Banking on money creation to heal UK financial system
Sunday, 08 March 2009 17:52
IT JUST DOESN’T pay to be a saver in the UK right now. With the Bank of England (BOE)’s historically low rate cut to 0.5% last Thursday, the sixth cut in a span of five months, yet another blow has been dealt to those relying on savings interest for income. Savings rates have more than halved since the central bank rate’s progressive decline from 5% before the first cut last October. The average UK easy access bank account rate of 0.9% may seem attractive to Singaporean savers, but it is a far cry from the highs of 3.5% seen last May. Cash ISA (individual savings account) rates have also fallen from a high of more than 6% during the heady pre-Icelandic bank collapse days; the prevailing best-buy rate is now 3%.
The latest interest rate cut has also paved the way for the implementation of quantitative easing (QE), which after months of speculation finally received the official green light from Chancellor Alistair Darling last Thursday. The Observer calls it the “nuclear” option in monetary policy terms, while The Times sees it as “the most forceful action yet” to tackle the economic recession. However one chooses to view it, there is no denying that QE — a yet unproven policy tool in the UK — will take the country into uncharted territory.
QE is popularly known as the printing of money but actually involves the creation of money supply through the purchase of assets. The Bank of Japan implemented it in the early 2000s to fight deflation, although its effectiveness remains questionable. The worsening state of the UK economy has called for such drastic measures, however, and with interest rates falling towards zero, the government has to seek alternative avenues to cut borrowing costs to stimulate the economy. As The Independent’s economic editor Sean O’ Grady puts it, it is all about getting money — spending power — into a demoralised economy.
The initial £75 billion ($165.3 billion) that the BOE will pump into the system is smaller than expected, but the Chancellor has given the bank permission to extend the amount up to £150 billion if necessary. The £75 billion will be used to purchase medium- and long-maturity conventional gilts in the secondary markets, and to part finance the previously announced £50 billion Asset Purchase Facility aimed at getting credit moving again through the purchase of corporate bonds. This demand for government and corporate bonds is expected to push up bond prices, which will in turn reduce yields and make corporate and public borrowing cheaper.
Speaking to The Daily Telegraph, Citigroup chief UK economist Michael Saunders believes that if done on a large-enough scale, QE is a powerful form of stimulus for the economy and is likely to ultimately stabilise the economy and buy time for the financial system to heal.
Still, managing QE can be a monumental task, given the complex decisions on how much money to create and what assets to buy. Vicky Redwood, consumer and debt specialist at research consultancy Capital Economics, was reported in The Independent as saying that the main practical difficulty with QE is knowing what to do and how much. Much depends on how vigorously the BOE embraces it; the main danger is doing too little, she adds.
QE also comes with other risks. The central bank could lose taxpayers’ money if corporate bonds default. Also, by entering the debt market, the government faces the longer-term threat of creating a bubble in the bond market, which could burst when the economy starts to improve again. This in turn will drive up interest rates, thus raising the cost of servicing the government’s staggering public debt, which, according to the latest official statistics, has hit £2 trillion with the banking bailout of the Royal Bank of Scotland and Lloyds.
By “creating” money, there is also the risk of a further weakening of the pound sterling and inflation; the policy needs to be monitored closely as increased money supply, coupled with falling production, could lead to demand outstripping supply and hyperinflation, ETX Capital senior trader Manoj Ladwa was reported as saying in the Financial Times. There is also the danger that, instead of achieving the objective of getting them to lend, banks may decide to hoard the additional money in their reserves, which is apparently what happened in Japan.
For QE to work, timing is crucial. Commentators feel that the biggest challenge for the Monetary Policy Committee is ascertaining when to scale back when the economy eventually begins to improve. Stopping too early could run the risk of sending the economy into a “double dip” recession, while stopping too late could result in the recession being replaced with inflation, warns The Times business and city editor David Wighton.
These are among the long-term risks that policymakers need to weigh against the shortterm threat of the current recession being pushed into a full-blown depression. With the UK economy expected to contract further — the BOE had last month forecast a y-o-y fall in output of almost 4% — many feel there is little choice but to move forward with what shadow chancellor George Osborne has called “a leap in the dark” and “a last resort”.
It seems rather ironic that just as a heavyspending, debt-laden population is wising up to its excessive ways and wants to preserve whatever it has left, it now has to contend with paltry savings rates and the possibility of having the value of its assets further eroded by inflation and a sinking currency.
Lim Yin Foong was editor of Personal Money, a Malaysian personal finance magazine published by The Edge Communications, from 2001 to 2006. She is currently based in the UK.
http://www.theedgesingapore.com/blogsheads/999-lim-yin-foong-2009/2808-banking-on-money-creation-to-heal-uk-financial-system.html
Showing posts with label qualitative easing. Show all posts
Showing posts with label qualitative easing. Show all posts
Thursday, 19 March 2009
Friday, 6 March 2009
Printing money: an easy guide to quantitative easing
Printing money: an easy guide to quantitative easing
The 'unconventional tools' that the Bank of England will use to fight the financial crisis.
Last Updated: 9:29AM GMT 06 Mar 2009
Interest rates are now as close as they can get to zero without causing malfunctions in the financial system.
In this new world, with the Bank of England shorn of its main tool for influencing the economy, the policymakers in Threadneedle Street have to turn to unconventional tools.
Some have been tried before with differing degrees of success. But whatever the tool, the objective is clear: to keep Britain from dipping any deeper into recession and becoming trapped in a debt-driven deflation and depression, as the US was in the 1930s.
With no room to cut rates, the Bank must instead turn to direct means of influencing the money supply. This is important. The nominal growth rate of an economy can be no greater than the speed at which money is growing, and flowing around the economy. This famous economic equation – the quantity theory of money – lies behind the Bank's decision to create £150bn of money.
Whether it will succeed is another question, but Thursday's announcement means it has thrown its weight behind this new policy of quantitative easing with more weight and vigour than any other central bank in history.
THE BANK OF ENGLAND'S EMERGENCY WEAPONS
Liquidity support
How does it work? The Bank lends out money in return for collateral – usually government or company debt – to instill confidence in the market and provide cash with which to trade. It has been doing this for over a year through its Special Liquidity Scheme and its successor.
Pros The system does not meddle directly with monetary policy – so does not interfere with interest rate decisions – and it directly ensures that banks' balance sheets are kept above water.
Cons Although it addresses liquidity problems –
ie. when financial institutions don't have enough cash to hand – it does not solve the credit crunch, in which banks are unwilling to lend cash at all.
Does it work? To an extent. It has ensured strains on the financial markets have eased in comparison with the early days of the crisis, but the amount banks are willing to lend remains extremely low.
Buying company debt
How does it work? The Bank buys, rather than lends against, the assets of private investors, be they pension funds, insurance groups or banks. The assets are most likely commercial paper (short-term company debt) and corporate bonds. It pays for the money from a pot of cash raised by the Government through issuing gilts – in other words without increasing the amount of cash in the system. This is what the Bank has attempted to do through the Asset Purchase Facility, and is what the Federal Reserve is doing in the US.
Pros If successful, it gets to the heart of the matter, reducing the cost of credit for companies and lubricating the capital markets for companies. Because the purchases are funded by the Government it is not particularly inflationary.
Cons It has proved very difficult for the Bank to get hold of the right type of commercial debt (in other words at a good price, and a type that won't default). Pay too little and you will leave the taxpayer facing a big bill in the coming years.
Does it work? To an extent. The Fed has bought billions of dollars worth of corporate debt, but with little impact on commercial bond spreads.
Buying gilts (Government debt)
How does it work? The Bank buys government debt off investors and banks rather than corporate debt. This is something the Bank had authorised by the Treasury yesterday. The aim is to bring longer-term interest rates down, ensuring that companies and lenders cut their own rates.
Pros: Gilts are gilt-edged, and so have very little chance of defaulting (and if the UK Government has defaulted that is a whole other kettle of fish to worry about) and there are plenty of them around, so are easy to buy.
Cons: It does not make any direct difference to companies' cost of borrowing, instead pushing down government interest rates: nice, but not the heart of the matter.
Does it work? Yes, if by that you mean getting long-term interest rates down. The Japanese did it in the past, but it has not yet been tried by the Fed.
Creating money to buy assets
How does it work? The Bank buys assets off private investors but funds those purchases by creating money (literally, with the push of a button; metaphorically, with printing presses). This is what the Government has now approved. The aim is to increase the amount of money in the economy, which will in turn increase either economic growth, inflation, or a combination of the two.
Pros: The UK faces a possible spate of debt deflation, and there are few more powerful weapons for a central bank to use than its printing presses. It can also aim to kill two birds with one stone and cut the cost of borrowing for companies by making cash more plentiful. With interest rates at zero, there are few other more powerful tools the Bank can employ.
Cons: In normal times, such a policy is potentially highly inflationary. There is every chance the Bank is unconsciously laying the ground for an uncontrollable wave of inflation in the future. Deflation is the big enemy at present but the threat may be overblown, and printing money – quantitative easing – will create a mess of unparalleled proportions to clear up afterwards.
Does it work? Yes and no. The only other time it has been used is by the Bank of Japan. As Japan is still trapped in stagnation, many say it failed. However, there is evidence the Japanese experience would have been worse had it not taken these measures. Some also argue that the BoJ was too slow to start quantitative easing.
The helicopter drop
How does it work? The bank prints money, piles it inside a helicopter, takes to the skies and scatters the cash across the nation. Suddenly, every family is richer – provided they get to the cash in time and have sharp enough elbows. This technically amounts to a tax rebate for everyone funded by money creation, and was christened a "helicopter drop" of money by economist Milton Friedman. In his eyes it was the most dramatic way for the central bank to get money out into the streets.
Pros: This instantly gets money into people's hands and, with any luck, gets them spending it in the high street. Those who don't spend can use it to pay off debt, which isn't such a bad thing either.
Cons It is so radical a policy it might scare away international investors from the UK. It displays a disregard for controlling inflation that could also send sterling plunging. It will summon up even more vivid comparisons with Zimbabwe and Weimar Germany.
Does it work? It has never been properly tried before. The Japanese and Koreans have experimented with issuing vouchers to their citizens in the hope of encouraging them to spend but these were – importantly – not funded with created money. Fed Chairman Ben Bernanke is convinced, however, that in desperandum it would pump up a deflated economy.
http://www.telegraph.co.uk/finance/financetopics/recession/4944762/Printing-money-an-easy-guide-to-quantitative-easing.html
The 'unconventional tools' that the Bank of England will use to fight the financial crisis.
Last Updated: 9:29AM GMT 06 Mar 2009
Interest rates are now as close as they can get to zero without causing malfunctions in the financial system.
In this new world, with the Bank of England shorn of its main tool for influencing the economy, the policymakers in Threadneedle Street have to turn to unconventional tools.
Some have been tried before with differing degrees of success. But whatever the tool, the objective is clear: to keep Britain from dipping any deeper into recession and becoming trapped in a debt-driven deflation and depression, as the US was in the 1930s.
With no room to cut rates, the Bank must instead turn to direct means of influencing the money supply. This is important. The nominal growth rate of an economy can be no greater than the speed at which money is growing, and flowing around the economy. This famous economic equation – the quantity theory of money – lies behind the Bank's decision to create £150bn of money.
Whether it will succeed is another question, but Thursday's announcement means it has thrown its weight behind this new policy of quantitative easing with more weight and vigour than any other central bank in history.
THE BANK OF ENGLAND'S EMERGENCY WEAPONS
Liquidity support
How does it work? The Bank lends out money in return for collateral – usually government or company debt – to instill confidence in the market and provide cash with which to trade. It has been doing this for over a year through its Special Liquidity Scheme and its successor.
Pros The system does not meddle directly with monetary policy – so does not interfere with interest rate decisions – and it directly ensures that banks' balance sheets are kept above water.
Cons Although it addresses liquidity problems –
ie. when financial institutions don't have enough cash to hand – it does not solve the credit crunch, in which banks are unwilling to lend cash at all.
Does it work? To an extent. It has ensured strains on the financial markets have eased in comparison with the early days of the crisis, but the amount banks are willing to lend remains extremely low.
Buying company debt
How does it work? The Bank buys, rather than lends against, the assets of private investors, be they pension funds, insurance groups or banks. The assets are most likely commercial paper (short-term company debt) and corporate bonds. It pays for the money from a pot of cash raised by the Government through issuing gilts – in other words without increasing the amount of cash in the system. This is what the Bank has attempted to do through the Asset Purchase Facility, and is what the Federal Reserve is doing in the US.
Pros If successful, it gets to the heart of the matter, reducing the cost of credit for companies and lubricating the capital markets for companies. Because the purchases are funded by the Government it is not particularly inflationary.
Cons It has proved very difficult for the Bank to get hold of the right type of commercial debt (in other words at a good price, and a type that won't default). Pay too little and you will leave the taxpayer facing a big bill in the coming years.
Does it work? To an extent. The Fed has bought billions of dollars worth of corporate debt, but with little impact on commercial bond spreads.
Buying gilts (Government debt)
How does it work? The Bank buys government debt off investors and banks rather than corporate debt. This is something the Bank had authorised by the Treasury yesterday. The aim is to bring longer-term interest rates down, ensuring that companies and lenders cut their own rates.
Pros: Gilts are gilt-edged, and so have very little chance of defaulting (and if the UK Government has defaulted that is a whole other kettle of fish to worry about) and there are plenty of them around, so are easy to buy.
Cons: It does not make any direct difference to companies' cost of borrowing, instead pushing down government interest rates: nice, but not the heart of the matter.
Does it work? Yes, if by that you mean getting long-term interest rates down. The Japanese did it in the past, but it has not yet been tried by the Fed.
Creating money to buy assets
How does it work? The Bank buys assets off private investors but funds those purchases by creating money (literally, with the push of a button; metaphorically, with printing presses). This is what the Government has now approved. The aim is to increase the amount of money in the economy, which will in turn increase either economic growth, inflation, or a combination of the two.
Pros: The UK faces a possible spate of debt deflation, and there are few more powerful weapons for a central bank to use than its printing presses. It can also aim to kill two birds with one stone and cut the cost of borrowing for companies by making cash more plentiful. With interest rates at zero, there are few other more powerful tools the Bank can employ.
Cons: In normal times, such a policy is potentially highly inflationary. There is every chance the Bank is unconsciously laying the ground for an uncontrollable wave of inflation in the future. Deflation is the big enemy at present but the threat may be overblown, and printing money – quantitative easing – will create a mess of unparalleled proportions to clear up afterwards.
Does it work? Yes and no. The only other time it has been used is by the Bank of Japan. As Japan is still trapped in stagnation, many say it failed. However, there is evidence the Japanese experience would have been worse had it not taken these measures. Some also argue that the BoJ was too slow to start quantitative easing.
The helicopter drop
How does it work? The bank prints money, piles it inside a helicopter, takes to the skies and scatters the cash across the nation. Suddenly, every family is richer – provided they get to the cash in time and have sharp enough elbows. This technically amounts to a tax rebate for everyone funded by money creation, and was christened a "helicopter drop" of money by economist Milton Friedman. In his eyes it was the most dramatic way for the central bank to get money out into the streets.
Pros: This instantly gets money into people's hands and, with any luck, gets them spending it in the high street. Those who don't spend can use it to pay off debt, which isn't such a bad thing either.
Cons It is so radical a policy it might scare away international investors from the UK. It displays a disregard for controlling inflation that could also send sterling plunging. It will summon up even more vivid comparisons with Zimbabwe and Weimar Germany.
Does it work? It has never been properly tried before. The Japanese and Koreans have experimented with issuing vouchers to their citizens in the hope of encouraging them to spend but these were – importantly – not funded with created money. Fed Chairman Ben Bernanke is convinced, however, that in desperandum it would pump up a deflated economy.
http://www.telegraph.co.uk/finance/financetopics/recession/4944762/Printing-money-an-easy-guide-to-quantitative-easing.html
Wednesday, 21 January 2009
What we do when interest rates fail
What we do when interest rates fail
Mervyn King sets out the future for monetary policy, writes Edmund Conway
Last Updated: 8:13PM GMT 20 Jan 2009
You know things have come to a pretty pass when the Bank of England Governor admits that his main tool for influencing the economy – the UK benchmark interest rate – is no longer working.
But that is precisely what Mervyn King did last night. In a remarkable speech, he told Britons for the first time to brace themselves for quantitative easing. His acknowledgement that the UK central bank will have to resort to this drastic new method – used rarely in the history of finance – is likely to go down as one of the landmark moments in the financial crisis.
Equally striking as his confirmation that the Bank may soon embark on a policy of directly pumping cash into the economy was his stark description of the scale of the current malaise. Activity and confidence throughout the global economy had "fallen off a cliff", he said, with shares in London falling at one of the fastest rates in history and exports and output from here to the Far East dropping dramatically.
It is only against such a backdrop that such drastic action is necessary, he said. The plan the Bank intends to follow bears some resemblance to the scheme already in place in the US. The Bank has been granted permission by the Treasury to spend up to £50bn on assets, which it will then keep on its books with a view to selling them off later. The assets, which include commercial bonds and asset-backed securities, will be bought off private investors in the secondary markets – but this time the Bank will give them cash in return for the investments. The result will be an expansion of the Bank's balance sheet. For those who really follow such things, this is not quantitative easing, but what Ben Bernanke recently described as "credit easing".
In Mr King's words, which are worth quoting at length: "The disruption to the banking system has impaired the effectiveness of our conventional interest rate instrument. And with Bank Rate already at its lowest level in the Bank's history, it is sensible for the [Monetary Policy Committee] to prepare for the possibility – and I stress that we are not there yet – that it may need to move beyond the conventional instrument of Bank Rate and consider a range of unconventional measures.
"They would take the form of purchases by the Bank of England of a range of financial assets in order to expand the amount of reserves held by commercial banks and to increase the availability of credit to companies. That should encourage the banking system to expand the supply of broad money by lending to the private sector and also help companies to raise finance from capital markets."
The new asset purchase scheme will in fact give the Bank two powers beyond the ability to expand its own balance sheet. The first is to influence the pricing of a particular species of investment. If it believes the markets for certain corporate bonds are frozen, for instance, it may concentrate on buying them to help improve liquidity.
Second, and perhaps most importantly of all, it can, with the permission of the Treasury, opt to under-fund the Government's budget deficit. This means selling off fewer gilts than is necessary to pay for the assets, and is similar to what Japan did in the late 1990s, and what the Federal Reserve has now moved onto now. This is real quantitative easing. Interestingly, however, Mr King was reticent on how and when such a move would take place. It is hardly surprising. This kind of central bank activity has the potential to be highly inflationary. That should not be an immediate concern, given that the UK is now facing deflation.
http://www.telegraph.co.uk/finance/comment/edmundconway/4299635/What-we-do-when-interest-rates-fail.html
Mervyn King sets out the future for monetary policy, writes Edmund Conway
Last Updated: 8:13PM GMT 20 Jan 2009
You know things have come to a pretty pass when the Bank of England Governor admits that his main tool for influencing the economy – the UK benchmark interest rate – is no longer working.
But that is precisely what Mervyn King did last night. In a remarkable speech, he told Britons for the first time to brace themselves for quantitative easing. His acknowledgement that the UK central bank will have to resort to this drastic new method – used rarely in the history of finance – is likely to go down as one of the landmark moments in the financial crisis.
Equally striking as his confirmation that the Bank may soon embark on a policy of directly pumping cash into the economy was his stark description of the scale of the current malaise. Activity and confidence throughout the global economy had "fallen off a cliff", he said, with shares in London falling at one of the fastest rates in history and exports and output from here to the Far East dropping dramatically.
It is only against such a backdrop that such drastic action is necessary, he said. The plan the Bank intends to follow bears some resemblance to the scheme already in place in the US. The Bank has been granted permission by the Treasury to spend up to £50bn on assets, which it will then keep on its books with a view to selling them off later. The assets, which include commercial bonds and asset-backed securities, will be bought off private investors in the secondary markets – but this time the Bank will give them cash in return for the investments. The result will be an expansion of the Bank's balance sheet. For those who really follow such things, this is not quantitative easing, but what Ben Bernanke recently described as "credit easing".
In Mr King's words, which are worth quoting at length: "The disruption to the banking system has impaired the effectiveness of our conventional interest rate instrument. And with Bank Rate already at its lowest level in the Bank's history, it is sensible for the [Monetary Policy Committee] to prepare for the possibility – and I stress that we are not there yet – that it may need to move beyond the conventional instrument of Bank Rate and consider a range of unconventional measures.
"They would take the form of purchases by the Bank of England of a range of financial assets in order to expand the amount of reserves held by commercial banks and to increase the availability of credit to companies. That should encourage the banking system to expand the supply of broad money by lending to the private sector and also help companies to raise finance from capital markets."
The new asset purchase scheme will in fact give the Bank two powers beyond the ability to expand its own balance sheet. The first is to influence the pricing of a particular species of investment. If it believes the markets for certain corporate bonds are frozen, for instance, it may concentrate on buying them to help improve liquidity.
Second, and perhaps most importantly of all, it can, with the permission of the Treasury, opt to under-fund the Government's budget deficit. This means selling off fewer gilts than is necessary to pay for the assets, and is similar to what Japan did in the late 1990s, and what the Federal Reserve has now moved onto now. This is real quantitative easing. Interestingly, however, Mr King was reticent on how and when such a move would take place. It is hardly surprising. This kind of central bank activity has the potential to be highly inflationary. That should not be an immediate concern, given that the UK is now facing deflation.
http://www.telegraph.co.uk/finance/comment/edmundconway/4299635/What-we-do-when-interest-rates-fail.html
Tuesday, 23 December 2008
Splitting between quantitative and qualitative easing
23-12-2008: Splitting between quantitative and qualitative easing
Special report by DBS Group Research
Email us your feedback at fd@bizedge.com
WHEN the Fed cut its interest rate target to between zero and 0.25% last week it marked the end of interest rate easing and the beginning of what most people refer to as quantitative easing - the outright purchase of assets to influence liquidity conditions in financial markets.
In fact, even an interest rate policy is really a quantitative policy when you get right down to it. The only way the Fed controlled its policy rate, Fed funds, was by buying and selling assets, mainly repos and reverse repos, in the market.
(The day-to-day conduct of monetary policy is not typically done via buying/selling US Treasuries in what are called open market operations but rather by buying repos or reverse repos. A repo (repurchase agreement) is a temporary loan to a securities dealer, often overnight and usually for a few days or less.
The Fed credits the dealer's bank with an increase in reserves at the Fed and the borrower places high quality collateral (government or agency securities) with the Fed. At the end of the period, the collateral is returned to the borrower and the bank's reserves are appropriately debited.
The repo is thus a temporary injection of liquidity into the market. A reverse repo works the other way. The Fed temporarily drains liquidity from the market by debiting the account (reserves) of a security dealer's bank and replacing the reserves a few days later.) Buying repos injected liquidity and lowered the Fed funds rate. Buying reverse repos did the reverse. By hook or by crook, quantitative policy has been the reality all along.
Still, there's a perception that with short-term rates at zero, we've now entered a new phase of monetary easing. A quantitative phase. The Fed is going to buy large quantities of assets and continue to expand its balance sheet.
Quantitative versus qualitative easing Isn't this expansion of the Fed's balance sheet - this quantitative easing - just printing money? The answer over the past year has been yes, mostly, but not entirely.
Fed purchases of troubled assets or loans to troubled firms injects liquidity into the system and raises the monetary base. But that rise could be offset by sales of other assets like government bonds.
How much offsetting (sterilising) the Fed does when it buys a chunk of dubious assets determines whether its purchases are translated into quantitative easing (monetary expansion), or qualitative easing - an extension of liquidity to a firm, which does not raise the monetary base but dilutes the assets' quality on the Fed's books.
In the past three months, the Fed's balance sheet has grown by US$1.25 trillion (RM4.38 trillion) or 2.5 times and the monetary base has doubled. With the Fed planning to buy another US$800 billion of assets, how it pays for these assets will influence the monetary base and could have important consequences for inflation and the value of the dollar. The quality/quantity split is key.
Splitting the cake How has the Fed chosen to split the cake so far? Very inconsistently. Between August 2007 (when the crisis erupted) and Sept 3, 2008, the Fed injected some US$339 billion into markets, sterilising 93% of its purchases of troubled assets with sales of government bonds. Seven percent (US$28 billion) was paid for with an increase in the monetary base. In September, though, the Fed's balance sheet grew by a whopping 50%, or US$428 billion.
About US$157 billion (37%) of that was financed by a rise in the monetary base. Then things went wild. Between Oct 1 and Dec 17, the Fed bought US$841 billion of troubled assets, growing its balance sheet by another two-thirds. Eighty percent of that expansion (US$672 billion) was financed by an expansion in the monetary base - by printing money.
Since Sept 3, the Fed's balance sheet has expanded 2.5 times thanks to US$1.6 trillion of new credit extended loans to illiquid firms. Some 53% (US$857 billion) has been paid for via quantitative easing (an expansion in the monetary base) and 47% via qualitative easing (sterilising, or swapping good bonds for bad).
Back to qualitative easing? The Fed's Dec 16 FOMC statement that large scale quantitative easing was on the cards raised a lot of eyebrows. After all, the monetary base has already doubled since September.
So at a subsequent press conference, "senior Fed officials" hastened to add that the split going forward would favour qualitative easing (sterilised asset swaps) over quantitative easing (money printing รก la Japan).
But that would be a big U-turn after the past two months of rolling the printing presses. How can you know for sure? You can't. The best you can do is to watch the data week by week.
The Fed's balance sheet - up close and technical Below, we discuss the evolution of the Fed's balance sheet since August 2007 and the present. Amongst it is the mechanics of some typical and, more recently, non-typical Fed transactions so that readers may see their effects on the monetary base and the quantitative/qualitative split in Fed policy. Readers familiar with the Fed's balance sheet and its mechanics may wish to skip ahead to the final section.
The good old days and Fed funds: Back in the good old days, the Fed's balance sheet was a pretty simple thing. On the asset side, the Fed held a lot of government bonds and not much else. Repos and reverse repos, used to fine-tune monetary policy on a day-to-day basis, were small. On Aug 8, 2007, reverse repos outnumbered repos by US$13 billion. Use of the discount window was extremely tiny and the Fed held US$40 billion of miscellaneous assets.
On the liability side were two items: currency in circulation and reserve balances, or simply reserves. Reserves are the deposits that banks must hold at the Fed. Minimum levels must be maintained on a daily basis. Banks which hold excess reserves may lend to banks temporarily short. The interest rate on these loans is called the Fed funds rate. As most are aware, this rate is the Fed's policy rate and through it the Fed controls, or used to anyway, other short-term market rates.
Open market operations: The most generic way to increase the money supply is called an open market operation (OMO). The first step is not necessary but typically begins with the Treasury issuing say a US$100 bond to a securities dealer in return for cash that it uses to cover its deficit. The Fed purchases the bond from the dealer, crediting the dealer's bank's account at the Fed for US$100. The bank may withdraw the funds from its reserve account at any time and since, in the past, reserves did not pay interest, it would typically do so fairly quickly. The US$100 bond issue has led to a US$100 increase in currency in circulation. If the Fed wanted to tighten liquidity, it would do the reverse, selling a Treasury bond into the market. The Fed would debit the dealer's bank reserves for US$100 and this would soon result in a reduction in the amount of currency in circulation. As member banks may always demand currency for reserves, the monetary base is the sum of these two Fed liabilities.
Repo injection: The Fed would typically engage in open market operations when it had heavy lifting to do, such as when it had changed the target for policy rates, Fed funds. For day-to-day fine-tuning of the Fed funds rate, repos and reverse repos would typically be used. Repos are loans extended for very short durations, usually a few days or less, secured with high quality collateral (UST or agency debt). As one would expect, a syphoning of liquidity via reverse repos would simply reverse the signs in the balance sheet entries. Interest rates on Fed funds would rise and would be transmitted out to the rest of the market.
Term Auction Facility (TAF) injections: By June 25, 2008, the Fed had extended US$150 billion of loans via the Term Auction Facility, or TAF. Other things equal, those TAF loans would have increased the monetary base just like the OMO or repo injections shown. But the Fed was worried that the TAF loans (and other injections that, between August 2007 and June 2008, amounted to US$339 billion) would have inflationary consequences. The Fed decided to offset these injections with sales of government bonds. Total assets have remained the same, as have total liabilities. This is, in effect, a simple asset swap. Again, the purpose is to provide liquidity to the TAF party in need without increasing the monetary base. The Fed's balance sheet becomes too small? Contrary to much market talk back in October, there are no constraints on the size of the Fed's balance sheet. The Fed can print money, which means it can buy any amount of assets. The sky's truly the limit. But the Fed's balance sheet can be constrained if it tries to buy too many assets without printing money. Once the Fed runs out of Treasuries, the sterilised asset swap can no longer occur. By September 2008, the Fed's supply of Treasuries had fallen by nearly half, thanks to sterilised asset swaps. In fact, it had fallen far lower than that because the Fed had already swapped another US$250 billion of Treasuries more formally in its Term Securities Lending Facility (TSLF) which the Fed records as an off-balance sheet item. In reality, 70% of the Fed's supply of Treasuries had been swapped by Sept 3, 2008. Unless the Fed could come up with some additional Treasuries, its rapidly growing portfolio of loans made through the TAF, the Primary Dealer Credit Facility (PDCF) and eight other programmes listed in the balance sheet would soon have to be financed by printing money alone.
On Oct 7, the Fed and the Treasury announced the Supplementary Financing Programme. What this amounted to, in effect, was a joint effort whereby the Fed would purchase the dubious assets as it had been and, since it was out of Treasuries, the Treasury would do the mopping up. A sterilised asset swap still obtained the result of two agencies being better than one.
There are various ways of viewing this from a balance sheet perspective. The most transparent way is probably to view the joint transaction in three distinct steps.
In step 1, the Treasury sells US$100 of bonds directly to the Fed. The Fed pays for the bonds by crediting the Treasury's supplementary reserve account. The Treasury promises not to withdraw or lend these funds so they do not affect the monetary base or the Fed funds rate.
In step 2, the Fed loans US$100 to a primary dealer, as per before, which leads a monetary base increase of US$100. In step 3, the monetary increase is sterilised by the sale of the newly acquired government bond. In net terms, primary dealers have received US$100 of new liquidity but the monetary base has not changed. In this case, the Fed's balance sheet has grown by US$100 but there is no monetary impact.
A more straightforward way of accomplishing the same thing would be for the Fed to issue its own bonds. The Fed's US$100 loan to a primary dealer broker leads to a rise in the monetary base of the same amount.
The Fed sterilises this injection with the sale of a Federal Reserve bond. This would be a pure asset swap although new Fed bonds would be issued (the size of the Fed's balance sheet would grow). If the Fed needs to expand its balance sheet to finance the acquisition of "large quantities" of assets without monetary consequences, then, in practical terms, it would seem to make little difference whether the Fed issued its own bonds for sterilisation purposes or bought them from the Treasury for onward sale to the market.
Why the quantity/quality split? And will it work? Besides avoiding the monetary consequences of large purchases of troubled assets, the Fed's qualitative easing is aimed at lowering the spread of various interest rates over the risk-free Treasury rate.
The Fed apparently feels that risk-free rates are low enough (10Y UST yields are currently at 2.13%). The hope is that by buying troubled assets and selling Treasury's, the yields on the two securities would come closer together.
Whether it will work remains unclear. Many consider the spread to be a function mainly of the probability of default on the part of the troubled borrower, not on the relative amounts of the securities bought and sold.
On this view, unless Fed loans actually lower the probability of default, the credit spread will remain. What matters to the borrower, though, and for that matter to the economy more generally, is not the spread he has to pay over the risk-free rate, but the actual rate at which he can borrow.
If the Fed wants to lower that rate, it may have to content itself with lowering the risk-free rate, for example, pursuing quantitative easing over qualitative.
Second, one cannot not forget the adage that leading a horse to water does not make it drink. The Fed can buy assets and credit the reserves of the banks. But unless the banks withdraw those funds and lend them onward in the market, it's all for naught.
This is currently a problem. The monetary base on Dec 17 was US$1.67 billion but half of that comprised reserves. Banks are not withdrawing the funds and putting them to use. This may be good from an inflation perspective but plainly not from a get-the-economy-going perspective.
Finally, one must not forget that many financial institutions have reported large losses and it is reasonable to assume that some, perhaps many, are insolvent. In such cases, Fed easing will not solve the problem but only postpone the day of reckoning. When it comes to putting off until tomorrow what can be done today, there is no quantity/quality split.
http://www.theedgedaily.com/cms/content.jsp?id=com.tms.cms.article.Article_62478269-cb73c03a-53897400-a8659b88
Special report by DBS Group Research
Email us your feedback at fd@bizedge.com
WHEN the Fed cut its interest rate target to between zero and 0.25% last week it marked the end of interest rate easing and the beginning of what most people refer to as quantitative easing - the outright purchase of assets to influence liquidity conditions in financial markets.
In fact, even an interest rate policy is really a quantitative policy when you get right down to it. The only way the Fed controlled its policy rate, Fed funds, was by buying and selling assets, mainly repos and reverse repos, in the market.
(The day-to-day conduct of monetary policy is not typically done via buying/selling US Treasuries in what are called open market operations but rather by buying repos or reverse repos. A repo (repurchase agreement) is a temporary loan to a securities dealer, often overnight and usually for a few days or less.
The Fed credits the dealer's bank with an increase in reserves at the Fed and the borrower places high quality collateral (government or agency securities) with the Fed. At the end of the period, the collateral is returned to the borrower and the bank's reserves are appropriately debited.
The repo is thus a temporary injection of liquidity into the market. A reverse repo works the other way. The Fed temporarily drains liquidity from the market by debiting the account (reserves) of a security dealer's bank and replacing the reserves a few days later.) Buying repos injected liquidity and lowered the Fed funds rate. Buying reverse repos did the reverse. By hook or by crook, quantitative policy has been the reality all along.
Still, there's a perception that with short-term rates at zero, we've now entered a new phase of monetary easing. A quantitative phase. The Fed is going to buy large quantities of assets and continue to expand its balance sheet.
Quantitative versus qualitative easing Isn't this expansion of the Fed's balance sheet - this quantitative easing - just printing money? The answer over the past year has been yes, mostly, but not entirely.
Fed purchases of troubled assets or loans to troubled firms injects liquidity into the system and raises the monetary base. But that rise could be offset by sales of other assets like government bonds.
How much offsetting (sterilising) the Fed does when it buys a chunk of dubious assets determines whether its purchases are translated into quantitative easing (monetary expansion), or qualitative easing - an extension of liquidity to a firm, which does not raise the monetary base but dilutes the assets' quality on the Fed's books.
In the past three months, the Fed's balance sheet has grown by US$1.25 trillion (RM4.38 trillion) or 2.5 times and the monetary base has doubled. With the Fed planning to buy another US$800 billion of assets, how it pays for these assets will influence the monetary base and could have important consequences for inflation and the value of the dollar. The quality/quantity split is key.
Splitting the cake How has the Fed chosen to split the cake so far? Very inconsistently. Between August 2007 (when the crisis erupted) and Sept 3, 2008, the Fed injected some US$339 billion into markets, sterilising 93% of its purchases of troubled assets with sales of government bonds. Seven percent (US$28 billion) was paid for with an increase in the monetary base. In September, though, the Fed's balance sheet grew by a whopping 50%, or US$428 billion.
About US$157 billion (37%) of that was financed by a rise in the monetary base. Then things went wild. Between Oct 1 and Dec 17, the Fed bought US$841 billion of troubled assets, growing its balance sheet by another two-thirds. Eighty percent of that expansion (US$672 billion) was financed by an expansion in the monetary base - by printing money.
Since Sept 3, the Fed's balance sheet has expanded 2.5 times thanks to US$1.6 trillion of new credit extended loans to illiquid firms. Some 53% (US$857 billion) has been paid for via quantitative easing (an expansion in the monetary base) and 47% via qualitative easing (sterilising, or swapping good bonds for bad).
Back to qualitative easing? The Fed's Dec 16 FOMC statement that large scale quantitative easing was on the cards raised a lot of eyebrows. After all, the monetary base has already doubled since September.
So at a subsequent press conference, "senior Fed officials" hastened to add that the split going forward would favour qualitative easing (sterilised asset swaps) over quantitative easing (money printing รก la Japan).
But that would be a big U-turn after the past two months of rolling the printing presses. How can you know for sure? You can't. The best you can do is to watch the data week by week.
The Fed's balance sheet - up close and technical Below, we discuss the evolution of the Fed's balance sheet since August 2007 and the present. Amongst it is the mechanics of some typical and, more recently, non-typical Fed transactions so that readers may see their effects on the monetary base and the quantitative/qualitative split in Fed policy. Readers familiar with the Fed's balance sheet and its mechanics may wish to skip ahead to the final section.
The good old days and Fed funds: Back in the good old days, the Fed's balance sheet was a pretty simple thing. On the asset side, the Fed held a lot of government bonds and not much else. Repos and reverse repos, used to fine-tune monetary policy on a day-to-day basis, were small. On Aug 8, 2007, reverse repos outnumbered repos by US$13 billion. Use of the discount window was extremely tiny and the Fed held US$40 billion of miscellaneous assets.
On the liability side were two items: currency in circulation and reserve balances, or simply reserves. Reserves are the deposits that banks must hold at the Fed. Minimum levels must be maintained on a daily basis. Banks which hold excess reserves may lend to banks temporarily short. The interest rate on these loans is called the Fed funds rate. As most are aware, this rate is the Fed's policy rate and through it the Fed controls, or used to anyway, other short-term market rates.
Open market operations: The most generic way to increase the money supply is called an open market operation (OMO). The first step is not necessary but typically begins with the Treasury issuing say a US$100 bond to a securities dealer in return for cash that it uses to cover its deficit. The Fed purchases the bond from the dealer, crediting the dealer's bank's account at the Fed for US$100. The bank may withdraw the funds from its reserve account at any time and since, in the past, reserves did not pay interest, it would typically do so fairly quickly. The US$100 bond issue has led to a US$100 increase in currency in circulation. If the Fed wanted to tighten liquidity, it would do the reverse, selling a Treasury bond into the market. The Fed would debit the dealer's bank reserves for US$100 and this would soon result in a reduction in the amount of currency in circulation. As member banks may always demand currency for reserves, the monetary base is the sum of these two Fed liabilities.
Repo injection: The Fed would typically engage in open market operations when it had heavy lifting to do, such as when it had changed the target for policy rates, Fed funds. For day-to-day fine-tuning of the Fed funds rate, repos and reverse repos would typically be used. Repos are loans extended for very short durations, usually a few days or less, secured with high quality collateral (UST or agency debt). As one would expect, a syphoning of liquidity via reverse repos would simply reverse the signs in the balance sheet entries. Interest rates on Fed funds would rise and would be transmitted out to the rest of the market.
Term Auction Facility (TAF) injections: By June 25, 2008, the Fed had extended US$150 billion of loans via the Term Auction Facility, or TAF. Other things equal, those TAF loans would have increased the monetary base just like the OMO or repo injections shown. But the Fed was worried that the TAF loans (and other injections that, between August 2007 and June 2008, amounted to US$339 billion) would have inflationary consequences. The Fed decided to offset these injections with sales of government bonds. Total assets have remained the same, as have total liabilities. This is, in effect, a simple asset swap. Again, the purpose is to provide liquidity to the TAF party in need without increasing the monetary base. The Fed's balance sheet becomes too small? Contrary to much market talk back in October, there are no constraints on the size of the Fed's balance sheet. The Fed can print money, which means it can buy any amount of assets. The sky's truly the limit. But the Fed's balance sheet can be constrained if it tries to buy too many assets without printing money. Once the Fed runs out of Treasuries, the sterilised asset swap can no longer occur. By September 2008, the Fed's supply of Treasuries had fallen by nearly half, thanks to sterilised asset swaps. In fact, it had fallen far lower than that because the Fed had already swapped another US$250 billion of Treasuries more formally in its Term Securities Lending Facility (TSLF) which the Fed records as an off-balance sheet item. In reality, 70% of the Fed's supply of Treasuries had been swapped by Sept 3, 2008. Unless the Fed could come up with some additional Treasuries, its rapidly growing portfolio of loans made through the TAF, the Primary Dealer Credit Facility (PDCF) and eight other programmes listed in the balance sheet would soon have to be financed by printing money alone.
On Oct 7, the Fed and the Treasury announced the Supplementary Financing Programme. What this amounted to, in effect, was a joint effort whereby the Fed would purchase the dubious assets as it had been and, since it was out of Treasuries, the Treasury would do the mopping up. A sterilised asset swap still obtained the result of two agencies being better than one.
There are various ways of viewing this from a balance sheet perspective. The most transparent way is probably to view the joint transaction in three distinct steps.
In step 1, the Treasury sells US$100 of bonds directly to the Fed. The Fed pays for the bonds by crediting the Treasury's supplementary reserve account. The Treasury promises not to withdraw or lend these funds so they do not affect the monetary base or the Fed funds rate.
In step 2, the Fed loans US$100 to a primary dealer, as per before, which leads a monetary base increase of US$100. In step 3, the monetary increase is sterilised by the sale of the newly acquired government bond. In net terms, primary dealers have received US$100 of new liquidity but the monetary base has not changed. In this case, the Fed's balance sheet has grown by US$100 but there is no monetary impact.
A more straightforward way of accomplishing the same thing would be for the Fed to issue its own bonds. The Fed's US$100 loan to a primary dealer broker leads to a rise in the monetary base of the same amount.
The Fed sterilises this injection with the sale of a Federal Reserve bond. This would be a pure asset swap although new Fed bonds would be issued (the size of the Fed's balance sheet would grow). If the Fed needs to expand its balance sheet to finance the acquisition of "large quantities" of assets without monetary consequences, then, in practical terms, it would seem to make little difference whether the Fed issued its own bonds for sterilisation purposes or bought them from the Treasury for onward sale to the market.
Why the quantity/quality split? And will it work? Besides avoiding the monetary consequences of large purchases of troubled assets, the Fed's qualitative easing is aimed at lowering the spread of various interest rates over the risk-free Treasury rate.
The Fed apparently feels that risk-free rates are low enough (10Y UST yields are currently at 2.13%). The hope is that by buying troubled assets and selling Treasury's, the yields on the two securities would come closer together.
Whether it will work remains unclear. Many consider the spread to be a function mainly of the probability of default on the part of the troubled borrower, not on the relative amounts of the securities bought and sold.
On this view, unless Fed loans actually lower the probability of default, the credit spread will remain. What matters to the borrower, though, and for that matter to the economy more generally, is not the spread he has to pay over the risk-free rate, but the actual rate at which he can borrow.
If the Fed wants to lower that rate, it may have to content itself with lowering the risk-free rate, for example, pursuing quantitative easing over qualitative.
Second, one cannot not forget the adage that leading a horse to water does not make it drink. The Fed can buy assets and credit the reserves of the banks. But unless the banks withdraw those funds and lend them onward in the market, it's all for naught.
This is currently a problem. The monetary base on Dec 17 was US$1.67 billion but half of that comprised reserves. Banks are not withdrawing the funds and putting them to use. This may be good from an inflation perspective but plainly not from a get-the-economy-going perspective.
Finally, one must not forget that many financial institutions have reported large losses and it is reasonable to assume that some, perhaps many, are insolvent. In such cases, Fed easing will not solve the problem but only postpone the day of reckoning. When it comes to putting off until tomorrow what can be done today, there is no quantity/quality split.
http://www.theedgedaily.com/cms/content.jsp?id=com.tms.cms.article.Article_62478269-cb73c03a-53897400-a8659b88
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