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Steven
"In response to the Great Recession, various central banks adopted unconventional policy measures once their traditional armoury was depleted i.e. policy rates were at the zero lower bound. As we approach the FOMC meeting next week, we highlight the various options available to the Federal Reserve, the impact thereof and the potential risks.
Once the Federal Funds rate was reduced to 0 to 0.25%, the Fed turned to its balance sheet to continue providing stimulus to the economy. The first such operation was the Large Scale Asset Purchase programme (LSAP) launched in November 2008 and also referred to as “Quantitative Easing 1” (QE1).
Within this programme, the Fed went on to buy $175 billion of agency debt and $1.25 trillion of mortgage backed and treasury securities. The second iteration of LSAP (QE2) was launched in November 2010 and included a programme of $600 billion in treasury security purchases. In return for the sale of these assets, banks received payment in the form of reserves at the Fed. The rationale behind quantitative easing is multi-faceted.
Firstly, in buying interest rate assets the Fed forces longer term interest rates lower and low rates encourage borrowing and investment.
Secondly, low interest rates provide incentive for investors to move out on the risk spectrum and invest in riskier assets such as equities. As equity prices rise, the wealth effect takes place and higher consumption ensues.
Thirdly, investors are driven into offshore markets in search of better yields thereby causing a weakening effect on the currency and this depreciation is expected to fire up export markets.
Fourthly, as government borrowing rates are reduced, there is more scope for expansionary fiscal policy. Effectively, these operations are intended to provide a boost to each component in the timeless identity: GDP = Consumption + Investment + Government spending + Net Exports. As a consequence of quantitative easing, the size of the Fed’s balance sheet grows larger with assets rising as security holdings are increased (see fig 1) and liabilities rise in line with the increase in bank reserves.
The Fed is well aware of the risks posed by these balance sheet operations. The risks surrounding the exit process are quite clear as the Fed may find it difficult to reduce the size of its balance sheet without triggering a violent rise in yields on long term-treasury debt and mortgage backed securities. Other concerns include market functioning in the treasury securities markets. As the Fed becomes a larger holder of treasury notes and bonds, there are fewer of these securities available to the rest of the market. Since, treasury securities are used as collateral in short term money markets, a large reduction in the supply of these assets may impede the credit extension process.
As a consequence of the Fed’s balance sheet operations, the amount of excess reserves in the banking system rose and the risk of excessive credit extension became evident. In order to prevent this outcome from materialising in an uncontrollable fashion, the Fed began paying interest on excess reserves (IOER) at a rate of 0.25%. The idea of reducing the IOER rate has been raised with the aim being to release a portion of the excess reserves into the real economy. Such action has already been taken by the ECB at their most recent meeting. The Fed will be very cautious about such a change in policy due to potentially hazardous consequences for money market funds due to their reduced profitability in a world of zero interest on excess reserves.
A third type of tool employed by the Fed falls under the category of “communication strategies”. Monetary policy effectiveness is very closely aligned with the ability of the central bank to manage inflation expectations. By committing to “maintaining exceptionally low levels for the federal funds rate at least through late 2014”, the Fed has attempted to induce higher inflation expectations. One possibility is for the Fed to extend this guidance to a later point. There are two main observations that suggest this strategy would not be particularly effective.
Firstly, an unchanged federal funds rate is already priced into the market as far out as 2015.
Secondly, questions will be raised regarding the continuity of this commitment given that Ben Bernanke’s term ends in January 2014. Despite these issues, there are no significant costs or risks to this strategy.
Given that recent economic developments point to lower global growth and, inferentially, lower rates of inflation and slower employment growth, the markets are primed for further action by the Fed in the form of QE3. The members of the FOMC will decide on whether or not the benefits gained from unconventional policies outweigh the potential risks of any such action. Also noteworthy is the fact that each new policy measure has had a smaller impact on risk markets. This fact may lead the Fed to delay further action until they are prompted to act due an occurrence of a fat-tail event. "
"The PSG Angle is an electronic newsletter of PSG Asset Management. To subscribe or read more, please go to to www.psgam.co.za".
Steven
Steven Morris Chartered Accountant (SA)
3 Bickley Road
Sea Point
Cape Town
8005
Mobile :+27 83 943 1858
Facsimile : 0866 712 498
E-mail : steven@global.co.za
Website : www.stevenmorris.co.za
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