During his recent presentation to Congress the Chairman of the Federal Reserve has made several statements both about the US economy and the policy response which he and his fellow members of the Federal Open Markets Committee (FOMC) made to the recession caused by the credit crunch. I have been asked about the significance of his statements both on here and elsewhere and so I thought that I would address them today.
Policy Responses by the US FOMC
If we look at interest-rates the first cut in the Federal Funds rate took place on the 18th of September 2007 when a 0.5% cut reduced it from 5.25% to 4.75% Since then there have been 9 further cuts taking the interest-rate down to a range of between zero and 0.25%. This established what has been called the Zero Interest Rate policy or ZIRP as unless they are willing to reduce interest-rates below zero in nominal terms we are now at the lower bound.
As the flexibility in a downwards direction for interest-rates is restricted by zero at this time ( just to be clear whilst some have talked of negative interest-rates there are no official plans for this) then if a central bank wishes to further stimulate an economy then as it can no longer influence the price of money it has to influence the quantity of it. Accordingly as the FOMC wished to further stimulate the US economy it has indulged in several stages of asset purchases or Quantitative Easing. Central Banks like terms such as Quantitative Easing as they make people forget that the real aim of the policy is to put money (liquidity) in investors hands which put that way sounds like printing money an image they wish to avoid! The FOMC has been quite happy to in effect print narrow money it just does not want it put like that.
There have been three variants so far of Quantitative Easing which have been called QE1, QE-lite and QE2. Between them they are planned to purchase around US $2.3 trillion of assets. the assets purchased were mostly mortgage-backed securities in QE1 but QE-lite exchanged some of these for US Treasury Bonds (government debt) and QE2 involves purchases of US $75 billion per month of US Treasuries.
So in a nutshell we have interest rate cuts in excess of 5% and US $2.3 trillion of asset purchases.
Can we measure the impact of this?
Ben Bernanke thinks that we can as he introduced a rule of thumb in this speech that a 0.25% cut in interest-rates is equivalent to between US $150 and 200 billion of asset purchases. He then refined this to say that the total level of purchases under QE2 of some US $600 billion are equivalent to an interest-rate cut of 0.75%. I have watched the video and these are his words.
A 75 basis point (0.75%) cut is a strong but not unusual move.
But then he goes onto to say this which is quite significant.
The movement of a wide variety of financial prices are quite consistent with that 0.75% cut in interest-rates.
Well Are They?
I established some benchmarks for future reference on the day that QE2 was announced back on the 3rd of November 2010 so let me quote them now.
The Dow Jones Industrial Average closed at 11,188 which was up 64 points. As to whether this welcomed a likely Republican swing or was just getting ready for the FOMC statement it is hard to say. In terms of government bond yields then the ten-year yields 2.57% and the thirty-year yields some 3.91%. Moving onto currencies then the trade-weighted US dollar index stands at 76.68. Another possible benchmark is the gold price which has a front month futures price of US $1354.
Of these benchmarks only the level of the Dow Jones Industrial Average backs up Ben Bernanke’s claims as it closed last night at 12,066 which is up by 878 points or just under 8%. Whilst this is a tick in the column it also adds fuel to the claims by some that the real aim of FOMC policy is to reward equity investors in a strategy which is labelled the “Bernanke Put”! Whether you believe in it or not the fact remains that equity prices have risen.
The way that longer-term interest-rates have risen poses a much more difficult challenge for Mr. Bernanke however. The ten-year government bond yield has risen to 3.42% which is up some 0.85% since then and the thirty-year is at 4.55% which is up 0.64%. If you think about it this is an odd result for a policy which if we move to the UK was being praised as REDUCING longer-term government bond yields and by implication other longer-term yields. Charlie Bean a member of the UK Monetary Policy Committee had thoughts on this subject which were put like this on a comment on here
that QE has reduced gilt (government bond) rates by 100 bps, investment grade rates by c. 75 bps and non investment grade by even more
So there you have it according to central banks their policy of asset purchases is apparently a success if interest-rates go down and also a success if they go up! The go up view is apparently because it shows a recovery in the economy. Of course any realistic assessment of anything involves criteria and as a whole if everything is a success then you plainly have no criteria…
The performance of the US dollar is intriguing as during Ben’s testimony it dropped and at one point was at 76.68 raisng a smile from me at least, at the irony of something which has been debated so much (the so-called “currency wars” problem) in fact having at that point exactly zero impact!
The gold price has risen since then to US $1432 per troy ounce which represents a rise of 78 dollars or 5%. Is a rise in the price of gold a success? This is the hardest to measure as it is the instrument most affected by other influences and has been driven higher by the unrest in North Africa and Arabia although if you take my view that the rise in world commodity and food prices has been partly caused by QE then you have a complicated situation with lots of feedback. So both sides could call this move a success although if you stop to think for a moment and think logically then the definition of a central banker should be that an objective should be a lower gold price which would be likely to raise the faith in fiat money rather than the reverse.
A Measure I wish I had used
With the surge in commodity and food prices that has taken place since the beginning of QE 2 I wish I had established benchmarks for commodity and food prices back then. However that does not stop me from looking at what they would have been! Back then the Commodity Research Bureau spot index was at 495 and it closed last night at 567.21 for a rise of 14.5%
If we think of those poor souls who are struggling to feed themselves in North Africa the CRB food component has risen from 420 to 495.81 for a rise of 18%
Of course correlation does not cause causation but if I was Ben Bernanke then my conscience would be troubling me and I doubt I would be sleeping well.
Thank you to those who raised the remarks by Ben Bernanke as it is an interesting subject. However I do have a qualification for his “rule of thumb” which is that I am of the opinion that as you approach what economists call the lower bound for interest-rates ( presumably forgetting the word zero!) then cutting interest-rates has a weaker and weaker effect. At zero itself the effect may disappear. So if we take Ben at his word then not only do we need his rule of thumb but we need also the interest-rate at which it applies, otherwise it lacks credibility.
If you put this another way you arrive at one of my reasons for raising UK interest rates towards 2%. An effect of this would be to make monetary policy in its conventional form effective again as from here a rise in rates would have an effect and a cut would have at least an initial gain. So we would be returning monetary policy to effectiveness although in UK terms we would still be some 2.5% of what is considered to be the neutral level. Many who get very upset at the idea of higher official interest-rates forget that the policy would still be expansionary merely less so. One of the themes of this blog is “exit strategies” and the problems that reversing policies create. My question for those who would not raise official interest-rates in the UK goes as follows, what are your criteria for a rise?
Finally if you take Ben Bernanke’s “rule of thumb” and apply it to the UK you come up with the UK’s version of QE being equivalent to a 2.5% cut in interest-rates.
The Euro zone and its problems
One of the features of the crisis that is being inflicted on Portugal Ireland and Greece is statements by Euro zone officials which involve aid for these countries which are then regularly shot down by politicians from the country most likely to get the bill! The German Chancellor Angela Merkel has been busy doing just that over the past few days. This leaves them yet again without any sort of strategy and as recent elections in Hamburg went badly for Chancellor Merkel she is unlikely to be in favour of new policies right now as there are other elections due in Germany this month.
This leaves Portugal who was hoping for some sort of Euro zone support, and by this I mean money rather than hyperbole, at the next summit on the 24th and 25th of this month in a painful interregnum. Her ten-year government bond yield remains stuck around 7.5% leaving her looking consistently insolvent and for those who record such things she has been like this for a longer period of time than Ireland and Greece survived before being forced to call for help. Whilst yesterdays auction raised some one billion Euros if we look a the bill which expires on the 17th of February 2012 she had to pay 4.06% against an already inflated 3.99% from mid-February. Compared with the official European Central Bank rate of 1% Portugal is forced to pay 3% more and that in such times is a severe penalty and illustrates the depth of her problem.
Some analysis from Barclays Capital has illustrated that the moves by the ECB have in fact allowed foreign investors (banks) to leave the Portuguese bond market. In 2010 they feel that the ECB bought some 20 billion Euros of Portuguese government debt whilst foreign investors aka banks sold the same amount. Convenient eh? We are back to the theme of this being a bank rather than a country bailout. As Portugal only issued 21.7 billion Euros of debt in 2010 then we can see that she has only one buyer of any size.