In the past few days I have read approximately 15 speeches and books by various economists, Fed Officials, Bernanke and Japanese Officials, on what to do when facing Deflation in a Zero-Interest Rate Environment.
My goal has always been to take the studies of academia and the teachings of the chart technicians and turn what I see and read into a profit. I’m not here to learn all the Depression and the Gold Standard and things like Novation and Quantitative Easing, for the sake of being a walking encyclopedia. I read and learn and study and battle my emotions in an effort to figure out where the markets are going and when is a good time to commit capital. That’s what I do. And these days, it seems to be all I do…
First, What is Quantitative Easing (QE)
A Central Bank normally impacts economic activity by targeting a specific short-term interest rate. Every day, the Central Bank injects or withdraws enough money from the banking system to keep the target rate at the desired level. The US Federal Reserve focuses its effort on the Federal Funds Rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.
When your target interest rate approaches zero, you are forced to use other policy tools to impact economic activity. Bernanke sites three –
- Provide assurances to the financial system that short term rates will be lower in the future than is expected
- Shift the asset mix of the holdings on the Balance Sheet of the Federal Reserve
- Increase the size of the Federal Reserve’s Balance Sheet beyond the level needed to get short term interest rates to zero. This is Quantitative Easing.
So QE is simply creating more money than the economy currently needs to keep rates at near zero %.
Japan
Japan is the only real experiment with QE. Experienced an economic malaise since late 1989, Japan found itself with an insolvent banking system, systemic deflation and a 0.15% Target Interest Rate.
“In 2001, Japanese banks were still in the process of reducing their large stock of nonperforming loans. In the months prior to the launch of Quantitative Easing, 19 Japanese banks experienced downgrades in their credit ratings.”
So the Japanese were faced with what we now faced – an insolvent banking system on the verge of massive downgrades, which would cause massive, system-wide deleveraging of bad assets. Remember what Bernanke just said the tools were to fight deflation when the Target Interest Rate is effectively 0% -
The Japanese Government assured investors that they would keep interest rates at 0%, until the country saw 12 months of stable or rising Consumer Prices.
The Japanese Central Bank began buying 400 Billion Yen per month in Long Term Japanese Government Securities
Excess Reserves held at the Japanese Central Bank by Japanese Banks went from 4 trillion Yen to 45 trillion Yen in five years.
Did it work? I don’t know. Japan is still around, but their stock market is at the same price it was at in 1981. Moreover, the bad banks were spared from having to restructure and become profitable. QE started at the Green Arrow and ended at the Black Arrow.
Where or not QE worked in Japan is apparently the subject of a roiling debate in economist circles. I couldn’t care less. I just want to know how to be prepared to protect myself and my clients.
Bernanke
After reading a lot of his work, I am convinced that he is not stupid and that he believes to his core that the main responsibility of the Federal Reserve is to offer a stable economy with maximum opportunity.
The great thing about Bernanke is that he tells you what tools he is going to use if he ever runs into a problem in the future. It’s like in the movie Patton, where George C Scott screams “Rommel… You magnificent ------, I READ YOUR BOOK!” I feel the same way when I read Bernanke’s speeches. Look at this beautiful speech he gave in 2004 entitled – Conducting Monetary Policy at Very Low Short-Term Interest Rates
http://www.federalreserve.gov/boarddocs/speeches/2004/200401033/default.htm
In this speech he lays out the three tools I cited above. I want to focus on the last two –
#2 Altering the Composition of the Central Bank’s balance Sheet
All you have to do is look at this chart to see how much the Fed has changed its Balance Sheet in the last year.
What the Fed is now really keying on is purchasing Long Term US Treasury Bonds. Bernanke has always hinted at the possibility of capping Long Term Interest Rates. You do this by putting a floor on prices. If somebody wants to sell a bound, you buy it at a price that lowers the yield to the level you desire.
The bailout of Citigroup a few days ago was the Fed admitting that it had undertaken QE to try and save the economy from Deflation and Depression. Look at how the Yield on the 30-year US Treasury has imploded since the announcement of the Citigroup bailout ($TYX is the 30-year Yield times 10) –
Look at how low rates are! Even worse, the Yield Curve is INVERTED on the long end (longer maturity rates higher than shorter maturity rates)! Are you kidding me? The Yield Curve is now pricing in even WORSE economic activity. Here is how the Yield Curve looked in June 2002. This was right before the Stock Market had its final plunge, before started its 9-month bottoming process.
See why I do all of this homework? See why I am looking over my shoulder on every short I take and am scanning charts everynight for hints of new potential leadership? I will be there, money in hand, when the markets do their bottoming process and leadership shows up.
There is precedent for capping Interest Rates. The Fed did it from 1942 to 1951.
It ended with rising inflation.
#3 Expand the Size of the Central bank’s Balance Sheet
“Besides changing the composition of its balance sheet, the central bank can also alter policy by changing the size of its balance sheet; that is, by buying or selling securities to affect the overall supply of reserves and the money stock.”
“(R)eserves can be increased beyond the level required to hold the (Target Interest Rate) at zero--a policy sometimes referred to as "quantitative easing."
The TARP, the Commercial Paper Purchase Program, the Money Market Purchase Program, the Term Auction Facility and all the other programs have massively expanded the Balance Sheet of the Federal Reserve. The Fed now has a total of $8.2 Trillion on and off of its Balance Sheet (up from $850 billion last year). Obviously, that is unprecedented.
The primary goal of all this purchasing is to drive down the cost of debt and credit creation (Interest Rates). Secondary benefits include deleveraging the books of banks, and lowering the cost of borrowing for the Government.
Here is how looks graphically -
There is now over $300 billion in “excess capital” sitting idly at the Fed. The money was created to allow the Fed to buy bonds from these banks in their effort to drive down interest rates. Wait, it gets better. Do you remember a few weeks ago when Paulson and Bernanke told Congress that they need the power to pay banks a rate of interest on the “excess reserves” banks held with the Fed? So now we actually paying these banks money for the privilege of buying their bonds at artificially inflated prices –
Why Are We Doing All of This?
You need to read Bernanke’s thoughts on the Depression to get an idea of what he is thinking –
http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm
“(T)he experience of the Depression helped forge a consensus that the government bears the important responsibility of trying to stabilize the economy and the financial system, as well as of assisting people affected by economic downturns.”
Bernanke believes that the Great Depression was result of the Fed not keeping enough money in the banking system. There were several causes
My goal has always been to take the studies of academia and the teachings of the chart technicians and turn what I see and read into a profit. I’m not here to learn all the Depression and the Gold Standard and things like Novation and Quantitative Easing, for the sake of being a walking encyclopedia. I read and learn and study and battle my emotions in an effort to figure out where the markets are going and when is a good time to commit capital. That’s what I do. And these days, it seems to be all I do…
First, What is Quantitative Easing (QE)
A Central Bank normally impacts economic activity by targeting a specific short-term interest rate. Every day, the Central Bank injects or withdraws enough money from the banking system to keep the target rate at the desired level. The US Federal Reserve focuses its effort on the Federal Funds Rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.
When your target interest rate approaches zero, you are forced to use other policy tools to impact economic activity. Bernanke sites three –
- Provide assurances to the financial system that short term rates will be lower in the future than is expected
- Shift the asset mix of the holdings on the Balance Sheet of the Federal Reserve
- Increase the size of the Federal Reserve’s Balance Sheet beyond the level needed to get short term interest rates to zero. This is Quantitative Easing.
So QE is simply creating more money than the economy currently needs to keep rates at near zero %.
Japan
Japan is the only real experiment with QE. Experienced an economic malaise since late 1989, Japan found itself with an insolvent banking system, systemic deflation and a 0.15% Target Interest Rate.
“In 2001, Japanese banks were still in the process of reducing their large stock of nonperforming loans. In the months prior to the launch of Quantitative Easing, 19 Japanese banks experienced downgrades in their credit ratings.”
So the Japanese were faced with what we now faced – an insolvent banking system on the verge of massive downgrades, which would cause massive, system-wide deleveraging of bad assets. Remember what Bernanke just said the tools were to fight deflation when the Target Interest Rate is effectively 0% -
The Japanese Government assured investors that they would keep interest rates at 0%, until the country saw 12 months of stable or rising Consumer Prices.
The Japanese Central Bank began buying 400 Billion Yen per month in Long Term Japanese Government Securities
Excess Reserves held at the Japanese Central Bank by Japanese Banks went from 4 trillion Yen to 45 trillion Yen in five years.
Did it work? I don’t know. Japan is still around, but their stock market is at the same price it was at in 1981. Moreover, the bad banks were spared from having to restructure and become profitable. QE started at the Green Arrow and ended at the Black Arrow.
Where or not QE worked in Japan is apparently the subject of a roiling debate in economist circles. I couldn’t care less. I just want to know how to be prepared to protect myself and my clients.
Bernanke
After reading a lot of his work, I am convinced that he is not stupid and that he believes to his core that the main responsibility of the Federal Reserve is to offer a stable economy with maximum opportunity.
The great thing about Bernanke is that he tells you what tools he is going to use if he ever runs into a problem in the future. It’s like in the movie Patton, where George C Scott screams “Rommel… You magnificent ------, I READ YOUR BOOK!” I feel the same way when I read Bernanke’s speeches. Look at this beautiful speech he gave in 2004 entitled – Conducting Monetary Policy at Very Low Short-Term Interest Rates
http://www.federalreserve.gov/boarddocs/speeches/2004/200401033/default.htm
In this speech he lays out the three tools I cited above. I want to focus on the last two –
#2 Altering the Composition of the Central Bank’s balance Sheet
All you have to do is look at this chart to see how much the Fed has changed its Balance Sheet in the last year.
What the Fed is now really keying on is purchasing Long Term US Treasury Bonds. Bernanke has always hinted at the possibility of capping Long Term Interest Rates. You do this by putting a floor on prices. If somebody wants to sell a bound, you buy it at a price that lowers the yield to the level you desire.
The bailout of Citigroup a few days ago was the Fed admitting that it had undertaken QE to try and save the economy from Deflation and Depression. Look at how the Yield on the 30-year US Treasury has imploded since the announcement of the Citigroup bailout ($TYX is the 30-year Yield times 10) –
Look at how low rates are! Even worse, the Yield Curve is INVERTED on the long end (longer maturity rates higher than shorter maturity rates)! Are you kidding me? The Yield Curve is now pricing in even WORSE economic activity. Here is how the Yield Curve looked in June 2002. This was right before the Stock Market had its final plunge, before started its 9-month bottoming process.
See why I do all of this homework? See why I am looking over my shoulder on every short I take and am scanning charts everynight for hints of new potential leadership? I will be there, money in hand, when the markets do their bottoming process and leadership shows up.
There is precedent for capping Interest Rates. The Fed did it from 1942 to 1951.
It ended with rising inflation.
#3 Expand the Size of the Central bank’s Balance Sheet
“Besides changing the composition of its balance sheet, the central bank can also alter policy by changing the size of its balance sheet; that is, by buying or selling securities to affect the overall supply of reserves and the money stock.”
“(R)eserves can be increased beyond the level required to hold the (Target Interest Rate) at zero--a policy sometimes referred to as "quantitative easing."
The TARP, the Commercial Paper Purchase Program, the Money Market Purchase Program, the Term Auction Facility and all the other programs have massively expanded the Balance Sheet of the Federal Reserve. The Fed now has a total of $8.2 Trillion on and off of its Balance Sheet (up from $850 billion last year). Obviously, that is unprecedented.
The primary goal of all this purchasing is to drive down the cost of debt and credit creation (Interest Rates). Secondary benefits include deleveraging the books of banks, and lowering the cost of borrowing for the Government.
Here is how looks graphically -
There is now over $300 billion in “excess capital” sitting idly at the Fed. The money was created to allow the Fed to buy bonds from these banks in their effort to drive down interest rates. Wait, it gets better. Do you remember a few weeks ago when Paulson and Bernanke told Congress that they need the power to pay banks a rate of interest on the “excess reserves” banks held with the Fed? So now we actually paying these banks money for the privilege of buying their bonds at artificially inflated prices –
Why Are We Doing All of This?
You need to read Bernanke’s thoughts on the Depression to get an idea of what he is thinking –
http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm
“(T)he experience of the Depression helped forge a consensus that the government bears the important responsibility of trying to stabilize the economy and the financial system, as well as of assisting people affected by economic downturns.”
Bernanke believes that the Great Depression was result of the Fed not keeping enough money in the banking system. There were several causes
