FED@O, Bencopter takes off! Now What? Crash Land??

Welcome to ZIRPistan…the zero interest rate policy world - which promises that the Phoenix would rise from its ashes. Phoenix is

"A mythical bird that never dies, the phoenix flies far ahead to the front, always scanning the landscape and distant space. It represents our capacity for vision, for collecting sensory information about our environment and the events unfolding within it. The phoenix, with its great beauty, creates intense excitement and deathless inspiration." - The Feng Shui Handbook, feng shui Master Lam Kam Chuen

And Bencopter is set out to do a Phoenix.

And for the sake of completeness let me elaborate from the FED Playbook (2003) as to what this means:

“Usually, the Fed attacks weakness in the economy by conducting expansionary open market operations. In a typical open-market operation, the Fed purchases Treasury bills from bond traders in the New York securities market. The effect is to increase liquidity in the economy–cash and bank reserves rise while the number of Treasury bills held by the public falls–and to lower short-term interest rates. Lower interest rates encourage consumption and investment, and greater liquidity provides the means to finance the new expenditures.

Unfortunately, conventional open market operations lose their effectiveness as the yield on Treasury bills is driven to zero. At a zero interest rate, a Treasury bill is no different from vault cash or large-denomination currency. An open-market operation is like the Fed offering to exchange twenty $1 bills for one $20 bill: The increase in liquidity is negligible. Moreover, there is no way to achieve any further reduction in the interest rate. Why would anyone accept a negative return on Treasury bills when they have the option of holding cash, which offers a zero return? With no increase in liquidity and no reduction in the interest rate, there is no reason to expect an open-market operation to produce any increase in household or business spending.

….Policy-makers can find themselves in serious trouble if they come up against the zero interest-rate bound during a period of falling prices–that is, during a period of deflation. That’s because what ultimately matters to households and firms is the real cost of borrowing–what economists call the real interest rate. The real interest rate is the difference between the market, or “nominal,” interest rate and the rate of inflation. It is the prospect of a low real interest rate that makes current consumption and investment spending attractive. The trouble is, even a zero nominal interest rate can produce an expected real interest rate that is too high if people expect a negative inflation rate.

For example, if prices fall at a 3 percent annual rate, then a zero nominal interest rate puts the real cost of borrowing at a positive 3 percent. The prospect of a 3-percent real interest rate might be just fine in a healthy, growing economy. It will be excessive, however, in an economy where the growth outlook is poor, or where fragile finances have led households and firms to become cautious about spending and banks to become cautious about lending.”

Explaining the various methods of tackling the situation the presentation further explains:

“We finally turn to the simplest strategy: buying other domestic securities. Even if the short risk less rate is equal to zero, other interest rates on other securities will generally be positive, and those securities could be targets for open market operations.

….it’s not necessarily desirable to have the Fed acting in markets for corporate debt or mortgages. Whatever benefits there might be from such actions would have to be weighed against the cost of putting the Fed in the business of allocating private sector credit–a task for which the Fed has no particular expertise, and which would likely subject the Fed to unwelcome political pressures.

How, then, would this strategy work? Following this avenue, the Fed could purchase any government debt with positive yields–for example, longer-term Treasuries. In broad terms, reducing the supply of these securities forces the private sector to re-balance its portfolio. The yields on the securities whose supply has shrunk must fall, in order to make people content with holding less of them. The prices of these assets, which move in the opposite direction from yields, must rise.

For consumers, the lower yields reduce saving and spur consumption. For businesses, the lower yields can mean a lower cost of funds, while the rise in the assets’ prices can improve businesses’ balance sheets or give them more valuable collateral with which to secure financing.

This strategy, while indeed the simplest to implement, is not without problems:

First of all: No one, we believe, has a good quantitative sense of the mechanics of this strategy–that is, what size operations are needed to secure a given stimulus?

Second, if the short risk less rate is zero, but other rates are positive, those rates must be positive for reasons–to compensate the holders of those assets for some form of illiquidity or risk. Under this strategy, the Fed takes those risks onto its balance sheet.

This leads us to a third point: the Fed is almost guaranteed to take a capital loss on its portfolio. If the strategy works, the economy picks up, interest rates go up, bond prices go down, and the value of the Fed’s holdings of longer-term Treasuries falls.

Finally, narrowing the yield spread between assets of long and short maturity can stress institutions, such as banks, that profit from that spread. On the other hand, it must be noted, a wave of deflation-induced loan defaults would no doubt also be stressful for banks.”

The document thus clearly spells out the motive, dynamics and the risks involved (all emphasis above is added). It clearly states that for the stimulus to work it has to be sizable and it has very little idea what this size could be. It also agrees that it’s crashing is also certain if the schema works. It is saved only if things do not work! So it appears that either the economy or the Fed has to go!! And if Fed does an open market operation on mortgages, corporate and other debt – where is the place to hide? Ashes are assured.

Incidentally through an array of lending programs, the Fed’s balance-sheet has soared from below $900 billion to more than $2 trillion, and is about to grow further.

The other point it makes is that consumers will spend as the rates are low to save. Even in 2003 the Fed was of the notion that US consumer saves! Given the consumer leverage in US and the pains they have suffered of late (see graphic) it is difficult to envisage that they will go on a spending binge. Credit at lower rates now will be used for refinancing thereby reducing the interest burden. Any surplus due to interest resets and lower prices of gas etc. is likely to be saved. If you thought develeveraging is done – watch when the consumer develeveraging accelerates.

And as regards the asset prices on balance sheets of business – the root cause of this crisis is that as no body knows the value of these assets. It is also clear that Fed had not envisioned that the this problem will involve bank assets in such large proportions that despite infusing substantial capital the tendency to hoard will be higher than to lend.

So while money supply has been added the willingness to lend is not perking up as the banks themselves are not too sure where the value of their assets stands now and more importantly what the value in future would be. They will require to fill future holes and hence the loss of appetite to lend. Therefore any addition to money base without the money flowing in the credit channel (velocity of money) is no good. On the other hand by not lending the banks are again creating potential holes in their traditional lending books as this will lead to businesses failing. Also the tightening of the credit norms is leading to further slowing of the money flow (see graphic).

In the context of Japanese experience I found this interesting snippet which is something one needs to watch out

“In Japan, these interventions have left the Postal Savings Fund insolvent as public money was used to support the JGB (Japanese government bond) market. Financial institutions were encouraged to hide their losses and even employees from the Ministry of Finance were installed in some cases engaging in loss postponing transactions of every kind. Major life companies were told not to hedge their risks for fear that this would make the markets decline even further…..”

In this sense the banks can find their balance sheets a little repaired as a result ZIRP. The MTM or mark to market losses on their debt portfolio will stand reduced or even show profits as interest rates fall across maturities and across many issuers. This will also help plug some pension fund holes with low discount rates. Remember this just a balance sheet date window dressing aided by Fed. Closely watch out as to how the pension funds handle the situation globally. From the reports I have been reading a sudden collapse cannot be ruled out. It also appears the pressure on banks to constantly raise capital to keep the capital adequacy ratios within acceptable limits is also going to be high.

Further are we at beginning of ‘carry trade V.2’? The pronouncement of ZIRP clearly provides such an opportunity especially with respect to emerging markets. In fact the foreign portfolio investment flow seems to have positive in December in markets like India mainly due to this factor and has propped up its market. As a result INR has also appreciated which is a double whammy for these traders. What it means for the future? We are already aware of the unwinding effects.

Imminent fallout of ZIRP is the depreciation of USD. Bernanke has espoused his thought very lucidly in early part of this century as to how deflation can be tackled in a “fool proof” manner using currency depreciation. (The dollar fell 3.9 percent to $1.3912 versus the euro on Friday from $1.3369 on Dec. 12, its fourth straight weekly drop. It slumped to a 12-week low of $1.4719 on Dec. 18. The dollar dropped 2.1 percent to 89.31 yen from 91.21, falling to 87.14 yen on Dec. 17, the lowest level since 1995. The euro increased 2 percent to 124.22 yen from 121.83).

“Even if the nominal interest rate is zero, a depreciation of the currency provides a powerful way to stimulate the economy out of the liquidity trap. A currency depreciation will stimulate an economy directly by giving a boost to export and import-competing sectors. More importantly, a currency depreciation and a peg of the currency rate at a depreciated rate serves as a conspicuous commitment to a higher price level in the future, in line with the optimal way to escape from a liquidity trap discussed above. An exchange-rate peg can induce private-sector expectations of a higher future price level and create the desirable long-term inflation expectations that are a crucial element of the optimal way to escape from the liquidity trap.

In order to understand how manipulation of the exchange rate can affect expectations of the future price level, it is useful to first review the exchange-rate consequences of the optimal policy to escape from a liquidity trap outlined above. That policy involves a commitment to a higher future price level and consequently current expectations of a higher future price level. A higher future price level would imply a correspondingly higher future exchange rate (when the exchange rate is measured as units of domestic currency per unit foreign currency, so a rise in the exchange rate is a depreciation, a fall in the value, of the domestic currency). Thus, current expectations of a higher future price level imply current expectations of a higher future exchange rate. But those expectations of a higher future exchange rate would imply a higher current exchange rate, a current depreciation of the currency. The reason is that, at a zero domestic interest rate, the exchange rate must be expected to fall (that is, the domestic currency must be expected to appreciate) over time approximately at the rate of the foreign interest rate.”

The depreciating currency helps the export sector and import-substitute sector while making imports expensive and hence adding to the inflationary pressure. It will also help those corporates with large overseas operations/profits to shore up profits in USD and their balance sheets with lower translation losses.

However a falling currency also makes the yield expectation higher. Can an economy that is essentially funded by foreigners afford flight of capital? Given last one year’s experience the US risk perception is not the same. What will be the country deleveraging effect? Given the level of quantitative easing/open market operations envisaged if and when the treasury bubble bursts – Fed could be bankrupt overnight.

Further such devaluation puts pressure on other countries to follow competitive devaluation policies and lower interest rates. Imagine all economies that matter at zero rates!! These competitive tendencies could lead to threat of protectionism. This more so for export oriented economies that apart from facing slower/lower demand have to face up to such currency volatility related issues. Local political pressures build up as jobs are lost and plants are shut. The temptation to throw trade barriers is very high. As Economist notes:

“Few fear a return to the punitive tariffs of the Depression, but Richard Baldwin, policy director of the Centre for Economic Policy Research, a research network, notes that during the Asian crisis in the late 1990s, some of the afflicted countries raised tariffs and rich countries responded with higher anti-dumping fees. It could be worse this time, he believes, because the crisis is more widespread. India, Russia and Vietnam have raised tariffs already this year. Trade litigation has also picked up. Mr Baldwin says the number of anti-dumping cases jumped by 40% in the first half of 2008.

Tariff increases may be the protectionist’s barrier of choice, despite limits agreed by members of the World Trade Organisation (WTO). This is because in the past decade many countries have unilaterally cut tariffs to well below those limits. They have plenty of room to raise them without breaking any rules.

If all countries were to raise tariffs to the maximum allowed, the average global rate of duty would be doubled, according to Antoine Bouet and David Laborde of the International Food Policy Research Institute in Washington, DC. The effect could shrink global trade by 7.7%.

There are other, more subtle, means of protection available. Marc Busch, a professor of trade policy at Georgetown University in Washington, DC, worries that health and safety standards and technical barriers to trade, such as licensing and certification requirements will be used aggressively to shield domestic industries as the global downturn drags on.”

So what is Fed trying to do? We have known that easy money and more debt did nothing but cause a greater problem down the road.

When you have a drug (Credit) addict you cannot withdraw as the withdrawal effects are violent & traumatic and could be fatal. So you keep administering the same drugs for some time as you talk through to make him/her mentally ready for the withdrawal trauma. And then you slowly start reducing the drug step by step. Obviously the ‘highs’ that were reached are now totally out of question. The process is painful and long. The cure too is uncertain. There will be lots of ups and downs. But if the addict has made up his mind to reform and is willing to withstand the agony, sure there is way – but it needs a lot of patience and very long term view.

Disclosure: No stocks discussed – No Positions

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