q2-2011; added to reinvestment of MBS proceeds, total purchases estimated at 110bn/mth.
  • Increasing avg duration of purchases from 4yrs in ‘QE1’ to 5-6yrs link
  • ‘Regular review’ of total size of program and ‘will adjust’ to meet its dual mandate opens possibility of increasing pace of purchases and lengthening period in which they are buying past next June

Release Date: November 3, 2010
For immediate release

Information received since the Federal Open Market Committee met in September confirms that the pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.

The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Sarah Bloom Raskin; Eric S. Rosengren; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

Voting against the policy was Thomas M. Hoenig. Mr. Hoenig believed the risks of additional securities purchases outweighed the benefits. Mr. Hoenig also was concerned that this continued high level of monetary accommodation increased the risks of future financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy.

Release Date: September 21, 2010
For immediate release

Information received since the Federal Open Market Committee met in August indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts are at a depressed level. Bank lending has continued to contract, but at a reduced rate in recent months. The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term.

Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period. The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings.

The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.

Voting against the policy was Thomas M. Hoenig, who judged that the economy continues to recover at a moderate pace. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and will lead to future imbalances that undermine stable long-run growth. In addition, given economic and financial conditions, Mr. Hoenig did not believe that continuing to reinvest principal payments from its securities holdings was required to support the Committee’s policy objectives.