Policy Complications Ahead?

Submitted by Rob Parenteau, CFA, and sole proprietor of MacroStrategy Edge and editor of The Richebacher Letter. He also serves as a research assistant to the Levy Institute of Economics.

A combination of falling asset prices and falling nominal incomes against the back drop of high private debt loads tends to pose a serious challenge to the ability of market economies to self adjust. In response to a financial crisis, the private sector tries to net save and favors liquid assets in the face of large losses of wealth and income uncertainty. Unless some other sector is willing to net deficit spend, nominal incomes will fall, reducing the ability of the private sector to service existing debt commitments. Spending will drop even as final product prices drop, profits will dry up, and delinquencies and defaults will spread.

In addition, unless some other sector is willing to accumulate risky assets or increase the stock of money, asset prices will fall, reducing collateral values and net worth. Bankruptcy and attempts to deleverage, with all their ensuing contagion effects, will spread. Along the way, as markets adjust along these paths, history suggests that societies can experience substantial dislocations. Hy Minsky traced out many of these dynamics decades ago based in part on the contributions of J.M. Keynes and Irving Fisher, but his work was mainly ignored or forgotten by professional investors and mainstream economists favoring the self-equilibrating properties of markets.

The response to recent dislocations in many countries has been to a) increase fiscal deficit spending to both meet the surge in desired private net saving and reduce solvency uncertainty for key financial institutions, while b) reducing policy rates to near zero and expanding central bank balance sheets through purchases of privately held assets (quantitative easing). Market self-adjustment mechanisms that can otherwise lead to market self-destruction are thereby believed to have been short circuited. A “corridor of stability” is being re-established as the guard rails of fiscal and monetary policy have been buttressed.

This time around, however, it may be more complicated than that. Two questions arise with regard to the policy fix underway: who is going to accumulate the issuance of government debt associated with large (and possibly prolonged) fiscal deficit spending, and are there inconsistencies introduced by pursuing a large quantitative easing approach at the same time?

The nub of the policy challenge is as follows. Central banks have dropped policy rates to zero and they have begun purchasing government debt, MBS, and even corporate debt while expanding their balance sheets. Their aim is clear: reduce the cost of private borrowing, and raise the price of less liquid assets by lowering the return on the most liquid assets, thereby forcing many investors to reach for yield in riskier asset classes. Raising prices of risky assets in this indirect fashion reduces insolvency fears, reverses wealth losses and hence adverse wealth effects on spending, and sends favorable financial signals to producers – all of which are expected to contribute to reversing downward economic momentum.

Zero (or near zero) policy rates plus outright purchases have drawn government bond yields down to historically low levels. Low yields on bonds introduce a high risk of capital loss to investors if yields return to historical norms (for bond geeks, think McCauley duration), and if investors cannot be sure they will hold the bond to maturity. The private sector will wish to raise their holdings in government bonds only if they perceive risk adjusted returns elsewhere are less attractive – yet this is antithetical to the very purpose of quantitative easing, which is to break the high liquidity preference of private investors by “trashing cash” and lowering the yield on default free government bonds.

If government yields back up – either because private sector portfolio preferences are taking their cue from QE and shifting toward riskier assets or because fiscal stimulus is helping economic activity which has the same effect – then mortgage rates are likely to back up as well, confounding any stabilization in housing sales.

Alternatively, if central banks step in to buy Treasuries and thereby contain the back up in Treasury yields, more professional investors are likely to conclude “monetization” is underway and they will try to increase their exposure to inflation hedges. The net result would be a likely rise in the relative prices of energy, precious and industrial metals, “commodity” currencies, and ag products and ag land – all of which, as inputs to final products, would tend to represent an adverse supply shock to the economy. In addition, raising the price of essentials like food and energy is more likely to crowd out consumer spending in discretionary items. Neither of these supply and demand effects are particularly supportive of an economic recovery.

The expectations management effort, this time around, looks somewhat challenging. We previously took the stance that central banks can peg government bond yields at a level of their choosing, much as they did during WWII. We now think the policy path that involves QE and rising fiscal deficits may prove more problematic given likely shifts in private portfolio preferences. Put simply, central banks may have created something of a “liquidity trap” by pulling government bond yields below historical norms with near ZIRP (zero interest rate policy) moves. In addition, to the extent QE operations are successful in encouraging private investors to migrate toward riskier assets, government bond yields are likely to rise if that asset class is to compete with expected returns on other assets.

This obviously endangers any incipient housing recovery, and we are hard pressed to imagine much of an economic recovery will transpire if home prices are still falling. Commercial banks could step into the breach with their $1tr in reserves, but they probably will need more clarity on future loan losses before they try to ride the yield curve like they did in 1991-3 in order to rebuild net interest income and capital. Alternatively, if central banks end up being the main bidders of government bonds as a last resort, this is liable to send private investors in search of even more inflation hedges. The subsequent relative price increases for industrial metals, energy, food, etc. could equally inhibit economic recovery by increasing costs of production and draining discretionary household income.

Many professional investors have concluded the policy response to date has once again reset the game. Bank stocks have doubled since their lows, and US equity indexes are up 30-40% since early March. A rise in interest rates and commodity prices is certainly typical of economic recoveries, but this has not been a typical recession. The housing market damage is unprecedented; so too is the dramatic shift of households to a higher saving rate and a net reduction of household debt. The fact is that housing and consumer durable spending historically have tended to lead the US economy out of recession. The higher mortgage rates and higher gas prices resulting from investor reactions to the policy push may get in the way. They are salt in existing wounds. Perhaps the fiscal thrust is so large this time around that a recovery can be led by different sectors like infrastructure and technology and a Japanese style stagnation can be sidestepped. On the above analysis, however, the way forward may be a bit trickier than many investors now expect.

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  1. kackermann

    I think the Fed is not giving weight to psychology in buying agency paper.

    They have bought a lot of this stuff in the hopes of priming the pump, but would an appetite for riskier asset classes extent to MBS's?

    I would be as nervous as a whore in church owning that paper with house prices far from stable.

    You can't put rouge on a corpse and expect people to dance with it. Not if they know it's a corpse.

  2. Brick

    Yes I think you have pretty much nailed the FED's problem, but I see the further falls in commercial real estate prices complicating matters further. My guess would be that the FED would opt for mild inflation further down the road and extend QE to longer dated government debt. The alternative would be to dampen down any green shoots expectation and to try to engineer more treasury debt take up. Pimco's new ETF's on treasury debt come to mind as perhaps an avenue for balancing.

  3. barnaby33

    In essence I think you've over complicated a large portion of whats happening. You can lead a person to credit, but you can't make them borrow, without starting a war that is.

    There are some question marks at the edges, such as, how much the Fed can monetize before bond market dislocation becomes evident? However the Fed cannot change the psychology of austerity and deleveraging that most Americans are currently thinking of.

  4. MacroStrategy Edge

    Kackerman – The point of the Fed bidding for MBS is to make investors feel they have established a floor on MBS prices, regardless of the fundamentals. Question is how they can hold that floor if 1) higher Treasury yields beget higher mortgage rates, and home price deflation takes longer to clear, and 2) if Fed QE operations are viewed by private investors as inflationary, and you get a feedback loop into inflation hedges and higher mortgage rates, then you've got monetary policy boxed in or checkmated.

    Brick – Item 2 is relevant to the first of your exit strategies. If the Fed deals with rising Treasury yields by announcing more Treasury purchases, inflation hedge trades go up, inflation expectations go up, and more private investors are eager to sell Treasuries to the Fed at current prices. Even if the Fed announces an official price floor/interest rate ceiling for long dated Treasuries, there is a risk they end up owning the whole market since many private investors will anticipate when the price floor/rate ceiling is removed, bond yields will go up, prices will go down, and those not holding bonds to maturity will experience capital losses in excess of their yield income from holding Treasuries.

    So this is part of the policy conundrum at the moment. I believe it bears some resemblance to the Soros 1992 pound sterling trade, where the Bank of England got boxed in.

    At this point it seems to me that the Administration can only hope that the fiscal stimulus is large and timely enough that it will swamp most of the effects of rising interest rates and rising commodity prices.

    Barnaby33: If the Fed's actions raise the price of corporate bonds and equities and lower the cost of mortgages enough to stabilize and then lift home prices, household net worth goes up, and the extend of the private sector deleveraging can be reduced. Private sector deleveraging is also enhanced by public sector releveraging: government spending more than they are recieving in tax revenues means the private sector must be earning more income than it is spending.

    Right now, though, the problem which has become apparent is that rates are backing up as investors migrate to riskier assets and build in inflation fears. That cannot be good for the main asset held by households, and so you are correct, it complicates the ability of the private sector to deleverage if mortgage rates are rising when home prices are still deflating near a 20% y/y pace according to Case Shiller.

  5. G Spot1

    Great summary.

    If higher rates and rising prices manage to choke off recovery, what would that mean with regards to inflation?

    Inflation and even hyper-inflation expectations are rising, but if consumer spending continues to decline and housing prices continue to fall, where does that leave us? Is there a correlation between economic recovery and inflation? Or are we at the mercy of foreign appetite for US bonds? Seems to me no one cared about the fed printing money until the "green shoots" showed up.

  6. john c. halasz

    I don't think that there is any real possibility of propping up housing prices and preventing their falling to sustainable levels, nor that such a policy would be desirable. To the contrary, given the over-building of new housing that has occurred, house prices are likely to overshoot to the downside and the excess supply would take years to clear. But the real problem with housing is not house prices, but the excess of debt attaching to them, with millions of underwater mortgages constraining or bankrupting household budgets. Add to that a banking system that is essentially insolvent, and it's plain that monetary policy can't work, since it is supposed to work, first of all, through manipulating the yield curve of the banking system, and, secondly, through stimulating "interest rate sensitive" sectors, which means, most of all, housing and construction, which won't be reviving anytime soon. But the attempt at unconventional monetary policy measures amounts to de facto fiscal policy anyway, since precisely insofar as it would work, it would produce large capital losses on the securities purchased by the Fed, which would have to be recapitalized by the Treasury in the end. What is really required is a wholesale re-structuring of the economy, both in the sense of re-structuring debt loads, which amounts to a collective Chapt. 11 re-organization, and in the sense of an inter-sectoral re-structuring to develop new areas of more balanced growth. It's hard to see how that would occur by means of the conventional prevailing policy regime, especially since a controlled depreciation of the U.S.$ is part of the required resolution, which implies, yes, both supply-side "shocks" and higher interest rates and increased net factor payments. AFAICT a much more robust public/fiscal intervention would be required to bring about a favorable resolution, including, among other items, public receivership for insolvent mega-banks, increased public regulation, a changed tax regime with re-distributive bite, including a net-worth surtax on the upper crust, (partly for claw-back equity reasons, partly to reassure foreign lenders about fiscal "discipline" in the light of a controlled $ depreciation), cost-containing universal health care, and some form of industrial policy with increased public investments. That would of course balloon the burden on the public fisc upfront, but it might avoid some of the impending dysfunctions of the current policy path or at least more equitably and efficiently distribute the burdens of re-structuring. One thing is for sure though: redressing the CA imbalances will involve increased foreign purchases and ownership of U.S. productive assets and companies, so the choice is not just a domestic one between private sector and public solutions. However, I'd doubt such a publicly led re-structuring policy regime would be ideologically acceptable to the prevailing political economy/power structure of this country, and any moves in that direction would be furiously resisted, so a thoroughly "compromised" and dysfunctional "resolution" is much more likely.

  7. Hugh

    I agree with John Halasz's assessment. The effects of quantitative easing seem mostly lost in the liquidity trap of the banks. I just don't see a point to it now. On the fiscal side, much more should be done to create jobs and promote job creation in sectors that can take the country in a more sustainable direction.

    As for the current stimulus, it is shaping up as too little too late. It is laughable to hear Obama announcing that he will create "or save" 600,000 jobs this summer. We have already lost 2.2 million since the beginning of the year. Even if most of those jobs Obama is talking about were new ones, it probably, best case, wouldn't amount to a quarter of what we have already lost this year alone.

    But given how crazy the Republicans are and how often the Democrats agree with them, I do not see our political system with those who are currently in it able to address any of the problems we have at any level.

  8. barnaby33

    If the Fed's actions raise the price of corporate bonds and equities and lower the cost of mortgages enough to stabilize and then lift home prices, household net worth goes up,

    On paper yes! The problem is that these are all paper games. Social mood determines credit markets (Minyanville). Society in general is not in the mood to take on debt. The Fed cannot awaken an appetite that has gone dormant. Furthermore the real damage of this down period is that it has ripped away the curtains revealing to what extent everybody has been living on borrowed money. Now don't get me wrong I'm sure lots of people would like go right back to the way things were, but you have to have a job for that. You also have to feel good about your future prospects. Two things I can assure you most people do not feel good about right now.

    Now if we could just get a nice war going, that would really help the Fed achieve its goals!

  9. longwaves

    Great, succinct and thoughtful piece. Yes, we have a true Gordian knot. There is no easy way to unwind this colossus.

  10. MacroStrategy Edge

    Yes, one of the points of the post was that monetary policy appears to be boxed in now, since investors have taken QE and near ZIRP as a reason to move into inflation hedges and higher risk assets, and move out of Treasuries.

    But this also becomes a thwarting mechanism against any further fiscal response along the lines described above, something Bernanke highlighted in last week's plea for longer run fiscal prudence.

    Nevertheless, it is time to go hunting for a new global growth model. The old one is broken. It may require seeding new industries with public/private investment or public coordination (think Sematech), and otherwise encouraging entrepreneurial solutions around issues like energy independence, water infrastructure, etc. The disappointment at the moment is so many resources have been marshalled to keep dying institutions alive when what we really need to do is to jumpstart some new industries or push existing ones up to critical mass.

    As for whether money values matter, especially asset prices, I submitted a new post that deals with this issue. Asset prices do indeed matter to real economic outcomes, and are not simply a reflection of them – or at least that has been our recent experience.

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