Every once in a while I entertain the fantasy of being at the helm of the Federal Reserve. In a moment of megalomania I am proposing this solution to situation that the FED finds itself: The velocity of money is extremely low as zero interest rates have led to a massive buildup of overnight reserves at the FED. Money’s low velocity is compounded (pun intended) by the bloated balance sheet that the Fed has attained through its massive QE program. Certain voices are maintaining that the severe flattening of the yield curve is precluding domestic banks from making greater profits, which results in less lending activity. It is not only the low profits impeding bank lending but also the massive amount of high quality collateral controlled by the FED that diminishes financing activity from the shadow banking sector via the REPO market. IF THE FED WERE TO BEGIN SHRINKING ITS BALANCE SHEET BY SELLING TREASURIES OF A 10-YEAR OR LONGER DURATION, THE YIELD CURVE WOULD STEEPEN AND THE REPO MARKET WOULD SPRING TO LIFE AS MORE HIGH QUALITY COLLATERAL WOULD CIRCULATE IN THE MARKET.
The FED could shrink its balance sheet instead of adjusting the FED FUNDS rate. By holding down the short end the curve would steepen unless the current bout of flattening was genuinely a symptom of global growth fears. But at least we would get some clarity from market forces. Now I am aware that some will be concerned that such a move by the FED would drastically raise long rates as the market becomes flooded with U.S. sovereign debt. I say not so quick for the amount of FED selling could be tied to the amount of ECB buying: $90 billion a month. The ECB‘s willingness to increase its balance sheet provides the perfect stabilizing mechanism to offset the Fed’s need to contract its Treasury holdings. A possible negative effect will be a rise in the DOLLAR but even this outcome may be softened by investor purchases of European sovereign debt, and, of course, European equity as Europe will be deemed a more desirable investment opportunity. The FED WANTS to raise rates to secure a measure of flexibility in responding to the next economic slowdown. It seems that having room to maneuver in the use of LARGE SCALE ASSET PURCHASES is far better than playing with overnight interest rates in the land of the zero bound. The ECB is providing the perfect out for the FED. This is some of our thinking in the land of 2+2=5.
***Just a bit more clarity on Brexit. In a Financial Times article, “France Attacks UK Corporate Tax Plans,” it was reported that French Finance Minister Michel Sapin warned the U.K. that any attempt to secure a competitive advantage by cutting corporate taxes would be viewed by France and Germany as hostile and would sully future negotiations. (“France and Germany are both concerned that the UK will be tempted to establish itself as a low-tax offshore jurisdiction on the EU’s outskirts in response to the leave vote.”) Brussels will do all it can to ensure against Brexit resulting in a positive outcome for the UK. Because the global financial system failed to collapse in response to the LEAVE vote, the self-proclaimed pundits are striving to prove themselves correct and raise the barriers of obstruction on the European island. Also, to those who throw mud on the Brexiters by labeling narrow-minded old-timers unconcerned about the next generation I raise this question: Where are all the voices of concern about the destruction of the youth of Spain, Portugal, Greece, Italy and France who are continuing to experience DEPRESSION levels of unemployment for the under-25 age group? THE EURO CURRENCY HAS LED TO POLICIES OF INTERNAL DEVALUATION TO MEET AUSTERITY BUDGETS IMPOSED BY BRUSSELS, RESULTING IN the devastation of European youth. As Williams Jennings Bryan might say, a generation has been crucified on a D-Mark Cross.
European youth unemployment: Spain 43.9%; Greece 50.4%; Italy 36.9%; Portugal 28.6%; France 23.3%; and Great Britain 13.2%. Maybe the wake-up call from the British citizenry had more foresight than the pundits allowed. Now about those Italian banks…
Tags: balance sheet, Brexit, ECB, Euro, European unemployment, Fed, Fed Funds, Mario Draghi, QE
July 12, 2016 at 6:34 pm |
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July 12, 2016 at 6:41 pm |
I agree it would be better to unwind the QE in a slow drip, no headline, predictable fashion rather than have markets suffer the “will they or won’t they” speculation that accompanies every Fed meeting. Put it on auto-pilot and let it dribble out over the next 3-4 years. If more tightening is needed go back to conventional Funds rate joystick.
Best part is we wouldn’t have to listen to so much Fed speak. They could just shut up!
July 12, 2016 at 6:43 pm |
Yra- Good idea for discussion at the FED. Why don’t you send it to them?
On the velocity issue, it seems to me that a lot of the problem is that there is too much money (kind of what you said). Therefore, the cost of money is cheap, as there are far more lenders than borrowers.
So, shrinking the money via permanent draining, would alter the supply/demand equation, making cash more scarce and more in demand, and driving up rates and velocity.
The Central Banks are killing velocity by flooding the markets with cash.
I think they know this, but are afraid to tighten because they believe the net effect on the economy would be negative, via decreased borrowing (cars, homes, credit cards, etc.),
They may be right in the short term, but they are creating a debt pyramid scheme, which will implode, at some point.
July 12, 2016 at 6:44 pm |
Labor participation rate much higher in EU than US. 2) Flat curve leaves door open for fiscal deluge and new long end supply.
July 12, 2016 at 7:38 pm |
UPEH–which country in Europe on the participation rate and it is not na apple to apples comparison as some different measures are used—–and you make a good point on the resulting flattening as being used for the fiscal deluge and this is certainly being discussed in Japan as a form of BOJ efforts to foam the runway for future fiscal stimulus
July 12, 2016 at 7:45 pm |
In checking Eurostats the entire EURO area is under 60%
July 12, 2016 at 7:42 pm |
I think social and political upheaval will be one things that will destroy the economic hegemony of the central banks. The key takeaway from the Brexit is the central bankers were wrong about the results, they are good not bad as predicted by the financial elites. CB’s have no idea what effect their policies have politically. With the Italian referendum, negotiations over the GB exit, conflict over the south china sea, European bank bailout bill and the presidential and congressional elections there are lot events that could trigger financial upheaval. Also dissent in the streets also could play a role in volatility.
July 12, 2016 at 7:46 pm |
David Cooper–no argument as there are many “balls in the air” and none are measured by the central bank models
July 12, 2016 at 10:11 pm |
Yra
Did you see this interview of David Folkerts Landau on CNBC today?
http://video.cnbc.com/gallery/?video=3000533646
This DB economist is in your camp on the fallacy of the ECB and Draghi.
July 13, 2016 at 4:58 am |
Frank C—-didn’t see it but I will watch it now
July 13, 2016 at 5:07 am |
Frank–thanks for posting this and he is as critical as a man in his position can be–thanks for the post and he needs to be listened to but as you know full well the fickle finger of fate points to the BIG German decision–do they create and provide for a massive transfer union and Bail-In all of the bad credit residing in the EU system—-it will be an issue in the next elections as well as the French elections because the Germans cannot be the sole agent—again maybe the Brexiters were more then xenophobes and didn’t want to burden their entire society with the debt load piling up in the European national state banks and the ECB
July 13, 2016 at 5:54 am |
Ambrose Evans- Pritchard column http://www.telegraph.co.uk on a review of the China Sea decision is a must read. Published 12 July is in the
Business Section of the website this AM
July 13, 2016 at 7:47 am |
Yra,
Your monetary policy prescription is simple, effective, logical, and very fitting to the present circumstances and needs. This is why it will never happen. Go ahead and send it to every Fed Regional Bank President, in addition to the Chair and listen to the silence. I’ve experienced just that same in sending my domestic content, graduated corporate income tax scheme to every Treasury Secretary, House Speaker, and Senate Majority Leader, going back to the G.W. Bush administration. The silence is deafening.
July 13, 2016 at 8:07 am |
The idea of a cautious and deliberate lightening up of the Fed balance sheet seems quite logical and particularly well timed given current market conditions.
As it relates to the influence of QE on the real economy, I have been thinking a lot more about a hypothesis that QE has not had as meaningful of an impact on the real economy to the extent likely envisioned by central bankers in no small part because corporate governance/long-term stewardship has become so imbalanced in favor of short-term(ism) practices/policies which will likely (in the long run) strip companies clean of their sources of competitive advantages and sources of growth but in the meantime fosters economic performance that leaves something to be desired along with copious amounts of shareholder destruction in the form of buying back billions and billions of dollars of stock at rather lofty valuations rather than re-invest in the companies people, plants, property, and equipment.
July 13, 2016 at 8:27 am |
Send it to the Donald..lets start a movement IRA for fed chair..
July 13, 2016 at 11:27 am |
Frank C.- If you pay attention to David Folkerts- Landau, chief economist for Deutsche Bank and read between the lines, he is saying that he is against bank bailouts and for bailins, but just not now. Not a word about his own bank, DB, which could bring the whole house of cards down. A recap of comments of last week and elaboration.
” As goes Deutsche Bank, so goes the world.”
Why do I say that? Deutsche Bank (DB) is the fourth largest bank in Europe but the largest bank in Germany, the engine that drives the economies of the European Union. Germany is the crutch for the sick peripheral states that allows the European Central Bank to continue their monetary policies keeping the ship afloat. Without Germany, the EU would collapse in short order.
DB is the most systemically important bank in the world, meaning that it is linked together with global markets and other firms in such a way that their failure could trigger a widespread financial crisis (IMF report). It is more important in this respect than HSBC, Credit Suisse, JP Morgan and Goldman Sachs. Its stock is down over 90% from its all time high. DB is leveraged at 40-1, greater than Lehman in 2008 which was at 33-1. It has over $2 trillion in total assets but has over $52 trillion in derivatives presenting huge counter-party risks.. All this with a market capitalization of only $18 billion and declining rapidly (down 60% in the last year).
With the financial world and Landau talking about Brexit and the failing Italian banks, eyes should be focused on DB.
Deutsche Bank has possibly become TOO BIG TO SAVE. And the implications of that statement are frightening.
“As goes Deutsche Bank so goes the world”.
July 13, 2016 at 6:44 pm |
It’s doubtful justice will be served, just as it has been for decades.
History proves criminal enterprise gets off scot-free again and again, while the remainder of society answers to unelected elites who finance political campaigns.
http://financialservices.house.gov/uploadedfiles/07072016_oi_tbtj_sr.pdf
July 13, 2016 at 11:39 am |
If short rates like LIBOR stayed low, why wouldn’t a bank just buy the collateral and park it without lending? Wouldn’t it be a better risk/reward dynamic for the bank than lending at LIBOR + 3% right now?
July 13, 2016 at 1:12 pm |
good rant found on bill fleckenstein’s websitee:
: If he is correct with the traditional, exponential “blow off” scenario, then maybe. Because we are dealing with CB manipulated bonds, rather than, say, commodities, or stocks, the play book might be different. Look what happened when most of Europe was about to cave in to “traditional” disciplines several years ago: CB bail out, of course. I think Oliver’s blow off scenario pushes to the end of the year (if it happens). However, there has been a lot of chatter about “bond bubble” for a couple of years now – especially in Japan – yet, they keep getting bid from somewhere. Savers, actuaries, pension funds, insurance companies, etc. have been taking the royal shaft for several years. No one seems to be able to challenge the CBs because they seem insulated. Besides, their absurd policies are popular because debtors of all stripes vastly outnumber savers or net lenders. Among private individuals, net debtors outnumber net savers by about 10 to 1. The assorted governments love zero rates because it allows for virtually unlimited, low or no cost financing for unrestrained fiscal (vote buying) policies. Also, heavily indebted entities love it because they can refinance higher cost debt with cheaper funds. The “Junk” entity can refinance 13% debt at 5% or so simply because the buyers are so desperate for any kind of yield regardless of risk, that you find the AAA buyer caving in and chasing C+ junk. I don’t know how long this nonsense can last. Never before have we had coordinated, global CBs with a sole mission of “protecting” the markets. I guess it’s the result of “Baby Boomer” upbringing that decreed that risk of failure be eliminated in favor of self esteem, or other sorts of new age psycho babble. All the grownups have left the scene and turned over control of the “system” to their pampered offspring. I hate to think what happens after the “Boomers” have left their screwed up world in the hands of their “Millennial” offspring with their arrested attention spans and over represented egos.
July 13, 2016 at 3:50 pm |
David–which Oliver blow off are you referring to?
July 13, 2016 at 7:48 pm
Michael Oliver….https://www.youtube.com/watch?v=AAPao_QH8xk&feature=youtu.be
July 13, 2016 at 6:25 pm |
Harker says Brexit is “transitory”, allright thanks for heads-up, Brexit is dead no doubt. Also, calls for two rate hikes (presumably economy is hottt?).
He’s a sage!
July 14, 2016 at 8:03 am |
Gotta get me some of those BOJ Perpetuals! 🙂
July 14, 2016 at 12:29 pm |
Is anyone following the debate on bailing out Lehman on CNBC?
At the time, the people in power said they could not bail out Lehman because they were not a commercial bank, then they bailed out AIG, which was far less of a bank than Lehman.
Now they say they couldn’t bail out Lehman because they didn’t have adequate collateral, but could bail out AIG because they did have adequate collateral.
If AIG had adequate collateral, they wouldn’t have needed a bailout. Add together AIG’s CDS losses (on CDOs and other things)
to their pledged collateral, and I would be surprised if they had much if any unencumbered collateral.
You can fool some of the people…………
July 14, 2016 at 12:39 pm |
Shocked–this argument is one lie piled on top of another.AIG had real systemic risk because of all the liabilities it was saddled with as well as AIG CDO adn CDS would have had to be paid and GOLDMAN and others would have been devastated by such action—no default meant the derivatives never had to be paid.Also,the vast amount of AIG global issued insurance policies would have caused severe problems—and many on Wall Street despised Dick Fuld almost as much as Bear Stearns