I am writing this in advance of Ben Bernanke making his presentation at Jackson Hole Wyoming today. It was a year ago almost to the day where the Fed Chairman announced the possible implimentation of QE2 – or a second round of quantitative easing. Is a third round of quantitative easing in the works? Let’s take a look at where things stand today relative to last year’s speech (full text here).
What Were the Perceived Risks Then
In his remarks, Chairman Bernanke noted several issues he saw as concerns and outlined four possible policy directions (3 recommended by the committee, one solution discussed from outside the committee). The two most notable concerns were people’s lack of confidence in the jobs market (and the household decisions people were making as a result), and small business owners difficulty in obtaining financing.
If these problems sound familiar to you today, that’s because a.) people still have no confidence in the jobs market, and b.) small businesses are still basically shut off from financing.
What Solutions Were Offered
The Fed Chairman discussed three possible FOMC options, two of which were ultimately used, one which was not. A fourth option was discussed but rejected outright as innappropriate.
QE2 – Second Round of Quantitative Easing
The first policy decision which you probably already know about, is Quantitative Easing. In this case, a second round of treasury bond and note purchases designed to keep demand for treasuries high and thus keep longer term rates low. To the extent that the policy goal was to maintain lower long-terms rates on Treasuries and mortgages, this has worked. Unfortunately, keeping long term rates low has not had the ultimate impact desired (job market expansion).
One concern raised by the Chairman in 2010 was the committee’s relative lack of experience in easing of this kind, and a lack of data on which to base expected outcomes. After $600 billion in further asset purchases I have to believe the FOMC has some data with which to work. One of the concerns in 2010 was related to the public’s “over-conservatism” in reaction to the downturn in the economy, housing, and job markets.
The public overshot the committee’s expectation in terms of their willingness to borrow and or spend. One blessing of that is that the balance sheets of households were improving at the time. That is still true in 2011. I believe one element of Chairman Bernanke’s speech today will address this – noting the continued deleveraging of balance sheets and unwillingness to take on risk – both in terms of banks and financial markets and households. In a nutshell (as we have been pointing out here at our economy blog posts) confidence of households and lenders is effectively zilch.
This lack of confidence comes from three areas: high commodities prices, high unemployment, and real estate market weakness. One of the committee’s weaknesses has been (by their own admission) a lack of experience with the potential impacts of their quantitative easing policy. They now know that by undertaking asset purchases as they have with QE2, they get a decent result at a long end of the yield curve but fail to control price inflation on highly volatile assets. Further one could argue that their QE2 program has created rampant speculation in those commodities (oil, gold, silver, grain, corn).
Is QE3 in the Works?
It remains to be seen what further policy options the Chairman suggests for 2011. One popular suggestion has been dubbed “Operation Twist” – whereby the Fed will further try to alter the yield curve to increase short term rates while keeping longer term rates low. This may have the effect of pulling resources out of speculative assets and back into deposit accounts, which would help shore up retail bank balance sheets. Improving retail bank balance sheets (in theory) would give those smaller institutions more confidence to offer small business loans that spur economic and jobs growth.
Second Policy Option – Extend Length of Communications
The second policy option discussed in 2010 was the ability of the FOMC to expand the length of communication for its policies. One impact of this would be to give lenders confidence that rates could be expected to remain at a certain level for a reasonable amount of time. One issue lenders have today (given the low rate environment) is the possibility of creating a loan portfolio with large quantities of long or medium terms loans at low rates only to suddenly see rates rise dramatically on their (short term) deposits. This is the exact kind of scenario that happened to many banks in the S&L crisis. Many banks had large portfolios of long term modest yield assets which were funded by short term deposits. This caught up those banks in what is called “duration risk” – having a mismatch of debts (high rate short term deposits) and assets (low rate long term loans).
The solution of course would be to communicate to potential Fed borrowers of the availability of short term low rate credit for an extended period… which the Fed Chairman did recently when he announced rates would be expected to be held at current low rates until 2013. We expect the Fed will continue to use their option of providing an “expanded forecast” in the future.
Policy Options 3 and 4: Decrease Excess Reserves Interest and Higher Inflation Target
Let me dismiss the 4th option outright. The FOMC made it clear in 2010 that they did not feel a higher inflation target was an appropriate solution. That will remain true today. Large scale purchasing power destruction is not in the best interests of anybody.
That leaves the 3rd policy option, lowering interest rates on excess reserves. This was effectively a non-starter last year given rates were so low then. Rates are already as historic lows and are likely to remain so, so it is uncertain as to why this policy decision from last year would change.
I’ll comment later below once the Chairman has said his piece. In the meantime, expect Operation Twist and further communication on a longer term rates forecast from the FOMC.