Winter 2009-10 has been especially severe across USA, Europe and Asia all the way to Northern China. There was a similar deep freeze in 1994/5 that knocked a full 1% off economic growth and that panicked treasuries including USA and UK to boost deficit spending for fear this was an advance indicator of a severe economic downturn. Winter even effects policy formation. Mr Bernanke began unveiling details of the Fed’s exit from bank support strategy two weeks ago in congressional testimony, but his actual appearance before lawmakers was cancelled because of a snow storm. It convenes today.When January's UK tax revenue for 2009 was predictably low at 6% down, slightly below expectations, and government cash-flow borrowing appeared high, there was also a Winter effect in this. Do not expect first quarter 2010 GDP therefore to be a sound indicator of how recovery and fiscal deficit impulse are behaving.
In addition there is palpable weakening in consumer confidence driven by political cynicism, party ya-boo politics, all the normal uncertainties in election years (UK general election in May and USA mid-terms: House - all 435 seats - and Senate elections - 36 seats - in November, to form the 112th Congress) when the voters will among other matters judge how well governments have dealt with the credit crunch and recession. In China, the response has been erratic, much juggling with ups and downs of money supply and snowing us with unbelievably positive statistics.Yet, the country’s banking regulator has had to order lenders to cut back on credit to local governments’ financial arms in an attempt to reduce future bad loans. Bnks exposure to property development is only rivalled by Rmn 6 trillions (c. $1 tn) of exposure to state entities, much or all of which is non-recourse loans!
No politicians anywhere underestimate confidence factors e.e. the Brown-Darling spat recently reported in Andrew Rawnsley's book over whether to tell the public last year that this would be the longest deepest recession or not! The 3 letters to the newspapers signed by 87 economists focus on market confidence, loose or tighter fiscal stances for longer or not, but acually UK recovery will be dictated more than anything else by what the USA policy makers do - twas ever thus for over a century, one reason why we go to war together.
Commentators are confused about the virtue of prudence and not having national debt or the private business and household sector debt overhang, and the risks or benefits of higher private saving, failing to appreciate that you cannot have private and public sectors exhibiting the same prudence at the same time; private savings are the exact (in macroeconomic accounting terms) counterpart to higher public sector borrowing, plus the economy's external account balance.
Inbetween, private and public debt balances and the net external account, is also the new (on an unprecedented 'peace-time' scale) and very fuggy world of central banks and treasuries off-budget and off-balance sheet operations. And central to that are the length of commitment and exit strategy by government from providing liquidity and capital support to banks. This is the subject of Ben Bernanke's grilling on Capital Hill a fortnight ago on the 10th. What the USA decides will be scrutinised and in some form copied by the UK though policy inspiration also flows from UK to USA.What may be surprising to those who know that banks remain very stressed, US banks have $1.2 trillions in reserves, also called "excess liquidity", not to be confused with 'capital' that is also about $1 trillion. The UK equivalent is about $500 billions, much higher in proportion to the size of the economy reflecting the immensity of international banking in the UK and UK banks' international exposures.
The Federal Reserve’s following after its Quantitative Easing comes Supplementary Financing Programme to drain excess liquidity from the financial by selling $200bn in short-term debt and store the proceeds at the central bank. The Fed is shrinking its balance sheet to begin preparing for when it is economically a good time to tighten monetary policy. Congress at the same time has authorised a raising of the Federal Debt Ceiling by $1.9tn to $14.3tn when the limit on total public debt of the USA is just shy of 12.4tn, after it was raised by $290bn in December to ensure the government could continue to function. This limit has been reached. The Senate and House similarly also passed amendments to legislation raising the debt ceiling requiring new budget items to be paid for, dubbed "pay-as-you-go." Ben Bernanke on the 10th faced US legislators about his central bank’s “exit strategy” from banking sector support - like preparing to packing his resources onto the down escalator as soon as it is clear eveyone else is on the up escalator.
“BB Gun” as he is affectionately known in some quarters, has had to deal with criticism from both Republicans and Democrats over the Fed’s role in the financial bail-outs, the ballooning of its balance sheet and its inability to foresee and prevent the boom and bust in US housing (mid-2005 – 2010). This is not unrelated to his plans to shrink the money supply in order to avert any splurge in inflation even if a dose of this might be helpful to shrinking debt burdens. US realtor firms websites all have picture of keys being handed over to represent 'sale agreed' - today the pictures are as likely to mean the opposite 'un-agreeing the sale'. Unlike in Europe, US mortgage borrowers cannot be pursued for the balance of the debt, and unlike Japan where mortgage debt can be pursued through three generations to the grandchildren of the original mortgage borrower - the only collateral for mortgage deals in the USA is the property itself, and getting foreclosures processed in court can take up to a year and a half.
When non-defaulting mortgagees decide to 'hand in the keys' without recourse, to become defaulters on houses that say were worth $500k and are now only $400k and maybe sit tight rent-free for 16 months saving $40k before foreclosure, the question arises ‘would it be better if banks took some of their mortgage credit losses by reducing mortgagees’ debt’ to ensure voluntary foreclosures are less, and, if so, how can this be done cost-efficiently and fairly? Sub-prime mortgages (a fifth of the total) are showing 25% defaults when prime borrowers’ defaults are less than 2%. The possibility of higher interest rates, and therefore higher borrowing costs for consumers and businesses, and mortgagees has politicians of both stripes concerned – particularly in an election year, r stoked by the Fed’s move last week to raise the discount rate – at which banks can borrow emergency loans from the central bank – 25 basis points from 0.5 per cent to 0.75 per cent, even if for now this will not filter through to impact borrowers much who are already bearing a high credit risk margin in rates of at least 100-200 basis points above un-stressed, more normal, period risk margins.The Fed has explained several times that the move represents an unwinding of emergency liquidity measures set up during the crisis, and is not a shift in monetary policy. That is yet to come and may be some way off, given the fragile state of the economic recovery.
In written remarks BB indicated that the central bank would tighten monetary policy in this cycle after ramping up tools, such as “reverse repos” and a “term deposit facility” to shrink the Fed’s balance sheet, which increased from $800bn to more than $2,000bn during the crisis. The $200bn plan – which also would have the effect of reducing excess reserves – is seen by some economists as another helpful manoeuvre .The FT view is that the Fed is developing its option – which central banks rarely have – of choosing by how much it wants to affect short-term interest rates through rate rises or, conversely, long-term interest rates through mortgage asset sales. I’m not sure this is totally the case given that US banks, if not so much as EU banks, have to buy and hold far more government bonds than in the past, for regulatory reasons, to increase and improve the quality of their capital reserves, and therefore demand for government paper remains high.
The main issue that should be addressed is how to halt banks and borrowers deleveraging to narrow their net personal and company debt or grow spare surplus, or in case of banks narrow their funding gaps.
The FT makes a spendid observation that the Fed (and we may add bank of England too) now have a significant degree of flexibility, by having entered the politically tricky territory of being able to allocate resources via the banking sector and other agencies within the economy.
The Fed, by holding so many mortgage assets on its balance sheet, “has opened itself up to criticism from various sources and has encouraged the idea that monetary policy decisions may be influenced by political or other special interests”, said Charles Plosser, Philadelphia Fed president in a speech on Fed independence last week. His view is that “This is not a healthy development.” Why not? His solution was that the Fed should, at the earliest opportunity, sell the mortgage assets and return to its pre-crisis balance sheet composition of mainly US Treasuries.
BB in his congressional testimony on the Federal Reserve’s “exit strategy” made clear that there were no imminent plans to tighten credit in the US economy, whose recovery is still early and fragile. But, he signaled that the US central bank is preparing for unwinding the extraordinary support for the financial system – and the enormous increase in its balance sheet – that it built up during the crisis. This means taking profits from the support, or if early letting other investors in banks have more of that? “He’s walking a tightrope,” said John Canally, an economist at LPL Financial reported by the FT; “He can’t afford to make a mistake.”
The Fed chairman did not give any hints about exact timing; that depends on US economic and financial conditions. The UK government’s stated view is similar, although the Conservative Opposition is more gung-ho to exit earlier, seemingly more confident about economic impact and less concerned about the profit to taxpayers. When the moment comes, the Fed is considering tightening the money supply through a combination of several measures, including an increase in the interest rate on reserves, which is now 0.25 per cent. “to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Fed banks.” The interbank wholesale money market rate spreads are currently still 100 basis points.
That focus on interest rates on reserves – though expected by many economists – represents a big departure from previous practice at the Fed, which for years has used increases in the Fed funds rate as its main policy tool to remove money from the system. But BB indicated that the Fed funds rate might not be as reliable in this cycle because activity and liquidity in that market declined with massive increase in the Fed’s reserves during the crisis. He added that a “term deposit facility”, which would encourage banks to store more money at the central bank instead of lending it out, and “reverse repos”, to allow the US central bank to borrow short-term (t-bills)in exchange for cash, to allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quickly if it choose to do so.
One has to wonder whether the Fed's measures and indications may bestir the banks to stop building up the Fed's reserves by doing more themselves to unravel the bank-support by reversing the swaps or buying back pledged assets and re-conditioning these as instruments to support their liquidity and capital balances. The real overhanging question, however is when will the banks stop deleveraging and at last begin expanding their lending. Surveys all show that consumer and business investor confidence are highly linked to ease of borrowing. This is circular, however, since banks take their cue as to whether and when to let lending expand based on consumer and business investor confidence!
Note that just like the Fed is sitting on measures to tighten credit conditions, it is sitting on massive mortgage assets it could see, just as banks are sitting on massive real estate portfolios they could sell, but none want to do this while the economy remains fragile. Hence, for now, the US Fed has no plans to sell mortgage assets before they reach maturity and is not expected to do so at the beginning of any credit tightening phase.
One of the earliest moves, as a sign that it view economic recovery to be hardening, Fed officials might increase the discount rate – at which commercial banks can borrow money from the US central bank at a preferential rate. Before the crisis, the discount rate stood 100 basis points higher than the Fed funds rate. This spread was lowered to 25 basis points amid the credit crunch turmoil after mid-2007.
“The economy continues to require the support of accommodative monetary policies,” BB said, adding,“However, we have been working to ensure that we have the tools to reverse, at the appropriate time, the currently very high degree of monetary stimulus.” Should we see this as a firm indicator? BB says no, because of the large amounts of reserves in the system there was a possibility the Fed funds rate would for a time be a “less reliable indicator than usual”.
It only hurts when I laugh!
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