Economic Notes: Ebb Tide
2/22/2010
By Patrick O'Keefe, Director of Economic Research, J.H. Cohn
“Only when the tide goes out do you discover who’s been swimming naked.” ~Warren Buffett
On signs of strengthening economic growth and improving financial conditions, the Federal Reserve is approaching the end of its hair-of-the-dog approach to stabilizing an economy that had overdosed on debt.
It has not yet withdrawn the treatment, but it has outlined how it will do so – someday.
In sum, the Fed’s “exit strategy” is as follows: where meltdown management entailed educated experimentation, “normalization” will involve informed improvisation.
It could hardly be otherwise given the nature and magnitude of the financial crisis. The Panic of 2008 was an economic game changer; and, perforce, the game will play differently in the future.
It would be imprudent, therefore, to assume that recovery is assured because catastrophe was avoided. Indeed, one key difference between hair-of-the-dog and cold-turkey remedies is the timing of the day of reckoning. In either case, however, if the treatment is to succeed withdrawal must occur.
The credit crisis began in the summer of 2007 with the implosion of mortgage-related derivatives. Initially, policymakers thought it was an isolated problem, one that could be conventionally contained. It wasn’t and it couldn’t.
Instead, as highly-rated investments toppled like dominoes, policymakers around the world were forced to improvise.
In March 2008, the Fed attempted to contain the crisis by arranging a shotgun wedding of two investment banks. To facilitate the merger, it took some $30 billion of sub-par assets onto its balance sheet, where they remain.
It financed the transaction through its unique capacity to print (i.e., create) money.
This was the first of many unconventional tactics that the Fed used in its ultimately successful campaign to stabilize the financial system. In toto, educated experimentation more than doubled the Fed’s balance sheet.
Now that economic growth is complementing financial recovery, the Fed is pursuing “a gradual return toward a more normal stance of monetary policy.”
A recent step in that direction involved adjustments to its discount window, where sound banks in need of temporary liquidity can borrow overnight.
Other steps were less visible since several of its hair-of-the-dog initiatives (e.g., targeted facilities, currency swaps) were designed to atrophy as the crisis abated. As the chart displays, they have.
Yet the Fed’s balance sheet has not declined to any considerable degree.
Why? Because even though financial conditions improved, credit flows remained constricted as both lenders and borrowers repaired their balance sheets.
In response, the Fed embarked on what Chairman Ben Bernanke once characterized as “credit easing.” That is, increasing systemic liquidity by purchasing securities in targeted credit markets (viz., Treasuries and mortgages) using newly created money.
Consequently, markets were fluid, rates were low, and the Fed accumulated assets.
Keep in mind that the money the Fed creates in adding assets to its balance sheet is deposited as reserves in commercial banks. Reserves the banks can use to make loans to businesses and households.
The size and composition of the Fed’s balance sheet is of limited import so long as the economy remains sluggish, the financial sector cautious, and our overseas financiers (e.g., China, OPEC, etc.) remain patient.
Conditions are changing, however. The economy is recovering, the financial sector’s risk tolerance is rising, and our lenders’ patience is being deficit tested.
The size and composition of the Fed’s balance sheet will come to the fore as a growing economy increases confidence among both borrowers and lenders – that is, as Main Street puts the Fed’s newly minted dollars to work.
As that proceeds, the Fed will need to drain liquidity to forestall rising inflation. As one of its past chairs remarked, it will have to withdraw the punch bowl before the party gets out of hand.
Historically, the Fed accomplished this by adjusting interest rates. But in the past, the Fed’s balance sheet was smaller and consisted mostly of Treasuries. No longer.
Now, its printing-press-financed assets are literally “money in the bank.” Much of it is concentrated in credit channels – residential mortgages and asset-backed paper (i.e., commercial mortgages) – whose already weak fundamentals make them especially vulnerable to the Fed’s policy shifts.
In outlining its exit strategy, the Fed expresses confidence that its new and enhanced tools will enable it to deal with these challenges. It also notes the benefits of giving markets advance notice -- of telegraphing its moves.
As the past three years have demonstrated, however, reality is full of surprises.
The Fed acknowledges this, hence its strategy of informed improvisation.
To that end, the minutes of the Fed’s January meeting report that its “members emphasized that they were prepared to modify [their] plans if necessary to support financial stability and economic growth.”
That’s Fed-speak for: “If we feel a draft as the tide recedes, we’ll don a swimsuit.”
Let’s hope it covers their assets.
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The statements, opinions, and conclusions contained herein are based solely upon the author’s own studies, research, and personal experience. Neither J.H. Cohn LLP nor the author makes any representation or warranty as to the accuracy or completeness of this information. J.H. Cohn LLP and the author expressly disclaim any liability for any loss or damage which may be incurred, of any kind whatsoever, as a result of or arising from the use of any of the information contained herein or reliance on the accuracy or completeness of it.