Fed Action

Yesterday was the first day since I started at GNA in July that I have not written a daily note. I didn’t get around to it in the morning, felt ropey in the afternoon, and was distracted by Ben Bernanke’s press conference in the evening. When that finished at about 8.30, I had forgotten all about the note!

There was a lot of interesting stuff in the FOMC statement and in Ben Bernanke’s press conference. In no particular order:

  • The period in which rates are expected to remain at exceptionally low levels was increased. Previously it was up to mid 2013; now it is up to late 2014. Note that this is not a commitment, merely an expectation.
  • The Fed has introduced an inflation target: 2% in the personal consumption expenditure price index (i.e. not CPI — BB said the reason for this was that the CPI had too large an imputed (“made up”) housing element, and did not include enough healthcare costs). This is a success for BB, who has long favoured an explicit target.
  • The median estimate for the natural rate of unemployment is around 5.5%.
  • BB went out of his way to emphasise that the Fed sees its dual mandate as symmetrical — i.e. that it is equally concerned with inflation and unemployment. At present, both are forecasted to be weaker than the Fed would like; if one were strong and the other weak, the Fed might take a softer line than usual on the strong one in order to support the weak one.
  • For the first time, the projections of individual FOMC members for when interest rates would rise were presented (anonymously). Despite some niggles from journalists, these were broadly consistent with the late-2014 language. Although BB said that these were projections for rates, it is not entirely clear to me whether participants will have given the rate they would like to see at each point given their own economic projections, or the rate they predicted that the committee would choose given their own economic projections.

The obvious question to ask is: if FOMC participants expect inflation to undershoot and unemployment to overshoot, why are they not already doing QE3? Tim Duy answers this question by observing that the previous Fed minutes suggested that the Fed was proceeding in stages towards further easing. The first stage was improved communication, which has now happened. QE3 might now follow as a second stage. This would be consistent with BB trying to give himself political cover for another round of QE by explaining how further easing fits with the analysis of the FOMC members. It would also explain why the Fed has tried other, lesser, easing measures including specifying and then extending the period during which rates will remain low and conducting Operation Twist: the Fed felt unable to embark upon QE3 without improved communications, but saw the need for further monetary stimulus. However, it is also possible that the Fed believes its ability to affect the unemployment rate is sufficiently limited that costs of further QE would outweigh the benefits as long as unemployment continues to fall at its present rate. The former interpretation suggests that QE3 is imminent; the latter that QE3 will come only if the rate of improvement in the economy slows down. I tend to favour the former interpretation.

What does all this mean for the condition of monetary policy? Having been disappointed by Operation Twist, markets appear to have accepted the extension of the period of low interest rates as an easing of policy, with gold, equities and Treasuries all rallying on the news. Breakeven inflation has jumped, which I take as a sign both that the Fed has eased, and that the market has taken seriously BB’s assertion that the committee places equal weight on the inflation and unemployment parts of its mandate. Further, since markets expected the future rate forecasts to show low rates beyond the middle of 2013, and since expectations are a key part of the transmission mechanism for monetary policy at present, it is quite arguable that the Fed actually eased policy a month ago, when it announced that the forecasts would be published. The idea that the Fed has loosened policy somewhat in the past month is consistent with the smooth upward pull of US equities since late December. The bar for QE3 has been lowered and the measure will probably come in Q1, provided that the economy does not strengthen substantially; if I am wrong about my choice of interpretation above, then QE3 will come only if the pace of economic improvement slows from its present trajectory, something that is quite likely considering the global slowdown that is presently in progress. In a way it does not matter which it is: the expectation that QE will kick in as soon as things deteriorate should be almost as strong a support for risk assets as QE itself; thus I think that there is a good argument for buying those risk assets that will benefit from monetary easing in the US, including US equities and high-yielding currencies. Of course, I am very demanding when it comes to entry points, and it is by no means certain that one will present itself; but I still have a long position in gold, which should benefit from a risk rally and from declining real rates (on account of falling nominal yields and rising inflation expectations).

European Credit Crunch

Via FT Alphaville, I read that the economist Richard Koo expects the requirement that European banks raise their capital over the coming months to create a credit crunch in Europe. He cites a historical parallel: Japan in 1997. Apparently Japan did not have a credit crunch until that year, despite the bubble having burst in 1990. The cause was the announcement by the Ministry of Finance that banks would be required to meet new international capital rules. The reason for this problem, then and now, is that banks have few sources of capital during a crisis: if the government does not inject capital, banks have to raise their capital ratios by selling assets and reducing liabilities. Koo compares the European action to telling an overweight patient with pneumonia to take more exercise and go on a diet — that may be good advice in the long term, but it will make the immediate problem worse.

Mario Draghi has said that the EBA bank capital exercise would probably not be undertaken again, knowing what we know now, although he diplomatically avoided saying that it was a mistake. Also, Merkel and Sarkozy are attempting to water down various provisions of Basel III in a craven attempt to help their own banks in the short term (for example, buy allowing banks to count the same capital towards both their banking and insurance operations, something that would be especially helpful to the large French banks). However, I think that the main problem remains: deleveraging by European banks is likely to create a credit crunch.

Ongoing Greek Fiasco

It is becoming increasingly likely that Greek bondholders are going to face a compulsory write-down and that the ECB is going to have to take some kind of a hit on its own holdings (perhaps a write-down to cost). The IMF is the main driver of this change. The fund is insisting that action be taken to bring Greek debt to a “sustainable path” — which still means 120% of GDP by 2020 — before it will disburse more funds. Since the Europeans need the IMF (or at least, think they need it — the Germans could afford to pay, but won’t), the IMF calls the shots. I think that any idea of a long in Greek bonds has gone away. I have been having a look at Portuguese government bonds as a potential long, but the short-term bonds are not priced for default and it is those in which I would prefer to play.

Cost of ECB Funding

Also via FT Alphaville — which, incidentally, is an excellent site — analysis by Nomura points out that the cost to a bank of an ECB loan is not the ECB’s 1% interest rate, because the ECB applies a haircut to the collateral that it takes for its loans. I do not fully understand the maths, but the following should give the gist. Imagine that a bank borrows €70 from the ECB using as collateral a credit claim with a face value of €100 which is subject to a 30% haircut at the ECB. At the ECB’s 1% lending rate, this costs the bank €70 x 1% = €0.7. Say that the capital charge for holding the asset is 5%. This means that €30 + €5 = €35 has to be funded by means other than ECB borrowing. Assume that the bank’s blended cost of funding is also 5%; then the cost of funding the €35 is €35 x 5% = €1.75. In total, the bank has paid €1.75 + €0.7 = €2.45. Hence its cost of borrowing from the ECB is 2.45%, not 1%.


Richmond Fed manufacturing survey 12, b.e. and rose. The regional surveys released so far suggest an increase in the ISM above 55 this month.
Japan trade balance showed the widest monthly deficit on the chart I was looking at which went back to 2000, vs. expectations for a surplus. Dec. The Asian slowdown is looking very real.
Australian CPI 0% QOQ. Trimmed mean CPI 0.6% QOQ. Annual inflation slowed to 3.1%. The RBOA may consider that it has room for easing.
German Ifo business confidence expanded again.
Italian retail sales -0.3% d.e. Nov. Data this late really is useless.
UK prelim. GDP -0.2% QOQ d.e.
UK mortgage approvals still rising MOM but remain quite low, Dec.
Pending home sales -3.5% MOM d.e. Dec. This did not reverse the 10.4% and 7.3% increases of the previous two months.
New Zealand held interest rates at 2.5%.
Gfk German consumer confidence rose, b.e.

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Durable goods orders
Initial claims
New home sales
Japan CPI
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Japan retail sales
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