E-piphany

Preliminary: My column from yesterday didn’t get posted in some of the places it usually does. If you missed it, and if you care, you can find it here.

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Stocks probed lower again this morning, with the S&P bouncing again off the 1040 mark. I suggested before my vacation that the 1046-1070 range was the “indecision zone,” while below that level it would be obvious to all that further declines are in store. It is starting to look more like the narrower 1040-1046 range is the Maginot line that the bulls are defending and the bears seeking to overrun. The data were supportive at the margin, with Consumer Confidence actually rising – but that was only because the “expectations” component rose from 72.5 from 67.5. The “present situation” component, which is the one that is actually correlated with stuff, fell to 24.9 from 26.4, and the “Jobs Hard To Get” subindex (which is correlated with the Unemployment Rate) rose to 45.7, the highest level since March although the chart below makes it plain that this is better considered to be a range trade itself.

Well, jobs ARE hard to get, after all

The long end of the yield curve was well-bid out of the gate, and the curve flattened with the 10y yield falling to 2.48%.

Neither stocks nor bonds responded meaningfully to the release of the Fed minutes, which said approximately what we all thought they would. “Many Fed officials” said the downside risks to the recovery had increased, and “several members” said the Fed should plan for more easing if needed. “Some FOMC Members” said that “waning fiscal stimulus may impede the recovery.”

It is clear from these small excerpts, although it was not so clear from Bernanke’s speech last week, that the FOMC basically “gets it” that the economy is slipping. I don’t think they get the extent of how badly it is slipping, but perhaps in the last couple of weeks they have (remember, these minutes are from early August).

This tends to mesh with my evolving view of how the Fed is likely to act (I referred to this evolution in my view in my comment yesterday), and when it is likely to begin to act, to support the economy. Until recently, I have held that since Congress is going to be hamstrung by politics and an empty purse from turning aside the tax increases that will slow growth in a very predictable way early next year, the Fed would employ QEII late this year by purchasing Treasuries rather than mortgages. I still think the most-likely meeting at which to expect some definitive move in this direction is the November 3^rd meeting, which happens to be the day after the election and so absolves the Fed from appearing to act politically (and also gives them a chance to see if the results of the election makes further fiscal stimulus more likely by, for example, letting most of the bums stay in office). But I also think the Committee may act sooner, perhaps as soon as the September 21^st meeting, because the economy seems to be deteriorating fairly quickly (an inter-meeting move the following month is also possible, but unlikely as it would smack of a political “October surprise”).

However, on careful reflection I think that outright Treasury purchases are not necessarily the first order from the FOMC. I think it makes much more sense, and is more opaque, for the Committee to lower the Interest On Excess Reserves (IOER) that the Fed currently pays banks for their excess reserves, not just to zero but to a negative number. That is, the Fed may effectively tax banks for holding excess reserves.

When the Fed pumped liquidity into the system in 2008-09, much of the liquidity ended up in excess reserves rather than being lent. We all know that, and much ink has been spilled analyzing the fact. This lack of transmission from narrow money to broad money is the reason that inflation didn’t respond, and moreover the reason that the stimulus mostly helped banks and not so much anyone else. Bank lending has been falling, and has continued to fall (see Chart), as excess reserves have remained very large. Banks are not lending because the expected return to lending is negative due to a high default rate and what is perceived as a high opportunity cost if inflation rises so that the bank is forced to fund low-rate loans with high-rate short-term money.

Bank credit is still contracting, albeit more slowly.

Much of the analysis over the last year has been done on the question of “what will happen to inflation if the excess reserves are lent out?” and the related question of how the Fed can prevent that. This is one reason the Fed is paying IOER: to stop the money from turning into an inflationary pulse. But that is no longer the dominant concern! And thus, if the Fed is going to pursue more quantitative easing, the first thing that ought to be done is to release the first quantitative easing. They can do this by making the IOER, currently 0.25%, significantly negative (say, -1.0%). What happens then? Even though the bank expects loans to have negative expected return, they now are relatively more attractive than losing a certain 1% by holding excess reserves.

(Incidentally, notice that the bank can’t meaningfully do the same thing to your savings account, because you always have the option to hold your money in cash. The bank can’t do that. The excess reserves are electronic journal entries, not currency, so the Fed can merely mark the value of the reserves down a little bit every day to effect a negative rate).

So why would the Fed do this? Notice the effect: instead of sitting in balances at the Fed, the reserves will be spent on Tbills, Treasuries, other securities, or loans. If the money is lent out, even (or especially!) at negative real yields, then you have your quantitative stimulus. If the banks buy Treasuries, then it is either the equivalent of the Fed buying those same Treasuries from the Treasury itself (that is, monetization – consider it delayed monetization since it is with the proceeds of the easing of 2008-09) if banks are buying those securities at auction, or banks are putting the money into the hands of former owners of Tbills or Treasuries, and those former owners may in turn buy stocks, or commodities, or spend it.

Any way you slice it, that is, a negative IOER will reduce the huge excess reserves pile and put those excess reserves into circulation. I suspect a zero IOER and then negative IOER is likely to precede the actual direct purchase of bonds by the Fed (which is more obviously monetization of the debt but not much different, really).

Now, Bernanke seemed to cool this possibility in his speech last week, but I think he left a door open. Here is the relevant passage:

A third option for further monetary policy easing is to lower the rate of interest that the Fed pays banks on the reserves they hold with the Federal Reserve System…The IOER rate, currently set at 25 basis points, could be reduced to, say, 10 basis points or even to zero. On the margin, a reduction in the IOER rate would provide banks with an incentive to increase their lending to nonfinancial borrowers or to participants in short-term money markets, reducing short-term interest rates further and possibly leading to some expansion in money and credit aggregates. However, under current circumstances, the effect of reducing the IOER rate on financial conditions in isolation would likely be relatively small. The federal funds rate is currently averaging between 15 and 20 basis points and would almost certainly remain positive after the reduction in the IOER rate. Cutting the IOER rate even to zero would be unlikely therefore to reduce the federal funds rate by more than 10 to 15 basis points…Moreover, such an action could disrupt some key financial markets and institutions. Importantly for the Fed’s purposes, a further reduction in very short-term interest rates could lead short-term money markets such as the federal funds market to become much less liquid, as near-zero returns might induce many participants and market-makers to exit. In normal times the Fed relies heavily on a well-functioning federal funds market to implement monetary policy, so we would want to be careful not to do permanent damage to that market.

It isn’t clear to me why the Federal funds market would function less well if rates were negative. If I am going to lose 1% if I hold excess reserves at the Fed, my market is -1.01% at -0.99%. Money market funds would have issues, but so what? We’re eliminating liquidity in the rest of the market by prohibiting proprietary risk-taking at dealers (JP Morgan today announced the closure of its commodity prop trading desk, and is reportedly planning to close all prop desks – which isn’t surprising, since this activity is basically prohibited under the Volcker rule. It isn’t clear whether this is near-term good or bad for the equity, since it will lower earnings but presumably raise the multiple, but it is certainly bad for market liquidity).

Moreover, in a later part of the speech the Chairman says, apparently off-handedly, “It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.” For example, if I may be so bold, the policy tool of negative IOER.

Money market funds might have negative yields. Banks cannot make deposit rates negative because then people would just pull cash from banks, and some money funds might similarly just pile up currency in a vault and yield zero (sort of like GLD), but most money funds will buy negative-yielding short Treasury debt. Retail accounts will take their money in currency, and the industry will shrink.

I don’t see why this is a big problem. If deflation really is a problem, then even negative yields can be positive real yields. Who cares about the nominal yield, anyway? That’s money illusion in action. And anyway, this is unlikely to be a long-term problem, since the whole point is to create inflation and this will bring higher rates.

So, in short, I think it makes lots more sense for the Fed to start with dramatic action on IOER than to increase the size of its balance sheet by buying Treasuries and creating more sterile excess reserves. Merely announce that IOER is going to be negative and people will connect the dots rather quickly, I predict.

That connection of the dots will ultimately lead to higher interest rates, either in anticipation of the inflation that would follow successful monetary stimulus or in response to it. And I think that’s where the next big let of the equity bear market comes: not when the growth outlook gets worse, as it is doing (although that will set prices back somewhat), but rather when the inflation outlook worsens due to the Fed’s activities. This may be a stair step lower, but the way you get equity prices lower is in response to an increase in investors’ long-term required returns…and the most-likely way those required returns will increase is if inflation expectations rise appreciably. That isn’t today’s trade, which is all about slower growth, a (misguided) fear of deflation, negative real returns on capital, and a conditioned reflexive response to “do something” in response to further recession. These are not equity-positive events, although they are bond-positive events. But the Big Trade is when both stocks and bonds decline as inflation expectations rise.

I’ll talk tomorrow about how I would position for that possibility.

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