The United States Federal Reserve's Open Market Committee (FOMC) is sticking to
its course for phasing out the additional purchases of mortgage-backed
securities (MBS). Notably, however, in its statement released on January 27,
reference to an improving housing market was omitted after recent bad news
about the sector.
The Fed rarely puts much weight on a month's worth of data, be they good or
bad; few have ever accused the Fed of being "ahead of the curve". Indeed, there
was one dissenting vote, Kansas City Fed president Thomas Hoenig, who argued
that the Fed should no longer commit to "exceptionally low levels of the
federal funds rate for an extended period".
But what if the housing market does not recover? In our
assessment, Fed chairman Ben Bernanke has made it abundantly clear that he
believes a recovery in the housing market is key to putting the economy back on
a sustainable growth path. With millions of homeowners "under water" in their
mortgage, that is, owing more on their homes than they are worth, we believe he
has a keen interest to push home prices higher. In the past, he has testified
in congress that going off the gold standard during the Great Depression
allowed the price level to rise to the pre-1929 stock market crash level and
was instrumental to get economic growth back on track.
Having said that, the Fed risks losing credibility if MBS purchase program were
to be re-started or extended, after clearly signaling that the program will be
phased out. In the near term, we believe the Fed is likely to sit back and
wait. That's because the Fed may truly believe that after "printing" close to
US$2 trillion, the economy will recover.
However, we believe the Fed may be underestimating the headwinds caused by
market forces that warrant further de-leveraging; conversely, in our opinion
the Fed is overestimating the impact of fiscal and monetary stimuli.
The stimuli, in our assessment, have been extremely inefficient: on the fiscal
side, programs like cash-for-clunkers do little more than provide a short-term
reallocation of spending. On the monetary side, the Fed's programs have mostly
substituted rather than encouraged private-sector activity. For example, when
the Fed offered commercial paper to GE at the height of the crisis, no
private-sector participant was able to effectively compete. Inefficient
monetary and fiscal programs mean that a lot more money may need to be spent
and printed to achieve what policy makers would like to achieve.
Amongst the unintended consequences caused by such policies may be a weakening
of the US dollar; that's because the purchase of government bonds and MBS
pushes rational investors - domestic and foreign - abroad in search of prices
set by the market, not regulators; however, consider that this consequence may
not be unintended. When it comes to a weaker dollar, policy makers have to be
careful not to get more than they are bargaining for. It is no coincidence that
European Central Bank (ECB) president Jeane-Claude Trichet often reiterates
that it is extremely important that the US is committed to a strong dollar
policy.
When the Fed buys securities, they are added to its balance sheet; we talk
about the Fed's balance sheet as a proxy for the money that has been "printed"
because such purchases require little more than a few keystrokes on the Fed's
computers. The term "creating money out of thin air" is an appropriate
description of the process.
While the Fed seems at ease creating money, it has never in its 100-year
history substantially reduced its balance sheet. When economists talk about
containing inflation, rarely do they mean going back to the lower price level
of a former era: they talk about leveling of at a higher plateau. Actually,
plateau may also be a misnomer considering that many modern economists equate
an inflation rate of 2% with price stability.
The reason why the Fed may likely sit back and wait through the near term is
that monetary policy typically takes six to nine months before impacting the
real economy.
This is not the first time the Fed has taken a breather since the crisis began:
while the Fed's balance sheet more than doubled, from a pre-crisis level of
about $800 billion, by the end of 2008, there was little net activity in the
subsequent six months. Some early emergency programs were phased out, while new
ones were being ramped up.
For purposes of the money that has been created, it doesn't matter whether the
Fed buys government bonds, mortgage-backed securities, typewriters or pays
wages to its staff, for that matter. The $1.25 trillion MBS program, while it
was started in the spring of '09, only had a net impact on the Fed's balance
sheet starting the summer of '09. The chart illustrates the evolution of the
Fed's balance sheet (we include the Fed's net commitments to buy MBS in the
aggregated total).
Now consider the scenario that the renewed weakness in housing is more than a
glitch, but the beginning of a new downturn. Credit conditions may continue to
be tight in the private sector, and the Fed's absence as an MBS buyer may push
the cost of borrowing up for everyone. Some government programs have also
tightened standards.
Bernanke has emphasized that his lending programs constitute credit easing with
their primary purpose to lubricate the financial system. He believes that
giving support to a specific sector of the economy is more efficient than
buying government bonds. This experiment, in our view, has been a grave
mistake: providing money to a specific sector of an economy is fiscal, not
monetary, policy.
By veering into the domain of congress, he has drawn its ire and attention;
political scrutiny of the Fed erodes the Fed's credibility, making it less
effective. The most effective Fed policy is one where a Fed official utters a
few words and markets move; emergency rate cuts, printing trillions of dollars,
are signs that Fed policy has become less and less effective.
If one takes Bernanke at his words, he will not return to buying
mortgage-backed securities to support the housing market merely because rates
are moving up. Given that these markets are "functioning" (market forces would
drive down home prices), credit easing should not be an option that is on the
table. The alternative? A jolt of quantitative easing, ie the purchase of
government bonds as pioneered by Japan in an effort to drive down the cost of
borrowing.
While we don't consider either credit easing or quantitative easing to be sound
monetary policy, there is an argument to be made that credit easing is
redundant because the Fed is typically only buying very high quality
securities, and given the interdependency and substitution effects, buying
government bonds is not so different from buying other highly rated securities,
in particular government-guaranteed agency mortgage-backed securities.
What makes this course of action even more likely is that a "jolt" of
quantitative easing may be a more palatable option to a broader base at the
FOMC than credit easing. Curiously, while we believe quantitative easing has
not achieved its goals in Japan, the Fed and Bernanke appear to point to Japan
as an endorsement of quantitative easing.
A big risk associated with quantitative easing is that the market considers
central bank purchases of government bonds as a way to finance government
spending. Contrary to the apparent newly discovered fiscal discipline in
Washington, we very much doubt the spending will abate.
Quantitative easing is rather risky, especially for those countries dependent
on foreign investment to support their currency (such as the US), as countries
whose central banks print money to finance government spending are at risk of
seeing a flight out of their currency. But maybe that's the jolt Bernanke
ultimately desires, as any inflation on the backdrop of a weaker dollar may
push up home prices yet again.
So if the Fed pauses, should investors wait before taking action? As far as we
are concerned, gold has risen from about $250 an ounce to over $1,000 an ounce;
the dollar has been in a decline versus the euro since briefly after the euro's
inception. The dollar's recent rally may provide an opportunity to diversify
out of the dollar, given the risk that the scenarios we describe play out.
Can the dollar rise while the Fed pauses and other market observers believe the
Fed will toughen its stance and mop up the liquidity, even if housing is
crushed in the process? That's certainly possible too.
We hope our discussion helps investors assess the risks and plan accordingly.
We would like to remind investors that nothing has really played out in this
crisis the way our policy makers have wanted it to.
The late Wim Duisenberg, former head of the ECB, once said he hoped and prayed
the global adjustment process will be slow and gradual. As we have mentioned in
the past, when central bankers revert to hopes and prayers, investors may want
to consider taking action.
Axel Merk is manager of the Merk Hard and Asian Currency Funds,
www.merkfund.com. Merk Insights provide the Merk perspective on
currencies, global imbalances, the trade deficit, the socio-economic impact of
the US administration's policies and more.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
