The Ghost of Ben Bernanke

You may think that Ben Bernanke, architect of the Federal Reserve's $4.5 trillion balance sheet, had faded into obscurity, but he's still alive and well and blogging on the Brookings Institute website that you can find here.  In a recent posting, he looks at the Federal Reserve's monetary toolkit and what ammunition it has left, particularly negative interest rates and their potential impact on the economy.  Here are the highlights.

Mr. Bernanke opens by noting that the U.S. economy is growing and creating jobs (no doubt, thanks to trillions of dollars worth of untested monetary policy experimentation), however, he notes that there is a "possibility" that the economy will "slow, perhaps significantly".  At that suggestion, he asks "What tools remain in the (Federal Reserve's) toolbox?".  That, indeed, is a very good question considering that the Fed has used three rounds of quantitative easing, the Twist and forward guidance to prod the reluctant economy back to life.  In this posting, he discusses the implementation of a negative interest rate policy, an as yet untried policy at least on this side of the Atlantic and Pacific Oceans.

Mr. Bernanke goes on to state the obvious:

"Given where we are today, how would the Fed respond to a hypothetical economic slowdown? Presumably the central bank’s first response, after dropping any plans to raise rates further, would be to cut short-term interest rates, perhaps to zero. Unfortunately, with the fed funds rate (the Fed’s target short-term rate) now between ¼ and ½ percent, and likely to remain relatively low, moving to zero provides much less firepower than in the past. For comparison, the Federal Open Market Committee (FOMC), the Fed’s monetary policy-making body, cut the short-term interest rate by 6.8 percentage points in the 1990-91 recession and its aftermath, by 5.5 percentage points in the 2001 recession, and by 5.1 percentage points at the beginning of the Great Recession in 2007-2008." (my bold)

He suggests the following solutions to the Federal Reserve's "painting itself into its current policy corner":

1.) Further Forward Guidance: The Federal Reserve could communicate to the markets and the public that short term rates will stay low for a much longer period of time.  This could allow long-term rates for such things as mortgages to drop closer to short-term rates although the outcome is far from certain.

2.) Further Quantitative Easing: By purchasing additional long-term assets for the Fed's already bloated portfolio, additional reserves are created in the banking system.  This would encourage borrowing and spending.  Let's see how well the unprecedented and highly experimental $3.6 trillion worth of QE did for mortgage borrowers since the beginning of the Great Recession:

Mortgage debt is down from its 2008 high of $14.8 trillion to its current level of $13.8 trillion after hitting a low of $13.2 trillion in early 2013.  So much for encouraging the banking system to lend to homeowners.  Obviously, further QE will be like pushing on a string.

3.) Negative Interest Rates:  Negative interest rates are the new buzzword among central bankers around the globe and have been implemented by the Bank of Japan, the ECB and a handful of European national central banks as well as being threatened by both the Federal Reserve and the Bank of Canada.  In the negative interest rate scenario, the banking system is charged interest on the reserves that they hold at their local central bank.  To minimize the impact of these fees on their bottom lines, the banking system will reduce their holdings at central banks and invest in other short-term assets that will drive the yields on short-term investments into negative territory as well as driving down the yields on longer term securities that have an impact on mortgage and business loans.  While this sounds like a great deal, let's see what has happened to the excess reserves that the American banking system has stockpiled at the Federal Reserve since the Fed started actually paying banks 0.50 percent to store their "money":

    

At $2.36 trillion, the American banking system is doing exactly the opposite of what the Fed needs it to do to get the economy borrowing and spending.

Mr. Bernanke goes on to explain why we should not be afraid of negative interest rates.  He notes that economists are accustomed to dealing with negative real interest rates (interest rates that have been corrected for inflation) as we can see on this graph which shows a 60 year history of the real effective Federal Funds Rate:

As you can see, for most of the period up to the Great Recession, the Federal Reserve had substantial monetary headroom to lower nominal interest rates during recessions.  This changed in 2008 as the Fed pushed nominal interest rates to the zero lower bound, totally removing any hope that they could lower interest rates further...unless, of course, they lowered nominal rates into negative territory.

Mr. Bernanke then explains the practical issues behind lowering interest rates into negative territory:

1.) Does the Fed have the authority to impose negative interest rates on the reserves that banks hold with it?  According to the Act which governs the Federal Reserve's operations, the Fed's fees must reflect the actual cost of providing the service over the long-run.  Since the cost of holding bank's reserves is low, it may not be legal for the Fed to charge banks for holding their reserves.

2.) How negative should rates go?  When rates become excessively low and punitive, Mr. Bernanke shows some contact with the real world by noting that consumers will simply hold/hoard currency.  Banks could profit by holding customers' cash for a fee or (and this is a big or), cash could be abolished or have an expiry date linked to its serial number.  Federal Reserve research shows that the interest rate paid on bank reserves in the United States could not be lower than -0.35 percent, however, rates in Europe are as now as low as -0.75 percent and there has been no sign of currency hoarding.  I'd add that this is likely because cash is becoming increasingly less utilized in some nations across Europe that have implemented negative rates.

3.) The effect on money market funds (MMF) could be problematic given that MMF investors have traditionally been promised that they can withdraw at least the full amount that they have invested because MMFs are widely regarded as completely risk-free.  When investors do not get their entire investment back, as very nearly occurred in 2008, it is termed "breaking the buck".  Implementing a negative interest rate policy could alter the MMF landscape, reducing an important source of short-term funding for the financial industry.

4.) The effect on the profits of the banking sector could be substantial if banks do not pass along negative interest rates to their customer base.  I suspect that this is highly unlikely to be a problem since banks are very creative when it comes to implementing new fee structures to ensure that their profits remain intact.  As well, Mr. Bernanke notes that interest rate margins would likely continue to remain positive in a negative interest rate environment because interest rates charged on long-term loans such as mortgages would most likely remain in positive territory.

Let's look at Mr. Bernanke's closing comments on negative interest rates:

"Overall, as a tool of monetary policy, negative interest rates appear to have both modest benefits and manageable costs; and I assess the probability that this tool will be used in the U.S. as quite low for the foreseeable future. Nevertheless, it would probably be worthwhile for the Fed to conduct further analysis of this option. We can imagine a hypothetical future situation in which the Fed has cut the fed funds rate to zero and used forward guidance to try to talk down longer-term interest rates. Suppose some additional accommodation is desired, but not enough to justify a new round of quantitative easing, with all its difficulties of calibration and communication. In that scenario, a policy of modestly negative interest rates might be a reasonable compromise between no action and rolling out the big QE gun." (my bold)

In closing, as was pointed out to me, I find two sentences in the second paragraph of his posting rather interesting and a bit puzzling.  Here's sentence one:

"I’ll conclude in these two posts that the Fed is not out of ammunition, and that monetary policy could help cushion a possible future slowdown." (my bold)

Here's the second sentence:

"That said, there are signs that monetary policy in the United States and other industrial countries is reaching its limits, which makes it even more important that the collective response to a slowdown involve other policies—particularly fiscal policy" (my bold)

Does this not sound like a contradiction?  A rather frightening contradiction given that over seven years of Federal Reserve "monetary medicine" has accomplished rather little given the risks that were taken?  The possibility that the Fed will dive further into uncharted monetary territory should give us good reason to ponder the wisdom of today's central bankers.

Ben Bernanke's - A Retrospective Look at His Effectiveness

Since Mr. Bernanke is updating us on the "state of the union" from a central banker's perspective, I thought that it would be a good idea to take a look back at his tenure as the man at the helm of the world's largest economy and how his policies have impacted a few aspects of life in America.  Here's what the economy looked like when Mr. Bernanke took the position of Chairman of the Fed on February 1, 2006.

Unemployment was 4.8 percent:

Here's what unemployment looked like after February 2006 (please note the change in scale):

Unemployment peaked at 10 percent in October 2009 and has fallen to 8.2 percent and has been stuck in a range from 8.1 to 8.3 percent since the beginning of 2012.

When Mr. Bernanke took over from his predecessor, this is what employment looked like:

In February 2006, 135,413,000 Americans were employed and employment growth was rising nicely after its post-recessional drop.

Here is what has happened to the number of employed Americans since then:

The number of employed Americans hit a peak of 138,023,000 in January 2008, then fell to a low of 129,244,000 in February 2010, a drop of 6.5 percent.  Since then, the number of employed Americans has risen to 133,088,000, a rise of only 3 percent.  The economy is not even close to making up for the jobs lost in the period from 2008 to 2010.

Real GDP per capita had grown from $44,081 in the year 2000 to $48,095 in 2006, a rise of 9.1 percent, as shown here:

By 2010, it sat at $46,844, a drop of 2.6 percent since Mr. Bernanke took office:

Here's what the Fed's benchmark interest rate looked like prior to Mr. Bernanke's rule:

Here's what it has looked like since, showing a modest amount of policy desperation:

While low interest rates seem good on the surface, sometimes they work against us.  Since longer Treasuries formed an important component of pension plans in the early part of the millennium, let's look at the interest rates on 10 year Treasuries.  The interest rate on 10 year Treasuries was a reasonable 4.57 percent in February 2006, down from its high of 6.79 percent in January 2000:

As shown here, ten year Treasuries are now yielding 1.52 percent, a drop of just over 3 percentage points since Mr. Bernanke appeared as Fed Chairman:

This has forced pension plans to look at riskier equity investments to meet their 7 to 8 percent expected rate of return and, thanks to this prolonged period of ultra-low interest rates, many pension plans are heavily under-funded.

Lastly, let's look at the M2 money supply prior to the Bernanke era:

From the beginning of the new millennium until February 2006, M2 grew from $4.633 trillion to $6.696 trillion, an increase of 44.5 percent.  

Here's what has happened since:

M2 money supply has grown to $9.992 trillion, an increase of 49.2 percent.  This is nearly double the level of January 2000.

As background information for those of you who are not aware, Congress sets the salaries of the Federal Reserve Board Members.  This year, the Chairman's salary was set at $199,700 and the other Board members receive $179,200.  The members of the Board of Governors are nominated by the President and, even though they are supposed to represent a wide range of industries, many of them tend to have banking backgrounds.  They are appointed for a 14 year term and they may not be reappointed.  Here's a quote from the Federal Reserve website:

"Once appointed, Governors may not be removed from office for their policy views. The lengthy terms and staggered appointments are intended to contribute to the insulation of the Board--and the Federal Reserve System as a whole--from day-to-day political pressures to which it might otherwise be subject."

Ben Bernanke was appointed as a member of the Federal Reserve Board on February 1, 2006, the same day that he started his first term as Federal Reserve Chairman.  His 14 year term as Board member ends January 31, 2020 and his current term as Chairman ends on January 31, 2014.

Now that we've seen how well Mr. Bernanke has done, here is a link to the Federal Reserve Bank of San Francisco website.  This game will allow you act as Federal Reserve Chairman, changing the federal funds rate and seeing how it impacts inflation and unemployment.

I wonder if Mr. Bernanke uses this as a policy tool?  Could it be any worse than all of that ineffective easing and Twisting?

Ben, The Fed and America's Housing Market: This Time It Really Is Different

A recent speech by Ben Bernanke sheds some interesting light on the housing situation in the United States.  In this speech entitled "Housing Markets in Transition", Mr. Bernanke goes on at length about what ails the U.S. housing market and how the issue is impacting the so-called economic recovery.  Here are a few salient points from his speech.

Mr. Bernanke opens by noting that, although the economic recovery began more than two years ago (officially in June 2009 according to NBER), it doesn't feel much like a recovery, particularly if you are one of the millions of long-term unemployed or if you happen to own or have lost ownership of a home.  The housing sector is an important driver of the U.S. economy and in a typical recovery, it is housing that drives the economy upward and onward.  Apparently, this time, things really are different.

Here's a quote from Mr. Bernanke:

"The Federal Reserve has a keen interest in the state of housing and has been actively engaged in analyzing the housing and mortgage markets.  Issues related to the housing market and housing finance are important factors in the Federal Reserve's various roles in formulating monetary policy, regulating banks, and protecting consumers of financial services. Traditionally, mortgage interest rates have been a key transmission channel of monetary policy; and banks' mortgage lending policies directly affect their own safety and soundness as well as the access of creditworthy households to mortgage credit."

Perhaps then he should explain why both he and his predecessor, Mr. Greenspan, chose to ignore signs in the housing sector that quite clearly showed that was not well back in 2006?

Mr. Bernanke goes on to note that part of the problem in the housing market is the imbalance between supply and demand, with the supply of available homes far outstripping the demand.  For instance, there are currently about 1.75 million vacant homes listed for sale across the United States, well up from the first half of the decade. Vacancies are particularly high in certain states, particularly of the "sun and sand" variety.  

Here is a graph showing the elevated homeowner vacancy rate (bottom curve on graph):

Homeowner vacancy was as low as 1.8 percent in early 2005; this rose to a peak of 2.9 percent in early 2008 and has dropped to 2.3 percent in the fourth quarter of 2011.  In the fourth quarter, homeowner vacancy rates were as high as 2.5 percent in the mid-west and 2.4 percent in the south down to 2.0 percent in the northeast as shown on this chart:

Here is a graph showing the drop in home ownership rates since the peak of the housing market in 2005 - 2006:

Home ownership peaked at 69.2 percent in 2004 and has fallen to 66 percent in the fourth quarter of 2011.

In combination, these two factors have done this to the median asking price for vacant sales units:

You will note that the median asking price for vacant units has dropped from a peak of just over $200,000 in 2007 to just over $130,000 in the fourth quarter of 2011.  Unfortunately for home-owners, it is this downward trend in the asking price of vacant homes that is putting downward pressure on the valuations of all real estate.

According to Mr. Bernanke, this problem is not going to end anytime soon.  In the past few years, roughly 2 million foreclosures have entered the market and this is likely to continue for the foreseeable future.  Once again, this puts additional downward pressure on the valuations of existing housing and also negates the need for the building of additional housing units.  Single family housing starts since 2009 have dropped to less than 500,000 units on an annual basis, down from more than 1 million prior to the Great Recession as shown on this graph:

In February of 2005, housing starts peaked at 2.207 million units and dropped to a low of 478,000 in April of 2009.  Despite the fact that the economy is nearly three years into recovery, housing starts are still mired at levels not seen in 60 years with starts in December of 2011 reaching a tepid 657,000 on an annual basis.

Nationally, this has been devastating.  Nationwide, house prices have plunged 30 percent in nominal value since the peak and 40 percent in inflation-adjusted terms.  In wealth terms, declines in housing prices have reduced homeowners' equity by more than 50 percent in total across the U.S. since the peak of the housing boom, wiping out more than $7 trillion in household wealth.  More than 12 million or one in five households with a mortgage are now underwater.  This has led to decreased spending; some estimates suggest that households reduce spending by $3 to $5 every year for each $100 in housing value lost.  In total then, reduced consumer spending ranges from $200 to $375 billion annually related solely to the dropping value of residential real estate.  On top of that, we have to add the spending lost by savers who have seen the return on their fixed income investments plummet to near zero.  This has a ripple effect throughout the economy; less spending means lower sales for corporations which results in lowered investments in both mechanical and human capital (i.e. jobs).  Since the housing construction sector is intimately related to housing sales, it has suffered the most.

Mr. Bernanke goes on to question why the recovery in housing has been so slow.  He notes that the outstanding amount of mortgage credit in the United States has contracted by 13 percent in real terms since it peaked in 2007; this is in contrast to other recoveries where mortgage credit began to grow four years after the peak of the previous business cycle.  This time really IS different.

Despite the Fed's best efforts to prod consumers to borrow and banks to lend by implementing a long, long period of a near zero Fed Fund rate and record low mortgage rates, banks have tightened their lending standards, an act that is similar to closing the barn door once the entire herd has escaped.  Lending is restricted for even the most credit-worthy of households.  Fewer than half of lenders are offering mortgages to lenders with a FICO score of 620 and a 10 percent downpayment; this is a far cry from lenders who used the "if you make fog on a mirror when we hold it under your nose" criteria for qualification during the early part of the decade.  These tighter standards have disproportionately impacted first-time homebuyers, even in parts of the U.S. where employment and the economy are solid.  Consumer credit data shows that the share of 29 to 34 year olds that were seeking a first mortgage dropped to 9 percent between mid-2009 to mid-2011 compared to a level of 17 percent between mid-1999 and mid-2011.  Demand for housing by first-time buyers is an important part of incremental increases in housing demand; as well, when first-time buyers abandon the market, they prevent other homeowners who live in so-called "starter homes" from moving up to larger homes since supply of starter homes is greater than the demand for them.

Here is a quote from Mr. Bernanke's speech about the mortgage issue:

"The problem of tight mortgage credit will not be solved easily or quickly. The Federal Reserve, in its supervisory capacity, continues to encourage lenders to find ways to maintain prudent lending standards while serving creditworthy borrowers. But the slow recovery of the housing market and the economy, continued uncertainty surrounding the future of the GSEs and the regulatory environment for mortgage lending, the likely continued absence of a private-label market, and more cautious attitudes by lenders are all barriers to rapid normalization of the flow of mortgage credit." (my bold)

It's too bad that the Fed seemed to ignore its "supervisory" capacity in the lead-up to the housing market collapse, isn't it?  Perhaps if Mr. Bernanke et al had been "supervising" banks and their easy lending standards during the first half of the decade, the whole mess wouldn't have occurred on their watch.

Mr. Bernanke goes on to offer a solution; adding the supply of vacant, real estate owned housing to the nation's rental market, a subject for a future posting.

Mr. Bernanke closes by noting that the overhang of empty and foreclosed homes in combination with unobtainable mortgages has impaired the economic recovery far beyond what would normally be expected in the third year of an economic “recovery”.  He notes that no single solution will be sufficient but that sustained efforts to unlock the factors that are holding back the housing market will pay dividends over the long-term.  Best of luck on that one, Ben.

Mr. Bernanke's Game of Congressional Chicken

In light of Mr. Bernanke's recent comments about playing a Congressional game of chicken with the debt ceiling, I thought that a brief look at the latest Monthly Budget Review for the month of May 2011 from the Congressional Budget Office would be in order.

For the first 8 months of fiscal 2011, the federal budget deficit reached $929 billion, $6 billion higher than the deficit for the first eight months of fiscal 2010.  Outlays rose by 6 percent and revenues rose by 10 percent on a year-over-year basis.  The deficit for the month of April alone was $40 billion and is estimated to be $59 billion for the month of May.  Outlays dropped by $48 billion compared to May 2010, however, most ($42 billion) of this drop is due to reduction in outlays for TARP.  The $6 billion difference from the previous fiscal year sets the United States on track for another $1.5 trillion deficit, the third year in a row that the deficit has exceeded $1 trillion.

Let's look at the revenue side of the ledger first.  On a year-over-year basis, Treasury receipts grew by $139 billion (10 percent) for the first 8 months of fiscal 2011 to $1485 billion.  Individual income taxes rose by a rather stunning 28.5 percent from $546 billion to $702 billion.  On the other hand, corporate income taxes rose by a rather paltry 4.8 percent from $81 billion to $85 billion.  Who said that Main Street Americans aren't paying more than their fair share!  Most impressively, everyone's friends at the Federal Reserve contributed an additional $9 billion to the American Treasury, based mainly on increased earnings on their larger portfolio (of QE Treasuries?).  

Now let's look at the spending side of the ledger.  Outlays for the first 8 months of 2011 rose 6 percent or $132 billion to $2414 billion.   Spending on unemployment benefits dropped the most, decreasing by 22.9 percent on a year-over-year basis largely because of declining unemployment (shocking!) and lower average benefits (not shocking!).  The largest spending increase on a year-over-year basis was on net interest on the public debt which should surprise no one.  In the first 8 months of fiscal 2011, net interest rose by 16.1 percent to $176 billion, nearly what the federal government spends on Medicaid.  Social Security spending was up 3.6 percent to $478 billion, Medicare spending was up 3.8 percent to $303 billion and Medicaid spending was up 5.4 percent to $189 billion.

Let's take a quick look at the "Debt to the Penny" number for today just to put things into perspective:

Certainly, as the world's number one central banker has recommended, Congress could stop playing politics and raise the debt ceiling for the umpteenth time once again, making the current debt ceiling the new debt floor.  Unfortunately, that is like sticking another finger in the fiscal dyke.  It solves nothing.  It is interesting to note that, on the spending side for fiscal 2011, the largest year-over-year increase was on net interest on the public debt despite ultralow interest rates.  Should the Federal Reserve raise interest rates to historical norms (as they no doubt will eventually do), more and more of the tax dollars that are remitted to Washington by working Americans will be spent on debt interest payments rather than entitlement programs.  Ceaseless additions to the total federal debt will have the same effect and will eventually constrain government's ability to fund much needed social programs.  As well, let us not forget the looming $100 trillion shortfall for the aforementioned entitlement programs as noted here.

Fortunately for Mr. Bernanke, he is highly unlikely to ever need to avail himself of Medicare, Medicaid or Social Security.  The same cannot be said for those Americans who live on Main Street.