Is the Fed “printing money”? What are the consequences?
Carlos M. Pelaez
©Carlos M. Pelaez, 2010
This post considers the statement by Chairman Bernanke on Fed monetary policy in a recent network interview. Suggestions for the subject and analysis by Carlos E. Obregon are highly useful and appreciated. Errors and omissions are solely of this writer. The contents are as follows:
I Bernanke’s CBS’s “60 Minutes” Interview
II Money Stock and Base Money
III Quantitative Easing Theory
IV Effects of Quantitative Easing
IV (1) Allocation Effects
IV (2) Duration Trap
IV (3) Mismatch of Assets and Liabilities
IV (4) Global Devaluation War
V Economic Indicators
VI Interest Rates
VII Conclusion
References
I Bernanke’s CBS’s “60 Minutes” Interview. The interview of Fed Chairman Bernanke in CBS’s “60 Minutes” aired on Dec 5 provides important information on policy needs and actions (http://blogs.wsj.com/economics/2010/12/05/bernanke-on-cbss-60-minutes/ http://www.cbsnews.com/video/watch/?id=7117930n&tag=cbsnewsMainColumnArea.6 http://www.cbsnews.com/video/watch/?id=7120553n&tag=cbsnewsMainColumnArea.6). According to Chairman Bernanke, there are two major factors of the need for further monetary stimulus by the Fed: (1) the economy is growing slowly, which is a major reason why lending is at low levels; unemployment is high, posing the risk of further slowdown of the economy; and the economy is barely growing at 2.5 percent, close to the level where growth may not be self-sustaining; (2) inflation is at a very low level, approximating the point where prices could fall or what would be an adverse situation of deflation. The action by the Fed consists of quantitative easing, or the purchase of $650 billion of Treasury securities to lower their yields with the objective of lowering interest rates to the private sector that could cause faster economic growth. In an answer to a question by CBS’s Scott Pelley, Chairman Bernanke criticized a “myth” that the Fed is printing money, which he denied categorically. He said that there is no change in “currency in circulation” and that the “money supply” is not significantly changing. The timing of policy is to withdraw the stimulus at the correct time. Presumably, that time would be when the economy is growing too fast and inflation accelerating. Chairman Bernanke also said that he was “100 per cent” confident that the Fed could raise interest rates in short notice, such as in “15 minutes,” or a quarter of the time of CBS’s “60 minutes,” to tighten the economy and preventing inflation. The timing would depend on the state of the economy and inflation, which is not the case currently.
II Money Stock and Base Money. Chairman Bernanke is roughly correct in asserting that there have not been wild increases in the “money supply” and “currency in circulation.” The textbook definition of the stock of money is M1 = currency held by the public plus demand deposits, or M1 = C + D, where C is currency held by the public and D demand deposits. Table 1 provides the estimates of the money stock of the US by the Fed. Currency in circulation or held by the public, C, increased in 2007-2010 by a cumulative 19.1 percent, which is a lower than 22.8 percent in 2003-2007. Demand deposits, D, increased at a faster rate of 56.0 percent in 2007-2010 than the decline of 8.4 percent in 2003-2007. The M1 money stock has increased by 28.9 percent in 2007-2010 that is significantly higher than 4.6 percent in 2003-2007. The higher rate of growth of money is not of concern because of necessarily loser monetary policy during a global recession.
Table 1, Currency Held by the Public (C), Demand Deposits (D) and M1 Money Stock (Dollar Billions Not Seasonally Adjusted)
| C | ∆% | D | ∆% | M1 | ∆% | |
| 12-2003 | 666.7 | 342.7 | 1332 | |||
| 12-2004 | 702.4 | 5.4 | 358.6 | 4.6 | 1401 | 5.2 |
| 12-2005 | 728.9 | 3.8 | 337.7 | -5.8 | 1396 | -0.4 |
| 12-2006 | 754.6 | 3.5 | 316.7 | -6.2 | 1387 | -0.6 |
| 12-2007 | 818.7 | 8.5 | 313.8 | -0.9 | 1393 | 0.4 |
| 10-2007 | 759.6 | 303.9 | 1368 | |||
| 10-2008 | 793.5 | 4.5 | 357.7 | 17.7 | 1461 | 6.8 |
| 10-2009 | 859.3 | 8.3 | 428.2 | 19.7 | 1662 | 13.8 |
| 10-2010 | 904.4 | 5.3 | 474.2 | 10.7 | 1764 | 6.1 |
Note: M1 also contains other minor items such as traveler’s checks and other checkable deposits, which is the reason why M1 is not equal to C + D in this table. After 2007 data are for the latest month available in 2010, Oct, to calculate 12-month changes.
Source:
http://www.federalreserve.gov/releases/h6/hist/h6hist4.pdf
http://www.federalreserve.gov/releases/h6/hist/h6hist1.pdf
The process of money creation by the central bank is by increasing base money, B, which can have a multiplier effect on the money stock, M1. In the complete model of Tobin (1969, 27), monetary policy occurs by central bank changes in “high-powered money,” or base money, B, which is considered exogenous, or determined by the central bank, while M1 is endogenous, or determined by actions of the public. The textbook definition of base money is that B consists of currency held by the public, C, plus reserves of banks deposited at the Fed, R, or B = C + R. In the framework of Friedman and Schwartz (1963, 1970) and Cagan (1965), the change over time of the money stock is given by equation (1):
dlnM/dt = (dlnB/dt) + [M/B(1-(R/D)](d-C/M/dt)
+[M/B(1-(C/M)](d-R/D/dt) (1)
Where M is M1, R/D is the reserve/deposit ratio, C/M the currency ratio, t time and ln the natural logarithm. The formula in (1) can be used in approximations as:
m = b + c + r + e (2)
Where the lower-case letters are the contributions to the growth of M1, m, by: growth of base money, b, the currency ratio, c, the reserve/deposit ratio, r, and an approximation error, e. The formula permits decomposition of the rate of growth of M1 in contributions by the central bank, b, and by the public, c and r. The issue of money by the central bank is not “printing money,” or printing more $100 bills but rather injection of bank reserves in commercial banks by open market operations to set a target for the fed funds rate, which is the rate of overnight lending among banks of reserves deposited at the Fed. The model of Brunner and Meltzer (1976), for example, has credit and money multipliers that are dependent on various variables but the simpler model is all that is required for current purposes.
Total reserves of depository institutions at the Fed, R, and base money, B, are provided in Table 2. Total reserves of banks fell by 4.4 percent between 2003 and 2007, but grew from $43 billion in Nov 2007 to $1038 billion in Nov 2010, by a multiple of 24 times or almost one trillion dollars. Base money, B, grew by 10.4 percent in 2003-2007, but 137.9 percent in 2007-2010. Schwartz (2009) complains that the Fed appears to work only with two amounts, zero, as in the interest rate of the fed funds set at 0 to ¼ percent, and trillions of dollars, as the increase of the Fed balance sheet, at $2.4 trillion on Dec 8 (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1), from much lower levels, such as $902 billion on Jul 25, 2007 (http://www.federalreserve.gov/releases/h41/hist/h41hist1.pdf)
Table 2, Total Reserves of Depository Institutions (R) and Base Money (B) (Dollar Billions Not Seasonally Adjusted)
| R | ∆% | B | ∆% | |
| D-2003 | 45 | 752 | ||
| D-2004 | 46 | 2.2 | 765 | 1.7 |
| D-2005 | 45 | -2.2 | 793 | 3.7 |
| D-2006 | 43 | -4.4 | 818 | 3.2 |
| D-2007 | 43 | 0 | 830 | 1.5 |
| N-2007 | 43 | 827 | ||
| N-2008 | 609 | 1316.3 | 1435 | 73.5 |
| N-2009 | 1140 | 87.2 | 2018 | 40.6 |
| N-2010 | 1038 | -8.9 | 1968 | -2.5 |
Note: After 2007 data are for the latest month available in 2010, Nov, to calculate 12-month changes.
Source: http://www.federalreserve.gov/releases/h3/hist/h3hist1.pdf
Bernanke is likely correct in the comments during the CBS “60 Minutes” interview (op. cit.) that there is no imminent risk of inflation for the US. The possibility of inflation appears to be as uncertain as the likelihood of some deflation. Economic forecasting is second to that of astrologers. There are three concerns on inflation. First, inflation is already a policy issue in emerging Asia with 2.8 percent in Australia, 3.5 percent in Singapore, 4.1 percent in South Korea, 4.4 percent in China, 5.8 percent in Indonesia and 8.6 percent in India (http://professional.wsj.com/article/SB10001424052748703785704575642630727213078.html?mod=wsjproe_hps_LEFTWhatsNews). Inflation in the euro zone is 1.9 percent, just below the target of the ECB of 2 percent. China has shifted its official monetary policy to tightening (http://professional.wsj.com/article/SB10001424052748703989004575652040187353212.html?mod=wsjproe_hps_LEFTWhatsNews). Brazil is taking strong measures to prevent accelerating inflation that reached 5.5 percent in the12 months ending in Oct to meet a year-end target of 4.5 percent (http://professional.wsj.com/article/SB10001424052748703350104575652620822381284.html
). The rise in commodity prices, affecting energy and food, is becoming a regressive silent tax on the US middle class experiencing tight budget constraints.
Second, when year-end consumer price inflation rose from 1.9 percent in 2003, at the time that the Fed had the first fears of deflation, to 3.3 percent in 2004, 3.4 percent in 2005, 2.5 percent in 2006 and 4.1 percent in 2007 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), the Federal Open Market Committee (FOMC) increased the target on the fed funds rate by 17 consecutive rounds of 25 basis points in meetings from Jun 2004 to Jun 2006, raising the rate from 1 percent to 5.25 percent.
Third, experience with continuing fiscal deficits and money creation tend to show accelerating inflation. Table 3 provides average yearly rates of growth of two definitions of the money stock, M1, and M2 that adds also interest-paying deposits. The data were part of a research project on the monetary history of Brazil using the NBER framework of Friedman and Schwartz (1963, 1970) and Cagan (1965) as well as the institutional framework of Rondo E. Cameron (1967, 1972) who inspired the research (Pelaez 1974, 1975, 1976a,b, 1977, 1979, Pelaez and Suzigan 1978, 1981). The data were also used to test the correct specification of money and income following Sims (1972; see also Williams et al. 1976) as well as another test of orthogonality of money demand and supply using covariance analysis. The average yearly rates of inflation are high for almost any period in 1861-1970, even when prices were declining at 1 percent in 19th century England, and accelerated to 27.1 percent in 1945-1970. There may be concern in an uncontrolled deficit monetized by sharp increases in base money. The Fed may have desired to control inflation at 2 percent after lowering the fed funds rate to 1 percent in 2003 but inflation rose to 4.1 percent in 2007. There is not “one hundred percent” confidence in controlling inflation because of the lags in effects of monetary policy impulses and the equally important lags in realization of the need for action and taking of action and also the inability to forecast any economic variable (Friedman 1953). Romer and Romer (2004) find that a one percentage point tightening of monetary policy is associated with a 4.3 percent decline in industrial production. There is no change in inflation in the first 22 months after monetary policy tightening when it begins to decline steadily, with decrease by 6 percent after 48 months (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 102). Even if there were one hundred percent confidence in reducing inflation by monetary policy, it could take a prolonged period with adverse effects on economic activity. Certainty does not occur in economic policy, which is characterized by costs that cannot be anticipated.
Table 3, Brazil, Yearly Growth Rates of M1, M2, Nominal Income (Y), Real Income (y), Real Income per Capita (y/n) and Prices (P)
| M1 | M2 | Y | y | y/N | P | |
| 1861-1970 | 9.3 | 6.2 | 10.2 | 4.6 | 2.4 | 5.8 |
| 1861-1900 | 5.4 | 5.9 | 5.9 | 4.4 | 2.6 | 1.6 |
| 1861-1913 | 4.7 | 4.7 | 5.3 | 4.4 | 2.4 | 0.1 |
| 1861-1929 | 5.5 | 5.6 | 6.4 | 4.3 | 2.3 | 2.1 |
| 1900-1970 | 13.9 | 13.9 | 15.2 | 4.9 | 2.6 | 10.3 |
| 1900-1929 | 8.9 | 8.9 | 10.8 | 4.2 | 2.1 | 6.6 |
| 1900-1945 | 8.6 | 9.1 | 9.2 | 4.3 | 2.2 | 4.9 |
| 1920-1970 | 17.8 | 17.3 | 19.4 | 5.3 | 2.8 | 14.1 |
| 1920-1945 | 8.3 | 8.7 | 7.5 | 4.3 | 2.2 | 3.2 |
| 1920-1929 | 5.4 | 6.9 | 11.1 | 5.3 | 3.3 | 5.8 |
| 1929-1939 | 8.9 | 8.1 | 11.7 | 6.3 | 4.1 | 5.4 |
| 1945-1970 | 30.3 | 29.2 | 33.2 | 6.1 | 3.1 | 27.1 |
Note: growth rates are obtained by regressions of the natural logarithms on time.
Source: See Pelaez and Suzigan (1978), 143; M1 and M2 from Pelaez and Suzigan (1981); money income and real income from Contador and Haddad (1975) and Haddad (1974); prices by the exchange rate adjusted by British wholesale prices until 1906 and then from Villela and Suzigan (1973); national accounts after 1947 from Fundação Getúlio Vargas.
III Quantitative Easing Theory. An important channel of transmission of quantitative easing is that “if money is an imperfect substitute for other financial assets, then large increases in the money supply will lead investors to seek to rebalance their portfolios, raising prices and reducing yields on alternative, non-money assets. In turn, lower yields on long-term assets will stimulate economic activity” (Bernanke and Reinhart 2004, 88). The commitment of the Fed to purchasing long-term securities is designed to impress on investors that prices will increase and yields decline for asset classes that are related to long-term borrowing costs of firms, such as corporate debt and asset-backed securities collateralized with loans.
The revealing model of Tobin (1969) provides the analysis of portfolio rebalancing (see Andrés et al. 2004). The model consists of a matrix of n rows of assets and m columns of private sectors. The sum of a row across all columns constitutes the net exogenous supply of an asset for the economy; the sum of a column across all rows is the net position of the sector. This accounting framework becomes a theory by specifying the rates of return for all assets and the net demand of all sectors for all assets. The portfolio balance equations have as an argument a vector of rates of return for all assets. The essential characteristic of base money is that its rate of return is determined exogenously by the central bank. The key sensitivity is that the ratio of the market value of capital to its reproduction cost, Tobin’s q, increases in response to an increase in base money, B, or ∂q/∂B > 0. Tobin (1969) argues that the fixed rate of return on money after increases in its supply causes increases in the rates of return of other assets. Higher demand for other assets would increase their prices or equivalently reduce their returns. Fed purchases of Treasury notes of maturities between 5 and 7 years with injection of base money would increase their prices or equivalently reduce their yields. Portfolio rebalancing would result in increases in prices of private-sector securities such as corporate debt securities or equivalently lower the cost of capital for companies to invest. The yields of securitization of loans of all types, including those originating in consumer credit, would decline, stimulating consumption of durable goods. Higher demand originating in investment and consumption would increase the rate of growth of economic activity, resulting in more hiring. The economy would escape from low growth and unemployment, eliminating the risk of deflation.
There is evidence that quantitative easing can lower Treasury yields. Following Vayanas and Vila (2009), Hamilton and Wu (2010) estimate the impact of quantitative easing of $400 billion of reducing the 10-year yield by 14 basis points before the crisis and by 13 basis points after short-term rates were set close to zero. Other estimates are in the range of 20 to 67 basis points and have been discussed in earlier posts.
IV Effects of Quantitative Easing. There is a long route of portfolio rebalancing between the purchase of long-term Treasury securities and the final impact on aggregate demand, economic activity and employment. Quantitative easing has four risks that may worsen economic conditions and create instability that may provoke another financial crisis. These effects are considered below in turn.
IV (1) Allocation Effects. Quantitative easing is a policy implemented when the interest rate is near zero. The fixing of interest rates at zero causes serious distortions in risk and return decisions that are augmented by the injection of trillions of dollars of base money. The portfolio balance equations in the Tobin (1969) model cover numerous financial risk assets. Monetary policy in the first round of fear of deflation with fed funds of 1 percent between Jun 2003 and Jun 2004 was implemented jointly with a yearly housing subsidy of $221 billion, policy of affordable housing and the purchase or guarantee of $1.6 trillion of nonprime securities by Fannie and Freddie. Short-term interest rates near zero combined with the housing stimulus distorted risk/return calculations. The carry trade consisted of borrowing at close to zero short-term interest rates and taking long positions in housing and risk financial assets such as commodities, equities, emerging equities, corporate debt, junk bonds and so on. These positions relied on rollover of short-term funding to benefit from the short-term rates in everything from adjustable rate mortgages to sale and repurchase agreements of securitized credit obligations. Liquidity was minimized because of the high alternative-return penalty of near zero interest rates. High risks were assumed in the belief that the Fed would maintain the near zero interest rates forever. Creditworthiness was ignored in the belief that increasing prices, such as in real estate, would cushion losses, such as by selling the house to cover the mortgage. Leverage was magnified because of the perceived certainty of returns in an environment of low interest rates indefinitely. The near zero interest rates of the Fed in 2003-2004 induced the causes of the credit/dollar crisis and global recession: excessive risks, high leverage, low liquidity, reliance on short-term funding and unsound credit decisions (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4).
The consequences of the global hunt for yields induced by monetary and housing policy are shown in Table 4. The second column shows a dramatic rise of 87.8 percent in the Dow Jones Industrial Average (DJIA) from 2002 to 2007, a more modest increase in the NYSE financial index of 42.3 percent in 2004-2007, an increase in the Shanghai Composite index of 444.2 percent in 2005-2007, jump in the Nikkei Average by 131.2 percent between 2003 and 2007, rise in the STOXX Europe 50 index of 93.5 percent in 2003-2007, and increase in the UBS commodity index by 165.5 percent in 2002-2008. Zero or near zero interest rates induced significant volatility by the carry trade from low yielding currencies into fixed income, commodities, currencies, emerging stocks and debt securities, junk bonds and any type of speculative position such as the price of oil rising to $149/barrel in 2008 during a global contraction (Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 203-4, Government Intervention in Globalization (2009c), 70-4). The 10-year Treasury traded at 3.112 percent on Jun 16, 2003, rising to 5.297 percent on Jun 12, 2007, collapsing to 2.247 percent on Dec 31, 2008, and rising to 3.986 percent on Apr 5, 2010. New house sales peaked historically at 1,283,000 in 2005, declining to 375,000 in 2009 while the median price jumped from $169,000 in 2000 to $247,000 in 2007 to fall to $203,000 in Jul 2010. The other two columns show the decline of risk financial assets during the credit crisis and the incomplete current recovery. Central bank policy induced the financing of nearly everything with short-dated funding at very low interest rates. When year-end consumer price inflation rose from 1.9 percent in 2003 to 3.3 percent in 2004, 3.4 percent in 2005, 2.5 percent in 2006 and 4.1 percent in 2007 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), the FOMC increased the target on the fed funds rate by 17 consecutive rounds of 25 basis points in meetings from Jun 2004 to Jun 2006, raising the rate from 1 percent to 5.25 percent. The combination of short-term zero interest rates, similar effects to quantitative easing by suspending the auction of 30-year Treasuries and housing subsidy caused a worldwide hunt for yields that ended in a world financial crash, global recession and serious distortions in risk/return calculations.
Table 4, Volatility of Assets
| DJIA | 10/08/02-10/01/07 | 10/01/07-3/4/09 | 3/4/09- 4/6/10 | |
| ∆% | 87.8 | -51.2 | 60.3 | |
| NYSE Financial | 1/15/04- 6/13/07 | 6/13/07- 3/4/09 | 3/4/09- 4/16/07 | |
| ∆% | 42.3 | -75.9 | 121.1 | |
| Shanghai Composite | 6/10/05- 10/15/07 | 10/15/07- 10/30/08 | 10/30/08- 7/30/09 | |
| ∆% | 444.2 | -70.8 | 85.3 | |
| STOXX EUROPE 50 | 3/10/03- 7/25/07 | 7/25/07- 3/9/09 | 3/9/09- 4/21/10 | |
| ∆% | 93.5 | -57.9 | 64.3 | |
| UBS Com. | 1/23/02- 7/1/08 | 7/1/08- 2/23/09 | 2/23/09- 1/6/10 | |
| ∆% | 165.5 | -56.4 | 41.4 | |
| 10-Year Treasury | 6/10/03 | 6/12/07 | 12/31/08 | 4/5/10 |
| % | 3.112 | 5.297 | 2.247 | 3.986 |
| USD/EUR | 7/14/08 | 6/03/10 | 8/13/10 | |
| Rate | 1.59 | 1.216 | 1.323 | |
| New House | 1963 | 1977 | 2005 | 2009 |
| Sales 1000s | 560 | 819 | 1283 | 375 |
| New House | 2000 | 2007 | 2009 | 2010 |
| Median Price $1000 | 169 | 247 | 217 | 203 |
Sources: http://online.wsj.com/mdc/page/marketsdata.html
http://www.census.gov/const/www/newressalesindex_excel.html
The second round of quantitative easing began to be signaled by members of the FOMC in Aug. The results are in Table 5. Nearly all risk assets in world capital markets rose while the dollar collapsed. The devaluation of the dollar has been arrested by the new concerns on sovereign risks in Europe. The effects of quantitative easing on investment and consumption may be restricted by the current environment of legislative restructuring and regulation that interferes with business models. There is an added uncertainty in government expenditures of 24 percent of GDP in 2010 with revenue at 15 percent of GDP and government debt rising to 90 percent in 2020 (http://online.wsj.com/public/resources/documents/WSJ-20111201-DeficitCommissionReport.pdf 8-9). The US budget deficit was $150.4 billion in Nov, the second month of the 2011 fiscal year and $290.9 billion in the first two months with estimates of another deficit exceeding $1 trillion (http://professional.wsj.com/article/SB10001424052748704457604576011683555582342.html?mod=WSJPRO_hps_LEFTWhatsNews). Total liquid assets, or cash, of nonfarm nonfinancial corporate business has risen from $1398.8 billion in 2008 to $1931.9 billion in the third quarter of 2010 (http://www.federalreserve.gov/releases/z1/Current/z1.pdf 66 L.102) or by 38.1 percent. The policy solution is not lowering interest rates pursued by the Fed but reducing uncertainty with policy changes of promoting confidence in the operation of business models. The combined uncertainty of legislative restructuring, regulation, continuing job stress of 27 million people unemployed or working part-time and future higher taxes and interest rates is not solved by more trillions of dollars of base money injections at zero interest rates. The Fed is crashing against a wall of uncertainty.
Table 5, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% to 12/10 | ∆% Week 12/10 | ∆% T to 12/10 | |
| DJIA | 4/26/10 | 7/2/10 | -13.6 | 1.8 | 0.2 | 17.8 |
| S&P 500 | 4/23/10 | 7/20/10 | -16.0 | 1.9 | 1.3 | 21.3 |
| NYSE Finance | 4/15/10 | 7/2/10 | -20.3 | -7.9 | 2.2 | 15.7 |
| Dow Global | 4/15/10 | 7/2/10 | -18.4 | -1.6 | 0.7 | 20.6 |
| Asia Pacific | 4/15/10 | 7/2/10 | -12.5 | 4.0 | -0.4 | 18.8 |
| Japan Nikkei Average | 4/05/10 | 8/31/10 | -22.5 | -10.4 | 0.3 | 15.7 |
| China Shanghai | 4/15/10 | 7/02/10 | -24.7 | -10.2 | -0.05 | 19.2 |
| STOXX 50 | 4/15/10 | 7/2/10 | -15.3 | -3.7 | 2.2 | 13.7 |
| DAX | 4/26/10 | 5/25/10 | -10.5 | 10.6 | 0.8 | 23.6 |
| Dollar Euro | 11/25 2009 | 6/7 2010 | 21.2 | 12.6 | 1.4 | -10.9 |
| DJ UBS Comm. | 1/6/10 | 7/2/10 | -14.5 | 5.8 | 0.2 | 23.7 |
| 10-Year Tre. | 4/5/10 | 4/6/10 | 3.986 | 3.324 |
T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)
Source: http://online.wsj.com/mdc/page/marketsdata.html
IV (2) Duration Trap. Quantitative easing with zero interest rates is combined with a policy of symmetric inflation target by which the Fed will strive to maintain inflation not lower than a little less of 2 percent (1.99 percent?) and not higher than 2 percent (2.00 percent?). This symmetric target can be justified in theory but it lacks operational credibility. If the lags in effect of policy are close to those estimated by Romer and Romer (2004), it would take 22 months of increasing interest rates before there is an impact on inflation. The financing of the $1 trillion budget deficit, refinancing of maturing debt and financing of increasingly burdensome interest payments also suggest rising yields or declining prices, causing expectations of capital losses in bond holdings. Quantitative easing can be viewed as flattening the yield curve of Treasuries with the objective of a similar effect in yields curves of securities financing capital investment and consumer loans. There is certainty that the Fed can increase interest rates in “15 minutes” as stated by Chairman Bernanke in the “60 Minutes” interview. The open market desk of the FRBNY can withdraw reserves in rapid transactions and the FOMC can determine by telephone conversation an increase in the rates of reserves of banks deposited at the Fed. The mere announcement of the measures could raise rates by even more than desired within the 15-minute time budget. Security yields are currently priced for inflation of around 1 percent. There is high uncertainty if the Fed will be able to hold inflation at 2.00 percent. Duration is the percentage change in bond prices resulting from a percentage change in bond yields. Duration is higher the lower bond yields and bond coupons, ceteris paribus. An increase in yields causes sharp declines in prices that cause high losses in bond holdings, especially in professionally-managed portfolios. Losses in bond portfolios are magnified by duration dumping during sharp increases in interest rates and spread across asset classes by margin calls and price haircuts that reduce positioning capital.
The worldwide crash of bond markets in 1994 began in the US in fear of inflation resulting from commodity prices that never materialized. The Fed increased the fed funds target from 3 percent in Jan to 6 percent in Dec with the yield of the 30-year Treasury jumping from 6.29 percent to 7.87 percent, causing price declines of 13 percent, and the yield of the 30-year mortgage rose from 7.07 percent to 9.20 percent (Pelaez and Pelaez, The Global Recession Risk (2007), 206-7). Policy errors such as this one raise doubts about the infallibility of monetary and fiscal policy.
Table 6 is updated with every post. It provides the actual yield and price of the 2.625 percent coupon Treasury maturing in ten years as observed on Nov 4, 2010, a day after the Fed announced new purchases of $650 billion of long-term Treasury securities. For other dates, the yields are the actual closing yields and the prices are calculated for a Treasury security with coupon of 2.625 percent maturing in exactly ten years from the date of yield observation. The final column provides the percentage change in price for a position purchased at the yield of 2.481 percent and price of 101.2573 observed on Nov 4 marked relative to the price at the date of observation of the other yields. The highest 10-year Treasury yield in a decade was 5.510 percent on Apr 1, 2001, for a loss of 22.9 percent relative to the price of 101.2573 on Nov 4. The lowest yield was 2.213 percent on Dec 19, 2008, in the worst part of the recession, for a gain of 3.2 percent relative to the price on Nov 4. The closing yield on Friday Dec 10 was 3.324 percent with a principal loss of 7.1 percent relative to the price on Nov 4 when the decision of a second round of quantitative easing was announced by the FOMC. There is no exit strategy from the $1.1 trillion reserves of depository institutions at the Federal Reserve Banks (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1) without a sharp increase in interest rates with adverse effects on the expansion path of the economy.
Table 6, Yield, Price and Percentage Change to November 4, 2010 of Ten Year Treasury Note
| Date | Yield | Price | ∆% 11/04/10 |
| 05/01/01 | 5.510 | 78.0582 | -22.9 |
| 06/10/03 | 3.112 | 95.8452 | -5.3 |
| 06/12/07 | 5.297 | 79.4747 | -21.5 |
| 12/19/08 | 2.213 | 104.4981 | 3.2 |
| 12/31/08 | 2.240 | 103.4295 | 2.1 |
| 03/19/09 | 2.605 | 100.1748 | -1.1 |
| 06/09/09 | 3.862 | 89.8257 | -11.3 |
| 10/07/09 | 3.182 | 95.2643 | -5.9 |
| 11/27/09 | 3.197 | 95.1403 | -6.0 |
| 12/31/09 | 3.835 | 90.0347 | -11.1 |
| 02/09/10 | 3.646 | 91.5239 | -9.6 |
| 03/04/10 | 3.605 | 91.8384 | -9.3 |
| 04/05/10 | 3.986 | 88.8726 | -12.2 |
| 08/31/10 | 2.473 | 101.3338 | 0.08 |
| 10/07/10 | 2.385 | 102.1224 | 0.8 |
| 10/28/10 | 2.658 | 99.7119 | -1.5 |
| 11/04/10 | 2.481 | 101.2573 | - |
| 11/15/10 | 2.964 | 97.0867 | -4.1 |
| 11/26/10 | 2.869 | 97.8932 | -3.3 |
| 12/03/10 | 3.007 | 96.7241 | -4.5 |
| 12/10/10 | 3.324 | 94.0982 | -7.1 |
Note: price is calculated for an artificial 10-year note paying semi-annual coupon and maturing on 12/02/2020 using the actual yields traded on the dates
Source:
http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3020
IV (3) Mismatch of Assets and Liabilities. Banks and other financial institutions are engaged in funding in the short-term at very low interest rates to create assets paying long-term interest rates for earning positive interest margin. Insurance companies and pension funds must match benefit payments with income from long-term securities. Quantitative easing is causing numerous issues with matching assets and liabilities. The Wall Street Journal informs that the FDIC measures a decline in net interest margins of banks with assets exceeding $1 billion to 3.74 percent on Sep 30 from 3.85 percent in Mar (http://professional.wsj.com/article/SB10001424052748703471904576003880782571372.html?mod=WSJPRO_hpp_LEFTTopStories). Insurance companies are forced into increasing premiums because of low-yielding long-term Treasuries to match benefits. Pension funds are experiencing capital losses in existing bond holdings together with increasing difficulty in matching future benefits at lower yields. The entire financial system is affected by quantitative easing and interest rates near zero in unpredictable and often harmful ways.
IV (4) Global Devaluation War. Another consequence of quantitative easing is provided by Krugman (1998, 162): “in the traditional open economy IS-LM model developed by Robert Mundell and Marcus Fleming, and also in large-scale econometric models, monetary expansion unambiguously leads to currency depreciation.” The suggestion by Chairman Bernanke to the Bank of Japan (BOJ) is very relevant to current events and the contentious issue of ongoing devaluation wars (http://www.iie.com/publications/chapters_preview/319/7iie289X.pdf, 161):
“Because the BOJ has a legal mandate to pursue price stability, it certainly could make a good argument that, with interest rates at zero, depreciation of the yen is the best available tool for achieving its mandated objective. The economic validity of the beggar-thy-neighbor thesis is doubtful, as depreciation creates trade—by raising home country income—as well as diverting it. Perhaps not all those who cite the beggar-thy-neighbor thesis are aware that it had its origins in the Great Depression, when it was used as an argument against the very devaluations that ultimately proved crucial to world economic recovery. A yen trading at 100 to the dollar is in no one’s interest.”
Bernanke finds dollar devaluation against gold to have been important in preventing further deflation in the 1930s (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm):
“There have been times when exchange rate policy has been an effective weapon against deflation. A striking example from US history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the US deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market.”
Devaluation, intentionally or as a side consequence, is an important part of increasing inflation and promoting growth and employment by means of quantitative easing. Table 7, updated with every post, shows an almost unilateral devaluation of the dollar against currencies of advanced and emerging countries, which is widely believed to be a consequence of quantitative easing.
Table 7, Exchange Rates
| Peak | Trough | ∆% P/T | Dec 10 2010 | ∆% T Dec 10 | ∆% P Dec 10 | |
| EUR USD | 7/15 2008 | 6/7 2010 | 12/10 2010 | |||
| Rate | 1.59 | 1.192 | 1.322 | |||
| ∆% | -33.4 | 9.8 | -20.3 | |||
| JPY USD | 8/18 2008 | 9/15 2010 | 12/10 2010 | |||
| Rate | 110.19 | 83.07 | 83.93 | |||
| ∆% | 24.6 | 1.0 | 23.9 | |||
| CHF USD | 11/21 2008 | 12/8 2009 | 12/10 2010 | |||
| Rate | 1.225 | 1.025 | 0.981 | |||
| ∆% | 16.3 | 4.3 | 19.9 | |||
| USD GBP | 7/15 2008 | 1/2/ 2009 | 12/10 2010 | |||
| Rate | 2.006 | 1.388 | 1.58 | |||
| ∆% | -44.5 | 12.1 | -26.9 | |||
| USD AUD | 7/15 2008 | 10/27 2008 | 12/10 2010 | |||
| Rate | 0.979 | 0.601 | 0.985 | |||
| ∆% | -62.9 | 40.3 | 2.8 | |||
| ZAR USD | 10/22 2008 | 8/15 2010 | 12/10 2010 | |||
| Rate | 11.578 | 7.238 | 6.854 | |||
| ∆% | 37.5 | 5.4 | 40.8 | |||
| SGD USD | 3/3 2009 | 8/9 2010 | 12/10 2010 | |||
| Rate | 1.553 | 1.348 | 1.307 | |||
| ∆% | 13.2 | 3.0 | 15.8 | |||
| HKD USD | 8/15 2008 | 12/14 2009 | 12/10 2010 | |||
| Rate | 7.813 | 7.752 | 7.773 | |||
| ∆% | 0.8 | -0.3 | 0.5 | |||
| BRL USD | 12/5 2008 | 4/30 2010 | 12/10 2010 | |||
| Rate | 2.43 | 1.737 | 1.707 | |||
| ∆% | 28.5 | 1.73 | 29.8 | |||
| CZK USD | 2/13 2009 | 8/6 2010 | 12/10 2010 | |||
| Rate | 22.19 | 18.693 | 19.031 | |||
| ∆% | 15.7 | -1.8 | 14.2 | |||
| SEK USD | 3/4 2009 | 8/9 2010 | 12/10 2010 | |||
| Rate | 9.313 | 7.108 | 6.907 | |||
| ∆% | 23.7 | 2.8 | 25.8 |
Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; ZAR: South African rand; SGD: Singapore dollar; HKD: Hong Kong dollar; BRL: Brazil real; CZK: Czech koruna; SEK: Swedish krona; P: peak; T: trough
Note: percentages calculated with currencies expressed in units of domestic currency per dollar; negative sign means devaluation and no sign appreciation
Source: http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000
V Economic Indicators. There are new signs of improving economic conditions in faster growth of trade, increases in household net worth, sales of merchant wholesalers and reduction in new claims of unemployment insurance. The Fed’s Flow of Funds Accounts of the United States estimates that “household net worth—the difference between the value of assets and liabilities—was an estimated $54.9 trillion at the end of the third quarter, up about $1.2 trillion from the end of the previous quarter” (http://www.federalreserve.gov/releases/z1/Current/z1.pdf). While household debt fell 1.7 percent and business debt increased by 1.7 percent in IIIQ10, federal debt increased by 16 percent, after increasing by 24.4 percent in IIQ10 and 20.5 percent in IQ10 and state and local debt rose by 5.2 percent in IIIQ10 (Ibid). Lowering yields of securities by quantitative easing is not inducing borrowing by the private sector. Consumer credit grew at the annual rate of 1.75 percent in Oct 2010; revolving credit fell at the annual rate of 8.5 percent; and non-revolving credit grew at the annual rate of 6.75 percent (http://www.federalreserve.gov/releases/g19/Current/). Sales of merchant wholesalers, seasonally adjusted, rose 2.2 percent in Oct relative to Sep and were higher by 13.4 percent relative to Oct 2009; inventories of merchant wholesalers rose 1.9 percent relative to Sep and 9.9 percent relative to Oct 2009 (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf). The news that caused optimism in financial markets was the reduction of the US trade deficit from $44.6 billion in Sep to 38.7 billion in Oct primarily by growth of exports of 3.2 percent in Oct relative to Sep, seasonally adjusted. Jan-Oct not seasonally adjusted exports rose by 21.2 percent, raising optimism in strength in world trade while imports grew 24.4, raising optimism on the domestic economy (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf). New claims for unemployment insurance fell by 17,000 in the week ending Dec 4 to 421,000 and the four-week average fell by 4,000 to 427,500 (http://www.dol.gov/opa/media/press/eta/ui/current.htm). Several weeks of improvements suggest reduction of new claims from 450,000 toward less than 425,000.
VI Interest Rates. The US 10-year Treasury sharply increased in yield to 3.32 percent on Dec 10 relative to 3.02 percent a week earlier and 2.65 percent a month ago. The 10-year government bond of Germany also rose to 2.97 percent for negative spread relative to the comparable US Treasury of 35 basis points (http://markets.ft.com/markets/bonds.asp?ftauth=1292172551998). The 2.63 coupon US Treasury maturing in 11/20 was priced at 94.31 for equivalent yield of 3.30 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-101210).
VII Conclusion. The policy of quantitative easing with zero interest rates is frustrated in the current environment because of inhibition of investment and consumption by uncertainties of legislatives restructurings, regulation, subpar growth, job stress of 27 million and expectations of higher taxes and interest rates. The adverse effects of quantitative easing with zero interest rates are: (1) “exuberant” valuations of risk financial assets such as commodities, equities, foreign exchange, junk bonds and so on in the carry trade of borrowing at near zero interest rates and going long in risk financial assets; (2) increasing yields of Treasury and private-sector securities if the increase of inflationary expectations of the symmetric inflation target is attained; (3) duration trap of long-term securities from high duration at low yields and coupons, resulting in major losses in bond holdings when yields inevitably increase; (4) distortions of maturity transformation in financial markets; and (5) disruption of international economic relations resulting from global devaluation wars. There is room for improvement of the economy by more traditional and less experimental monetary and fiscal policies.
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©Carlos M. Pelaez, 2010
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