by Gary North
by Gary North
Recently by Gary North: An Unofficial Translation of Bernanke's Jackson Hole Speech, Part 2
I had a little fun over the weekend at the expense of Dr. Bernanke. I translated his Jackson Hole speech out of academic Keynesianism into investment-grade English. I added a little humor, because Dr. B. is not what I would call a laugh-a-minute guy when he gets behind a podium.
In his speech, he opened with praise for what a great job the world's central bankers and politicians did to save the economy in 2008.
On the whole, when the eruption of the Panic of 2008 threatened the very foundations of the global economy, the world rose to the challenge, with a remarkable degree of international cooperation, despite very difficult conditions and compressed time frames.
We can take this about as seriously as we would take similar self-praise by the head of FEMA after Katrina. Yet even that's not close enough. It's more like self-praise from the Army Corps of Engineers describing the levies. Maybe we should think of Greenspan as the Army Corps of Engineers and Bernanke as FEMA.
The speech was longer than usual. He devoted less time than usual to listing the history of what everyone knows about. He devoted more time — about half the speech — to tools that the FED has to deal with any return of a financial crisis. He spoke of "additional monetary accommodation through unconventional measures." What are these tools?
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.
These are: (1) print money, (2) publish more press releases, and (3) stop paying interest at all.
The first one is the tried and true method of all central banks, all of the time. Yes, there are new developments, such as swapping liquid Treasury debt at face value for toxic assets owned by the largest banks. But, when push comes to shove, central banks buy assets with newly created digital money.
The second one is PR. Everyone knows this. The fact that he mentioned this indicates how few tools the FED has.
This brings us to tool #3.
The FED increased the monetary base by about $1.3 trillion in October 2008. This was the largest one-month increase in the history of the FED. Nothing else comes close. The FED was in panic mode. To double the monetary base in one month was hyperinflation.
But nothing much happened to the total money supply. That was because commercial bankers offset the purchase by depositing most of it into their accounts for excess reserves at the FED. The normal money multiplier effect of fractional reserve banking did not go into effect. The new money was mostly sterilized by the commercial banks.
The FED wanted this to happen. This was why, on October 6, it inaugurated a new policy: paying banks interest on excess reserves.
This policy had been scheduled to go into effect in 2011. It was speeded up because of the emergency.
Paying interest on excess reserves gave bankers a way to protect their funds without risk. For two weeks, the FED paid 0.75% on these reserves. Then this was dropped to 0.65% for two weeks, then increased to 1% for five weeks. Then it was cut to 0.25% on December 17, where it has remained ever since.
This saved the economy from an increase in consumer prices of at least 100%, since October's increase in the monetary base more than doubled the base. With excess reserves rising, the money multiplier fell as never before: from above 1.5 to below 1.
But this offset has also kept the famous Keynesian multiplier from working its hoped-for magic. The two stimulus programs — one by Bush and the other by Obama in early 2009 — totaled about $1.5 trillion. There was supposed to be a booming economy. The Obama Administration as recently as June 17 forecasted a "Summer of Recovery" for 2010. On a page devoted to the Recovery Act, we read:
As the summer heats up, it is becoming clear that it could quite possibly be the most active season yet when it comes to recovering our economy. There are Recovery Act-funded projects breaking ground across the country that are creating quality jobs for Americans and economic growth for businesses, large and small.
This summer is sure to be a Summer of Economic Recovery.
It did not happen. Excess reserves kept it from happening. Excess reserves are going to keep it from happening.
EXIT STRATEGY, R.I.P.
The U.S. Treasury has a committee for rolling over the debt, the Treasury Borrowing Advisory Committee. Representatives from the world of finance are on it.
On November 4, 2009, there was a meeting of the committee. We are not told which committee member made this assessment, but it raised the problem facing the Federal Reserve: how to avoid rising long-term interest rates after the economy begins to recover. The threat is this: a collapse of the non-Treasury bond market. In short, the popping of the corporate bond market.
The Committee then turned to a presentation by one of its members on the likely form of the Federal Reserve's exit strategy and the implications for the Treasury's borrowing program resulting from that strategy.
The presenting member began by noting the importance of the exit strategy for financial markets and fiscal authorities. It was noted that the near-zero interest rates driven by current Federal Reserve policy was pushing many financial entities such as pension funds, insurance companies, and endowments further out on the yield curve into longer-dated, riskier asset classes to earn incremental yield. Treasury securities have benefitted from the resultant increase in demand, but riskier assets have benefitted even more. According to the member, the greater decline in the indices for investment grade and high-yield corporate debt relative to 10-year Treasuries and current coupon mortgages displays this reach for yield. A critical issue will be the impact on the riskier asset classes as market interest rates move away from zero.
Why would market rates move away from zero? Because the recovery finally gets rolling. Banks start lending. Demand for loans increases.
The presenting member then looked at the likely sequence of the Federal Reserve's exit strategy. The member acknowledged that the central bank must address the uncertainty and fragility of the economic recovery and the dependence of the housing market on low rates. It was suggested that the most likely sequence would be the draining of excess reserves from the banking system, the cessation of the mortgage-backed securities purchase program, and only then raising the Fed funds target rate.
We have now seen the reduction of the FED's MBS portfolio. The FED then started buying T-bonds in order to keep from draining reserves. So far, the exit strategy is on hold. I think it will remain on hold.
The exit strategy problem refuses to go away. On March 4, a Vice President of the New York Federal Reserve Bank offered this assessment.
When the time comes to tighten monetary policy, the Federal Reserve will be embarking on a tightening cycle like no other in its history. First, this tightening cycle will have two policy dimensions, in that the FOMC will have to decide on the path of its asset holdings in addition to the path of the short-term interest rate. Second, we will be using tools to drain reserves that are new and that will have to be implemented on a scale that the Fed has never before tried. And third, we will be operating in a framework of interest on reserves that has not been fully tested in U.S. markets.
All of that may sound risky. However, I believe the Federal Reserve is positioned to minimize any risks involved. Most important, we have worked hard to ensure that we have all of the tools needed to exit, and FOMC members have begun to describe a strategy for using them that is cautious along several dimensions. In addition, if we communicate effectively, the markets should be clearly informed and well prepared ahead of the exit. These are the points that I will emphasize in more detail.
Yes, it sounds very risky. But, he assured his audience, the FOMC has tools to solve this problem.
Tools to solve the exit strategy problem are tools to solve the monetary deflation problem. But if the FED starts unloading these assets, thereby contracting the monetary base, bankers may sense that the Great Deflation has been launched. What is the best security against that? Why, more excess reserves! Push the money multiplier even lower! That will do it.
Yes, it surely will: the Great Deflation will become Great Depression 2.
THE OPPOSITE TOOLS
This brings us back to Bernanke's speech. He said that one tool to force the economy back on track is the lowering of the rate of interest paid on excess reserves. But this rate has been 0.25% for almost two years. Commercial banks are content to get less on excess reserves than they are paying to depositors. They are losing money on over a trillion dollars in reserves.
Bankers are afraid of what will happen to their commercial real estate loans. They are keeping these on the books at original loan value, yet we know that CRE is down about 40% since late 2007. It's a disaster, and it is getting worse. Fear keeps them sending their funds to the FED rather than lending. Every commentator knows this by now. Bernanke knows it.
So, what possible good will a reduction from 0.25% to even 0% do? What difference at the margin will this make? Hardly any. He knows this. He admitted:
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.
In short, it's peanuts. The economy will not boom because of this minor change.
This brings us to a theme I keep returning to: a negative rate on excess reserves. Finally, a major economist has mentioned this: Alan Blinder, Bernanke's colleague at Princeton. But he is more than a colleague. Blinder was formerly the Vice Chairman of the Board of Governors of the FED. On August 26, the day before Bernanke's speech, Blinder gave an interview to National Public Radio. Here is what he said.
"And, in fact, you don't have to stop at zero; you could actually charge banks for the storage privilege," he says. "The idea is to free up some of this money and get it out into the marketplace. And hopefully some of it finds its way into new bank lending. That's what we really need."
Blinder hopes Bernanke will signal that the Fed is ready to do that in his speech Friday. Blinder also suggests that the Fed could tell bank regulators, who are being tougher in the wake of the financial crisis, to ease up a bit on healthy banks and encourage them to make more loans.
These moves might not have the power of an interest rate cut in normal times, but Blinder says the Fed is running out of options.
(Dr. Blinder is afflicted with an unfortunate name for a central banker or an economist. The reader sees it and thinks, "blind, blinder, blindest." It does not occur to him that it might be pronounced Blynder.)
Yet even here, Bernanke faces a problem. The banks are allowed to meet reserve requirements by holding currency in their vaults. If, in order to escape the negative fee, bankers started ordering currency, that would let them escape. The multiplier would still not multiply. Their risk of bank robberies will rise. But they could do this if they were determined not to hold fewer reserves. There is nothing like a vault full of currency to calm depositors' hearts, but a vault full of currency does not get the recovery moving.
This decision to hold currency would not be deflationary. Moving excess reserves to currency does not reverse the fractional reserve process. Only withdrawals of currency by depositors has that effect. But the bankers can, if they are willing to hold currency, counter a negative rate that gets higher than they want to pay.
Could the FED charge a fee to banks for excess currency held in their vaults? Of course. I can see the headline: "Federal Reserve Imposes New Tax on Reserve Currency Held in Bank Vaults." Then add this subhead: "Bernanke Insists That the Banks Are Safe Enough Without Holding Currency in Reserve. The Public Should Not Be Alarmed." Why, it's Obi-Wan Kenobi! "There is nothing to see here. Move along." Want to start bank runs across the nation? That could do it.
So, Bernanke's main tool is the old favorite: buying assets with newly created digital money. He has talked of unwinding, but this is not an option, given his present predicament.
Bernanke's speech led to a run-up of the Dow of 165 points. The run-up lasted one day.
The man talks of multiple tools to let the FED exit from the doubling of the monetary base in October 2008. It is all talk. The FED dares not do it.
He talks about tools for getting the recovery rolling again. This is basically one tool that is banker-proof: inflating in the good, old-fashioned way: buying assets.
He is trapped. He wants to avoid both options: monetary deflation and monetary inflation. So, the FED does nothing to dramatically increase or decrease the monetary base.
All his talk about an exit strategy — unwinding — was a mirage. The Treasury Committee knows it. A hint of unwinding in this stagnating economy would cause a sell-off of stocks.
Ever since the big run-up of 2008, that is what the FED has done.
There was no Summer of Recovery. There will be no Fall of Recovery. There will be a fall in the recovery.
In the middle of this fall will come Congressional elections. Then will come two years of gridlock.
Bernanke is trapped. I would like to say that it could not happen to a more deserving man, but that would be false. It ought to have happened to Greenspan.
September 2, 2010
Copyright © 2010 Gary North