Now that the FED has provided the U.S. and world financial system with a suit of liquidity, it is trying to figure out how to reduce the amount of material. The word “TAPER” is not my favorite for it fails to define what I believe is the goal of the FOMC. Who cares if the FED reduces it security purchases? That is not the problem. If the economy has any real traction the current balance sheet of more than $3 TRILLION should be quite sufficient to keep interest low. The dilemma is how to remove the LIQUIDITY without causing a collapse in Bernanke’s beloved PORTFOLIO BALANCE CHANNEL.
If the economy has real strength, the issue will be how to shrink the balance sheet without causing interest rates to rise dramatically. If the FED were to begin selling its Treasuries into the market, bond prices would fall and yields rise possibly undoing all the beneficial work of the QUANTITATIVE EASING programs. Downsizing the FED PURCHASES is just a statement that the FED believes the liquidity additions are no longer needed and tapering by itself should be deemed a positive for EQUITIES and the DOLLAR. THE CHALLENGE IS SHRINKING THE BALANCE SHEET WITHOUT PUTTING TREMENDOUS UPWARD PRESSURE ON INTEREST RATES.
There are many theories about how to go about reduction of FED assets: reverse repos, scheduled asset sales, raising interest on overnight reserves. Yet one plan keeps popping up: LETTING THE FED’S SECURITY PURCHASES ROLL OFF NATURALLY, meaning just hold them to duration so that the bonds are relinquished by calendar attrition. The FED has securities of many different durations so the roll off would be a gradual reining in of liquidity. The problem then becomes the issue of a massive monetary overhang gaining velocity as the economy improves. Monetary theorists have continually warned that is has been the low VELOCITY of MONEY that has kept growth down. (This is the money part of Richard Koo’s “Balance Sheet Recession”–if people are improving their balance sheets and paying down loans the money the FED puts through via QE fails to provide the needed boost to the economy.) When the economy gathers strength the more liquidity will be available for lending and thus the fear of rapidly rising inflation. THE FED IS AWARE OF THIS DILEMMA OF SPOOKING THE FRAGILE RECOVERY OR ALLOWING RAPID INFLATION.
After rereading the recent Jeremy Stein speech and reading other pieces, the FED seems to believe that it can control the inflationary effects of a roll off by instituting macro-prudential regulation. The FED can utilize liquidity regulation and capital requirements to control the velocity of its massive QE programs. By placing restrictions on type of bank assets that are needed for liquidity coverage ratios, the FED can significantly restrict the amount of credit available to the economy. Also, the FED can insist on higher capital requirements under the guise of TOO BIG TOO FAIL in order to prevent the large banks from over leveraging their balance sheets.
Severe credit rationing in the times of abundant liquidity may allow the FED to play for time and thus not unload its assets in a fire sale manner. The unknown is how this will negatively effect an economy addicted to credit and may well be the reason Pimco sticks to its views about the NEW NORMAL. Credit rationing by FED MACRO PRUDENTIAL REGULATION MAY WELL BE THE NEXT CHAPTER. Of course, what I propose is mere conjecture, which is why at Notes From Underground 2+2=5.
***Just a quick note on the recent activity in the yield curves. Since the “surprise” cut by the Reserve Bank of Australia, the Aussie curve has widened 24 basis points in a very short time. This is a positive for as I argued Aussie dollar strength was an effect of an overly tight monetary policy. The recent steepening has resulted in a 4% decline in the Aussie dollar. This was a successful interest rate cut to promote a policy of countering a slowing economy. The Japanese 2/10 has also begun to steepen and has widened out of its previous range. The Japanese curve will be more difficult to play on a day-to-day basis because of the massive amount of BOND buying by the BOJ. The Aussie stock market and the Japanese Nikkei index have both performed well as the central banks have eased policy. For the Aussie all ORDS , it may take another 75 basis points of cuts to get the equity market back to the highs of 2007-08.
***Bloomberg reported today that the Japanese money managers were net buyers of foreign bonds after purportedly cutting foreign bond holdings in the period of their fiscal year-end (March 31). For those G-7 members who say the Japanese are adhering to previous agreements about currency intervention because the BOJ is not buying foreign bonds this is of course technically correct but structurally wrong. If the BOJ is buying in all the JGBs (10-year Japanese bonds) then the sellers to the BOJ will have to replace those assets with other bonds or equities.
Japanese insurance companies have to fund annuity payments and will have to find “safe” foreign bonds to supplant the JGBS. So yes, the BOJ is just driving the get-away car. Also, I am linking to a piece from the BLOG, Observing Japan, written by my son Tobias Harris (not the basketball player), titled, ON ABENOMICS. Toby is a very valuable resource on all things Japan.