Over the coming months, the Fed will broaden its policy initiatives and widen the range of markets it actively targets.
After the recent Fed FOMC meeting, there is now no doubt that the Fed has embarked upon a path of Quantitative Easing (QE). QE is when the Fed stops focusing on an interest rate target and directs its efforts towards providing a higher level of reserves in the banking system. Reserves make up part of the monetary base and, through the money multiplier, translate into money supply growth.
This move to QE is another manifestation of the willingness of the Fed to do whatever it can to combat this economic crisis. The speed and breadth of policy response on the part of the Fed has been unprecedented. Coupled with this we also have a huge Obama stimulus package, rumoured to be in excess of one trillion dollars, about to be unveiled.
Notwithstanding this policy response, most investors seem unconvinced that policymakers will be able to stimulate us out of this deep economic hole.
Most investors point to the fact that the crisis is already 18 months old and despite continued policy interventions, things have only progressively gotten worse. While true, investors have forgotten that the real heavy lifting on the policy front has only just begun over the last couple of months. It is only from October onwards that we have seen government-funded bank recapitalizations, government guarantees for bank refinancing and the removal of counterparty risk issues. It is also only in the last month that various Fed programs to buy non-government paper have started to get operationalized.
A similar situation also prevails in the UK and eurozone. There has been a lot of talk of bailing out the financial system, but concrete action is a relatively recent phenomenon. Even on fiscal policy, we have seen announcements, but the money has not been spent.
Any actions taken today will have a normal lag of at least 9-12 months, before the full economic benefits are visible.
The perception on the part of most investors that fiscal and monetary stimuli have already been tried and failed is, therefore, incorrect. The real economic impact of all the policy measures is still in the pipeline and yet to be felt. It is premature to declare policy measures as ineffective.
Beyond the point of there being lags, investors also seem to be underestimating the breadth and scale of the policy response. While Obama’s stimulus package keeps rising with the latest count being at a trillion dollars, even at the Fed, policy is not static.
The Fed’s balance sheet has already increased from $800 billion to $2.2 trillion, with the majority of the increase coming post the collapse of Lehman. There really is no limit to the potential size of the Fed’s balance sheet, as with its ability to print money and create reserves it can buy as many assets as needed to get the job done. Between 1998 and 2005, the Bank of Japan’s balance sheet increased from 10 per cent to 30 per cent of GDP as it implemented its version of QE. While the Fed’s balance sheet has exploded from 6 per cent of GDP in August to 15 per cent in November, clearly it can do more.
Two critical constraints that may have hampered the Fed being more aggressive in normal times are currently non-operative.
In normal times there are severe constraints on undertaking the type of monetary expansion proposed and already implemented by the Fed. This constraint is the fear of stoking inflationary expectations and, therefore, suffering a rise in bond yields which would short-circuit the stimulative effects of monetary easing. But today, deflationary expectations are so overwhelming (with TIPS yields implying market expectations of near zero inflation over the next 10 years) that the Fed can ramp its balance sheet, with limited adverse consequences in the bond markets.
The other potential constraint on the Fed would be a collapse in the dollar. In normal times, one would have expected a dollar rout as the Fed kept stimulating. However, over the next few months, one should expect every other major economy to follow a similar policy prescription of zero interest rates and quantitative monetary expansion. This is already the case in Japan and Switzerland and will surely become so within months in the UK. The only major currency left will be the euro, implying that any dollar flight will have to be into euros. Given the current economic and political difficulties in the euro bloc, can we really expect investors to rush into this currency? What will a sustained euro appreciation do to a eurozone already threatened by a potentially more intractable recession than the US ?
If the euro strengthened dramatically, it may force the ECB to go down the same route as the Fed.
Yes, the dollar may weaken somewhat and that will suit US policymakers but due to a lack of choice, we are unlikely to see a dollar collapse which could constrain policy action.
Over the coming months, therefore, we should see the Fed broaden its policy initiatives and widen the range of markets it actively targets. The Fed has already put in place programs to purchase commercial paper, mortgages and asset-backed securities. One should not be surprised if they soon start targeting corporate bonds as well.
The Fed is going around a dysfunctional and recapitalizing financial system and liquefying asset markets directly.
While investors remain sceptical, the fact is that policymakers are throwing everything they can at this crisis. The authorities have the ability to ratchet up the policy response with limited short-term constraints.
While we cannot be certain, the odds surely favour the authorities eventually succeeding.
As for India, the bulk of our policy response has to be on the monetary front. With limited fiscal flexibility, the RBI will have to figure out a way to force the banks to lend. We seem to have overcome the liquidity crisis but now have a confidence crisis amongst bankers which is constraining lending.
The US authorities are going around their dysfunctional financial system, through both direct intervention in asset markets and a strong fiscal response. We cannot do much on the fiscal but if banks continue to dither on lending, will the RBI consider intervening directly in asset markets to ensure the real economy is not starved of credit?
