Saturday, November 22, 2008 6 comments ++[ CLICK TO COMMENT ]++

How far can the FedRes go with its quantitative easing?

I just read a report from HSBC and it essentially says that the FedRes has shifted its focus to a quantitative easing strategy. You will recall that this has been the strategy followed by Japan in the past decade.

(source: The Fed’s balance sheet expansion by Ian Morris. Flashnote, HSBC Global Research. November 21, 2008.)

The week of 17 September is when for all intents and purposes the Fed unofficially shifted from interest rate strategy to quantitative easing, as it was from that time the Fed’s balance sheet exploded from USD900bn in early September to USD2.2trn now, or from 6% of GDP (which is about typical) to 15%. The catalyst for this strategy shift was the failure of Lehman Brothers and AIG. As evidence for the shift, it was also from mid-September that Fed funds began trading well below target on a sustained basis (the weighted average of daily trading has been about 0.3% recently). This is despite the Fed’s currently paying a 1% Fed funds rate of interest on reserves, which was meant to put a floor on how low funds could go, in theory (interest paid on excess reserves was initially set at -0.75 from FF, then changed to -0.35, and then finally on November 5 changed to a zero spread).

One the criticisms of Japan is that it did not do enough. So how far can the FedRes go with this strategy?

The Fed’s balance sheet has plenty of room to expand if things get worse, because there is no limit on how large it can go. It is well below the 30% of GDP peak that Japan saw in its deflationary experience, and arguably Japan did not do enough, so presumably an aggressive Fed could take it to 50% of GDP or even higher if things got dire.

HSBC says that the FedRes can possibly go up to 50% of GDP, which is around $6 trillion. The following chart from the HSBC report compares the present US Federal Reserve situation versus Japan:

This situation in Japan is not quite the same what American is facing. On the positive, Japanese citizens had high savings when the crisis hit. In contrast, the only one with high amounts of cash are non-financial American corporations. Japan also did not face a credit crisis in the middle of their real estate bust. However, assets, particularly equities, were severely overvalued in Japan whereas they are not in America. USA doesn't have one big problem that hit Japan. One of the serious problems for Japan--and this is why Japan may never recover--is that its demographics picture is very poor. Japanese population is shrinking and the hardship of the collapse in the early 90's made it even worse (many chose not to have kids due to weak earnings and difficulty affording housing, among other issues.) Demographics in America is pretty positive, partly due to immigration. So if America ends up in a deflationary collapse--I don't think it will--then it won't be quite like Japan.

(I'm actually coming around to the thinking that there may be a mild deflationary boom in America, assuming deflationa isn't severe. This is very rare in the world nowadays (it was more common when we had hard currencies) but I just wonder if the stars are aligning in America's favour. For instance, if the consumer was suffering when oil was around $100, I wonder what prices of around $50 will do. Just a thought at this point.)

Essentially what is happening is that the US government is leveraging up while the financial institutions are leveraging down. Unfortunately, I think this strategy is going to hit a brick wall when it becomes obvious that the government can't compensate for any de-leveraging from the consumer. The only hope, and it is only a hope because it is largely outside anyone's control, is that the consumer de-leverages over a few decades rather than in one or two years. If all the consumers in America cut back their spending and sharply increased their savings within an year or two, the world will go into a depression. I don't think it will happen because corporate balance sheets (of non-financial corporations) are strong and the eocnomy is mostly service. A large number of businesses would have to go bankrupt and layoff workers and I don't think it will happen.


6 Response to How far can the FedRes go with its quantitative easing?

November 23, 2008 at 2:40 AM

Japan's problem wasn't so much that it didn't do enough but that it waited so long to start taking the right steps. Morgan Stanley economist Joachim Fels makes this point in an essay I quote from in a post on my site.

November 23, 2008 at 8:08 AM

Now that the Fed is working the dread magic of quantitative easing there is in my opinion nothing that can stop them. Printing money costs nothing, except inflation down the line. But then, breaking deflationary expectiations is exactly the point. I think the Fed will continue quantitative easing until significant inflationary pressure has built up (and other CB's will join them, even JCT & crew).

Note that this will greatly mitigate the impact of the huge government deficits we will be seeing. Not only can some of the debt be monetized directly, but a burst of inflation will then reduce the real value of the rest.

In macro terms, I now expect a W shaped double recession, first a deflationary bust, a recovery as massive monetary and fiscal stimulus takes hold and another, inflationary, bust as central banks slam on the brakes, Volcker-style, to keep inflation from spiraling out of control. This could take as much as a decade to fully play put.

As long as delevering in the private sector can be stopped from becoming a death spiral to zero the economic picture is likely to be painful but not disastrous.

November 23, 2008 at 1:42 PM

Good point Dave. My understanding is that Japan didn't pursue anything seriously until late 90's. It's hard to blame anything though. They were facing something they didn't face before.

November 23, 2008 at 1:54 PM


What are the implications of your current view? I'm thinking of investing in junk bonds, which have fairly high yields. Would that be a poor bet if we get inflation in the latter part of the decade? How about stocks?

I don't have a strong view but I just don't see the inflationary outcome in the second part of the decade that you are expecting. I think slowly rising inflation seems more likely than high inflation.

The reason I don't see high inflation is because the actions of all the central banks and governments pale in comparison to the wealth destruction. We have rarely seen such wealth destruction in nearly all assets.

I think what can cause inflation is if we enter a war (hope not :( ) or if governments erect barriers to trade.

My view, which hasn't changed recently, is that the economy (US as well as the world) should do ok. We will get a recession that is probably similar to 1974 or 1982.

However, I think investments will do poorly. Corporate profit margins will contract regardless of how the economy does (it's way too high in historical terms.) Speaking as someone with contrarian impulses, the fact that almost everyone is calling for a bottom or a rally makes me think that we won't see a bull market for quite a while.

November 24, 2008 at 2:51 PM


Initially, yes deflationary pressure from the massive delevering taking place will win. However, a look at the Fed balance sheet suggests the Fed is very agressive about flooding the world with money and they can generate money in unlimited quantity very easliy so they will win that. Other central banks are not far behind I think. The lesson from Japan as Dave points out is that you shouldn't wait with drastic measures but should instead move quickly and decisively. Paul Krugman and others have also made this point, also regarding the Great Depression.

In addition to central banks flooding the world with free money governments are preparing to blast away with fiscal stimulus packages. The UK has anounced a big scheme and team Obama is making noises of launching a $500B+ package first thing in the morning once their man is in the White House. Other governments are moving in the same direction if slower.

I do expect the authorities to win this. Bernanke wasn't kidding when he said a determined central banker can always get inflation, if necessary bu dropping freshly printed cash from helicopters. Judging by it's balance sheet the Fed has skipped the helicopters and rented some B-52's from SAC to carpet bomb the world with dollars. So the determiniation is there.

The problem with printing massive amounts of money is that it generates inflation and quantitative easing cannot be undone as easily as it can be started. Once the base money supply has been increased massively, as it has been recently, inflation will take off like a rocket once normal credit creation resumes and the deflationary pressure from delevering subsides. A gentle increase in inflation is unlikely in my opinon because the base money supply has increased so enormously and under normal conditions this will spark a very fast increase in total money supply. Remember that each dollar in the base money supply allows several dollars in credit to be created.

Meanwhile, politicians being, well, politicians, governments will be loth to control spending once the economy stabilizes. Politicians love spending any time and when the central bank makes the spending "free" by monetizing the extra government debt they will love it even more.

So what I expect is that massive fiscal stimulus will not be withdrawn when the private economy recovers and we will see overheating demand just as the money supply balloons. That is a perfect recipe for high inflation.

And thus the second part of the W kicks in as central banks move to soak up the excess liquidity they are creating now and push the economy back into recession with sky-high interest rates.

November 24, 2008 at 3:05 PM

So what will I be doing investment wise considering the above?

First of all, I will remember the basics, good companies bought at deep discounts to fair value will turn out fine regardless of the macro picture.

Second, as I have learned to my cost this past year "cheap" isn't good enough and you can and should get companies at truly massive discounts to fair value. There is no need to hurry and good companies will be available at sub 50% bookvalue and/or sub P/E 5.

Third, bonds will do quite well initially but could run into trouble once the inflation genie get's out of it's bottle. Still, the next 3-4 years at least should be good for bonds.

Fourth, I am rather bearish on the overall market. The delevering cycle we're in is far from over and cannot be stopped, only countered and when it has been countered ballooning government deficits and inflation will create pleny of worry. A partial rerun of the seventies is distincly possible in the inflationary part of m scenario and that was a lousy decade for stocks. Remember point one though.

Last but not least, I think income yielding investments will be good. The dividend yield on the S&P500 is now higher then the yield on 30-year treasuries for the first time since 1958 and the yield will improve further as stock prices sink. Bonds of course generate income but will likely see their real returns eaten by inflation. Stocks on the other hand should see rising nominal dividends, at least for comapnies with pricing power.

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