Fed Policy: Easy In, Hard Out (IV)Guest Post
This is the fourth in a series of posts regarding the Fed’s balance sheet, and quantitative easing. Unlike the first three, I’m not going to do the graphs of the composition of the Fed’s balance sheet that I did before, because I’m not sure it’s relevant to the present argument.
I want to quote a few passages from prior articles, because it has been so long. From the conclusion of article 3:
My main point is this: even with the great powers that a central bank has, the next tightening cycle has ample reason for large negative surprises, leading to a premature end of the tightening cycle, and more muddling thereafter, or possibly, some scenario that the Treasury and Fed can’t control.
The main thing that I got wrong in the prior parts of this series was assuming longer interest rates would rise, leading to a tightening of short-term interest rates. I expected my scenario 2 ( Growth strengthens and inflation rises), and we got scenario 3 ( Growth weakens and inflation remains low). Regarding scenario 3, I said:
3) Growth weakens and inflation remains low. This would be the main scenario for QE4, QE5, etc. We don’t care much about the Fed’s balance sheet until the Fed wants to raise rates, which is mainly a problem in Scenario 2.
I also thought that the Fed would have a hard time taking back the policy accommodation:
But when the tightening cycle comes, the Fed will find that its actions will be far harder to take than when they made the “policy accommodation.” That has always been true, which is why the Fed during its better times limited the amount of stimulus that it would deliver, and would tighten sooner than it needed to.
Back to the Present
The hullabaloo over raising the fed funds rate over 3% has passed. A debt-laden economy slowed down faster than expected, leading long rates to fall, and the yield curve inverted. The Fed has been loosening amid an economy that is middling-to-weak, grudgingly, because unlike most other loosening cycles, nothing has blown up yet.
(An aside: The Fed could have fought back via a balance sheet-neutral swap of all their bonds longer than 10 years for an equal amount of T-bills,and short T-notes. That would have steepened the yield curve.)
But we are in an environment where the Fed is trying to deal with everything, like an overworked superhero. Repo markets having trouble? Flood the short-term lending markets with liquidity, and reverse the shrinkage of the Fed’s balance sheet.
By removing risk from the repo markets, it incents players there to get more aggressive, because they know the Fed has their backs. Better to let the players know that the repo market is subject to considerable volatility. They need to consider liquidity conditions like any other prudent investor, realizing that losses are indeed possible.
The Fed needs to return to the days of Volcker and Martin, where they let risk markets go their own way, and focus on the real economy only. They won’t do that, because past Fed easy accomodation has led to a lot of debts, both public and private.
Monetary policy accommodation is “easy going in, but hard going out.” The financial markets now think of low rates and ample liquidity as a birthright, not a temporary accomodation, partially because servicing the debt in a low interest rate environment is a lot easier. It is also partially because rates were so low for so long that expectations have adjusted.
I don’t see how the Fed gets out of this situation. Sitting and waiting, swapping away the long Treasuries would not be the worst idea in the world. But when there is a lot of debt, it tends not to get paid down in a orderly way during a recession. Defaults will come cheaper by the dozen.
I don’t think avoiding financial fragility at this time is the best long-term option. The banks are in decent shape, despite the repo market. Corporate bonds and loans and low-end consumer loans will bear most of the losses in the next recession. Best to take the hit, and let everyone know that the Fed does not exist to facilitate speculation, but to restrain inflation, and promote labor employment.
Then maybe, post recession, we can get a growing economy, a normal-shaped yield curve, and a less-indebted economy… excluding the indebted US and municipal governments, which truly are hopeless.
Article by David Merkel, The Aleph Blog