by Gary North
by Gary North
Recently by Gary North: An Unofficial Translation of Bernanke's Jackson Hole Speech, Part 1
Here we get to where the rubber meets the road.
In the remainder of my remarks I will discuss the policies the Federal Reserve is currently using to support economic recovery and price stability. I will also discuss some additional policy options that we could consider, especially if the economic outlook were to deteriorate further.
Translation: This section ought to goose the stock market for a day or two.
In 2008 and 2009, the Federal Reserve, along with policymakers around the world, took extraordinary actions to arrest the financial crisis and help restore normal functioning in key financial markets, a precondition for economic stabilization. To provide further support for the economic recovery while maintaining price stability, the Fed has also taken extraordinary measures to ease monetary and financial conditions.
Translation: We screwed the pooch, 2001—2007, and we were about to lose the sucker. We all did what Keynes said we should. First, the politicians increased the government deficits on an unprecedented level. Second, central banks counterfeited money as never before. Third, everyone held press conferences saying everything possible was being done to solve the problem. Anyway, Hank Paulson held press conferences. I avoided most of them, and when I showed up, I said nothing. He was a lame duck. I figured I'd let him take the heat. It worked.
Notably, since December 2008, the FOMC has held its target for the federal funds rate in a range of 0 to 25 basis points. Moreover, since March 2009, the Committee has consistently stated its expectation that economic conditions are likely to warrant exceptionally low policy rates for an extended period.
Translation: The FOMC of course has done nothing since late October of 2008 except to tell the Federal Reserve Bank of New York to swap liquid Treasury debt for toxic assets at face value, in order to bail out the big banks, and to sell Treasuries and buy Fannie and Freddie toxic assets, in order to bail out the Treasury. The FOMC announces the fix and then does nothing. The FOMC has nothing to say about the Federal Funds rate. The commercial bankers are so scared that they have cut back lending and have increased excess reserves, so the Federal Funds rate has collapsed to about 0.15%. That's the rate at which banks lend money to banks overnight to cover any need for reserves. Banks no longer need to borrow to get reserves. They have a trillion dollars in excess reserves. So, the FedFunds rate will stay at zero.
Look, the FOMC has been selling assets since March, and still the rate is close to zero. The banks set the rate; we don't. So, we hold meetings every six weeks and issue a press release saying we have decided to keep the rate low. You people believe it, so we keep saying it. Anyone who can read a money supply chart knows it's a crock, which means none of the financial media.
Moreover, since March 2009, the Committee has consistently stated its expectation that economic conditions are likely to warrant exceptionally low policy rates for an extended period.
Translation: This means that we think the bankers are going to remain terrified about the fragility of the recovery for an extended period of time. Who can blame them?
Partially in response to FOMC communications, futures markets quotes suggest that investors are not anticipating significant policy tightening by the Federal Reserve for quite some time. Market expectations for continued accommodative policy have in turn helped reduce interest rates on a range of short- and medium-term financial instruments to quite low levels, indeed not far above the zero lower bound on nominal interest rates in many cases.
Translation: The FOMC has reduced the monetary base since March, since nobody actually looks at what we have been doing, only what I say. If I said we have begun to deflate, the Dow might fall 500 points. So, I can say here that the futures market does not anticipate tightening, when in fact the futures market is signaling tightening. Futures speculators look at what The FOMC does, not what I say. It's stock fund managers who listen to what I say. They don't have their own money on the line at a leverage ratio of ten to one. Futures speculators do.
The FOMC has also acted to improve market functioning and to push longer-term interest rates lower through its large-scale purchases of agency debt, agency mortgage-backed securities (MBS), and longer-term Treasury securities, of which the Federal Reserve currently holds more than $2 trillion.
Translation: The mortgage market would have crashed if Fannie and Freddie had collapsed, leaving the Treasury holding the bag, since Paulson nationalized the two F's. So, we sold T-bills or swapped them with large banks for toxic assets, and replaced them with toxic mortgage debt at face value. It made sense to us, and it made sense to investors. That's why I can still appear in public. Paulson and Bush are gone. If I weren't here, the only man between us and financial Armageddon would be Geithner. That scares you as much as it scares me.
The channels through which the Fed's purchases affect longer-term interest rates and financial conditions more generally have been subject to debate. I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve's purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed's strategy relies on the presumption that different financial assets are not perfect substitutes in investors' portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets.
Translation: That ought to keep you busy. That's as close to Greenspan's central bank Esperanto as I choose to go.
Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.
Translation: We loaded up on junk debt, since we answer to nobody — or Congress, which is the same thing. We bought this crap at face value, thereby transferring newly counterfeited money to the investors who unloaded the crap on us, and who then bought corporate bonds with the money we handed over to them. We have subsidized the corporate bond market. That's our job. We never forget this. Congress has yet to figure it out. Neither have the media.
The logic of the portfolio balance channel implies that the degree of accommodation delivered by the Federal Reserve's securities purchase program is determined primarily by the quantity and mix of securities the central bank holds or is anticipated to hold at a point in time (the "stock view"), rather than by the current pace of new purchases (the "flow view"). In support of the stock view, the cessation of the Federal Reserve's purchases of agency securities at the end of the first quarter of this year seems to have had only negligible effects on longer-term rates and spreads.
Translation: You are growing sleepy. Just relax. Think calming thoughts. Your eyelids are getting heavy. There is nothing to see here. Move along.
The Federal Reserve did not hold the size of its securities portfolio precisely constant after it ended its agency purchase program earlier this year. Instead, consistent with the Committee's goal of ultimately returning the portfolio to one consisting primarily of Treasury securities, we adopted a policy of re-investing maturing Treasuries in similar securities while allowing agency securities to run off as payments of principal were received. To date, we have realized about $140 billion of repayments of principal on our holdings of agency debt and MBS, most of it prior to the end of the purchase program. Continued repayments at this pace, together with the policy of not re-investing the proceeds, were expected to lead to a slight reduction in policy accommodation over time.
Translation: We substituted T-bonds for F/F debt, both of which are forms of government debt. The press thought this was significant. So, who are we to say it's all accounting book entries? The press said this pointed to quantitative easing. So, we started selling off assets, meaning we started deflating. Except for futures traders, nobody noticed. Boy, are the media dumb!
However, more recently, as the pace of economic growth has slowed somewhat, longer-term interest rates have fallen and mortgage refinancing activity has picked up. Increased refinancing has in turn led the Fed's holding of agency MBS to run off more quickly than previously anticipated. Although mortgage prepayment rates are difficult to predict, under the assumption that mortgage rates remain near current levels, we estimated that an additional $400 billion or so of MBS and agency debt currently in the Fed's portfolio could be repaid by the end of 2011.
Translation: As investors try to get a return on their money above the Federal Funds rate, they are lending to home buyers again. So, home sellers get out of the older mortgages, which were issued through F&F. That depletes our portfolio. We are unloading this risk onto investors. When we finally inflate, they will be ruined: 30-year credit at 4%. Mortgage rates will go to 20% once we crank up the digital presses. The market value of 30-year loans will collapse. So, if you can lock in a 30-year mortgage at 4%, do it.
At their most recent meeting, FOMC participants observed that allowing the Federal Reserve's balance sheet to shrink in this way at a time when the outlook had weakened somewhat was inconsistent with the Committee's intention to provide the monetary accommodation necessary to support the recovery.
Translation: We're deflating. No one notices, except futures speculators.
Moreover, a bad dynamic could come into at play: Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening — a perverse outcome.
Translation: We're Keynesians here. We don't deflate for very long. So, we will buy T-bonds to replace the paid-off MBS.
In response to these concerns, the FOMC agreed to stabilize the quantity of securities held by the Federal Reserve by re-investing payments of principal on agency securities into longer-term Treasury securities. We decided to reinvest in Treasury securities rather than agency securities because the Federal Reserve already owns a very large share of available agency securities, suggesting that reinvestment in Treasury securities might be more effective in reducing longer-term interest rates and improving financial conditions with less chance of adverse effects on market functioning.
Translation: When we buy T-bonds, this lowers long-term rates, including mortgage rates. This subsidizes housing. So, falling mortgage rates will tempt lenders to buy Fannie and Freddie debt while rates are still at a high 4%. We will unload the rest of our MBS at face value. We will get out of this market in time.
Also, as I already noted, reinvestment in Treasury securities is more consistent with the Committee's longer-term objective of a portfolio made up principally of Treasury securities. We do not rule out changing the reinvestment strategy if circumstances warrant, however.
Translation: If big banks get into trouble again — if!!!! — we will bail them out. That's our job. We do it well.
By agreeing to keep constant the size of the Federal Reserve's securities portfolio, the Committee avoided an undesirable passive tightening of policy that might otherwise have occurred. The decision also underscored the Committee's intent to maintain accommodative financial conditions as needed to support the recovery.
Translation: I keep saying "accommodative," which means "inflationary," because we have in fact been deflating. No one notices, except futures speculators.
We will continue to monitor economic developments closely and to evaluate whether additional monetary easing would be beneficial.
Translation: I say "additional monetary easing" because we have been deflating. Nobody notices, except futures speculators.
In particular, the Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly. The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do.
Translation: We will inflate. This will eventually pop the bond bubble. I am not about to say this in public.
As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.
Translation: If we could actually forecast accurately the costs and benefits of FED actions, it would help. We can't. But nobody notices. Not even futures speculators.
Notwithstanding the fact that the policy rate is near its zero lower bound, the Federal Reserve retains a number of tools and strategies for providing additional stimulus. I will focus here on three that have been part of recent staff analyses and discussion at FOMC meetings: (1) conducting additional purchases of longer-term securities, (2) modifying the Committee's communication, and (3) reducing the interest paid on excess reserves. I will also comment on a fourth strategy, proposed by several economists — namely, that the FOMC increase its inflation goals.
Translation: We can (and will) (1) inflate; (2) issue press releases; (3) drop the rate we pay on excess reserves from 0.25%. If you think 0.25% is not much, you forget about negative rates. We can charge a fee. This will force banks to start lending, at which time the doubled monetary base of October 2008 will start heading towards a doubled M1. You want quantitative easing? You'll get it!
A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve's holdings of longer-term securities.
Translation: Greenspan created a housing bubble. I can create a bond bubble. Don't think I can't.
One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions.
Translation: We don't know what we're doing. We never do. But I admit it here, so as to maintain the illusion that we are not equally blind in all the rest of our operations.
However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.
Translation: Explaining what is happening is no picnic when you don't know what is happening.
Another concern associated with additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed's ability to execute a smooth exit from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might lead to an undesired increase in inflation expectations.
Translation: The public may finally catch on to the fact that the only tool the FED really can trust is mass inflation. We're going to inflate. That's our job. It has been our job ever since 1914. We do it well: 95% reduction in purchasing power, if you believe the Bureau of Labor Statistics' Inflation Calculator.
To mitigate this concern, the Federal Reserve has expended considerable effort in developing a suite of tools to ensure that the exit from highly accommodative policies can be smoothly accomplished when appropriate, and FOMC participants have spoken publicly about these tools on numerous occasions.
Translation: We have them but we don't dare use them, because none of them can be implemented without creating depression, deflation, and a collapse of the major capital markets, including the Treasury market, since the government would go bust.
A second policy option for the FOMC would be to ease financial conditions through its communication, for example, by modifying its post-meeting statement. As I noted, the statement currently reflects the FOMC's anticipation that exceptionally low rates will be warranted "for an extended period," contingent on economic conditions. A step the Committee could consider, if conditions called for it, would be to modify the language in the statement to communicate to investors that it anticipates keeping the target for the federal funds rate low for a longer period than is currently priced in markets. Such a change would presumably lower longer-term rates by an amount related to the revision in policy expectations.
Translation: If necessary, we'll call in Greenspan to write our press releases. He owes us because of the mess he left behind.
Cutting the IOER rate [rate paid on excess reserves] even to zero would be unlikely therefore to reduce the federal funds rate by more than 10 to 15 basis points.
Translation: When I say we can cut it to zero, that's meaningless. I admit it. What I'm really saying is that we can start charging on excess reserves: negative rates. But I am not about to threaten this in public. Futures traders would understand what this means: the threat of mass inflation when banks start lending and fractional reserves begin to multiply the money supply.
A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability.
Translation: Since we already define "price stability" as "steady price increases," you know what result that would produce. Buy gold.
Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets — including inflation risk premiums — would rise.
Translation: The bond bubble would pop.
Each of the tools that the FOMC has available to provide further policy accommodation — including longer-term securities asset purchases, changes in communication, and reducing the IOER rate — has benefits and drawbacks, which must be appropriately balanced.
Translation: None of the options will work. Every one of them will lead to mass inflation.
Under what conditions would the FOMC make further use of these or related policy tools? At this juncture, the Committee has not agreed on specific criteria or triggers for further action, but I can make two general observations.
Translation: This is why nobody up here knows what to do if we start to lose this sucker. But I'll fake it.
Regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally.
Translation: When push comes to shove, we are going to inflate.
Although what I have just described is, I believe, the most plausible outcome, macroeconomic projections are inherently uncertain, and the economy remains vulnerable to unexpected developments.
Translation: We don't know what's going to happen.
The Federal Reserve is already supporting the economic recovery by maintaining an extraordinarily accommodative monetary policy, using multiple tools.
Translation: We have not inflated since October 2008, but nobody notices, except futures speculators.
Should further action prove necessary, policy options are available to provide additional stimulus. Any deployment of these options requires a careful comparison of benefit and cost. However, the Committee will certainly use its tools as needed to maintain price stability — avoiding excessive inflation or further disinflation — and to promote the continuation of the economic recovery.
Translation: When all else fails, we'll inflate.
[The original speech is here.]
August 30, 2010
Copyright © 2010 Gary North