Monday, June 08, 2009

SMACKDOWN WEEK: Epiloge: At that speed are you sure we'll be able to pull out in time?

So Accrued Interest has settled it once and for all. Inflation risk is low. The Poll proves it! I posted a new poll asking if readers like the SMACKDOWN format, where I spend several posts on the same subject in greater depth. If you liked it, vote. If you hated it, vote.

As a final point on the inflation subject, I wanted to look forward, to the future, the horizon. Obviously the dire consumer situation isn't going to last forever. Even though much of the wealth destruction I mentioned last week isn't going to recover in a V-shape, we will reach some sort of equilibrium in housing eventually. Even given a L-shaped recovery in housing, consumers eventually get back on their feet. Maybe they can't spend their home equity but they'll still spend their earnings. We will also reach some sort of equilibrium in personal savings, which I think will wind up in some relatively low, but still elevated level.

So inflation isn't dead. Not yet. And thus the Fed will eventually have to pull way back on its current policy accommodation. How and when will this happen, and what are the risks.

The biggest risk is Fed independence. You want to know what really worries me for the long-term? Fed independence.

I believe firmly that the men and women who are responsible for normal Fed policy actually learned the lessons of the 1970's. That inflation is an insidious problem, and once it takes hold, its is painful to wrench out of the system. I realize many readers will disagree, given the aggressive policy of the last 12 months, but spend a day going back and reading Ben Bernanke's old speeches, and I think you'll agree. Policy of the last 12-18 months has been all about eliminating a Great Depression style debt deflation. Once that battle is won, I believe the Fed's policy makers will want to wind down their non-traditional policy maneuvers.

There are those who say they can't remove these policies in a timely manner. I don't get this argument, as it seems to be merely based on the sheer size of the programs. Remember that inflation is a rate of change, therefore stock measures aren't terribly relevant. Its all about marginal changes.

To see what I mean, consider the Fed's MBS purchase program. As of June 3, the Fed had $428 billion in MBS on their books. To simplify, let's call that $428 billion in incremental demand in period 1. If they Fed just held their position, no new buys or sells, what's the inflationary impact in period 2? None right? No marginal demand for MBS from the Fed, no money printed. So execution of the exit is relatively easy.

To me its all about timing and will. The timing is a bit of a guessing game. I think we have seen some legitimate green shoots since January of this year. Consumer spending is way down, but no longer seems to be collapsing. Thus there should be some commensurate slowdown in the pace of the Fed's policy actions. Its also clear that the Treasury buying program has been a major failure, in that it spooked foreign investors. I expect the Fed to let the Treasury program die a quiet death, and let that be their first removal of some accommodation.

But do they have the will? There are those that say the Treasury has made the Fed its padawon. The Fed is creating inflation to help solve the Treasury's debt problem. I don't think this is the case, but its a scary thought. It would represent a return to Nixon-era central banking, where the Fed was highly political and thus unwilling to tackle inflation with the steady hand necessary.

Consider this. Will a Fed with an expanded mandate, as the primary regulator of banking and possibly other elements of the financial system, becomes more political? Probably. Will Congress get more oversight of the Fed-as-regulator? Certainly. Will that translate into less independence on the monetary policy side? Its a very big risk.


Aaron said...

I think a lot of the worry about the expanded Fed balance sheet is not inflation but losses. Will they be able to unload that $428bn in MBS without moving the market and taking a big hit? And if they just hold it, will the Fed get repaid in full?

I'm not saying it's a given that the Fed will see major losses, just that I'll breathe a lot easier when the Fed is back to a lean balance sheet filled with Treasuries.

Unknown said...

I think you are right lack of independence = inflation, since we have never seen a government that thinks it benefits from low inflation or deflation. Oh yes, and the only real way to "fix" the housing problem is inflate the housing prices.

Accrued Interest said...

In MBS, the Fed could, theoretically, take delivery of their TBA MBS (they don't actually have any pools on their books, or so I'm told), then just let them run off. There would be no cash on cash losses, even if there were some mark-to-market losses.

I think the only place the Fed currently has credit risk of any import is within Maiden Lane.

Donald Pretari said...

I prefer to think of Bernanke as a Sith, who will unleash Darth Drawdown when the time comes. That's why I've become a fan of his.

Don the libertarian Democrat

Michael H said...

Inflation lags changes in the Fed's balance sheet so your marginal change theory doesn't really hold water. It's like saying I can turn my thermostat up to 120F at noon and not worry about roasting later in the afternoon because I didn't make any changes at 1PM.

My assumption is that at some point in the future the Fed will need to actually decrease the size of it's balance sheet in short order. I don't see how the Fed can do that without taking losses. And since the Fed can't take losses, they can't unwind their balance sheets.

Maybe I'm naive in assuming that after a QE situation that the Fed's balance sheet would actually shrink.

Instead maybe they will choose to play with reserve or capital ratios to constrain money supply growth.

Alex Morrow said...

I like the smackdown format

Accrued Interest said...

I agree that there is a lag to any Fed action. But since I don't think their action is sufficient to create inflation as it is, I don't think they need to actually sell the MBS/Agency/Treasury bonds to "remove" the stimulus. Letting it run off should be enough.

Certinaly you'd agree that the impact on interest rates is fleeting unless they keep buying right?

In Debt We Trust said...

If gold moves out of contango then we have signs of higher inflation. Until then, the deflation bugs rule.

anonymous said...

"To see what I mean, consider the Fed's MBS purchase program. As of June 3, the Fed had $428 billion in MBS on their books. To simplify, let's call that $428 billion in incremental demand in period 1. If they Fed just held their position, no new buys or sells, what's the inflationary impact in period 2? None right? No marginal demand for MBS from the Fed, no money printed. So execution of the exit is relatively easy."

The point about period 2 is that the banks might want to reduce their reserves, ie use the money. so right now, there is no consequence to increased reserves, but all the risk is if they withdraw and loan in period 2. Bloomberg said today the Fed will no issue debt to withdraw the reserves, so the Fed is left only with interest on reserves as a tool to hold them in (I totally discount selling the crap back to the market...). If you followed the interest on reserve debate in october, you will remember it was set up to divorce fed fund rate from quantity of reserves and that didn't work (there is a good NY Fed paper on this). So why should it work to hold them in ? How much will they need to pay to accomplish that ? and where will the money come from ? print print print...

In Debt We Trust said...

I just thought of something. What impact does the Chinese fiscul stimuli packages have on inflation?

shivz said...

To Accrued Interest,
Thanks for the two-article enlightening analysis.

Query: Do you want to convey the impression that debt, and more debt, can be assumed now, and money and more money, printed now (so long as indicators stay as per your previous article), and that, nonetheless, painless exit, i.e., avoiding inflation, is possible just by (right) timing plus(what they call) the fine-tuning?

Accrued Interest said...


Sorry I missed this comment.

Obviously there is a limit to everything. I'm merely saying that that limit is a good bit away from where we are now.

I'd also say the Federal deficit is a bigger problem that anything the Fed is doing.

shivz said...

I am afraid you missed, just a bit, my point.

You are saying that the "limit is a good bit away from where we are now", and I'll take it from there.

Assuming, just for the sake of argument, that you know where the limit is (and more money is, correspondingly, borrowed and printed), and given your remark that "the Federal deficit is a bigger problem than anything the Fed is doing" (with which I fully agree), here is, again, my question:

Is it your opinion that, once recovery is underway, exit is just a matter of fine-tuning, i.e., without additional shocks, or adverse repercussions, to the 'real' economy?

Accrued Interest said...

I think a second recession, similar to the 1980's twin recessions, is a distinct possibility. Because the Fed is going to have to tighten the reigns, just as they did after the 1980 recession.

As I say this, bear in mind that it doesn't have to be technically recessionary. Right now its kind of looking like the Fed never put enough stimiulus into the system to create a booming recovery. So it might be that the tepid recovery will be made even more tepid by removal of easy money.

Now its also possible that they just slowly reduce their extraordinary programs in just the right pace, and we get a strong recovery. But that's a long shot. Monetary policy usually doesn't work like that.