Many are skeptical of the Fed’s ability to boost the US economy. Some believe that further stimulus might actually be damaging. Although the potency of monetary policy is diminished when private debt is high, there are many tools that could raise demand. Thus, we believe the US is not in a liquidity trap; for instance, if US policymakers bought $1 trillion of houses with printed money, the stimulus would be sizeable.
Monetary policy is still operational. It is always within policymakers’ (the central bank’s or government’s) power to create new money balances via the purchase of assets from the non-bank private sector. Operation Twist, the Fed’s action in the U.S. Treasury market to lower longer-term (risk-free) interest rates, may have little to no effect on nominal spending. However, it does not follow from this that the Fed is impotent, merely that more radical solutions may be needed. Possibly in conjunction with the administration, there are plenty of avenues that could be pursued. Given the poor outlook for the US economy and the political paralysis at home and abroad, Operation Twist* is unlikely to be the Fed’s last move.
‘Conventional’ monetary policy – controlling short-term market interest rates – affects the economy in many ways; it’s most immediate impact is on raising asset prices and lowering the exchange rate. ‘Unconventional’ policies are specifically designed to alter monetary conditions by bypassing the banking system and are specifically undertaken when the banking system faces significant balance sheet constraints. So far, these have largely taken the form of asset purchases of government debt and agency mortgage backed securities (MBS). However, the central bank could stimulate monetary conditions with purchases of other riskier assets, financed by a loan from the central bank (or banking system).
In this crisis, policymakers have heeded one of the lessons of the Japanese crisis – when banks are in trouble, ‘conventional’ monetary policy will not be sufficient. By buying financial assets from the private sector, policymakers are able to affect the liquidity, duration and credit risk of the private sector’s portfolio. As firms and households rebalance their portfolios, the prices of substitute assets should rise. Crucially, the more the risk profile of the private sector’s balance sheet is disturbed, the greater the effect on asset prices and nominal spending.
Those who imply Fed impotency fail to acknowledge the considerable scope for policymakers to move down the risk curve in their asset purchases. Were the Fed, hypothetically, to create $1 trillion of new deposits to finance purchases of $1 trillion of high yield munis, high yield corporate bonds, US houses or troubled mortgages, the effects on demand would be substantial. The Fed would be taking a long maturity, illiquid asset which could well see further capital losses and replacing it with a highly liquid bank deposit. Beyond the direct effects this might have on the bond or housing market, it would leave the private sector’s balance sheet in far better health.
The efficacy of monetary policy is not just measured by its ability to boost asset prices and create money, but also by the effect these have on nominal spending. This is where balance sheets and Keynesian analysis are hugely relevant. External factors – like the extreme imbalances in global demand and distorted exchange rates – are a major constraint on the US recovery. Monetary policy is certainly not a sufficient condition for strong US growth, but it is an important weapon against deflation risks. The most significant domestic problem is surely the housing market. 23% of mortgagors, roughly 14 million households, are underwater. If policymakers want to help the US economy, this is where they should focus; significant changes here could set the foundation for a turnaround.
In October, we believe the market will focus on U.S. earning reports, the European debt crisis and growth indicators coming out of China.
Michael Ashley Schulman, CFA
Hollencrest Capital Management