Monday, March 4, 2013

The Impact of the Fed's "Unconventional Policies"

A recent examination of Federal Reserve policies since the beginning of the Great Depression by the Congressional Research Service provides us with an interesting analysis of the Fed's policies and their repercussions.

As we all know, the Fed has been busy as beavers, picking up assets through three rounds of purchasing, known as QE 1, 2 and 3, the first round of which began on November 25, 2008.  This has seen the Fed's balance sheet balloon to unprecedented levels, up from $0.9 trillion in 2007 to $2.9 trillion at the end of 2012.  Here is a graph showing the growth in the Fed's asset base:

Here is a graph showing the liabilities on the Fed's books:

Thus far, the Fed has not announced the ultimate size of QE 3 or when it will end.

Here is a timeline showing when the Fed made major announcements on their new experiment:

We also have to remember that the Fed used "Operation Twist" to push interest rates further along the yield curve down, however, since this policy saw long bonds swapped for shorter bonds, the size of the Fed's overall balance sheet did not change.

All of these actions have boxed the Fed into a corner from which there appears to be no escape.  Interest rates are already at their zero bound and, unless Mr. Bernanke wishes to experiment with negative rates, his hands appear to be tied.  More than four years into this experiment and there is little to show for the risks taken.

Given that all of this was intended to prod already heavily leveraged consumers and businesses to spend/invest by pushing interest rates ever lower, what impact has all of this "Hail Mary" action by the Federal Reserve had?

The "announcement effects" are as follows:

QE 1 lowered interest rates on a 10 year Treasury, BBB-rated corporate bonds and mortgage-backed securities (MBS) by 1 percentage point.

QE 2 lowered interest rates on these same securities by about 0.14 percentage points.

Operation Twist lowered interest rates on these same securities excluding MBS by less than 0.1 percentage points and by 0.25 percentage points on MBS.

Here is a graph showing the impact:

Note that the "announcement effects" wear off with time and that fixed income interest rates are impacted by a host of other factors, not the least of which has been the flight to "safety" as bond investors fled European debt and viewed U.S. Treasuries as a "safe haven".  This also has the effect of pushing up prices (since prices will rise as demand increases) and results in lower interest rates.

How effective has all of this been and where could problems occur?

1.) Bank Lending:  The Fed's asset purchases are financed by increasing the reserves of the banking sector as shown on the red line on this graph:

This theoretically allows banks to expand lending thereby stimulating the economy.  However, since the Great Recession, banks have chosen to hold these reserves at the Fed rather than lend against them, in fact, total bank lending in the third quarter of 2012 was still 5 percent below its pre-crisis peak.  It seems that banks would rather hold additional reserves at the Fed and collect 0.25 percent interest on their reserves rather than take the risk of lending funds to consumers and businesses.  Apparently, once burned, twice shy!

2.) Impact on the Federal Deficit:  The profits of the Fed are remitted to the Treasury and added to its general revenues.  Since the Fed's balance sheet is now bloated with interest-bearing Treasuries, its net income (profits) have increased.  In 2012 alone, the Fed's net income was $91 billion of which $80.5 billion came from interest income.  Remittances to the Treasury for 2012 reached $88.9 billion, well up from $47.4 billion in 2009.  This could all come to an end if interest rates do rise since the Fed paid out $3.8 billion in interest on its inventory of bank reserves in 2011 alone.  While the Fed's remittances do have an impact on Washington's overall deficit, the impact of $88 billion on a $1 trillion annual deficit is rather insignificant.

3.) Monetizing the Debt:  According to the strict definition of debt monetization, the Fed is not actually financing the deficit directly through the creation of money since they are not buying newly issued Treasury securities directly from the U.S. Treasury, rather , the Treasuries are being purchased on the secondary market.  That said, when the Fed buys Treasuries, the Treasury must pay interest to the Fed. These interest payments become profits to the Fed which, in turn, remits them back to the Treasury where they are added to general government revenues.  This means that, technically, the Fed has made an interest-free loan to Washington.  The more Treasuries that the Fed buys, the more Washington benefits so it could be in the Fed's best interest to print more money to purchase more Treasury debt.  Like I said, technically, this is not really monetizing the debt, it just smells like it.  You say tomato, I say tomahto.

4.) Penalizing Savers:  Americans who are fortunate enough to have saved a few farthings for their retirement years find themselves losers under the current low interest rate environment.  Despite the hard luck stories of over-leveraged consumers during the Great Recession, the Fed is deliberately setting interest rates low to induce even more spending and discourage saving.  Here is a look at what has happened to the personal savings rate over the past few years:

Just before the Great Recession, the savings rate hovered between 2 and 3 percent.  The rate rocketed up to just over 8 percent and, over the period of a year-and-a-half, fell back to just over 3 percent.  Since the end of the recession, the rate has hovered between 3 and 6 percent, falling to between 3 and 4 percent until the most recent months.  It looks like Mr. Bernanke has been successful at getting Americans to reduce the amount that they are saving.  As well, let's not forget the impact of ultra-low interest rates on private sector pensions which find themselves in a precariously underfunded position.

5.) Real Estate Market Distortion:  Through the purchases of MBS and other agency debt, QE has been deliberately used to support America's ailing housing market.  Rather than admitting that creatively low interest rate policies by America's banking sector was responsible for overinvestment in the housing market during the boom years, the Fed keeps trying to get American consumers to buy houses, thereby stimulating the economy.  Apparently, the Fed did not learn from history; by creating a vast pool of liquidity, the use of QE could result in additional risk taking which would create yet another asset bubble.

The Federal Reserves current policies find it caught between a rock and a hard place.  Nearly five years of stimulus, high levels of liquidity and low interest rates have really done little to resuscitate the economy.  The use of unconventional policies, while it may have prevented another Great Depression, has been an unmitigated failure from the viewpoint of Main Street America.  As the Fed is and will continue to find out as the years pass, ultra-low interest rates can be a double-edged sword.  The benefits of this policy could well be outweighed by the risks, particularly an uncontrolled surge in inflation.

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