Tag Archives: Fed

India squeezed by QE3


US Federal Reserve chairman Ben Bernanke’s comment on rolling back the monetary stimulus package couldn’t have come at a more inopportune time for the Indian economy.

The rupee has crashed to a new low, nearly touching 60 and still counting. As portfolio investors pull out funds, the slide in equity markets continues.

Blame it on QE3. It sounds like the name of a scientific project, but it is essentially a financial market jargon for the third round of quantiative easing or QE by the US central bank.

It involves a large purchase of bonds by the Fed to pump in loads of cheap money into the financial system to aid the American economy. Part of these funds came to emerging markets such as India that were still delivering returns in high double-digits a year.

The tide has since turned.

Financial investors have begun selling Indian stock since the beginning of May and with the curtains likely to come down on the US stimulus package, one can safely expect more billions to move out.

A weak rupee can also fan inflation by making fuel and other imported goods costlier. Oil companies fear that if the trend sustains for a few more days, retail prices of transport fuel would have to be hiked again, which can fan inflation.

Higher inflation will also limit the RBI’s ability to cut interest rates, dimming hopes of lower loan EMIs for individuals.

Also, the record current account deficit (CAD) may restrict the RBI’s elbow room to prop up the rupee by dipping into its $290 billion of foreign exchange reserves, enough to cover imports for seven months, analysts said.

“A reversal of capital inflows would likely wreak havoc on the rupee, as financing the CAD becomes difficult,” said Sonal Varma, economist at research firm Nomura.

“Return of foreign capital in the short term will critically depend on adopting the right policy mix to attract higher investment inflows and improve growth prospects of the economy,” said DK Joshi, chief economist, CRISIL Research.


Tapering the Taper Talk



Peter Schiff

Friday, June 21, 2013

As usual the Federal Reserve media reaction machine has fallen for a poorly executed head fake. It has fallen for this move many times in the past, and for its efforts, it has tackled nothing but air. Yet right on cue, it took the bait once more. Somehow the takeaway from Wednesday’s release of the June Fed statement and Chairman Ben Bernanke’s press conference was that the central bank is likely to begin scaling back, or “tapering,” its $85 billion per month quantitative easing program sometime later this year, and that the program may be completely wound down by the middle of next year.

Although this scenario is about as likely as an NSA-sponsored ticker tape parade for whistle blower Edward Snowden, all of the market segments reacted as if it were a fait accompli. The stock market – convinced that it will lose the support of ultra-low, long-term interest rates and the added consumer spending that results from a nascent housing bubble – sold off in triple digits. The bond market, sensing that its biggest and busiest customer will be exiting the market, followed a similarly negative trajectory. The sell-off in government and corporate debt pushed yields up to 21 month highs. In foreign exchange markets, the dollar rallied off its four-month lows based on the belief that Fed tightening will support the currency. And lastly, the gold market, sensing that an end of quantitative easing would eliminate the inflationary fears that have partially fueled gold’s spectacular rise, sold off nearly five percent to a new two-and-a-half year low.
All of this came as a result of Bernanke’s mild commitments to begin easing back on permanent QE sometime later this year if the economy continued to improve the way he expected. The chairman did not really elaborate on what types of improvements he had seen, or how much farther those unidentified trends would need to go before he would finally pull the trigger. He was however careful to point out that any policy shift, be it for less or more quantitative easing, would not be dependent on incoming data, but on the Fed’s interpretation of that data. By stressing repeatedly that its data goalposts were “thresholds rather than triggers,” the chairman gained further latitude to pursue any stance the Fed chooses regardless of the data.
Yet the mere and obvious mention that tapering was even possible, combined with the chairman’s fairly sunny disposition (perhaps caused by the realization that the real mess will likely be his successor’s problem to clean up), was enough to convince the market that the post-QE world was at hand. This conclusion is wrong.
Although many haven’t yet realized it, the financial markets are stuck in a “Waiting for Godot” era in which the change in policy that all are straining to see will never in fact arrive. Most fail to grasp the degree to which the “recovery” will stall without the $85 billion per month that the Fed is currently pumping into the economy.
What exactly has convinced the Fed that the economy is improving? From what I can tell, the evidence centered on the rise in stock and real estate prices, and the confidence and spending that follow as a result of the wealth effect. But inflated asset prices are completely dependent on QE and are likely to reverse course even before it is removed. And while it is painfully clear that expectations about QE continuance have made a far bigger impact on the stock, bond, and real estate markets than any other economic data points, many must be assuming that this dependency will soon end.
Those who hold this belief have naively described QE as the economy’s “training wheels.” (In reality the program is currently our only wheels.) They are convinced that the kindling of QE will inevitably ignite a fire in the larger economy. But the big lumber is still too dampened by debt, government spending, regulation, and high asset prices to catch fire – all we have gotten is smoke instead. A few mirrors supplied by the Fed merely completed the illusion. The larger problem of course is that even though the stimulus is the only wheels, the Fed must remove them anyways as we are cycling toward the edge of a cliff.
Although Bernanke dodged the question in his press conference, the Fed has broken the normal market for mortgage backed securities. While it’s true that the Fed only owns 14% of all outstanding MBS (the “small fraction” he referred to in the press conference), it is by far the largest purchaser of newly issued mortgage debt. What would happen to the market if the Fed were no longer buying? There are no longer enough private buyers to soak up the issuance. Those who do remain would certainly expect higher yields if the option of selling to the Fed was no longer on the table. Put bluntly, the Fed is the market right now and has been for years.
A clear-eyed look at the likely consequences of a pull-back in QE should cause an abandonment of the optimistic assumptions behind the Fed’s forecast. Interest rates are already rising rapidly based simply on the expectation of tapering. Imagine how high rates would go if the Fed actually tried to sell some of the mortgages it already owns. But the fact is the mere anticipation of such an event has already sent mortgage rates north of 4%, and without a lifeline from the Fed in the form of more QE, those rates will soon exceed 5%. This increase will greatly impact the housing market. Speculative buyers who have lifted the market will become sellers. More foreclosure will hit the market, just as higher home prices and mortgage rates price any remaining legitimate buyers out of the market. Housing prices will fall to new post bubble lows, sinking the phony recovery in the process. The wealth effect will work in reverse: spending and confidence will fall, unemployment will rise, and we will be back in recession even before the Fed begins to taper.
In fact, the rise in mortgage rates seen over the last month has already produced pain in the financial world, with banks reporting a rapid decline in refinancing applications. By the time rates hit 5%, the current rally in real estate will have screeched to a halt. With personal income and wage growth essentially stagnant, individual buyers are extremely dependent on the affordability allowed by ultra-low rates. A near 50% increase in mortgage rates, which would result from an increase in rates from 3.25% to 5.0%, would price a great many buyers out of the market. Higher rates would also cool much of the housing demand that has been coming from the private equity funds that have been a factor in pushing up real estate prices in recent years. Falling home prices would likely trigger a new wave of defaults and housing related bankruptcies that plunged the economy into recession five years ago.
A similar dynamic would occur in the market for U.S. Treasury debt. Despite Bernanke’s assurances that the Fed is not monetizing the government’s debt, the central bank has been buying nearly 70% of the new issuance in recent years. Already, rates on 10-year treasury debt have creeped up by more than 50% in less than two months to over 2.5%. Any actual decrease or cessation in buying – let alone the selling that would be needed to unwind the Fed’s multi-trillion dollar balance sheet – would place the Treasury market under extreme pressure. Since low rates are the life blood of our borrow and spend economy, it is highly likely that higher rates will lead directly to lower stock prices, lower GDP growth, and higher unemployment. Since rising asset prices and the confidence and spending they produce is the basis for Bernanke’s rosy forecast, new lows in house prices and a bear market in stocks will likely reverse those forecasts on a dime.
Lost on almost everyone is the effect higher interest rates and a slowing economy will have on federal budget deficits. As unemployment rises, tax revenues will fall and expenditures will rise. In addition, rising rates will not only make it more expensive for the Fed to finance larger deficits, it will also make it more expensive to refinance maturing debts. Furthermore, the profit checks Fannie and Freddie have been paying the Treasury will turn into bills for losses, as a new wave of foreclosures comes tumbling in.
It’s fascinating how the goal posts have moved quickly on the Fed’s playing field. Months ago the conversation focused on the “exit strategy” it would use to unwind the trillions in bonds and mortgages that it had accumulated over the last few years. Despite apparent improvements in the economy, those discussions have given way to the more modest expectations for the “tapering” of QE. I believe that we should really be expecting a “tapering” of the tapering conversations.
As a result, I expect that the Fed will continue to pantomime that an eventual Exit Strategy is preparing for a grand entrance, even as their timeline and decision criteria become ever more ambiguous. In truth, I believe that the Fed’s next big announcement will be to increase, not diminish QE. After all, Bernanke made clear in his press conference that if the economy does not perform up to his expectations, he will simply do more of what has already failed.
Of course, when the Fed is forced to make this concession, it should be obvious to a critical mass that the recovery is a sham. Investors will realize that years of QE have only exacerbated the problems it was meant to solve. When the grim reality of QE infinity sets in, the dollar will drop, gold will climb, and the real crash will finally be upon us. Buckle up.

Bernanke Prepares to Step Off the Gas: Why Now?

June 19, 2013

Bernanke Prepares to Step Off the Gas: Why Now?

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Ben Bernanke spooked the markets on Wednesday by confirming that the Federal Reserve is getting ready to draw down its policy of pumping tens of billions of dollars into the bond market each month—a strategy known as quantitative easing. After Bernanke spoke, the Dow closed down about two hundred points and interest rates rose slightly as the bond market sold off.

Now, a fall in the stock market of less than 1.5 per cent is nothing to worry about: over the past two years, the Dow has risen by more than twenty-five per cent. But it does raise the question of why Bernanke is choosing this moment to signal that the Fed is getting ready to step off the gas. (That’s his lame metaphor, not mine.) With the sequester still in effect, and likely to be so for the foreseeable future, fiscal policy is acting as a damper on the economy, and G.D.P. growth is still pretty modest—2.4 per cent in the first quarter of 2013 and perhaps as low as two per cent in the second quarter. Moreover, the Fed’s preferred measure of inflation is running at just 1.05 per cent, well below its target of two per cent.

In such circumstances, and with the unemployment rate still above 7.5 per cent, the central bank would normally be expected to provide as much support as possible for the economy. Indeed, some shrewd people on Wall Street expected Bernanke to rein in expectations of an early end to quantitative easing in his press conference today. But he did the opposite, saying that if the economy evolves as the Fed thinks it will, the tapering off of quantitative easing will start later this year, and the program will come to an end by middle of next year.

So why is the Fed getting ready to tighten policy? One argument, a dubious one, is that, actually, it isn’t. In keeping the federal-funds rate at close to zero and continuing to purchase bonds at a reduced rate, the central bank will still have a very expansionary stance. That’s what Bernanke argued on Wednesday. Technically, it’s true, but it ignores the impact of his statements on Wall Street. The way quantitative easing works is by giving a boost to the markets and putting downward pressure on the dollar. Now that investors know the policy is most likely coming to an end next year, they will act upon that news immediately, which could lead to a sharp fall in the stock market and a sizable increase in mortgage rates. And if either of those things happen, the Fed’s forecast of more rapid growth in the second half of this year and the first half of next year could prove to be overoptimistic.

Nobody said that managing the U.S. economy is easy, especially when the mechanism for setting fiscal policy is as dysfunctional as it is these days. The mystery is why Bernanke and his colleagues didn’t wait to see a pickup in growth before announcing their intention to change course, rather than doing it now, when the economic outlook is still pretty uncertain.

One possibility is that they are more confident about the recovery gathering pace than many other people are. In the forecasts they released today, they saw economic growth accelerating to 3.0 to 3.5 per cent next year. But that was only a bit higher than the March projection of 2.9 to 3.4 per cent. Another possibility is that policy makers are more concerned about the return of risk-taking, and the possibility of another bubble emerging, than they are letting on publicly.

The most likely explanation, though, is the simplest one. When the Fed started this latest round of quantitative easing, last September, it was worried about the possibility of another economic downturn. With the housing market recovering more strongly than many experts had expected, and consumer spending holding up pretty well despite the payroll-tax increase that took effect at the beginning of this year, that possibility has receded. To quote the statement that Bernanke and his colleagues put out Wednesday: “The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall.”

From the Fed’s point of view, quantitative easing was always a form of insurance. Now that the likelihood of a disaster has diminished, they don’t think it will be necessary for much longer. But that reasoning depends on the assumption that removing the insurance policy won’t have any significant negative effects. In the coming weeks and months, we will find out if that assumption is warranted.

Exiting from Monetary Stimulus: A Better Plan for the Fed





unconventional monetary policy

Policy Innovation Memorandum No. 30

Author: Benn Steil, Senior Fellow and Director of International Economics

Exiting from Monetary Stimulus: A Better Plan for the Fed - exiting-from-monetary-stimulus-a-better-plan-for-the-fed

Publisher Council on Foreign Relations Press

Release Date March 2013


The U.S. Federal Reserve’s monetary stimulus efforts have an undesirable side effect that needs to be managed with great care: the Fed has amassed a huge stock of mortgage-backed securities (MBS) that it will eventually want to liquidate without damaging the nascent housing recovery. What is needed to accomplish this is a relatively simple but innovative scheme whereby the Fed can, in one transaction, transform its MBS holdings into an equivalent amount of U.S. Treasury securities. Such an arrangement would allow the Fed to use conventional means of raising interest rates when inflation threatens without the worrisome economic and political consequences of selling mortgage-backed securities.

The Problem

In a sustained, extraordinary policy undertaking to counter the enduring economic headwinds of the 2008 financial crisis,
the Fed has pumped trillions of dollars of liquidity into the banking system over the past four and a half years. It has accomplished this by buying, with newly conjured dollars, a historically unprecedented amount and variety of securities. In the process, its balance sheet has ballooned from $900 billion to $3.1 trillion, and it is expected to expand further, to about $4 trillion, later this year.

At some point as the economy normalizes, most likely around 2015 according to the Fed’s current view, the Fed will wish to begin tightening monetary policy in order to prevent the exceptional level of liquidity in the banking system from feeding into inflation. It would normally do this by selling securities from its oversized balance sheet.

The big challenge the Fed will face in carrying this out, however, will be managing the economic and political impact of liquidating the huge stock of MBS it has amassed—currently amounting to nearly $1 trillion, and expected to reach $1.5 trillion by the end of the year. Doing so has the potential to drive up mortgage rates, depress house and real estate prices, and trigger intervention from policymakers reacting to aggrieved constituents.

Federal Reserve Board chairman Ben Bernanke appears to be very aware of such risks, and he has suggested that the Fed might, at least initially, use alternative means of tightening monetary conditions—not involving securities sales—when the time comes. Yet these means are likely to be less effective, as well as equally controversial.

Getting From Here to Normal

If the amount of MBS outstanding remains roughly flat over the coming year, and the Fed winds up swallowing $1.5 trillion of the total stock, it will own a massive 30 percent of the market. This is not the sort of market in which the Fed will wish to be selling securities when it judges the time right to tighten monetary conditions. Such sales have the potential to generate large and sudden falls in the price of MBS, making it costlier for banks to issue mortgages and therefore driving up their rates—rates that the Fed has worked hard to push down over the past four years.

Bernanke has been anxious to assure the markets that he has other tools in his chest for tightening monetary policy—two in particular. The first is to entice banks to move a portion of their excess monetary reserves held at the Fed to term deposits (similar to CDs), which would lock up that money for a fixed period. The second is to use “reverse repos,” in which the Fed continuously borrows money from the banks, using its Treasury securities as collateral.

Though repos are collateralized, and term deposits are not, the two tools are functionally identical. Both reduce the amount of funds banks have available to loan out, which serves the Fed’s purpose of restraining credit growth and inflation. But both also have a hidden catch: the Fed will lose control over interest rates.

If the Fed is unwilling to sell its mortgage securities in order to tighten policy, and if it is instead determined to drain a specific quantity of bank reserves through term deposits or the like, it will have to pay whatever rate the market demands. Simply put, the Fed must choose between managing the level of reserves and managing rates. It cannot do both.

Yet the Fed is unlikely to be willing to allow rates to rise as far and as fast as the market may demand in a term deposit auction. Indeed, the European Central Bank (ECB), which has carried out many such auctions since 2010, places caps on the rates it pays. In consequence, seven of its auctions have failed, meaning that the ECB failed to withdraw euros from the market despite its public pledges to do so. The Fed will lose credibility at a crucial time if it does the same.

Therefore, a conventional Fed approach to monetary tightening—selling securities from its balance sheet—is the better one, at least provided that the composition of its balance sheet does not force it to sell illiquid and sector-specific securities like MBS. The question then becomes how the Fed can normalize the composition of its balance sheet—that is, fill it completely with Treasury securities—before it needs to tighten monetary policy.

The Plan

The Fed should sell its MBS portfolio to the Treasury at face value in exchange for an actuarially equivalent amount of Treasury securities, newly issued for the purpose of facilitating the swap. The maturity of these new Treasury securities could be set either to match the expected maturity of the Fed’s MBS portfolio or to allow them to roll off at the same pace as the Fed expects it will wish to contract its balance sheet (each approach has its own technical merits). The transaction would be neutral for the size of the Fed’s balance sheet; only the composition would change.

There is a clear precedent for the Treasury doing this. The Housing and Economic Recovery Act of 2008 (HERA) gave the Treasury the authority to purchase MBS guaranteed by Fannie Mae and Freddie Mac. The Treasury started buying MBS in October 2008, stopping in December 2009 when the face value of its holdings reached $192 billion. The effect of these transactions was to transfer riskier securities from the private sector to the public sector.

In the case of the proposed Fed-Treasury securities swap, however, there is no such transfer of risk from the private sector to the public—one arm of government is merely swapping securities with another. The overall financial risk to the government as a whole remains unchanged.

Benefits Versus Costs

The benefits to the government, however, in terms of carrying out monetary policy effectively would be considerable. Instead of having to sell MBS on the market in order to soak up dollars and restrain credit growth and inflation, the Fed would be able to sell Treasury securities. The market for Treasury securities is the deepest and most liquid in the world, meaning that disruption to the market would be minimal while the impact on mortgage rates and house prices would be more moderate and less sudden than if the Fed was selling MBS. In consequence, there will also be less alarm in Congress over the possible negative economic side effects of the Fed tightening monetary policy.

Concern may be raised in Congress about the risk to the Treasury of absorbing the Fed’s MBS portfolio. Of course, the value of the securities can rise or fall as mortgage default rates and other factors change. The U.S. taxpayer will bear that risk for as long as any arm of the U.S. government holds them. Yet it is worth noting that if the Treasury buys them from the Fed at face value, it will immediately acquire a portfolio with unrealized gains of roughly $53 billion, according to the Fed’s most recently published estimate. And if the Treasury simply holds the MBS until they mature, it will avoid the losses the Fed would suffer if it were obliged to sell those same securities in an environment in which interest rates were rising (and bond prices, therefore, falling).

In short, the Fed swapping its mortgage-backed securities with the Treasury in return for Treasury securities is better for U.S. taxpayers. It preserves the value of the securities. More important, it is better for sustaining the recovery of the U.S. economy, as it affords the Fed an exit strategy from its long period of extraordinary monetary interventions that will be less disruptive to the mortgage and housing markets.

Valid concern may still be raised that the Treasury, in buying the Fed’s MBS portfolio, would be abetting the Fed in escaping responsibility for managing the necessary aftermath of its extraordinary market interventions. Bernanke has acknowledged that “the hurdle for using nontraditional policies should be higher than for traditional policies” because of the attendant costs, such as exposing the Fed to abnormally high financial risks. Yet if such costs can be off-loaded onto another arm of government, they may be insufficiently accounted for. HERA offers a template for future crisis interventions that addresses this concern—a template in which only the Treasury, and not the Fed, intervenes in markets other than those for its own securities.