Visualizing The Fed's Clogged Plumbing
In advance of ever louder demands for more, more, more NEWER QE-LTROs (as BofA's Michael Hanson says "If our forecast of a one-handle on H2 growth is realized, then we would expect the Fed to step in with additional easing, in the form of QE3") , it is an opportune time to demonstrate just what the traditional monetary "plumbing" mechanisms at the discretion of the Fed are, and more importantly, just how completely plugged they are. So without any further ado...
Keep in mind that this is a simplistic, pre-"$20 trillion in US Shadow Banking liabilities" perspective. When accounting for all pathways, including the ability to repo Federally "reserved" assets within the $45 trillion BoNY/State Street collateral "cloud", the above figure gets far more complex, and explains why every incremental dollar in monetary easing will likely go straight into massively overvalued paper investments, and shortly thereafter, into hard non-dilutable assets. Which in turn, when considering icnreasingly fewer Americans are spending on staples like mortgage, explains why the threat of runaway asset prices is higher now than ever before. Although we agree: aggregate demand will have long way before it ramps up to capacity, at least in the traditional monetarist sense. So for now, and looking solely at the traditional representation, here is why even more QE will likely have no actual favorable impact on aggregate demand, once again via BofA:
Credit channels: most severely cracked
Of the six channels listed in Figure 1, all are impaired in one way or another. The most disrupted arguably are the credit channels (left side of the figure). The narrow credit channel is largely impaired because banks are hoarding reserves (more than $1.5 trillion in excess reserves currently are on deposit at the Fed);loan growth remains quite soft. The broad credit channel is blocked as collateral values are still impaired in many sectors — most notably real estate.
The data reveal that aggregate lending is still depressed: historically, loans and leases of the US banking sector have grown around 7% annualized, and has averaged that pace for the past 50 years. But during the last recession, loan growth collapsed — a much larger decline than any period on record — and has only turned up in the past year. Most of this growth is due to commercial and industrial loans; both consumer and real estate lending are still contracting.
The January Senior Loan Officers’ Survey revealed a significant decline in the net percent of banks willing to make consumer loans, suggesting that lending standards are starting to tighten again. This may reflect a desire by banks to further improve their capital positions. Meanwhile, loan demand remains weak in a number of sectors. The exception has been large corporates, who have lots of cash on hand already and ready access to the capital markets. In effect, the rise in commercial and industrial lending is helping those least in need. To fully restore the flow of credit will likely take at least another year or two.
Interest rate and wealth channels: leaks continue
The interest rate channel typically works through cuts in the federal funds rate rippling through the term structure, lowering all rates. But with the funds rate pegged at 0 to 0.25% since late 2008, this channel has been completely cut off. Similarly, the wealth channel, as illustrated in Figure 1, has also sprung a large leak. Traditionally, cutting interest rates and expanding the money supply would be expected to boost asset prices. But now, despite the large increase in the monetary base, the “money multiplier” crashed and has remained low: for M2 it is less than half its pre-crisis value — and below one for M1 (Chart 3)! This drop is in large part a consequence of the weak lending environment noted above.
Portfolio balance channel: laying new pipes With these two channels — historically the most potent — backed up, the Fed has innovated, attempting to influence longer-term rates by removing duration risk from the market (asset purchases) and by reducing expectations for future short rates (forward guidance). In some regards, these new tools are more direct than the pre-crisis ones. The Fed arguably has been relatively successful in bringing down rates at the long end. This, in turn, has benefited capex investment and mortgage refinancing, thereby modestly stimulating demand.
Through its asset purchases, the Fed also is trying to boost asset price levels —another route to a wealth effect via a portfolio balance channel. Note that thischannel works not through the liabilities side of the Fed’s balance sheet (the traditional mechanism), but the asset side. (This also makes the portfolio balance channel the asset-side counterpart to the traditional monetarist channel of figure 1 on the liabilities side.) This approach has seen some success through higher equity prices (although we doubt the majority of the rise in stock prices can be pinned on the Fed, given the strength of US corporate fundamentals). But it has arguably not yet helped boost house prices, which remain the most significant asset for a majority of US households. Household net worth fell from 6.5 times personal disposable income pre-crisis to about 4.7 times thereafter, and remains less than 5 times income (Chart 4). The problems in the housing market have continued to undermine many transmission channels, including this one.
Exchange rate channel: an interrupted flow
The exchange rate channel has arguably had some success, with the tradeweighted US dollar index dropping over 14% (5% annualized) from its early 2009 high. Cumulatively it is down 9% (2% annualized) from its August 2007 level, when the Fed began aggressively easing policy (Chart 5). The exchange rate impact of the Fed’s bond buying was largest after QE1 was extended. Conversely, Operation Twist has had no noticeable effect on the dollar. As the dollar fell from 2009 through 2011, US exports boomed, which added to growth and, to a lesser extent, employment. With the pace of depreciation having slowed, the marginal boost to trade should soften as well.
While this channel was relatively more effective than many others, it also is not especially large. It was, however, one of the least popular — at least globally. Emerging markets did not welcome the drag on their exports from stronger currencies, nor the “hot money” that led to capital inflows chasing higher returns. And to the extent that global investors also jumped strongly into commodities, the rise in these prices (especially food) could be inflationary in EM economies, while higher energy prices could squelch the recovery in developed markets. Small increases aren’t a big deal — but if the commodity markets become hypersensitive to Fed easing and overshoot, it then becomes a potential problem.
To date, most Fed officials have not given much credence to this concern, and Fed researchers have found little evidence to support a causal link between the Fed’s asset purchases and higher commodity prices. Rather, they point to adverse supply shocks and stronger demand, especially from faster growing EM economies themselves. We may never see the day that most Fed officials acknowledge their actions could have boosted global commodity prices.
Digging down: confidence and expected inflation channels As if Figure 1 is not potentially confusing enough, there are other potential channels for further bond buying to impact the economy. One is through inflation expectations. The various QE programs where implemented in the face of sharp declines in inflation expectations (Chart 6); Bernanke argued in his lectures this past week that asset purchases guarded against deflation risk. Restoring longterm inflation expectations to the Fed’s 2% target not only satisfies that part of the Fed’s dual mandate, it also eases financial conditions by making real interest rates more negative — reinforcing the interest rate channel for policy.
Also not represented in Figure 1 is a confidence channel. In times of elevated uncertainty or outright crisis, Fed easing can offset negative shocks to sentiment that threaten to feed upon themselves. In effect, the Fed can potentially put a floor under market sentiment. As such, the Fed is likely to react to a sharp, broadbased sell-off in asset prices that foretells of a collapse in confidence. But as the crisis environment fades, we would expect the Fed to be more tolerant of regular volatility in asset markets. Indeed, the threshold for the Fed to react to stock prices — which is not a standard part of the Fed’s economic assessment, but surely is correlated with growth and sentiment — is likely higher today than during the prior few years. Investors should be cautious not to put too high of a strike price on the so-called “Bernanke put.”