The Fed's Exit Strategy

[Sharky]

Re: The Fed's Exit Strategy

So for a while the US issued redeemable silver certificates, then it stopped issuing them but would still redeem them, then it stopped even redeeming them, then in 1971 those certificates went out of circulation entirely. Is that about right?

Close, except that US Notes are different from Silver Certificates; they were the Treasury's version of true fiat money. See:

http://en.wikipedia.org/wiki/United_States_Note

20th century silver certificates are marked with a blue seal, US Notes have a red seal and FRNs have a green seal.

[c1ue]

Re: The Fed's Exit Strategy

I agree. I'm hoping we experience this as just economic stagnation and high inflation.

That is high optimism. iTulip has said it would be a major downward adjustment of living standards. I also specifically highlighted Poland and US living standards converging over time.

This is more like a falling economy and high inflation.

Of course, hope is not a policy.

Wrong there bucko - we elected a President based on hope. Yes We Can.

[Raz]

Re: The Fed's Exit Strategy

Hi stanley. This is a rather long post -- unfortunately, its length does not reflect my actual knowledge of the subject, but only my amateur interest. With the understanding that I'm not presenting myself as any kind of expert on the banking system, I'm happy to share my thoughts...

My sense is that we're on a trajectory to end up with a lot of the smaller banks gone, and a few big zombies. I assume there will also be a few banks mixed in with the zombies which are reasonably healthy -- either through better risk management during the bubble, or through preferential treatment afterwards. However, they may not be very profitable.

My thumbnail narrative for the banking crisis is that once loans started going bad, the write-offs and write-downs both ate into bank capital and induced the banks to cut back on the issuance of new loans. As the rate of credit creation dropped, so did the economic activity and asset valuations driven by constant credit expansion, with the result that cash-strapped consumers are continuing to default on loans, and are also less eager to borrow. This set up a positive feedback loop that threatened a deflationary spiral, and widespread failure of banking institutions. So far, the policy response has been directed at arresting the panic (which would have accelerated a collapse), trying to break the deflationary feedback loop, and buying some time to get credit expansion going again.

The authorities were successful in arresting the panic. It will take time to determine how successful they are at stopping the deflationary feedback loop and getting credit expansion going again -- people are still losing their jobs, and will continue to default on loans. If I read bart's charts correctly, it looks like credit is flat after a sharp drop -- but it hasn't been flat for very long, and hasn't made a sustained turn upwards yet. In any case, I accept the view that with debt securitization dead for the moment -- and continued access to foreign credit in question -- a rapid return to the conditions of the credit bubble simply aren't in the cards.

In my mind, the part of this that most directly relates to the health of the banking sector is the intervention to recapitalize the major banks, or at least conceal their deficiencies. The Fed's lending against dubious assets, printing, and interest rate policy accommodation, the government's injection of capital, and the suspension of the mark-to-market rule, seem to have addressed the immediate problem of capitalization for the big banks. That said, the capitalization problem for those banks that were saved by relaxation of mark-to-market will resurface as more loans go bad over time. After all, mark-to-myth doesn't pan out if you hold a bundle of bad loans to maturity. Also, some of the institutions that are okay now even without balance sheet sophistry will find they have problems, as further losses accrue in other categories of debt.

The only way to avoid future capitalization problems is either (a) putting enough cash in the hands of the indebted to pay their bills and avoid default, (b) the transfer of the debt from those who cannot pay to those who can, or (c) allowing the banks to get the bad loans off their books by selling them at something close to their mark-to-myth valuation.

A bonafide economic recovery, wage inflation, or inflation of the assets which secure the loans would accomplish (a). I'm doubtful that an economic recovery can precede clearing of the debt overhang, although I think this is what the policy-makers hope for. One might argue that they think a resumption of credit-driven asset price inflation would be a recovery. In any case, as regards homes, that well is dry. So, in this category, they are probably going to end up settling for wage inflation, whether by accident or design. (Note that my supposition there will be wage inflation doesn't mean that inflation will be driven by wage inflation.)

Government bailouts fit the bill for (b). However, government bailouts are constrained by politics and means. I believe that further direct bailouts of the banking system will not be possible by the time that new capitalization problems surface. Therefore, the authorities will have to accomplish their ends by other means.

Various initiatives from the Treasury were focussed on (c), but the more recent ones were short-circuited by the mark-to-market rule change (haven't heard much more about PPIP since then). The Fed's monetization of agency MBS also have that character, although I think that program is more about manipulating mortgage rates than getting mortgages off the books of banks. That said, to the extent that there is oversight and auditing of any such sales, in any kind of legitimate market "to make sure the public doesn't over-pay", these programs will be less effective at averting a capitalization problem. From the standpoint of patching bank balance sheets, the whole point of the intervention is to over-pay. Like direct bailouts, programs like PPIP may become decreasingly politically viable as time passes.

Elsewhere, I hypothesized that the Fed's monetization of mortgages might turn into a weird combination of (a) and (c) in which banks can sell the MBS to the Fed at "face value" but the Fed then rewrites the loan terms to the benefit of the debtors. That's complete speculation, but it's one mechanism by which both the capitalization needs of the banks and the cash flow needs of the consumer can be addressed. This is the sort of thing that I think we might be driven to, after direct bailouts are no longer feasible.

It should be pointed out that avoidance of future capitalization problems is not assured -- the answer could be "none of the above", in which case bank failure is also on the table. Smaller banks are going under, and will continue to do so. It may be that if fresh capitalization problems are encountered when there are fewer easy policy choices (i.e. bailouts or transfering private debt to the public is no longer expedient), the worst of the larger banks that have been protected so far will actually be shut down.

Turning at last to the specific issues raised in your post, I don't think it's technically true that the money destroyed to date is more than the Fed has printed in response to the crisis... depending upon what you regard as money. By their nature, the Fed's moves to shore up bank capitalization all focus at the base of the inverted monetary pyramid, so it's certainly true that the Fed's "printing" could be overwhelmed by the contraction of credit as banks reduce their lending against their reserves, or fail. However, again refering to Bart's charts, it appears that we've lost about $1T from the sum of M3 and credit, whereas the Fed has commited to printing $1.25T to cover the purchase of MBS alone. My thinking is that the economically significant factors so far are the drop in asset value, and the reduction -- and temporary reversal -- in the rate of credit expansion.

So, to date, it seems like the actual contraction of money plus credit hasn't been larger than the Fed's printing. On the other hand, neither has the Fed gotten credit expansion and asset price inflation roaring again. Consequently, loans will continue to go bad, eating into bank capital. The question, I suppose, is whether the continued failure of small banks -- and the eventual capitalization problems of the big banks -- will be so severe as to both threaten the banking system and outpace the policy response. Your reference to the shadow banking system also touches on this point, as the shadow banking system is posited to be a potential source of vast and abrupt losses.

With the caveat that I am even less an expert on the shadow banking system than on the regular banking system, my impression is that if we were going to sustain a sudden whammy from left field -- such as a $50T derivatives Gotterdammerung -- it would have happened by now. (Won't this be fun to quote, two months from now, when we're all wearing barrels on suspenders.) The fact that it hasn't happened yet suggests a couple of things to me. First, by dint of being a shadow banking system, things don't have to play out mechanically, with transparent transactions executed in the public view. Broadly speaking, although there would be winners and losers on paper once everything had been netted out, the participants as a group would be immolated if the chain reaction were ignited. They have the motive to see that this doesn't come to pass, and the occult nature of the market gives them the opportunity to make sure it doesn't. Second, certain events that are widely supposed to trigger derivatives Armageddon have come and gone -- this adds credence to the supposition that the participants are being circumspect about the exact letter of their contracts. Also, I interpret some of the government's interventions as heading off the tumble of early dominos. Anyway, it seems likely to me that if a serious problem from this avenue developed which the market participants failed to contain themselves, we would see another demonstration of the government's recent attitude toward contract law.

In conclusion, I don't think the banking system will collapse, although I don't expect it or the economy to be healthy for quite some time. I'm not much of an original thinker on these matters, so you could say that my expectation for the future is an inflationary depression. As metalman pointed out, the Fed is prepared to control inflation that results from a pick-up in economic activity and lending against the reserves it has created, but inflation is likely to come from another direction -- POOM. And as jk points out, even then, the Fed might have the tools to contain inflation, but since they wouldn't already have a recovery, they probably wouldn't have the political will to use them.

I'd say your thoughts were excellent and well worth sharing.

How did a scientist and a Marine learn so much about banking, finance and economics?

[bart]

Re: The Fed's Exit Strategy

...
Turning at last to the specific issues raised in your post, I don't think it's technically true that the money destroyed to date is more than the Fed has printed in response to the crisis... depending upon what you regard as money. By their nature, the Fed's moves to shore up bank capitalization all focus at the base of the inverted monetary pyramid, so it's certainly true that the Fed's "printing" could be overwhelmed by the contraction of credit as banks reduce their lending against their reserves, or fail. However, again refering to Bart's charts, it appears that we've lost about $1T from the sum of M3 and credit, whereas the Fed has commited to printing $1.25T to cover the purchase of MBS alone. My thinking is that the economically significant factors so far are the drop in asset value, and the reduction -- and temporary reversal -- in the rate of credit expansion.
...

I've recently changed the base proxy I use to track estimated money destruction from the Philadelphia Banking Index (BKX) to Goldman Sacks (GS) stock, on the basis that it more fairly reflects the true shadow banking system., etc.

[rj1]

Re: The Fed's Exit Strategy

I think Obama will have his American Excess card cancelled by Congress within a few months.

I'd love to see Congress turn off the spigot and start the investigations ... it would restore a little faith ... and slow down the printing press.

The Congressional Democrats will never do that. Obama is clearly the most popular person in their party and they rode his coattails hard last November. Do you think anyone out there thinks highly of Pelosi or Frank or Murtha or Reid? The only time his party is going to stand up to Obama is if he's not spending enough money.

[thedanimal]

Re: The Fed's Exit Strategy

I hope you all find this an appropriate place to post this article. I wonder how it fits into this puzzle of the exit strategy, or lack thereof.

Fed Said to Retreat From Seeking Power to Sell Its Own Bills

June 9 (Bloomberg) -- The Federal Reserve has backed off from seeking a new tool to forestall inflation, refraining from asking Congress for the power to issue its own debt, according to a person familiar with the matter.

[ASH]

Re: The Fed's Exit Strategy

I hope you all find this an appropriate place to post this article. I wonder how it fits into this puzzle of the exit strategy, or lack thereof.

Fed Said to Retreat From Seeking Power to Sell Its Own Bills

Definitely! Thanks for posting that link.

[BigLandbaron]

Re: The Fed's Exit Strategy

The Congressional Democrats will never do that. Obama is clearly the most popular person in their party and they rode his coattails hard last November. Do you think anyone out there thinks highly of Pelosi or Frank or Murtha or Reid? The only time his party is going to stand up to Obama is if he's not spending enough money.

Agreed while Obama has full access to OUR fast cash, disagree after his American Excess card gets cancelled through bipartisan action as a result of mass constituent emails/phone calls/lack of buyers of long debt/uncooperative CBs and a flood of general complaints to congressmen/senators about what is going on in Washington and on Main Street. With no more money to spend promoting HOPE ... no HOPE will remain ... and virtually every DEM campaign promise will be left unfulfilled ... everyone will want the Obamamaniacs out of office (except the banksters of course). No one will be more disgusted than the DEMS who drank lots of koolaid spiked with HOPE to get Obama elected. :mad::mad::mad: Infuriated citizens will want blood from someone ... my guess is from those who are in power. Let the mud slinging begin! I want torches, pitchforks and frog marches!!!

But, I am certainly not a fortune teller. I pray we have a soverign currency and country based on our original constitution and the rule of law after the smoke clears. I didn't vote for Obama, but he had my best wishes as he took office. I HOPED I was wrong about Obama's plans to spend spend spend (and tax tax tax!) ... unfortunately I have seen nothing to disprove to me how disasterous these plans will be if fully carried out.

BIG

[stanley2008]

Re: The Fed's Exit Strategy

Thanks Ash for the time you spent providing this thorough and excellent response.

[thedanimal]

Re: The Fed's Exit Strategy

Well, the Fed seems to be exiting *some* positions already:

Fed Trims Emergency Lending Programs as Crisis Wanes

June 25 (Bloomberg) -- The Federal Reserve will let one of its emergency programs expire and trim two others in a sign that improving financial markets allow a first step toward ending its unprecedented interventions.

The three programs provide cash or Treasuries to securities brokers and money-market funds and were authorized under a provision allowing special loans under “unusual and exigent circumstances.” Five programs, including currency swaps with other central banks, were extended by three months to Feb. 1, the Fed said in a statement in Washington.