When the Federal Reserve went “all in” as wags liked to put it on December 17, with its declaration that it would use “all available tools” to fight looming deflation. The bond and currency markets both took note, with the dollar falling sharply before rebounding and mortgage interest rates falling (nicely done, to get much of what you want via an announcement, rather than action).
In fairness. the Fed contended then that what it is doing is not quantitative easing:
….the senior Fed official said the central bank’s approach is distinct from quantitative easing and different from what the Japanese did. The Fed’s balance sheet has two sides, the official explained: assets with securities the Fed holds (including loans, credit facilities, mortgage-backed securities) and liabilities (cash and bank reserves). Japan’s quantitative easing program focused on the liability side, expanding cash in the system and excess reserves by a large amount. The Fed’s focus, however, is on the asset side through mortgage-backed securities, agency debt, the commercial paper program, the loan auctions and swaps with foreign central banks. That’s designed to improve credit-market functioning, the official said. By expanding the balance sheet by making loans, the official explained, the focus is not on excess reserves but on the asset side. That securities-lending approach directly affects credit spreads, which is the problem today — unlike Japan earlier, where the problem was the level of interest rates in general, the official said.
I am not sure the difference between conventional quantitative easing and the Fed’s version (which we have called QE2) matters, in the sense that neither gets at the real problem. The Fed seems to be stuck in “if your only tool is a hammer, every problem looks like a nail” syndrome. The Fed has come up with a tremendous number of hammer-variants, but it is still acting as if the underlying problem is liquidity, when the issue is solvency. If a large number of borrowers are unable to pay their debt, making more debt available cheaply is no solution. It might enable a few at the margin who encountered bad luck to tide themselves over until they get themselves straightened out, but in more cases, the net effect would merely be to prolong the inevitable, with the end result that the borrower defaults on his debt, but with an even larger principal balance to write down.
What we need is more thought and effort devoted to the painful but necessary exercise of how to do triage on borrowers. Believe it or not, some are OK and might even be in a position to expand (there are countercyclical businesses), some could be made viable with a modest haircut, and some are beyond rescuing. Instead, we seem to be firmly on the path of putting off the day of reckoning as long as possible. That is the course of inaction the Japanese took, and we can look forward to even worse outcomes, since Japan had a robust export sector and a largely healthy global to sell into economy (save the 1997-8 Asian crisis and the dot-bomb recession).
Nevertheless,the Bank of England appears ready to emulate the US program despite its questionable logic. The Bank of England was permitted on Monday to engage in quantitative easing, but the announcement was sufficiently vague as to leave commentators scratching their head, particularly since the Bank has already gone a way down that road (which begs the question of why an announcement was needed).
Today, Mervyn King provided some clarification in a Tuesday evening speech. From the Independent:
The Bank of England will start buying up corporate bonds within weeks to unblock capital markets and free banks’ balance sheets so that they can lend to support the economy, Mervyn King, the Bank’s Governor, said last night.
In his first speech of the year, Mr King outlined radical plans for the Bank to buy up an initial £50bn of illiquid assets in the market to increase the flow of credit, with the option of ex-tending the scheme to boost the money supply by effectively creating new money. The asset purchases will come on top of a raft of other measures designed to get banks lending to limit the impact of the recession.
Mr King told a CBI dinner in Nottingham that the Bank was ready to use “unconventional measures”….
The Government is wary of taking on extra risk by buying corporate credit outright, and Mr King stressed that the Bank would only buy assets that played a key role in the financial system and for which there would be strong dem-and in normal conditions.
“There is a fine dividing line between helping to oil the wheels in markets that are temporarily impaired and artificially supporting markets in which there is no underlying demand,” the Governor said. “Such asset purchases involve taking more credit risk on to the public sector balance sheet. That is why the Bank will consider purchasing only high-quality assets.” He highlighted as potential purchases high-quality corporate bonds, whose risk spreads had been driven to their highest since the mid-1970s because of illiquid markets. Bank buy-ups of commercial paper could also ease that market, though it is less important in the UK than in the US, he added.
This is far more prudent than the course the Fed is taking, and that the US could be embarking on with the TARP. One of the big worries with large scale monetary expansion is that is merely counteracts (at best) debt deflation, so the money growth does not produce inflation, until it eventually succeeds. Normally, a central bank would then go into reverse, and try to mop up the excess liquidity by selling assets on its balance sheet (the cash payments by buyers reduce money supply). But if the Fed’s balance sheet is loaded with dreck, it would risk selling assets at a loss, and too many losses means it would have to go hat in hand to the government for a rescue.
The devil often lies in the detail, and the details of the Bank of England program could prove to be a meaningful improvement on the US version.