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.