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Project Weimar: Why QE2 Could be More Inflationary Than You Think
Two simple charts tell it all. Bonus: at the end, we explain how to make Paul Krugman squirm.
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"In my darkest moments, I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places."
-Dallas Federal Reserve Bank President, Richard W. Fisher, October 19, 2010
This is the condensed version of what I wrote the other day. Just about everyone now expects the Fed to purchase half to a cool trillion or more in Treasury purchases over the next year. As Tyler pointed out a few weeks ago, "The problem, as we also concluded, is that there are simply not enough Treasurys across the entire curve, in existing or projected issuance, to satisfy the Fed's possible total monetization needs!" Indeed. But, the possibility remains that the money simply ends up as excess reserves at the Fed like last time, right? Why worry about inflation as the 10 year grinds ever lower and lending continues to fall? As I wrote:
The thinking goes: the Fed bought $1.75 trillion in assets. The banks took some of this money, levered it, and ramped the risk markets for a year. They left a trillion (or so) parked at the Fed to earn 0.25% interest, where it remains today. If the Fed prints another half (or whole) trillion over the next year to purchase Treasurys, we can expect more of the same. Banks don't want to lend, and what they don't use to bid up risk assets (such as junk stocks, Indian rice futures and now gold), they'll continue to deposit at the Fed.
This assumes, however, that the Fed's bank subsidies vis-à-vis its permanent open market operations are uniform in effect across asset classes, which is not the case. The Fed's $1.25 trillion in MBS purchases merely covered the banking system's collective lousy bets on the mortgage industry. The banks happily put their MBS securities to the Fed and for the most part left the digital zeros in their reserve accounts. The $200 billion in Agency debt purchases (Fannie and Freddie paper) allowed China, et al to swap out its Agency holdings for Treasurys, as Chris Martenson explained in August, 2009. Finally, it was the Fed's $300 billion in long term Treasury purchases that really goosed the risk markets, as we concurrently explained.
This should be no surprise, as Treasurys are highly liquid, "riskless" securities, and have been the Fed's instrument of choice in managing short term interest rates for years. If the Federal Funds rate strayed too far above from the target rate, the Fed would arrange a temporary (or sometimes permanent) purchase of Treasury bills or coupons on the open market from its primary dealers. The intent and result was that the PD's would put the newly minted money to work, where it would compete with other short term investment money for yield. With a greater supply of money available for short term lending, yields would fall accordingly. The opposite would apply when the Fed Funds rate is below the target rate, whereby the Fed would extract liquidity by selling Treasurys to raise short term rates.
From time to time, the amount of money printing or extraction required to achieve a target rate is deemed to be too much by the Fed, so it capitulates and the FOMC adjusts the target rate. This is why the actual Fed Funds rate usually leads the target rate, leading some to believe the Fed is impotent when it comes to interest rate policy. However, the Fed's modus operandi is that it leads the markets as much as possible with expectations, then matches or exceeds expectations until the markets demand too much, after which it backs off a bit. Make no mistake, the Fed exerts considerable influence over interest rate and monetary policy--more now than ever with its unprecedented collection of interventionist tools.
The below chart shows the progression of Bernanke's mad science experiments. Readers have likely been immunized against shock by the hockey stick monetary charts that have littered the blogosphere for nearly two years; however, what is likely a new presentation is the breakdown of bank reserves by bank type. The Fed's H.8 Release (Assets and Liabilities of Commercial Banks in the US) divides banks among the largest 25 domestic banks, all other (small) domestic banks, and foreign banks. The line item for Cash Assets is an excellent proxy for reserve deposits, as it:
Includes vault cash, cash items in process of collection, balances due from depository institutions, and balances due from Federal Reserve Banks
Such balances (Fed reserves) comprise most of the Cash Assets and the other items do not fluctuate enough or are not large enough to be of concern. Accordingly, the below story unfolds:
Notable is that Federal Reserve balances have been drawn down from the February 24, 2010 peak by $249 billion, of which $169 billion is non-borrowed (those extra reserves that banks can, and have, removed from Fed custody). While the small banks have kept their cash assets nearly constant since December, 2009, large banks have withdrawn $211 billion and foreign banks $96 billion from their respective peaks. These are material sums. Also notable is that QE Lite, now two months old, is not popping up in bank reserves. Importantly, though, we do see M2 ticking up again.
For anyone who still doubts the power of the Fed's open market Treasury ops, it's instructive to zoom in on the second and third quarters of 2008--a time when fears were escalating over the imminent Bear Stearns collapse.
Like a good shop-vac, Treasury open market operations work just as well in reverse--risk on/risk off. Judging by the spread between the 13 Week T-Bill rate and the Fed Funds target rate, it's clear that the markets were demanding more than a 75 bps drop at the March 18, 2008 FOMC meeting. Regardless, the order was given to reign in liquidity until the two converged, which they nearly had by the last such operation on May 21, $144 billion later. The dramatic slowing in money supply growth was noted by EPJ at the time. Whether Gentle Ben was blindly targeting an arbitrarily set metric or deliberately tightening while talking an easing game to engineer one of the century's greatest market meltdowns is unknown. Historical Fed duplicity tends to make one think the worst, though it's important not to ascribe too much prescience to these people--much less omniscience.
My conclusions can be read at the end of the post, but summarized, are quite simple. Treasury purchases and sales have historically influenced short term rates and, in turn, the money supply. However, even in a post-IOER world, the primary dealers don't and won't have the inventory to make the future purchases sterile. The amounts are multiples of what was done in 2009 (at least with respect to Treasury purchases, which is the juice). The minimum expected amount of QE2 Treasury purchases is $500 billion over the next year. Add in another $320-$360 billion for QE Lite, and we have a total minimum of $820-$860 billion. Current domestic bank inventory of Treasury and Agency debt is only $550 billion. We know there will be asset price inflation and monetary base inflation, but the numbers suggest the broader money supply will be inflated as well, especially if the upper end of expectations of $1.5 trillion are fulfilled.
Okay, now to the fun stuff:
As Econophile pointed out the other day, and as Robert Wenzel at EPJ updates this morning, Austrian economics author and scholar Bob Murphy has challenged Paul Krugman to a debate. If Krugman simply accepts, funds donated through The Point ($31,535 and counting) will be passed along to FoodBankNYC.org. CNBC's John Carney also wrote about it here.
If you'd like to watch Paul Krugman's eyes turn brown as he defends the worst economic decisions since the Great Depression (or look like a complete dick for denying a worthy charity of critical funds), don't hesitate to vote with your digital wallet here. All were asking is a measly tithe--that is, 10% of ZH readers' funds gained from front running the Fed's POMOs.
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Analysis beyond my paygrade.
So is this saying that the excess reserves by the banks has started to drop from its high levels earlier in the year? And if so, is it because they are trying to stay solvent as various loans don't get repaid?
Also, if there are not enough Treasuries to be bought doesn't that mean we can expect the Fed to purchase RMBS and CMBS junk at par shortly?
He's saying that the excess reserves are being withdrawn and are bidding up prices, especially commodities--inflation resulting from Fed intervention. He's saying Treasury will issue more debt for the Fed to purchase--more inflation. He's warning you not to underestimate how effective Fed monetary intervention might be.
He's warning you not to underestimate how effective Fed monetary intervention might be.
Based on the last three years as defacto unemployment climbed to 30.5% with bankruptcies and foreclosures?
http://cwcs.ysu.edu/resources/cwcs-projects/defacto
Would not put money on it
McDonalds raising prices soon; because they have to; owing to price increases in their feedstocks; inflation exists, and when it exists it accellerates.
I didn't say I agreed with him, I just summarized his argument.
I do agree with his analysis; and with you; unemployment will probably not respond to the tsunami of dollars; Stagflation is now known to be possible, (when it first appeared in the '70s, it was "officially" impossible, according to the economists of the time, just in case you were optimistic about our very own economists now), and is a very likely scenario.
Keynes is dead, outlived by the neoKeynesians and their historical revisionism
The large bank drain on cash reserves is [partly] a solvency issue. The point is that we cannot expect them to simply shovel any new monetization back into their sterile reserve accounts at the Fed. Some of the new monetization will be offset by writedowns, but not all, based on the printing scale currently expected.
As to RMBS and CMBS, the Fed's established procedure is to create an entity, such as the Maiden Lane triplets, shovel worthless securities into it and pay/loan the seller cash. It purchases Agency MBS directly. Either of these could be used to paper over the roboforgergate mess. However, the Treasury purchases will continue as the "supply problems" are easily resolved by rewriting a few Fed regulations.
Why not, if there is about $13 trillion of debt, what's the problem with buying 1 or 2 trillion?
I think what he's trying to get at is that the Treasury can issue more debt so the Fed can buy it. This would give Congress more to spend on pet projects and building monuments in their name. Also gets Congress off the Fed's back as far as audits and investigations ("Pettman"). Win-win for everybody involved.
Yes, and let's not forget "buying votes".
Actually, votes are quite cheap; it is "counting" the votes that really costs. collusion and silence are not cheap.
Yes, see Tyler's post here for more detail on the Tsy "shortage"
...building monuments in their name...
No doubt those are shovel ready.
Krugman has the look and feel of a madman. Bootlicker for the NWO
Is that National Wifle Organisation?
I don't think he is mad. He clearly has been promised a bunker at a ranch in Paraguay though.
He's not a very attractive whore, but his datebook is certainly paid up. He also writes articles about the "horrors" of global warming for the Times; I wonder what his hourly rate is.
Does anyone listen to Krugman anymore?
Willliam,
Do you do work for hire? I need a design for a (lady)pirate flag. I want to give it to my boyfriend for Christmas. He has a little sailboat that needs dressing up....
:o)
Defenders of government largesse.
Only those that pull the levers, unfortunately. Have you done Teen Wolf? He could be the dad.
Someone tell EB the difference between Fed Reserves expanding and credit, money multiplier, supply and velocity contracting
Who can do business with 46% real interest rates?
(Falling leveraged asset prices + nominal rates)
Fed pushes on a string while FinReg dismantles the casino and Treasury market buyers and the economy are on strike
TIPS auctioned at negative nominal interest rates telegraphed rising real interest rates
Obama Cabinet and Congress days numbered
Here's what I said after the jump:
It's a very reasonable post and I have the same bias you do; I think the error they will fall into will be inflationary; but we have to wait and see.