I received numerous e-mails and comments in response to Friday’s piece, many of which were very reasonable critiques, all of which I appreciated. One basic question which was asked multiple times was why I make a distinction between what the Fed is currently doing (quantitative easing) and debt monetization. I’m going to try to answer this question below. As always, please feel free to comment and/or write me an e-mail if you have further questions. I welcome the debate. If however you start an e-mail with, “You idiot!” I am somewhat less likely to respond.
First, let’s frame the discussion. If one defines debt monetization as simply the creation of money for purpose of buying government debt, then there isn’t a distinction between the Fed’s quantitative easing program and debt monetization. In fact, by that simple definition, there is no difference between the Fed’s normal open market operations, which often involve doing repos with Treasury collateral, and debt monetization. But as a trader, I don’t give a dewback's tail what you call it. I care what the effect is. Clearly there is some distinction to be drawn between old-school open market operations, today’s quantitative easing program, and full scale debt monetization, at least in terms of degrees. So let’s agree that there is no utility in turning this into a discussion of semantics.
Is this a case of the argument of the beard? That is to say there is no difference between $1 of debt monetization and $1 trillion because you can’t pin down exactly where it stops being open market operations and when it becomes something else? No. We can draw a distinction, even if its somewhat subjective. And from this distinction we can create more objective signposts for when there is an evolution of the policy.
Consider what the definition of quantitative easing is. Its simply the process of printing a small moon-sized amount of new money (or creating bank reserves as its done in practice) and unleashing it on the economy. It is not necessarily the process of buying government debt with the proceeds of created bank reserves. The purchasing of government debt is merely a convenient, and potentially highly effective, means of getting that new money out into the economy.
The intent of quantitative easing is to create inflation. I know, shocking thought, right? But the reality is that sometimes the market-clearing rate of interest is actually below zero. That is that demand for savings is so great that it overwhelms demand for credit. This is the so-called liquidity trap. Real interest rates need to be negative, but nominal interest rates can never be negative. The Fed can only cut to zero. Thus we need more inflation. That would allow nominal rates to fall below the inflation rate, resulting in a negative real rate. Here is a good piece by Paul Krugman on the subject. It was written in 1998 to describe the problems in Japan, but its relevant for the U.S. today. I’ll pull out one section to save you the trouble:
"If this… [liquidity trap]… bears any resemblance to the real problem facing Japan, the policy implications are radical. Structural reforms that raise the long-run growth rate (or relax non-price credit constraints) might alleviate the problem; so might deficit-financed government spending. But the simplest way out of the slump is to give the economy the inflationary expectations it needs. This means that the central bank must make a credible commitment to engage in what would in other contexts be regarded as irresponsible monetary policy - that is, convince the private sector that it will not reverse its current monetary expansion when prices begin to rise!"
Ben Bernanke himself referenced this strategy back in 2002, before he was Fed chair. (By the way, a time when the deficit wasn't nearly the problem it is now). Currency, he explains, only has value because of its scarcity. If you need inflation (i.e., you need the currency’s value to decline), just make more money! "The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."
So we can debate whether or not the U.S. is in such a dire predicament as to necessitate this radical monetary maneuver, but its clear to me that the Fed’s current programs are designed around the above thinking. We’re trying to fight deflation to prevent a Japanese-style disaster.
Debt monetization, on the other hand, has the intention of extinguishing government debt through creation of new money. That is, the government is alleviated from its debt burden by way of the printing press. Has this, in fact, occurred? Any honest person, no matter what your opinion on the situation, can only answer maybe. As I stand here now, this 12th day of October in the Year of our Lord Two Thousand and Nine, I don’t know what the Fed will eventually do with the Treasuries it has purchased. If they are held to maturity, I’d have to admit that the Fed did indeed participate in debt monetization. Maybe it was on a limited scale, but it was monetization none-the-less. I also don’t draw any distinction between Agency debt (Fannie Mae/Freddie Mac/Federal Home Loan Bank) and Treasury debt. Both are de facto debt of the tax-payers. I’ll make some distinction in regards to Agency MBS which isn't debt of the government, rather a guarantee by the government.
Whether you agree with me or not, there is my view on the current situation. What’s more interesting is what it all means for the markets. One commenter accused me of drawing a distinction without a difference. Very fair. I basically just said that I don’t know whether the Fed is going to monetize the debt or not. Does it actually matter which it is?
Let’s say, for the sake of argument, that the Fed ends its bond buying program by March 2010 without increasing the amount purchased, as they currently have pledged. I know the hard-core monetization believers believe they will need to keep the printing presses going in order to nominally service our debt. That’s not my view, and I don’t know if anything other than time will convince that group otherwise anyway. So I’m going to let that go for now.
I’m saying if they finish buying all they said they’d buy and do no more, they could either figure out some means of unloading their positions over time, or else hold to maturity, effectively monetizing that portion of the debt. Does it matter?
One way to think about this is just to consider the impact of printing money, regardless of what is done with the proceeds. Classically, we’d expect the impact to all be related to inflation: higher interest rates, weaker dollar, higher commodities prices, higher inflation.
The Fed announced its program to purchase Agency and Agency MBS on November 25, 2008. Here is where we were the day before the announcement.
- 10-year Treasury: 3.32%. We’re marginally higher now at 3.38%.
- 2-year Treasury: 1.21%. We’re marginally lower now at 0.97%.
- Dollar: The DXY was 86.081 on 11/24. Now 76.139. 11.55% lower.
- Commodities: The CRB was 243.80 on 11/24. Now 266.26, or 9.21% higher.
- CPI: The All Items Index stood at 216.889 in October 2008. Now its 0.67% lower at 215.428.
Mixed record. Really Treasury rates are basically unchanged and consumer prices are marginally lower. Not what you’d expect. Commodities and the dollar are reacting exactly as you’d expect.
Interesting to note that the Treasury program was announced on March 18. The Agency program was expanded on that same date. Same info from March 17:
- 10-year Treasury: 3.01% on 3/17, now 3.38%.
- 2-year Treasury: 1.03%, now 0.97%.
- Dollar: 86.933 vs. 76.139. Shows just about all the dollar decline came after the announcement of the expansion.
- Commodities: The CRB was 216.46, now 266.26. Here again, all the gain has been post expansion of quantitative easing.
So if the Fed’s goal was to weaken the dollar in order to create inflation, it looks like its working. Maybe it isn't showing up in the CPI numbers much yet, but it certainly is showing up in actively traded markets where the purchasing power of a dollar is most relevant. Furthermore, the market may be telling us that the first foray into QE wasn't enough. Only with our combined strength can we bring an end to this destructive deflation!
And that’s just the question, isn't it? No one would claim that printing money was a good idea if deflation weren't such a legitimate threat. To me, the fact that the Fed decided to buy Treasuries isn't the important point. Just the act of printing $1.5 trillion dollars to finance all these purchases is the key. They claim that part of their goal was to lower interest rates and thus encourage borrowing. Maybe that was part of the motivation. But I truly believe the Fed saw consumer and business borrowing collapsing at a disastrous pace and choose to answer with a deflation busting level of quantitative easing. Dropping the newly printed money from a helicopter isn't practical. Buying Treasury bonds is.
I’m asking you, dear reader, that if you object to what the Fed is doing, ask yourself why? Is it because you object to printing money? Or buying of government debt? Because if it’s the later and not the former, then ask yourself what else was the Fed supposed to do with the money? If it’s the former and not the later, then you must argue that deflation isn't a threat. That the complete collapse of credit creation has no impact on the de facto money supply. That’s a legitimate point of view, but not one where I can concur.
So then it comes to a matter of the exit strategy. If the Fed holds on to the debt, then the impact of the recently created new cash will reverberate beyond the current crisis and into a time when economic activity has normalized. That’s the dark path the Fed must not go down. Fed officials have recently said that an accommodative policy is warranted for an extended period. But policy needn't be this accommodative for an extended period! We've heard that the Fed is testing reverse repos as a means of removing excess reserves when the time comes. Here’s to hoping that they start removing those excess reserves is a measured way sooner rather than later.
That being said, what if the Fed uses reverse repos to remove all monetary impact of their quantitative easing project and yet never actually sells any securities. They just let everything roll off. By my original definition, that’s debt monetization. But would it matter? Would the impact on inflation, the dollar, commodities, etc., be radically different than if they slowly sold off their Treasury and Agency portfolios? Probably not.
So then it comes back to intention. Why did the Fed decide to embark on this QE journey? Is it the Fed’s intention to help the Treasury service its debt? Or is it to battle the economic circumstances in which we've put ourselves? I can’t answer that question definitively. I think it’s the later, but I’m not in on the FOMC meetings. I don’t really know.
Bringing all of this back to Echo Base, here are my conclusions. If you focus too much on the Treasury/Agency purchases, you are missing the key likely market impact. The new money creation is the primary thing here. What is done with the money is secondary. A weaker dollar, higher gold/oil/agricultural prices are not symptoms of a run-away Fed, but symptoms of an economy that was threatening deflation and now is more normalized. Finally, we need to watch how committed the Fed is to an exit. Are they willing to risk a double dip recession? Because that might be what it takes to remove the massive monetary stimulus that’s been created thus far. So far they've talked a good game. Let’s see what they actually do.