Archive for November 2008
From The Economist print edition
As their economy slides, America’s policymakers are turning to unconventional devices. Our first article looks at the bold new steps taken this week by the Federal Reserve and the Treasury. Our second examines policy in Europe
THE Federal Reserve’s interest-rate target is at 1%. The recession is deepening. And the question is being asked repeatedly: when will America’s economic policymakers start using truly unconventional measures to stimulate the economy?
The answer is that they already have. Without making any formal declaration, since early September the Fed has expanded its balance-sheet rapidly to counter the credit crunch. Under the guise of successive new programmes, each with a less memorable acronym than the last, the Fed is substituting its balance-sheet for that of the contracting private financial system to keep the American economy from being starved of credit. This week the central bank and the Treasury unveiled their latest big initiatives.
America’s financial system is undergoing a radical reassessment of what are acceptable levels of capital, leverage and interest rates. Some institutions have failed; those that have not are intent on reducing their leverage (ie, their volume of loans for each dollar of capital). The Fed has no hope of stopping this: it is merely trying to slow it down, by providing a home for the assets that the financial sector is shedding. The alternative would be plunging asset values, a complete withdrawal of credit and economic catastrophe.
Ben Bernanke, the chairman of the Fed, has repeatedly promised to use “all of the powers at our disposal” to get credit flowing again. This week’s initiatives are another demonstration of what he means. The Fed and the Treasury agreed to guarantee $306 billion-worth of assets belonging to Citigroup (see article). They then created a $200 billion facility to purchase asset-backed securities. Most radically, the Fed promised to buy up to $500 billion-worth of mortgage-backed securities (MBSs) guaranteed by government-sponsored enterprises (GSEs), including the now nationalised mortgage agencies, Fannie Mae and Freddie Mac, and up to $100 billion-worth of their direct debt. The effect was immediate: yields on the securities plunged by 40 basis points, and the 30-year mortgage rate fell from a shade over 6% to 5.8%.
The MBS purchases are significant; for the first time they turn the Fed into a direct lender to consumers. Many homeowners, though they do not know it, will be sending their monthly mortgage payments to the Fed. The Fed will finance these programmes with newly created reserves: that is, it will print money. Its balance-sheet, which has ballooned from $900 billion to $2.2 trillion since August, could grow by another $800 billion, making it a larger lender than any commercial bank.
It is tempting to look to Japan for a map of where the Fed may be heading next. Faced with sinking asset prices, insolvent banks, moribund growth and deflation, the Bank of Japan (BoJ) eventually lowered its policy rate to zero in 1999. In 2001 it announced “quantitative easing”: through large-scale purchases of government bonds, it would fill the banks with excess reserves that it hoped they would lend out, stimulating loan growth.
These routes are open to the Fed. It could cut its federal funds rate target from 1% to zero, though that would make it hard for some parts of the money market to function. It may not do much good, since the actual funds rate is already trading well below the target. To give it more impact, the Fed could commit itself to keeping the funds rate at zero for some time or until the economy or inflation meet some predetermined conditions. Such a commitment could drag down long-term Treasury-bond yields. Academics have concluded that Japan’s quantitative easing had little benefit except to buttress expectations that its policy rate would be zero for a long time. Alternatively, the Fed could target long-term rates via purchases of Treasuries, as it did from 1942 to 1951. That strategy could gain in appeal if big government deficits start to press bond yields higher.
Yet these options are not the most appealing for the Fed. The reason is that while it, like the BoJ, is now involved in a form of quantitative easing, it is doing so with completely different goals and in a very different environment.
One way to see this is to compare Japan in April 1995, when the BoJ’s policy rate was 1%, with America in October (see chart 1). Core inflation was slightly negative in Japan at the time, against 2.2% in America last month. That means real interest rates were significantly higher and conventional monetary policy less stimulative in Japan than in America today, says Tom Gallagher of ISI Group, a broker-dealer, who made the comparison.
Where America fares worse is in credit conditions. In 1995 Japanese corporate-bond yields were just 16 basis points higher than government-bond yields; the spread in America last month was 350 basis points. In a nutshell, Japan’s problem was deflation and moribund investment; America’s is rising fear of default, illiquidity and the need of so many lenders to reduce leverage, which collectively are choking off private credit and blunting conventional monetary policy. Although the federal funds rate target is far below the 5.25% of last summer, mortgage rates are only a little lower (see chart 2). Corporate borrowing rates are much higher.
The change in the perception of credit risk since the crisis began is similar to the change in the perception of terrorism risk after September 11th 2001. What investors once deemed safe levels of capital and liquidity they now consider dangerously thin. Before, banks “had just-in-time capital available, just-in-time funding…a lot of liquidity,” Vikram Pandit, Citigroup’s chief executive, said this week, “We’ve gone from that to, if you really need sizeable funding, you have got to go to a central bank. If you need to raise a lot of debt, you need an FDIC guarantee.” (The FDIC, or Federal Deposit Insurance Corporation, is a bank regulator.) Citi’s assets, which peaked at $2.4 trillion a year ago, were down to a little over $2 trillion by the end of September. With the Treasury’s injection of equity this past week, Citigroup’s core capital is now almost 15% of total assets, once an astronomically high ratio but one that many banks will now be expected to attain.
The pressure on investment banks to reduce leverage is even greater, because they rely more on fickle wholesale funding and less on stable, federally insured deposits. As a firm that depended heavily on proprietary trading and underwriting, Morgan Stanley boasted $33 of assets for each dollar of capital a year ago. By the end of October, the leverage ratio was below 16, according to the company. To get it there it both raised new capital (from sources including the federal government) and shrank its balance-sheet, to “significantly less” than $800 billion by the end of October from more than $1 trillion in May. “Clearly we’re in a world of reduced leverage,” Colm Kelleher, the firm’s chief financial officer, told investors recently.
The deleveraging of firms like Morgan Stanley and Citigroup creates problems for borrowers throughout the economy because the yields on the assets they sell rise. Borrowers must fight for a shrinking supply of new credit. Those that get it must pay far more. The rest cancel investments, lay off employees and hoard cash.
Initially Mr Bernanke sought to ease the pressure to deleverage by offering to finance banks’ holdings of illiquid securities on easy terms. But investors began to question the ability of bank capital to withstand a wave of recession-related defaults. The Treasury’s Troubled Asset Relief Programme (TARP) aims to quell those fears by injecting equity into banks so that they can reduce their leverage without shrinking their balance-sheets.
However, there are limits even to this. The Treasury has stuck to purchasing preferred equity to minimise the risk of loss and avoid having any say in running the bank. But the high interest rate the Treasury receives on such stock reduces banks’ profits. And rating agencies and regulators consider preferred stock a less permanent and therefore inferior form of capital to common equity.
Simon Johnson, an economist at the Massachusetts Institute of Technology, thinks the Treasury should start purchasing common equity instead, as the British government has done. With banks’ market values so low, that would leave the government with large stakes, and perhaps majority ownership of some banks. Mr Johnson suggests creating an arm’s length control board to oversee the government’s ownership, free of political meddling.
Still, helping banks recapitalise only partly mitigates deleveraging. Many large buyers of debt assets have simply disappeared, such as “structured investment vehicles”, or SIVs, that used short-term financing to buy up asset backed securities, often from banks seeking to free up capital. At one point they held up to $400 billion in assets. But, unable to roll over their funding, they have been either reabsorbed by banks or closed. In October one of the last big SIVs, Sigma Finance Corporation, with $27 billion in assets, collapsed. Its liquidation by creditors is thought to have contributed to the plunge in prices of asset-backed securities which has made it impossible for new securities backed by student, credit-card and car loans to be issued.
When the average person hears the term “asset-backed securities” he may well think of some of the crazier structures built on the rickety base of subprime mortgages. That would be wrong. Securitisation is decades old, mundane and vital. Banks and other lenders routinely pool their student, car, small-business and credit-card loans, and residential and commercial mortgages into securities and sell them to investors, leaving room for them to make new loans. The deleveraging of banks may be inevitable and healthy, but the disappearance of the securitisation market is not. Without it, “millions of Americans cannot find affordable financing for their basic credit needs,” Hank Paulson, the treasury secretary, said on November 25th. The facility he and the Fed unveiled that day will buy up to $200 billion of newly issued, top-rated asset-backed securities. The TARP will absorb the first $20 billion of losses; the Fed will lend the rest. It may eventually purchase commercial and residential MBSs that are not guaranteed by a GSE.
The facility may thus eventually do what TARP was meant to: relieve banks of their illiquid assets. But it does so by in effect leveraging each TARP dollar many times over via the Fed’s balance-sheet. “Policymakers seem to have concluded that leverage got us into this mess and leverage can get us out,” quipped Stephen Stanley, an economist at RBS Greenwich Capital. “Is it just me, or can you see a future for these guys running a hedge fund?”
The Fed’s decision to purchase MBSs is in some ways even more radical: it represents a direct foray by the Fed into lending to consumers: Though it has had the authority to buy the MBSs and debt of Fannie Mae or Freddie Mac since 1966, it has not done so since 1997 for fear of conferring government backing to ostensibly private companies. Those concerns disappeared when the Treasury in effect nationalised the companies in September.
The Treasury and the agencies themselves had been buying MBSs but in spite of that the yields continued to rise, in part because of the government’s mixed signals on whether it stood behind the companies. The Fed’s announcement carries clout because of the size. There is no reason why the Fed need stop at $500 billion; between them, Fannie and Freddie have $4 trillion of MBS outstanding and $17 billion of their own debt. In going further, the Fed would in effect take over the roles of the mortgage agencies itself. And in theory, it could find creative ways to do the same for the corporate-bond market. Mr Bernanke is willing to try almost anything.
Yet these strategies do carry risks. One is inflation. Having expanded its balance-sheet so rapidly, the Fed may not have the foresight or courage to shrink it fast enough once the crisis passes, and the extra liquidity could fuel an overheating economy. But with unemployment perhaps heading for 9%, from 6.5% now, that risk seems remote.
Another risk is that the Fed and the Treasury have taken on more commitments than they can credibly keep. With budget deficits that could top $1 trillion a year, plus trillions of dollars more in guarantees to mortgages and bank debt, some investors may question America’s ability to shoulder all this debt. They could react by selling the dollar, although with the entire world in recession, the lack of appealing alternatives makes that less plausible.
More likely, they could just back away from Treasury bonds until the yields rise enough to compensate them for the higher risk of default. Ireland represents a cautionary tale: since it guaranteed the debts of its banking system, credit-default swaps have widened sharply on its sovereign debt, implying rising concern that the Irish government may one day default. America is a much bigger country and its currency happens to be the world’s premier reserve currency. So it can print as much as it likes. For now, anyway.
With rates down to 1%, the Fed may next try more unconventional steps
AFTER the most eventful and creative six weeks in the history of central banking, a half-point interest rate cut by the Federal Reserve on Wednesday October 29th was almost anti-climactic. Nonetheless, it was an important strike at the deepening recessionary forces surrounding the American economy, and the Fed made it more significant by jettisoning concerns about inflation from the statement accompanying its action.
The Fed also announced new dollar swap lines with four big emerging-market central banks to help them cope with shortages of dollars that are roiling their financial markets. It is a sign of how the locus of the crisis has shifted from developed to emerging markets, requiring a corresponding shift in policy. The swaps will complement a new $100 billion liquidity facility announced by the International Monetary Fund that countries in solid macroeconomic shape can access without the usual conditionality.
Within America the financial crisis is showing signs of easing, but the economic crisis is only just starting, as the Fed broadly acknowledged. “The pace of economic activity appears to have slowed markedly,” the Federal Open Market Committee, the central bank’s policy panel, said in lowering the target on the federal funds rate to 1% from 1.5%. “Moreover, the intensification of financial market turmoil is likely to exert additional restraint.”
The Fed noted both the staggering scale of the recent policy stimulus—it called its own lending initiatives “extraordinary”—and implied that more is probably on the way by saying that: “Downside risks to growth remain.” That simple sentence was made more striking because it was no longer coupled with a reference to the risk of inflation.
Inflation concerns have lingered over the Fed’s actions since the crisis began in August of last year and at times held it back from even more aggressive action. Its concerns were understandable as long as commodity costs were soaring and in the face of a lower dollar. But commodities have dramatically reversed course and the dollar has rebounded. The new optimism on inflation is due not just to falling energy costs—petrol in America is now $2.66 a gallon, compared with $4.11 in mid-July—but to a weakening economy that some economists think could eventually push unemployment over 8%, up from 6.1% in September. The Fed now expects inflation to fall “in coming quarters to levels consistent with price stability.” In practical terms, that means to between 1.5% and 2%. In August inflation was 4.5% (using the price index of personal consumption), or 2.2% excluding food and energy.
A federal funds rate target of 1% is freighted with symbolism. The Fed’s decision to lower the rate to that level and hold it there in 2003-04 has been regularly blamed for inflating the credit bubble that led to the current crisis. Policymakers did not appear to worry about the similarities: the vote in favour was unanimous. Appropriately so. The crisis may have been brought on by too much risk taking, but animal spirits have since swung dangerously far in the opposite direction. Spreads between the federal funds rate and other short-term rates are astronomically wide, reflecting both the lack of lending capacity by banks whose capital is under pressure, and rising probability of default by borrowers which naturally leads to wider spreads. While a lower federal funds rate will not narrow that spread, it will reduce the actual level of short-term rates and should help at the margin.
How much lower can the federal funds rate go? Certainly at least to 0.5%, a level it has not been close to since the 1950s. But beyond that, things get tricky. Ordinarily, the Fed can keep the federal funds rate on target by adding or draining reserves from banks. But its liquidity operations have left banks with billions of excess reserves to lend out, forcing the federal funds rate well below target on most days. The Fed now pays interest on reserve deposits at 35 basis points below the federal funds rate target. So banks will leave reserves at the Fed once the market rate on federal funds falls to that deposit rate, which is the new de facto target. So that means if the Fed wants to maintain a 35 basis point spread between what it pays on reserves and the federal funds target rate, it might be hard to get the funds rate target much below 0.5%.
Even if the Fed did target zero, it might encourage banks just to leave their money at the Fed rather than lend it to each other, causing the federal funds market to dry up. It would also make it hard for money market mutual funds to pay a competitive yield and cover their operating expenses. Money would flow out of them and into government-guaranteed bank deposits, straining bank capital ratios.
For these reasons, before pushing its rate to zero, the Fed might want to consider variants of “quantitative easing”. This means expanding its balance sheet through the purchase of either government bonds or increased loans to the private sector. It has already in effect taken this route through its many liquidity programmes and swap lines with central banks, which have doubled its balance sheet to $1.8 trillion. But it could go much further.
On Wednesday it announced another such step: the creation of new swap lines with Mexico, Brazil, Korea and Singapore of $30 billion each to enable those countries to provide dollar liquidity to their banks. It is unusual though not unprecedented for the Fed to make such arrangements outside of the rich world economies.
Bold as its actions have been, the Fed cannot battle the recession alone. It needs fiscal policy as well, both to recapitalise lenders through the Troubled Asset Relief Programme–both banks and nonbanks, such as insurers—and to stimulate spending directly through increased public spending or tax cuts.
|Copyright © 2008 The Economist Newspaper and The Economist Group. All rights reserved.
America and Europe appear to be heading for severe recessions
AS RECENTLY as a month ago, there were still hopes that America and Europe might just pull back from the precipice of a recession. Those hopes have been dashed. The economies of the rich world seem to have fallen off a cliff. The question now is the height of the drop.
|The wheels come off|
Central banks are trying to cushion the fall. On October 29th the Federal Reserve lowered its target for the federal funds rate to 1%, matching the trough it reached in 2003. It may cut again. With remarkable speed, worries have shifted from inflation, which is still around 5%, to deflation. Fed officials still think that, if even pessimistic forecasts came to pass, inflation would not fall below zero. But Macroeconomic Advisers, a forecaster, now reckons that core inflation will fall to 1.3% by 2010, too close to zero for the Fed’s comfort. They expect the Fed to cut the federal funds rate to 0.5% in December and then, with scant room for more cuts, that it may try to stimulate growth using unconventional measures such as further expanding its lending facilities to banks and other firms.
The rate cut was needed. America’s economic data have become starkly weaker since the bankruptcy of Lehman Brothers in mid-September. The latest GDP numbers, released on October 30th, showed that output fell by an annualised 0.3% in the third quarter. Surveys of manufacturing activity have shifted down. Weekly initial claims for unemployment benefits have shot up. A monthly index of consumer attitudes compiled by the Conference Board, a research group, plummeted to a record low of 38 in October, down from 61.4 in September.
Confidence surveys are unreliable predictors of consumer spending. But the destruction of wealth through falling stockmarkets and tightening credit conditions are already having an effect. On a seasonally adjusted basis, light-vehicle sales in September were the lowest since 1992, according to Autodata Corp, a research firm. On October 28th Whirlpool, an appliance maker, gave warning that low home sales would cut revenue and Royal Caribbean Cruises, a cruise operator, lowered profit estimates because of “a significant deterioration recently in new bookings”.
A similar downward lurch is under way in Europe, where the European Central Bank seems poised to cut interest rates for the second time this autumn on November 6th. The Munich Ifo Institute’s index, which measures the mood of German businesses, sank to its lowest level for more than five years in October. Volvo wins the prize for statistic of the crunch to date. The Swedish firm said it had received a mere 115 orders for heavy trucks in Europe in the third quarter, down by 99.7% on the 41,970 order bookings during the same period of 2007.
America and Europe cannot count on exports to make up for faltering domestic demand, because the crisis has spread to emerging markets. Airbus and Boeing, for example, had counted on orders of 300 aircraft from India in the next five years to help offset slower demand in Europe and America. Some of those are in jeopardy. Jet Airways, India’s largest domestic carrier, announced its biggest quarterly loss in more than three years on October 25th.
Economists disagree about how bad it will get. Dean Maki of Barclays Capital says that falling wealth tends to affect consumer spending over many years rather than right away. It is just the opposite with changes in real income because of petrol prices. Consumer spending could conceivably be lifted by the sharp drop in oil prices that has unfolded since July, which Macroeconomic Advisers estimates to be worth more than $100 billion on an annualised basis. Mr Maki notes that consumer confidence plunged after the September 11th terrorist attacks but that Fed rate cuts enabled interest-free loans which dramatically boosted car sales. Another small positive sign is that home sales rose slightly in September and that house prices have actually risen in a few cities.
These glimmers may be snuffed out by the unprecedented tightening in credit now under way. According to Ed McKelvey of Goldman Sachs, the only comparable modern precedent is the federal government’s short-lived imposition of credit controls in early 1980, which produced a dramatic downturn in American consumer spending. That episode ended when controls were removed. Today, credit restraint chiefly depends on how long it takes the private sector to respond to policy actions such as the Fed’s commercial-paper purchases and the widespread recapitalisation of weakened banks. “Government is working as hard as it can, but in the end it’s the private sector that does the lending,” he says.
From The Economist print edition