Quantitative Easing and the Karate Kid
I got home Friday evening shortly before the wife picked up the kids from Karate. After a few minutes I heard the garage door open, and I knew the kids would be excited to tell me all about their first day so I went to meet them. My seven year old daughter got out of momma’s car wearing a karate uniform, flip-flops, and a pony tail. It was quite a sight. With all the interest of an adoring parent I walked over and asked her how her first karate lesson went. She responded immediately by launching her tiny seven year old fist directly into my mid-section with Bruce-Lee-like-ferocity. After a brief discussion about not using your new karate powers on people that aren’t attacking you I congratulated her on the well executed strike.
As I pondered the incident later it began to remind me of the Feds Quantitative Easing program. What good is acquiring a new tool (karate or quantitative easing for that matter) if you don’t intend to use it? The Fed hasn’t brought up the topic of Quantitative Easing because they don’t intend to execute it. In an era that history will record as one with unusual clarity in Fed communications, they have brought the QE topic center stage.
A few weeks ago we had St. Louis Fed President Bullard come out and discuss how a new round of QE should look. Specifically he stated that in his mind any new Quantitative Easing would be done through the purchase of Treasury securities rather than via more Agency purchases. He also said that he would expect a degree of flexibility in the program that would allow the Fed to buy at any point on the Treasury curve that they deemed appropriate. A few days later the FOMC announced that they would be using their MBS cash flows to purchase longer dated Treasury securities.
The announcement to purchase Treasuries with MBS cash flows was as much an indicator of a sentiment shift inside the Fed as it was about the direction of Treasury yields. A rough calculation showed that they may have $200 billion per year in MBS cash flows to play with. In and of itself this isn’t expected to cause a huge shift in yields. However…the fact that they felt this was even necessary was the biggest news as it opened the door for further action.
Now that they’ve cracked the ice by using MBS cash flows to fund Treasury purchases, let’s look at the prospect for additional purchases. Its speech time at the Fed. Now is the time when the voting members go on the road, talk to various groups around the country and use these platforms to tell us what’s on their mind. This is essentially a window into the next FOMC meeting. With that in mind let’s look at the latest speech from the New York Fed President…William Dudley.
Dudley speaks
On October 1st, 2010 Dudley spoke to the Society of American Business Editors and Writers at their Fall Conference. Sounds like a real hum-dinger doesn’t it?
Dudley begins his remarks by acknowledging that this recovery has been very tepid. He also reminds us that the dual mandate of the Fed is to maintain full employment and price stability. Everything the Fed says and does needs to be measured against this set of goals. Given the current set of conditions Dudley views the current levels of inflation and employment, along with their expected timelines for improvement to be “wholly unsatisfactory”. He goes on to state that it looks to be “several years before employment and inflation return to levels consistent with the Federal Reserve’s dual mandate.”
A portion of the speech is the kind of canned recap of the financial crisis that we are all used to reading. In this speech it is used to lay the groundwork to get to this conclusion: The recovery has lost steam and hit a soft patch…soft patches in the recovery process tend to occur…but this soft patch is more worrisome than others. The first difference between this soft patch and others is that it is longer in duration. The second difference (and one that concerns them greatly) is that it is occurring at a time when the overnight rate is already at zero percent. From both a monetary and fiscal policy perspective they have done everything they can to get a fire going under this economy…but so far all they’ve gotten is a little smoke…and even that is fading.
Next he touches on some familiar topics like the lack of household savings and how the housing market and cheap credit provided the ammo for consumers to fuel their spending binge. Basically he says that it took a while for this problem to build up, and now that it has crashed it will take a considerable time to recover. He sees some favorable trends in the household sector and to ensure that they continue “the economic environment needs to become more supportive”. Notice that he didn’t say “stay” supportive…he said “needs to become more” supportive. This is not a sit and wait attitude…the only way you can read that is that more action must be taken.
What can they do?
The way Dudley sees it there are two things that the Fed can do to help this process move along. First is that they can communicate better about what they are trying to do and how they will do it. Second is that they can increase the level of monetary stimulus through their balance sheet.
On the first point (communication) he states that by clearly expressing their intent to return inflation levels toward the Feds preferred range they can help anchor inflation expectations. This in turn should reduce the probability of further disinflation or (and he mentions the really scary scenario here)…the debt deflation spiral. If you would like to review the Debt Deflation Spiral you can pull out the Market Update piece I wrote on 12/18/08. If you don’t have it just let me know and I can shoot you a copy.
The Fed has been placing a heavy emphasis on their need for clear communication of their intent…this is a huge sign to those of us in the market that we need to be listening to what they are saying in these types of speeches. They will be broadcasting their intent frequently and in more concise terms than many of us are used to hearing from Fed officials. Gone is the era of “Greenspan speak” where Fed officials spoke in vague circular references with the apparent intent of befuddling anyone who heard them. This Bernanke led Federal Reserve understands the importance of communication and will be uncharacteristically transparent in their statements. Our most recent example might be this speech by Dudley as he lays his thoughts on more quantitative easing.
How much will they buy?
The plot thickens with this speech as Dudley provides us a yardstick for measuring the effect of more QE but doesn’t give us a hint as to how much he’d like to see. By his estimates a $500 billion purchase of Treasury debt would provide the equivalent of a reduction in the Fed Funds rate of one-half to three-quarters of a point. He cautions that this relationship depends on the market’s perception of how long the Fed will hold these securities.
From here you can use this yardstick to scale the potential magnitude of their purchases. If they are in the news saying they think an additional 50 bps of easing would be warranted then you know they are looking at around $500 billion in purchases. If 100 to 125 bps seems to be preferred, then it’s on the order of $1 Trillion in purchases. Now that we have this yardstick we can put it together with other speeches to get a gauge of what might be coming.
Why lower rates?
You might be asking yourself “why lower rates”? Money is already cheap enough…people that don’t qualify for a 5% loan won’t magically qualify for a 4% loan. Much of the reasoning goes back to the goal that has proved most elusive for both the Fed and the politicians…a refi wave.
They have talked about generating refi activity from day one of this crisis. Consumer spending drives 2/3’s of GDP…it is a high priority item. The consumer has been reeling; he has been rocked in all quarters of his life. His job is in jeopardy, his home is in jeopardy, his 401k has been crushed, and his very lifestyle is in danger. He has been deleveraging out of self defense and he just doesn’t have the discretionary income to spend right now.
What does all of this have to do with lowering rates? If they can ignite a refi wave then they can get an extra few-hundred dollars per month into the pockets of millions of consumers. Whether they spend it immediately or use it to accelerate the liquidation of existing debt it will help speed our time to recovery.
Below is a list of positives that Dudley lists for lowering interest rates via another round of QE:
- Support the value of assets
- Make housing more affordable
- Support consumption by enabling households to refi
- Facilitate debt restructurings that allow negative equity borrowers to refi
- Reduce the cost of capital for businesses
It comes down to this
The bottom line: absolute levels of unemployment and inflation, along with the time frame over which they are expected to improve are unacceptable. The longer this situation exists the more exposed we are to another shock. Right now the economy is in the ditch...if we stay here long enough then the next “shock” could bury us.
It’s a bit like the kid on the playground that walks in front of the swing-set and gets wrecked. You cringe watching it but then you realize that things are in danger of getting much worse because as he’s trying to square himself away and get back up…here comes the swing again. Dudley would really like us to not be hit twice by the swing and he views Quantitative Easing as the tool to shield us from that blow.
Dudley concludes with this statement: “Thus, I conclude that further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident that we will see better outcomes for both employment and inflation before too long.”
So there you have it…if there isn’t an immediate and robust reversal in the data then Dudley is going to vote for another round of QE. How much will it be? Who knows…but the yardstick he laid out is measured in $500 billion increments.
If you have any questions on this material or if there is anything I can be doing for you just let me know.
Steve Scaramastro, SVP
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