Debate around the 2015 rate hike intensifies

Posted by Walter

Following Janet Yellen's Senate Banking Committee testimony, the Fed seems to be quite deliberate in preparing for a rate hike in 2015. It's hard to imagine taking such action in the disinflationary environment we find ourselves in, but market participants are increasingly accepting that possibility. That's why we've seen the equity markets pull back somewhat and the dollar continue climbing.

Source: barchart

The problem of course is that the dollar's strength is already pressuring US manufacturing and there is more to come.

Manufacturing orders have fallen sharply, with the dollar contributing to some of the declines.

However it seems the Fed is likely to be less focused on the dollar and instead concentrate on wages, where we are supposedly seeing a few pockets of wage pressures. Here is a quote from the NY District Beige Book report.

NY Fed: - The labor market has continued to strengthen since the last report, with some reports of increased wage pressures. One major New York City employment agency maintains that the job market has tightened considerably in recent months and that it is stronger, across the board, than it has been in eight years. This contact also notes that wages have accelerated, especially for workers with any computer skills. More broadly, business contacts report that they continue to increase employment, on balance, and considerably more firms plan to add than cut jobs in the months ahead. Service-sector firms also indicate increasingly widespread wage hikes.

This hardly qualifies as wage pressures at the national level, but it's something the FOMC will watch closely. As of now the market expects the Fed to hike at fairly regular intervals starting in early Q3-15.

There is quite a bit of debate around the timing of the first hike - especially given the psychological importance of that policy change. For example Morgan Stanley economists argue that the low core inflation will keep the Fed on hold until next year. The core PCE measure lags the headline number and will take some time to recover. It's difficult to see the Fed hiking with core PCE below 1.25%.

Source: @pdacosta, Morgan Stanley

Nevertheless an increasing number of economists and Fed officials feel that a 2015 liftoff is on - if anything as a symbolic exit from the zero rate policy.

MarketWatch: - Kansas City Fed President Esther George said she would support a decision to hike short-term interest rates in mid-year. "While the FOMC has made no decisions about the timing of this action, I continue to support liftoff towards the middle of the year due to improvement in the labor market, expectations of firmer inflation, and the balance of risks over the medium and longer run"

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Distinguishing the Fed's securities purchases from monetary expansion

There has been a bit of confusion about what today's FOMC announcement means with respect to Quantitative Easing. The statement says that " the Committee decided to conclude its asset purchase program this month". It's important to point out that while this is the end of the Fed's bond purchases (for now), the US monetary expansion has ended this past summer. The outcome is visible in the the banking system's excess reserves, which flattened out around July.

That in turn resulted in the US monetary base leveling off at just below $4.1 trillion, as the so-called "money printing" effectively ended in July.

This begs the question: How is it that the excess reserves and the monetary base stopped growing this summer while the securities purchases and the balance sheet expansion continued through October? The answer has to do with some other balance sheet items that offset ("absorbed") reserve creation. The key item to consider here is the Fed's reverse repo position, which became more impactful as the securities purchases ebbed.

While the Fed's securities program is just ending now, the US monetary expansion was finished months ago. Therefore, other than its psychological effect, today's announcement should have a limited impact on the economy.

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The low volatility paradigm and diminishing return expectations

What happens in an environment - such as the one we are in currently - that is characterized by prolonged periods of low volatility? One of the effects of diminished price swings is the decline in return expectations. As an example, the chart below shows the spread demanded by investors in US high yield bonds vs. the volatility of total returns in that market.

This low volatility regime originates from the policies of major central banks, policies that have been both highly accommodative and relatively transparent - at least in the intermediate term. And any market conditions that are viewed as a form of tightening or rising uncertainty are often met with further accommodation. This is particularly true in the US. For example the markets’ negative reaction to the Fed’s looming taper last year was met with a delay and a reduction in taper’s size (“small taper”). The risk that monetary policy will materially deviate from markets’ expectations without the Fed making an accommodative adjustment has diminished significantly, resulting in lower volatility across the board.

Some have suggested that this Fed-engineered muted volatility regime is precisely the reason for low real interest rates. The reduced uncertainty around monetary policy trajectory results in lower volatility in fixed income markets, dampening return expectations. These lower return expectations mean that investors are willing to live with lower coupon in return for smaller swings in the value of their investments.

Deutsche Bank: - If pre-crisis rules for financial engagement [Fed’s involvement in the markets] raised both the volatility in the economy and the return in the economy, then reducing that volatility should reduce economic return. QED: the real rate of growth may be permanently both more stable and lower. … Returns in fixed income may depend progressively less on price and more on income.

The other effect of operating in a low volatility regime for prolonged periods is increased risk taking – often in the form of higher leverage. We've seen this manifested in higher NYSE margin debt and growing leverage of LBO transactions for example. Janet Yellen however continues to downplay the potential for asset bubbles and other threats to financial markets resulting from low volatility. The view at the Fed is that, at least for now, financial stability can be achieved through regulation - including containing asset bubbles. That assumption of course remains to be proven, given some of the past failures of sophisticated financial regulation (see example).

For now the markets have faith that regulation will indeed maintain financial stability in the face of highly accommodative monetary policy and low volatility. And as the low volatility regime becomes the norm, return expectations decline across the board and investors become lulled under the warm blanket of asset price stability provided by the central banks.

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The Fed preparing markets for the reverse repo facility (FRFA)

The Fed's "full-allotment overnight reverse repurchase agreement facility" (FRFA) - a mechanism to control short-term rates (see post) - is no longer just an academic exercise. Given how dysfunctional the interbank market has become (see post), using the fed funds target as the only post-QE monetary tool is no longer an option. FRFA allows the Fed to set a floor under the overnight secured lending rate (repo) by offering to borrow funds from a broad array of market participants - not just banks - at a fixed rate. Because this facility is effectively a riskless deposit with the Fed (legally it's a loan to the Fed), there shouldn't be any meaningful private transactions at rates below the FRFA rate - thus the rate floor. This mechanism also prevents the overnight rates from becoming negative - as was the case in some markets in Europe - to make sure that money market funds continue to function.

The Fed has been testing the facility since last September and seems to be happy with the results. The demand for the facility picks up sharply when the FRFA rate is about 4-5 bp below the private market repo rate. That's the discount that investors are willing to accept on their "deposit" rate in order to keep their money with the Fed rather than with a private institution.

Source: NY Fed (GCF stands for General Collateral Financing,
meaning that any treasuries can be used as collateral as opposed to specific securities)

Late last year the Fed raised the maximum FRFA bidding amount to $3bn from $1bn, as testing progresses to the next phase. When the program becomes fully operational, these amounts would increase dramatically.

One by one the Federal Reserve officials are preparing the markets for the FRFA implementation. Once QE winds down, the FRFA fixed rate becomes the next monetary policy tool.

1. Simon Potter (last month):

WSJ: - ... Simon Potter, who runs the New York Fed's markets group, gave a big thumbs up the reverse repo program based on what he's seen with the testing.

He said in his speech the overnight reverse repos "may strengthen the floor for short-term interest rates and, with it, the Federal Reserve's control of money market rates, by surmounting the competitive and balance sheet frictions seen in money markets and by extending the central bank's payment of interest to a wider universe of relevant counterparties."

2. Bernanke:

CBS: - Looking into the years ahead, Bernanke said the central bank has the tools -- including adjusting the rate on excess bank reserves and so-called reverse repurchase agreements, or repos -- to return to a normal policy stance without resorting to asset sales.

"It is possible, however, that some specific aspects of the Federal Reserve's operating framework will change,” he said. On the economy, Bernanke noted unemployment remains elevated at 7 percent, and said the number of long-term unemployed Americans “remains unusually high.”

3. Dudley:

BW: - Dudley said the Fed may decide to extend a program involving so-called reverse repurchase transactions aimed at giving it greater control over short-term borrowing costs.

The new tool, called the fixed-rate, full-allotment overnight reverse repurchase facility, is intended to put a floor under short-term money-market rates. It allows banks, broker-dealers, money-market funds and some government-sponsored enterprises to lend the Fed unlimited amounts of cash overnight at a fixed rate in exchange for borrowing Treasuries in reverse repo transactions.

4. Williams:

BW: - Federal Reserve Bank of San Francisco President John Williams said reverse repurchase transactions may be an effective way for the Fed to control interest rates when it starts withdrawing unprecedented stimulus.

“This is potentially a very useful tool,” Williams said to reporters today after a speech in Phoenix. “It allows us to manage short-term interest rates more directly even at the same time that we have a very large balance sheet and lots of excess reserves.”

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From our sponsor:

Who benefits from the Fed's decision?

The FOMC's decision yesterday to continue buying securities at the same pace moved a number of markets. But who exactly benefited from these moves (h/t George H)?  Here are a few select markets.

Stock investors got a nice boost and precious metals investors enjoyed a strong spike. These folks should be quite happy. But then we also saw copper spike almost 4%. It's not difficult to predict how US manufacturers and building contractors feel about that.

Mortgage rates declined - a full 14 basis points. So that's the impact on the "real economy" of delaying "taper"? To make matters worse the decline in jumbo mortgage rates was higher than in conforming mortgages. Between the pop in investment portfolios and the drop in jumbo rates, those who are well off to begin with are more likely to benefit from this policy decision. Was that the intent?

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Other central banks impacting US money supply

Guest post by Lee Adler (The Wall Street Examiner)


When the Fed prints reserves by buying MBS and Treasuries with money that did not exist previously, this increases bank deposits (liabilities) and cash assets pretty much dollar for dollar. I have run charts showing this relationship, but something went wrong beginning in January.

That something was the breakdown in Treasuries holdings, as Eurozone banks began to unwind the LTRO trade at the first opportunity in January.

The Fed is not the only actor in this game. All the major central banks conduct operations with the Fed’s 21 Primary Dealers. US money supply data represents not just the US but is a pretty big slice of the whole world and reflects other central bank policies and the flows of capital between nations and banking systems.

Treasuries were liquidated to pay down the LTRO. At the same time we saw the echo of that in US commercial bank repo lending and other securities lending to nonbanks, extinguishing the offsetting deposits.

The forced March liquidation of leveraged holdings by big Chinese shadow institutions also showed up here. The BoE has also been running tighter policy.

So the Fed and BoJ are fighting an uphill battle to keep money supply inflating. US money supply would still be increasing dollar for dollar with the Fed’s purchases, but their friends, the other central banks, are no longer cooperating.

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From our sponsor:

Low money multiplier does not justify ultra easy monetary policy

An number of readers responded to the post (here) on growth in US monetary base with "so what?" After all the so-called "money multiplier" has been at historical lows - meaning that the Fed's monetary expansion has not made its way into the broader economy. The argument is that all this new liquidity is "trapped" in bank reserves, as lending remains tepid.

According to this traditional school of thought, you need sharp growth in the broader money supply to generate inflation - a major threat to the economy. But there is a problem with this argument.

Greenspan's Fed also believed that as long as the money multiplier was at historical lows, loose monetary policy is justified. And in 2002-2005 the money multiplier was indeed at historical lows. This is what the trend looked like to economists before the crisis.

Inflation of course was not a major issue at the time - at least not by historical standards. And the Fed continued with loose monetary policy, as fed funds target rate hit 1% during 2003-2004. The fed began to raise rates in the second half of the decade, but by that time it was too late. Rate increases ultimately served to burst the housing bubble in 2006.

What many economists failed to realize - and many continue to do so today - was that the risk of excessive liquidity is not necessarily the overall price inflation. With US wages stagnant, those looking for a 70s-style inflation will not find it. Instead liquidity manifests itself in asset bubbles, which is exactly what was happening in the housing market at the time when the money multiplier was at the lowest levels in recent history (chart above). Plus in a global economy, inflation (including wage inflation) was simply exported to emerging markets nations.

Economists and market participants however find ways of rationalizing asset bubbles - just as they did with the housing market in the US and China's double digit growth (among other bubbles) during the first half of last decade. That's why using the traditional money multiplier as a rationale for an ultra loose monetary policy is not prudent.

As an example of where this excess liquidity may be ending up today, consider the fact that the average US corporate junk bond yield ended up at an all-time low of 5.93 last week (chart below). Of course market participants have dozens of ways of rationalizing this trend - just as they did with other markets many times before.

Therefore before dismissing the expansion in the US monetary base as inconsequential, consider the fact that in spite of low money multiplier, excess liquidity will find ways to distort markets right under our noses. And you don't need to generate headline inflation in order for these distortions to damage the economy when the correction finally takes place.

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Trendline on the unemployment rate projects the Fed ending zero rate policy by late 2014

The Fed's new approach to targeting a specific unemployment rate (called the "Evans’ Rule") may shed some light on how long the monetary easing may continue. Credit Suisse did a simple linear extrapolation from the peak unemployment rate in 09. Such approach sets the end of the program for late 2014. That of course assumes the unemployment rate will continue declining in a linear fashion (which may be unrealistic given the structural shift in employment). It also assumes that labor participation (something the Fed is tracking closely, though it's not part of the official target) will improve with falling unemployment - another "leap of faith".

Source: CS

This extrapolation gets to the "target" considerably faster than the FOMC's "middle of 2015" projection or even the Fed Funds futures curve market expectation (Feb-2015 contract now implies full 25bp).

Fed Funds futures implied rate

The new unemployment targeting program (combined with inflation tolerance level) is expected to make for a more flexible policy tool because the FOMC would be less reluctant in adjusting its rate expectations. CS researchers think both the FOMC and the futures markets will adjust to an earlier date as the unemployment rate continues to decline (some comments in brackets [ ] ).

CS: - The Fed’s date guidance by no means “nailed down” the markets expectations but certainly made them stickier as innovations to the Fed’s rate guidance would not be costless. On the margin the Fed would have traded some credibility for flexibility at some future date when an inward shift in the date became necessary. [English: with the old approach, changing the expected date of the end to zero rates would have been harder, though not impossible.]

In the final analysis we think the market will realize the Fed can and will move the thresholds if unemployment continues to fall rapidly on the back of lower unemployment. But that will take time to sink in. In the meantime we think the blue eurodollars [2015] are free to trade.

Still, a linear trendline fitted to the unemployment rate since the peak in 2009 would suggest reaching 6.5% in late 2014. A continuation of the more recent pace of declines would imply and even earlier date. 

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From our sponsor:

Taylor rule suggests that the overnight rate should be over 1%

John Taylor, the author of the Taylor Rule, has argued on numerous occasions (even prior to the QE3 announcement) that the Fed's policy has been too accommodative. In fact if one applies a form of Taylor Rule to current conditions, not only is the Fed's balance sheet expansion inappropriate, but the overnight rate should actually be raised in order to reach a balanced monetary policy. In addition, the overnight rate should be rising steadily going forward (see chart below) instead of being held at zero into 2015, as the FOMC has telegraphed.

DB: - Taylor, who introduced the “Taylor rule” for setting short term policy rates in his seminal 1993 paper, has argued that policy rules suggesting negative interest rates – and hence the need for unconventional policy tools such as LSAPs – are calibrated to inappropriate time periods or include suspect estimates of long term equilibrium short rates. A Taylor-type rule, which places equal weight on the output gap and inflation gap, uses 2% as the equilibrium short rate, and uses an Okun’s law coefficient of 2.3 suggests that Fed funds should already be over 1% and should rise steadily during the period in which the current FOMC has made its conditional commitment to policy accommodation.

Source: DB

DB argues however that if Romney were to become president by some chance and remove Bernanke from the Fed, the central bank's policy would not change materially. Even with a new hawkish Fed chairman (like John Taylor for example), the dovish nature of the FOMC lineup going forward would prevail at maintaining the status quo monetary policy at the Fed.

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Financial fragmentation across the Eurozone can not be ended by extending ECB credit to periphery governments

Resolving the issue of broken monetary transmission (discussed here) in the Eurozone will take more than buying periphery government bonds. David Powell from Bloomberg used the Taylor Rule to determine policy rates that would be appropriate for the various nations as well as the Eurozone as a whole. The concept was first described by the San Francisco Fed:

FRBSF: - The Taylor rule is a policy guideline that generates recommendations for a monetary authority’s interest rate response to the paths of inflation and economic activity (Taylor 1993). According to one version of this rule, policy interest rates should respond to deviations of inflation from its target and unemployment from its natural rate (Rudebusch 2010). A simple version of this rule is:

Target rate = 1 + 1.5 x Inflation – 1 x Unemployment gap.

The target rate recommended by the rule is a function of the inflation rate and the unemployment gap. That gap is defined as the difference between the measured unemployment rate and the natural rate, that is, the unemployment rate that would cause inflation neither to decelerate nor accelerate. The literature shows that this simple rule or close variations approximate fairly well the policy performance of several major central banks in recent years (see Taylor 1993 and Peersman and Smets 1999).

The current ECB policy rate turns out to be right on target (in agreement with the Taylor rule) for the Eurozone as a whole, but the policy rates diverge wildly across the euro area countries.

Bloomberg: - A Taylor Rule demonstrates the drastically different monetary policies required in those countries as a result of their domestic economic conditions. The model, based on coefficients estimated by the Federal Reserve Bank of San Francisco, signals the main policy rate should be minus 7.75 percent for Spain. It should be minus 3.75 percent for Portugal, minus 3.5 percent for Ireland and minus 10 percent for Greece. Germany is at the other end of the spectrum. It requires a main policy rate of 4.25 percent.

Source: Bloomberg

And as discussed here, this divergence made depositors question the sustainability of the euro due to potential re-denomination risks (in addition to bank solvency) and encouraged them to move funds out of Spain. Similar trends are taking place in other periphery nations.

Bloomberg: - Those economic divergences appear to have led depositors to question the sustainability of the monetary union in the absence of large-scale fiscal transfers to cushion the weakness in certain countries. In Spain, the level of deposits from non-monetary and financial institutions, excluding government, declined by 74.2 billion euros in July, a record large drop, according to monthly data from the ECB. The year-over-year rate of growth stood at minus 10.9 percent.

ECB's asset purchases are unlikely to convince depositors to reverse this trend of capital flight. What's more, many Eurozone periphery citizens will continue to move deposits out of the Eurozone altogether. These euros will then be "trapped" as part of the foreign reserve accounts of the Swiss National Bank (discussed here) and Danmark's Nationalbank (discussed here).

Bloomberg: - Draghi will probably have to convince market participants of the economic sustainability of the monetary union before the financial fragmentation of the region is ended. The large-scale extension of central bank credit to potentially insolvent countries is unlikely to accomplish that.

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Mainstream economists do not understand how monetary policy is transmitted

Guest Post by Lee Adler (The Wall Street Examiner)

Barry Ritholtz called attention this morning to a Monetary Policy Transmission flow chart by Bloomberg’s Joe Bruesuelas this morning that purports to show the reason behind “ZIRP’s more modest impact on the broader economy than the outsized impact we see on risk assets.”  I don’t mean to single out Mr. Brusuelas here. He’s a great guy, and from the things I’ve seen of him, he’s usually right on target with his economic analyses. But like all other economists who are puzzled by the reason the Fed’s policies have not had much apparent impact on the economy as they have had on the markets, he misses the most important and critical access of the route through which Fed policy reaches the economy.  Here’s his flow chart.

Click to enlarge

What this chart illustrates is not so much the blockages to monetary policy transmission as the failure of mainstream economists and pundits to grasp the simplest and most important fact of how monetary policy is transmitted.

US consumer spending has been surprisingly brisk

US consumer confidence (discussed here) may end up being somewhat better than initially thought. The sentiment figures from the University of Michigan (as opposed to the Conference Board measure) actually improved in August, though remain below the pre-recession average.

Bloomberg/BW: - Consumer confidence improved more than projected in August as merchant discounts and record-low interest rates help U.S. households bolster finances. The Thomson Reuters/University of Michigan final sentiment index climbed to 74.3, a three-month high, from 72.3 in July. The gauge averaged 89 in the five years leading up to the recession.

If consumer spending is any indication of confidence, the U Michigan numbers may be closer to reality (see this discussion comparing the two sentiment indicators). US chain store sales figures for August have been surprisingly robust.

ICSC: - The preliminary tally of major chain store sales for August (fiscal month ending August 25) is up 6.0% (less drug stores) and appreciably above the 4.6% comp-store pace for July. Comments about back-to-school sales are generally favorable. The August growth rate is the strongest reading since March 2012 (+6.8%).

The broader gauge of consumer spending from the Commerce Department looks to be reasonably strong as well.

Reuters: - U.S. consumer spending got off to a fairly firm start in the third quarter, rising by the most in five months and offering hope economic growth would pick up this quarter. ... The Commerce Department said consumer spending increased 0.4 percent in July after a flat reading in June. 

US consumers remain uncertain about the future yet seem to have a healthy appetite for shopping. Consumer spending has improved materially since the recession.

Source: ISI Group

This is fairly good news for the US economy, but let's hope that rising food and energy prices (especially if exacerbated by the US monetary policy) don't bring consumer spending to a grinding halt.

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ECB rate cut impact will be marginal at best

The markets were not impressed by today's policy announcement from the ECB. Sovereign spreads are wider, the euro is lower by 1.1%, and European stocks are down 1.2% on the day. Here is what the ECB's Governing Council had decided:

ECB:

1. The interest rate on the main refinancing operations [MRO] of the Eurosystem will be decreased by 25 basis points to 0.75%, starting from the operation to be settled on 11 July 2012.

2. The interest rate on the marginal lending facility will be decreased by 25 basis points to 1.50%, with effect from 11 July 2012.

3. The interest rate on the deposit facility will be decreased by 25 basis points to 0.00%, with effect from 11 July 2012.

What does this mean for financial institutions and the ECB's attampt to ease credit conditions across the Eurozone?

1. About €180bn is currently borrowed under the MRO, and the rate cut should provide some relief for periphery banks who are the primary users of the facility. But the cut translates into savings of about €37.5 million euros a month - for all the banks using the facility combined. This is clearly helpful but is going to make little difference in these banks' behavior (in terms of credit) because they are looking for liquidity relief, not a tiny reduction in their borrowing costs.

2. Only €0.7bn is borrowed under the marginal lending facility. That's less than €150 thousand a month in savings - not even worth discussing.

3. Setting the deposit rate to zero (something the Fed had also considered) will have an impact on German and other stronger Eurozone institutions who have a great deal of excess liquidity. Thus far these banks have been moving funds between the reserve accounts and the deposit facility. That's because they need to maintain a minimum average balance in the reserve account (which pays zero interest on excess reserves). Once they achieve that average for the month (by holding an excess amount over a few days) they would move the funds back into the deposit facility which paid them 25bp.

ECB Deposit Facility (€MM)

Now with the reserve account and the Deposit Facility both paying zero on excess reserves, they will simply leave the money in the reserve account. Other than this change, banks' behavior is not driven by what they receive on excess reserves and whether the reserves sit in the Deposit Facility or the reserve account. It is highly unlikely therefore that the difference between 25bp and zero on deposits at the ECB will somehow encourage these stronger banks to extend more credit.

The markets were hoping for more action from the ECB on the heels of the recent summit. The hope was that if the politicians make a move in the "right direction", the ECB will reward them with more "non-standard monetary policy measures". But Draghi thought otherwise and of course the markets reacted accordingly.


For further discussion on the ECB rate cut see this post by Kostas Kalevras.

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Draghi gives a new meaning to "behind the curve"

Bloomberg/BW: - The European Central Bank left interest rates on hold as the debt crisis tightens its grip on the euro-area economy, increasing pressure on policy makers to deliver further stimulus.
...
“The ECB might want to wait for further corroborating data to conclude that its second-half-of-the-year recovery expectations are challenged,” said Silvio Peruzzo, an economist at Royal Bank of Scotland in London. “We do not exclude the possibility that the ECB might pre-announce it this week, recognizing the increasing downside risk to the economy.”

Wait for further corroborating data? The Eurozone PMI came out yesterday, pointing to a sharp deterioration across the Eurozone. Waiting for the GDP numbers when you have a reliable leading indicator (as can be seen from the chart below) borders on irresponsible.

Source: Markit Partners

What's more, it's not just the Eurozone periphery which is experiencing a contraction. France's PMI is showing that the nation's economy is in real trouble. The GDP is sure to follow.

Source: Markit Partners

Mario Draghi: - “The baseline scenario in our staff projections didn’t change. At the same time, we have to acknowledge that the baseline scenario is based on assumptions. After the cut-off date of these projections” we had “confidence indicators and they all point in a direction that wasn’t upward.” At the same time, hard data were more positive. “You have conflicting signals. We are fully aware that the most recent soft data are on the downside. We monitor all developments closely and we stand ready to act.”

So obviously Draghi and company have seen the PMI numbers. But because they came "after the cut-off date" the PMI numbers can't be used for policy decision? Are they saving it for the next meeting? It's a strange way to run policy and may further damage the ECB's credibility. The Fed has been accused of being "behind the curve" in the past, but this takes the phrase to a whole new level.

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The ECB has completely lost control over the monetary policy for Greece

The Bank of Greece balance sheet has expanded sharply this year. This of course is part of the ECB's balance sheet expansion on a consolidated basis. But the Greek central bank's balance sheet by itself is now almost €200 billion. That's an unprecedented amount for Greece and represents over 65% of the nation's annual GDP. It is also close to a 50% increase year-over-year.

Bank of Greece balance sheet ( €mm, source: BoG)

One would expect at least some impact on the monetary aggregates from such a dramatic expansion. Yet the money supply measures, both narrow and broad have collapsed. We've seen this before with other periphery nations such as Italy. But nothing on this magnitude.

Greece contribution to Eurozone's money stock year-over-year growth (source: BOG)

This trend shows a massive drain of liquidity out of the system that will result in a total seizure of credit. How can the ECB claim any control over the monetary policy when a 50% increase in the Greek central bank's balance sheet results in a 16% decline in M1 and nearly a 20% decline in M3 money stock?  Greece is now in a  permanent state of extraordinarily tight monetary conditions no matter what the central bank does. In such an environment there is absolutely no hope for any growth, let alone fiscal consolidation. It seems the only possible solution for Greece may be to take control of its own monetary policy, which would require abandoning the euro. An ugly outcome, but given the ECB's inability to stabilize Greece's rapidly shrinking money supply, there may be little choice.

Update: see some insightful comments below from Kostas Kalevras on the topic.

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India's central bank - between a rock and a hard place

The Reserve Bank of India (RBI) is in a tough spot. With the headline wholesale inflation coming in at 9.1% and the core at 7.8%, the standard approach would be to keep tightening. But how much tighter can the monetary policy get before choking off growth?

MarketWatch: In late October, India’s central bank delivered its 13th hike in interest rates since March 2010, raising its key lending rate to 8.5% and its borrowing rate to 7.5%. But it signaled that a pause was likely at its next meeting.

And now RBI faces another problem: the rapid sell-off in the rupee, driven by capital outflows.

Chart shows stronger USD vs. INR (Bloomberg)

The weaker currency is going to exacerbate the inflationary pressures driven by more expensive imports. India imports crude oil, machinery, fertilizer, and chemicals – which may drive fuel and food prices higher. Another product that India imports is gold. So when people scratch their heads as to why gold is down over 5% in a single day, the answer should be simple – risks around a slowdown in Asia.

In addition to inflationary issues, as foreign capital flows out, there is some concern that certain banks or corporations may run into a liquidity problem. RBI is expected to address these quickly, but investors don’t want to take chances.

MarketWatch: There has also been mounting concerns that India’s regulated banking system, along with many Indian firms, might be facing borrowing and liquidity issues, given high interest rates domestically, shrinking global investments, and the sliding rupee.

Given the importance of India as a major global economy, this development is of significant concern for global growth.

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Implied Real Rate tells a story of loose monetary policy and asset bubbles

There are numerous ways to measure how easy the monetary policy is at any particular time. Quantitative easing aside, one can look at the overnight rates as the simplest measure of stimulus levels. The Fed Funds rate fluctuating between 12 and 25 basis points feels sort of accommodative.

Of course a better measure is the real rate, which is the nominal overnight rate less inflation. The lower the real rate the more stimulus is being provided. Unfortunately inflation in the form of CPI releases is a backwards looking indicator. Any monetary policy is meant to set the stage for the next few years and should be more reliant on forward looking indicators of inflation. One such indicator is the inflation rate implied from TIPS. There are clearly issues with both TIPS and the CPI measure itself, but the implied inflation measure gives a decent forward looking indicator implied by the markets.

Many economists view low real rates that exist today as restrictive because of tighter credit in the current environment. However the market implied inflation rate already takes into account the current and the expected credit conditions. Therefore the Implied Real Rate is in fact a more holistic indicator of how loose the monetary policy really is as viewed by the markets.

Let's define the Implied Real Rate as follows:

Implied Real Rate = (Fed Funds Effective rate) - (inflation rate implied by the 10-year TIPS).

The Implied Real Rate is now at about -2%, the lowest level since TIPS have been first issued. That certainly feels quite accommodative, but let's compare the situation to the last cycle. In particular, let's look at how accommodative policy impacted asset levels - here we use S&P500. The last big drop in the Implied Real Rate was back in the 2002 - 2004 period, which launched the famous liquidity driven asset bubble.





Here is what the measure looks like right now.





Given the similarities, is the accommodative monetary policy that is currently in place setting us up for another crisis? Is the Fed behind the curve? Many argue that there will be time to take the liquidity out. By then however it may be too late:

From HSBC:
The remarkable thing about such liquidity-driven asset bubbles is their long-cycles, underlining the eventual potency of loose monetary policy. Also, successive monetary tightening over the course of the bubble has apparently little impact: once the financial accelerator goes into full throttle, it takes aggressive tightening to pop the bubble – and, more often than not, policy-makers are reluctant to step up for fear of bringing down the house.

To illustrate that effect, in 2004 the monetary policy did in fact begin to gradually get tighter, as the Implied Real Rate began to rise. But as HSBC points out above, this gradual tightening is (and in fact was) ineffective, and asset prices continued to rise unabated.




Mr. Bernanke, maybe it's time for action.

SoberLook.com

Bernanke's next steps

Let's take a quick look at options currently available to the Fed and their potential next steps. With the dollar under pressure and bank reserves at historical highs, one would think the Fed is getting uneasy with all the liquidity in the system. Now that the short-term liquidity facilities are winding down, much of the new securities purchases will increase the balance sheet and grow the money supply. Many beleive this will surely lead to inflation.

To address this, the Fed has the following two tools (outside of outright securities sales):

1. Purchase new securities (RMBS, Agency paper, etc.) on repo (sterilized purchases). The Fed would effectively buy the securities and immediately lend them out for some period, taking in cash collateral. This takes these securities out of the market, but does not increase the money supply because the proceeds from these sales would not be available to the dealers (the proceeds become the cash collateral). This could be done not only with new purchases, but with securities already on Fed's balance sheet (about $1.5 trillion worth). To accomplish this on a scale that makes a difference, the Fed needs to set up repo lines with banks and dealers outside of the Primary Dealer group. The primary dealers may not have the capital to absorb such massive amounts of repo transactions on their own.

2. The Fed could also raise rates. But this wouldn't be simply raising the Fed Funds Target Rate. Instead the Fed now has the ability to raise interest rate on the reserves that banks keep with the Fed. That immediately creates a floor on rates because banks have no incentive of lending at levels at or below the reserve rate. Instead they can simply deposit the funds with the Fed on a riskless basis. This tool has been used by other central banks for decades.

The first tool may be set up relatively soon, particularly for new purchases, but it's usage should be fairly modest in the near-term. The rate increases however are months away. Here are two reasons for the Fed's dovish approach:

1. The Fed will not take any rate action until they see improvement in employment. And as we discussed earlier, this may take a while. This is particularly true because many recent jobs (the "bubble jobs") were created on the back of construction spending.

2. The Fed (among numerous measures available to them) watches one key indicator quite closely: the rate of change in "broad" money supply relative to the "narrow" money supply. It's a measure of how effective the liquidity injections have been in stimulating lending. Banks can be loaded with cash, but if they don't lend, the cash is not making it's way into the broader money supply (the banks effectively stay overcapitalized). And that means the broader economy is not benefiting from the liquidity the Fed had provided, which limits it's growth. The chart below shows the relative growth of M1 (narrow measure) and M2 (broader measure). Until M2 picks up significantly, the Fed will do very little in terms of tightening.


source: St. Louis Fed


Inflation is unlikely to pick up until credit is available in the broader economy to allow corporations and individuals to pay higher prices. With broader money supply responding this slowly, significant price and wage increases are unlikely in the near-term.

The possibility of the Fed actually selling securities from it's balance sheet outright is even less likely. Such sales may impact long-term rates, which may have a negative effect on housing and the consumer, and the Fed will categorically not go there. The RMBS securities, the agency paper, and even treasuries they have bought, will stay on Fed's balance sheet for years to come, possibly to maturity.

Jim Rickards suggests that the Fed is targeting high inflation

Conspiracy theories surrounding the Fed are a dime a dozen these days. They either have to do with Goldman or the New World Order or some hidden funds. But once in a while a theory pops up that is worth some consideration.

We've discussed in the past that there are plenty of folks out there who would love to see the dollar devalue. Either because it may start a nice commodity rally or will help US exports - there are plenty of people rooting for a weaker dollar.

But Jim Rickards suggests that the US government should be added to that list. And not because it will help US exports, but simply because by devaluing the dollar the US stands a better chance to be able to fund the massive deficits. Inflation makes debt become less painful. Mr. Rickards argues that the target for the US government is to cut the dollar roughly in half of it's current value in 14 years in order to plug some of the deficit holes. This idea actually has some merit because not only does inflation help the deficit issue, but it also helps to stabilise housing prices, which is key for this recovery. With housing prices stable, the banking system can recover more easily as well.

Mr. Rickards view is that the Fed's objective is a slow devaluation to avoid sudden commodity price spikes. To that extent the Fed is watching gold price as an indication of their success. A gradual rise in gold price works, but a more sudden rally will have the Fed raising rates. It's unlikely the Fed has this sort of thing as their official goal, but it is possible that some at the central bank feel that some inflation is a good thing. The debate of course remains as to how much should be tolerated.

A signal from the Fed?

At first glance, there wasn't anything unexpected in the FOMC statement today. But reading more into the wording, the following difference in the language between this statement and the one from last month may have significance:

From the FOMC statement August 12:

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.

From the FOMC statement September 23:

In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability.

Many Fed watchers have interpreted this as a signal that the Fed is planning to do something different. Some beleive it is related to the beginning of an end to the liquidity buildup. Yes, the rate will stay at zero, but it is likely that the remaining securities purchases will be "sterelized", meaning some won't be outright buys, but instead may be repo transactions . The Fed may not want significant additional quantitative easing.