PIMCO - IO Feb 2009 Gross Beep Beep

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PIMCO - IO Feb 2009 Gross Beep Beep: "The simplicity of the solution, however, is not easily achieved once deflationary momentum takes hold. Animal spirits, once dampened, are hard to reignite; “fear of fear itself” dominates greed. Under such circumstances, the benevolent hand of government is required and Keynes is reincarnated in an attempt to plug the dike via fiscal spending and imaginative monetary policies that support asset prices. PIMCO has recently been contracted to assist in several publically announced programs which have helped in that effort: the CPFF, which has benefitted commercial paper yields, and the Federal Reserve’s purchase program for agency-backed mortgage loans, which has lowered 30-year mortgage rates to 4.5% and fostered the affordability of new and secondary housing prices. These two programs, in our opinion, have been the major policy successes to date – not because of our involvement – but because they have supported and increased asset prices whose decline has been the major deflationary thrust behind the real economy. Stop asset prices from going down and with a 12-month lag, unemployment will stop going up, and President Obama’s targeted three million new jobs will have a fighting chance of being achieved."

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Fed Warns of Global Deflation

Image via Wikipedia southfloridabusinesswatch.blogspot.com]

“The Fed statement yesterday said its prediction of a “gradual recovery” in the U.S. economy later this year has “significant” risks of failing to materialize. At their meeting, central bank officials gave updated forecasts for gross domestic product, inflation and unemployment that will be released with meeting minutes on Feb. 18.

It sounds like the worry is not so much recession as it is depression,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. “We can only hope that the famous long and variable lags of monetary policy will eventually kick in.”

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Fed-style QE is Printing Money

Image via WikipediaBarclays Capital lays out a primer for what the Fed is really doing for monetary policy. The Fed can't drop interest rates below 0%, but there are other weapons in the Fed arsenal. Barclays Capital in their most recent Weekly Market Monitor talks in depth about the current Fed policy called Quantitative Easing. (See Help! What is Quantitative Easing?)

"Without making a formal announcement, the Fed has already moved to a policy that is effectively QE. While its policy objective is still the fed funds rate, the Fed's balance sheet has more than doubled over the past three months to over $2 Trillion as it has expanded its emergency lending programs, foreign currency swap lines, and open market purchases. When the Fed began creating new lending facilities last year, it financed them by selling Treasuries, thereby keeping its balance sheet from expanding.

A few months ago, the Fed ran low on Treasuries it could sell and began to expand its
balance sheet; however, it sought to soak up or sterilize this expansion through the use of a special Treasury bill program. The Treasury sold bills and deposited the proceeds in its account with the Fed, and the Fed used the proceeds to extend loans to banks based on illiquid collateral. While the Fed's balance sheet was being grossed up, the Treasury was soaking up cash through bill issuance and systemwide liquidity was unchanged.

The Treasury program is being wound down and the expansion of Fed programs is being
financed through increases in excess bank reserves. In this case, the Fed is extending the same collateralized loans, generating excess reserves, and grossing up its balance sheet without sterilizing the transaction through the Treasury facility. Thus, the Fed is currently "printing money" and the over-provision of reserves to the banking system is far beyond what would be required to meet the FOMC's target funds rate."

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Help! What is Quantitative Easing?

Image via WikipediaA great Weekly Economic Monitor from Barclays Capital this week. (If you don't get it, start building a relathipship with the Barclays team. Their research is the best.)

Quantitative easing (QE) is the name given to a three-part monetary policy program implemented by the Bank of Japan (BOJ) from March 2001 to March 2006. At the outset of the program, the BOJ believed that economic conditions warranted monetary easing as drastic as is unlikely to be taken under ordinary circumstances, and therefore made the following changes to its policy strategy:

1. A switch in the operational objective of monetary policy the policy instrument from an overnight interest rate to current account balances(bank reserves plus deposits of non-bank financial intermediaries at the central bank).

2. A reduction in the overnight interest rate to zero.

3. A commitment to maintain the new procedures until y/y CPI inflation registers stably at zero percent or higher.

Virtually all developed-world central banks conduct monetary policy in the same way: by adjusting the supply of bank reserves balances in accounts commercial banks maintain at the central bank in order to target a specific short-term interest rate. The amount of reserves supplied is a passive variable in this process. Banks demand a certain quantity of reserves to meet reserve requirements plus an additional, much smaller, amount of precautionary reserves. The central bank simply meets the amount of reserves demanded at the targeted interest rate. As a result, the total amount of reserves in the banking system is, in a normal environment, very close to the level of required reserves (i.e there are very little excess reserves).

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Is Deflation a Risk in 2009?

According to the Barclays Capital Weekly Economic Monitor, there "is little immediate risk of deflation."
The report goes on to say that although headline inflation will fall into negative territory (yr to yr) heading into fall 2009, this is primarily due to falling in energy prices. Once energy prices "find a bottom, inflation will naturally rise back to the level of core inflation. This is a case of a big fall in one relative price, not a broad-based deflation."

The report goes on to say that the real risk of deflation comes in 2010. If the unemployment rate does not come down quickly from the presumed 8% peak, core inflation will drop steadily and could pierce the lower end of the 1-2% Bernanke bands in 2010. This risk argues for continued very accommodative monetary policy for a long time to come. Presumably, the Fed will want to exit from its aggressive market interventions as quickly as the capital markets safely allow. These programs distort the capital markets, put tax dollars at risk, and should be phased out as soon as it is safe.

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