Mr. Bernanke Needs to Speak Out About QE3...or, Has He?

Fed Chairman Ben Bernanke takes pride in the fact that he has increased he openness of the Fed and has helped to provide greater transparency into the understanding of what the Federal Reserve is doing with regards to monetary policy.

Right now, however, he is staying pretty silent. 

The market concern is about whether or not the Federal Reserve is going to engage in another round of quantitative easing…QE3.

I believe that Mr. Bernanke is staying quiet at this point for political reasons. 

He stated just the other day that the Federal Reserve is not swayed by political factors.

We can save the further discussion about the political nature of the Fed for another day.

The Fed’s dilemma right now is that if jumps into an overt position on implementing QE3 it will be accused of acting for political reasons.

The Republicans will jump all over a Federal Reserve that seems to be “pumping up” the economy right before the election.  Should the Federal Reserve begin a QE3 before the November election, it…the Fed…will be accused of supporting a desperate president in his bid for re-election.  How political can this be?

The Fed has published the minutes of its last Open Market Committee meeting and the discussions within the committee showed mixed feelings about starting up a QE3.  But, even the weak economic information released in the last week or so have not been severe enough to change the minds of the decision makers…and, especially Bernanke.

The minutes do reflect that the Fed is keeping a watchful eye on the economy.  The Fed has promised to act strongly if the economic situation gets much worse.

There is real concern, however, over just how much monetary policy can do at this particular time.  First, there is the concern that it can do little to impact the unemployment rate.  The unemployment rate is a “real” economic variable and is determined by “real” economic variables.  Monetary polity does not work with “real” economic variables.

Second, there is the time lag in the effect that monetary policy has on the economy.  One can argue that the Fed has done all it can do to impact the economy over the next six- to nine-months and that anything else done now would have next to no effect on the economy before the November election.

This presents the question to Open Market Committee members: “Why start out now on a major monetary initiative like QE3 which would bring about tremendous political criticism when this initiative would have next to no impact on the economy before the election?”

The most the Federal Reserve can do at this time to generate confidence is to assure the financial markets that “if the economy gets worse” that it would take appropriate actions to combat a worsening situation.  And, Fed officials must continually provide evidence that it is “on the watch” and ready to move. 

The release of the minutes of the Open Market Committee serves this purpose.   The essence of the minutes was the split between committee members over whether or not the Fed should engage in further easing.

The other major issue besides the state of the economy, which will not go away is the condition of the banking industry.  Readers of this blog know my position on this:  the banking system is still quite fragile with many banks still unsure about the value of their assets, especially in the areas of residential real estate and commercial real estate. 

I believe that the Federal Reserve feels comfortable that it has done what it can to keep the banking system functioning and that the injection of $1.5 trillion in excess reserves into the banks allows the banking system to continue to function smoothly so that the FDIC can continue to close banks without creating significant disruptions to the industry.

Through the first half of 2012, more than one bank is still being closed every week at least one other bank per week is acquired and hence is merged out of existence.  The banking system continues to shrink!

There is little else the Federal Reserve can do at this time with respect to the health of the banking system.

Can Mr. Bernanke tell us all of this in a way that will convince us?  Should Mr. Bernanke tell us all of this in an attempt to convince us?

My belief is that Mr. Bernanke has already told us all that he is going to tell us at this time.  Mr. Bernanke has told us that the Federal Reserve is not going to act in a political way.  In other words, for the near term, the Fed is going to do pretty much what it has been doing in the recent past.  It will continue to try and “twist” interest rates, but no new excess reserves will be created in this effort.  And, the Federal Reserve will continue to watch the economy closely and stands ready to act if it appears as if the economy is sinking into another recession.  But, don’t expect anything more.

Other than the fact that I don’t believe that “operation twist” can really be effective, I believe that Mr. Bernanke and the Fed are “spot on” concerning what monetary policy should be at this time.  To me, the primary thing that is currently impacting US Treasury rates is the “flight to quality” in financial markets that is taking place internationally and this is dominating what the Fed is doing and everything else.    

Federal Reserve Can Do Little At This Time

By historical standards the rate of growth of both measures of the money stock, M1 and M2, are quite high.  Still the reasons for these high growth rates are related to people moving assets around their balance sheets rather than the stimulus injected into the banking system by the monetary authorities.  Money stock growth is not occurring because loan growth is increasing.

In May, 2012, the year-over-year rate of growth of the M1 money stock was just about 16 percent within the 16 to 18 percent range the year-over-year growth rate this measure of the money stock has grown in the first five months of this year.

The M2 measure of the money stock grew at a 9.5 percent rate of year-over-year increase, a rate consistent with its behavior since the end of last year.

These measures are growing as rapidly as they are, not due to the monetary stimulus of the Fed working its way through the lending of the banking system, but because people continue to shift assets in their balance sheets away from short-term interest bearing assets to transactions balances that pay little or no interest.

This shift in funds, as I have argued for over the past two years or so, should not be interpreted as a sign that people are buying things.  On the contrary, people are still moving their funds from short-term interest bearing assets to transactions balance for two reasons.  First, many people are without jobs or without full-time jobs or who face housing problems need to keep their money in a form that can provide for daily needs.  Second, with interest rates so low people are not earning enough in the short-term interest paying assets to justify them to keeping their funds there.

In the first case, the currency component of the money stock is still increasing at historically high rates, 8.5 percent, year-over-year in May, and this I continue to interpret in a pessimistic way.  People need to hold cash when times are tough. 

In addition, the demand deposit component of the M1 money stock is increasing at a 36 percent annual rate in May, an extraordinarily high year-over-year rate of growth.  Where are these funds coming from? 

Well, small time deposit accounts are down over 17 percent, year-over-year, retail money funds are down 3.5 percent, year-over-year, and institutional money funds are down slightly more than 8 percent, year-over-year.  People are taking funds out of short-term interest bearing accounts and putting these funds into demand deposits.

The increase in demand deposits is not being generated by the commercial banks lending out money to support consumer or business spending!

We can see the effect of this on bank reserves.  Total bank reserves have actually declined year-over-year by slightly less than 2 percent.  However, required reserves have risen by 31.5 percent over the same time period.  The increase in required reserves is a result of the shift in other bank accounts that have lower reserve requirements to demand deposit accounts that have a much higher reserve requirement. 

The interesting consequence of this is that excess reserves in the banking system have actually declined over the past year.  They have not declined by much, but the have declined sufficiently to cover the amount of reserves the banks’ need to cover the increase in required reserves to back up the rise in demand deposits.

This decline in the excess reserves in the commercial banking system is matched by a similar decline in the reserve balances commercial banks keep at Federal Reserve banks. 

Overall, in comparing where the Federal Reserve was last year with where it is at the present time there are two things that stand out in terms of the actions of the central bank. 

First, the Fed supported the substantial increase in the demand for currency in the economy.  In this matter, the Fed supplies currency to the public “on demand”.  That is, the Fed exercises no control over the amount of currency that is in the economy.

Second, there were substantial actions on the part of the Fed over the past year to combat what was going on in the rest of the world.  Three major line items on the Fed’s balance sheet relate to this: central bank liquidity swaps; dealing in assets denominated in foreign currencies; and reverse repurchase agreements with “foreign official and international accounts.” 

This second area that stands out is not surprising given all the problems that have been faced in Europe and elsewhere.  The Federal Reserve has provided help when and where it can.

Otherwise, the other activity that the Federal Reserve has engaged in over the past year can fundamentally be called “operating transactions.”  That is, the Fed acts to offset seasonal or special transactions to maintain relatively steady reserve balances.  For example, when cash flows out of the banking system in the Thanksgiving/Christmas time period, the Fed usually injects reserves to cover the outflow.  After the first of the year when cash flows back into the banks the Fed will reverse their previous injection.

These actions are call “operating transactions” because they help to stabilize the movement of funds in and out of the banking system that are just routinely operational.  And, these operations still have to be maintained even in the face of all the excess reserves that now exist within the banking system.

Bottom line: very little has changed in the banking system in recent months and, hence, the Federal Reserve has been relatively quiet.  There still remains a contingent of individuals in the financial markets that are calling for the Fed to engage in a third effort at quantitative easing.  My guess, however, is that QE3 will not be forthcoming, even in the face of the lower revised numbers for GDP in the first quarter of this year.

There are three reasons for this.  First, further quantitative easing will have little or no effect in stimulating faster economic growth.  There are just two many structural problems in the economy for the United States to achieve faster economic growth at this time.  What would the banking system do with more than $1.5 trillion in excess reserves?

Second, the handling of the insolvency problems within the United States banking system is going very smoothly. (See my post on “The Condition of the Banking System”.) Right now, there is nothing else the Federal Reserve can do to help this process go any better.  Thus, the Fed needs to leave well enough alone.

And, third…this is an election year.  The Fed has been criticized in the past for attempting to ease monetary policy to support a sitting President.  It does not want to look political in its actions.  

The Federal Reserve does not have unlimited capabilities.  The officials at the Fed need to know when to act, but they also need to accept the fact that there are times when they can do little or nothing to help a situation.  In these latter cases they need to back off.

To me, now is a time when the Fed need to stay quiet, continue to execute its routine “operating” duties, but still stay alert.  There is very little benefit that the Fed can achieve now through further actions, but there are potential costs of attempting to be too active.  

The Federal Reserve Was Quiet in the First Quarter

In the first quarter of 2012, the Federal Reserve was very quiet.  The reserve balances that commercial banks held at the Fed actually declined by about $4.0 billion during the quarter to total $1.563 trillion on March 28.

Securities held by the central bank declined by slightly more than $15.0 billion as the Fed’s portfolio of Treasury securities, Federal Agency securities, and mortgage-backed securities all fell during the period.  Over the last four weeks of the quarter, very little took place in the Fed’s holdings although, in aggregate, there was a small decline.  

The factors supplying reserve funds to the banking system actually declined by about $48.0 billion but this was offset by around $44.0 billion in factors absorbing reserve funds.

The biggest item impacting the decline in reserve funds being supplied was the reduction in Central Bank liquidity swaps that occurred as the financial crisis in Europe resided and most of this took place in the last four weeks of the quarter. This was offset on the liability side of the Fed’s balance sheet by a number of operational factors, none overly significant.

These data just reconfirm the signals that Chairman Bernanke has given Congress, financial markets, and the academic world about the current stance of monetary policy.  The Federal Reserve is not doing a lot right now, but will not back off from the quantity of reserves it has injected into the banking system over the past two years, and stands ready to do more if the need should arise.

And, short-term interest rates continue to remain exceptionally low.  Since the Fed is doing little or nothing to supply more reserves to the banking system, the fact that the short-term interest rates are staying so low implies a lack of strength in the demand side of the market.  This, I believe, is an important thing to keep our eyes on because if the demand for funds begins to pick up, this will put pressure on short-term interest rates and the Fed will either have to step in to prevent this rise because of economic or banking reasons, or, let the rates begin to increase.  This is an area to watch.    

This all sounds pretty dull, but…the central bank really likes things dull!

For one, only 16 banks were closed by the FDIC in the first quarter of 2012, compared with 18 banks being closed in the last quarter of 2011.  We will have to wait for over a month and a half before we know how many more banks left the banking system through mergers and acquisitions.  Last year, the banking system lost, on average, 60 banks per quarter and only 23 of these were banks that were closed by the FDIC.  The number of commercial banks in the banking system continues to decline, but in an orderly and calm fashion.  Dull is good!

Economic growth continues, but it is not exceptional. (For more on this see my post http://seekingalpha.com/article/469671-gdp-growth-the-road-ahead-and-the-investment-climate.) There is not too much more that the Fed can do in terms of stimulating more rapid economic growth, but it does hope to contribute to a turn-around in the housing area. 

But, the economy is growing, and, baring shocks related to gas prices, a collapse of the eurozone, or an economic slowdown in China…among other things…it should continue to grow over the next several years, although the expansion will not be robust. 

This is not all bad since many households and businesses are still reducing debt loads and trying to get their finances in order. 

The problem is in the employment area.  It is not just that the unemployment rate continues to stay too high, it is that under-employment still hovers around 20 percent.  A reason the unemployment rate might not drop too much over the next six to twelve months is that if the job market becomes more active, people who are now not considered to be a part of the labor force will re-join the labor force hence helping to keep unemployment rate higher than desired.

One thing is apparent and that is the Fed does not seem to be doing anything dramatic about getting the unemployment rate done more rapidly in advance of the Presidential election in the fall.  Given the lag-in-effect of monetary policy, the Fed has done just about all it can to achieve lower unemployment numbers this summer and fall. 

This may be one reason why we are not seeing the announcement of another round of quantitative easing.  The current Fed has already been accused of being one of the most “political” central bank administrations ever.  Announcing another round of quantitative easy at this time would only exacerbate those cries.  And, in my mind, would be able to achieve little or nothing in terms of a more vibrant economy and labor market through the end of the year. 

Thus, I believe the Fed will remain relatively benign over the course of 2012.  Again, dull is good when it comes to central banking.  But, this doesn’t mean that the central bank will not act during the year if there is a real need for action, coming from the banking sector, the economy, Europe, or elsewhere. 

Commercial Banks: How Safe is the Banking System?

The commercial banking system in the United States does not seem to be “out-of-the-woods” yet, in spite of the fact that 15 out of the 19 largest banks in the country recently passed the stress test administered by the Federal Reserve. 

For one, many executives of the commercial banks involved don’t seem to understand how the Fed got many of its results. 

In conference calls held after the results of the stress tests were released the banks raised major questions over how calculations of capital were made.

“Healthy institutions want to understand why there were some large gaps between their own capital estimates and the Fed’s, according to people close to those banks.  Some of the five lenders that didn’t pass the test say questions about the Fed’s scoring complicate reapplying for approval to raise dividends or buy back stock…” (http://online.wsj.com/article/SB10001424052702303812904577299611815199568.html?mod=ITP_moneyandinvesting_0)

Problems in interpretation were bound to occur, but, to my mind, the commercial banks have created their own nightmare.

The real problem:  mark-to-market accounting, or, the lack of it.

Executives in commercial banks don’t like mark-to-market accounting.  The basic reason is that they don’t like to admit that they have made mistakes or that they have taken on too much risk or that they just don’t want to deal with messy issues. 

When the value of bank assets decline, either because loans have gone sour or because interest rates have risen and the market value of securities have dropped, analysts argue that the banks should mark their assets to market so that they can get a real picture of how the bank is performing…whether or not the bank is solvent.

Bankers argue back that they shouldn’t be made to mark their assets to market “after-the-fact” because that forces them to change their balance sheets that were not expected of them before.  And, they also plan to hold their securities to maturity, when they would get their full value repaid, and they also need time to “work-out” their troubled loans as the economy improves.  They argue that analysts, by asking for them to go to mark to market accounting, are changing the “rules of the game” after the economic and financial environment has changed. 

So, the bankers can put on riskier loans, buy securitized bonds, mismatch maturities, place SIVs off-balance-sheet, and so forth, and when the economy turns south, they do not have to reveal to the public…and the regulators…what their decisions have done to the health of the bank!

They ask, “I have mismatched maturities to earn a few more basis points on my return of assets to try and keep up with the competitors, and now, since interest rates have gone up I have to mark the longer term assets to market?”

Well, you took the risk, you must own up to the consequences.  Arguing that you intend to hold the assets to maturity doesn’t “hold water” because as short-term interest rates continue to increase you will either have to sell your assets or work with a negative interest rate spread.

Also, Mr. Banker, when you made riskier loans…like subprime loans…you were stretching for yield.  You made the choice.  As the market moves, so does the value of your assets.  Own it.

  

Since the commercial banks have fought the development of an adequate mark-to-market accounting process, the Federal Reserve…and others…have tried to create a substitute for this accounting treatment of assets.  This substitute is called the “stress test.”

The “stress test” works with assumptions.  “Last November (the Fed) published test assumptions, such as a 13% unemployment rate in a U. S. recession.

But the Fed is resisting full disclosure of its methodology, hoping to retain the flexibility to make future changes and prevent the banks from gaming the numbers…”

The commercial banks “game” their own accounting numbers by not marking their assets to market.  The fear with stress tests is that the commercial banks will “game” the tests if they know what the Fed’s assumptions are.  The commercial banks want it both (all) ways.

And, how well off are the commercial banks?

Jesse Eisinger writes in the New York Times about the annual report of the Federal Reserve Bank of Dallas.  Although the article concentrates on the issue of “too big to fail”, Eisinger does print a quote from an essay in the annual report written by Harvey Rosenblum, the head of the research department at the Dallas Fed.

Rosenblum wrote: “Monetary policy cannot be effective when a major portion of the banking system is undercapitalized.  Many of the biggest banks have sputtered, their balance sheets still clogged with toxic assets accumulated in the boom years.” (http://dealbook.nytimes.com/2012/03/28/banking-regulator-calls-for-end-of-too-big-to-fail/?ref=business)

This from the head of a research department within the Federal Reserve System!

And, what about the other banks in the system?

As last reported by the FDIC there were 814 commercial banks on the list of problem banks.  There are many more on the edge of becoming problem banks.  The number of commercial banks in the United States dropped by 240 last year and only 92 of these were bank closures.  In both cases, the numbers included no banks that could be called “the biggest banks.”

You wonder why the Federal Reserve has pumped almost $1.6 trillion in excess reserves into the banking system?

I have argued for more than two years now that the Fed’s ease is not just about getting the economy going again.  In my opinion the Fed has been as generous as it has been in order to allow the FDIC to close or to approve the acquisitions of troubled banks in an orderly manor so as to allow the banking system to adjust to its “insolvency” problems as smoothly as possible.

I agree with Mr. Rosenblum, I think that there are still too many “toxic assets” on the balance sheets of commercial banks…large, medium-sized, and small.

Without some kind of adequate mark-to-market accounting process in the commercial banking system, we will continue to be “in the dark” with respect to the health of banking institutions and banks will be able to continue to “game” us.

Having an adequate mark-to-market system in place will cause bank managements to conduct their businesses in a less risky fashion.  And, only by having an adequate mark-to-market system in place will bank managements move to address the problems they face in real time, something they currently are loathe to do.  

Ben Bernanke: "Please Understand Me!"

“Please Understand Me,” the title to the 1984 book building on the Myers-Briggs personality-type tests, constantly comes to mind each time I hear a new effort by Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, to “communicate” with the public.

Tuesday, Mr. Bernanke gave the third of his scheduled four lectures at George Washington University about Federal Reserve monetary policy.  This has followed efforts to get the minutes of the meetings of the Open Market Committee out to the public in a more timely fashion; efforts to have periodic meetings with the press to discuss the policies of the central bank; and the recent efforts to make the economic and interest rate forecasts of the members of the Open Market Committee available to the public. 

Now, Mr. Bernanke has felt the need to get out among “the people” and discuss the conduct of monetary in a series of four lectures aimed at expanding, within an academic environment, his rationale and analysis of what the Federal Reserve did and what the Federal Reserve has achieved. 

The continuously expanding efforts of Mr. Bernanke to get his personal viewpoint across only lends credence to the feeling that “the world”, especially the financial community, doesn’t understand what Ben is trying to do and how his efforts are succeeding. 

No one in such a leadership role that I can think of has felt the need to plead, within the community that he operates, to justify his actions, as Mr. Bernanke has.

Can you imagine Paul Volcker or William McChesney Martin (Fed Chairman from April 1951 to February 1970) publically defending their actions while they were still in office?

“The Fed’s efforts prevented a ‘total meltdown’ of the financial system at a time when fears of a second Great Depression were ‘very real,’ Mr. Bernanke said Tuesday…” (http://professional.wsj.com/article/SB10001424052702303404704577307800005459694.html?mod=ITP_pageone_1&mg=reno64-sec-wsj)

It was not pretty…what the Federal Reserve did…but it achieved its end.  A second “Great Depression” did not take place. 

Mr. Bernanke, a student of the Great Depression who learned a great deal from Milton Friedman, pursued a policy that was consistent with Friedman’s analysis of the events of the 1930s.  In the period 1929 to 1933, Mr. Friedman estimated that the Federal Reserve allowed the M2 money stock in the United States to decline by one-third!  The conclusion that Mr. Friedman drew from this is that the Federal Reserve should have done whatever was possible to have kept the M2 money stock from declining!  

This lesson did not escape Mr. Bernanke under the circumstances. The Fed’s policy during this period of financial crisis was to throw as much “stuff” against the against the wall as possible to make sure that enough of the “stuff” stuck on the wall that another Great Depression would be avoided.

What is there not to understand with this policy?

Sell Bear Stearns, rescue AIG, bailout the banking system, by mortgage-backed securities and so forth…. 

And, in a time of panic, when uncertainty reigned, anything was acceptable. (http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic)

This was all “stuff” that was thrown against the wall. 

Mr. Bernanke has followed the game plan.  The money stock did not decline in this instance.  However, the Fed does not control the money stock directly.  In terms of things it can control, like the monetary base, the Fed expanded the monetary base from about $850 billion in August 2008 to $1.7 trillion in January 2009.  In February 2012 the monetary base averaged about $2.7 trillion.  Excess reserves at commercial banks rose from about $2.0 billion in August 2008 a current level of around $1.6 trillion.

This expansion of monetary assets is historically unique!  The “stuff” got put out there!

And, the “stuff” will stay out there as long as there are weak spots in the economy and the financial system.  For example, the banking system is still extremely weak with more than 800 banks on the FDIC’s list of problem banks and more than that are on the edge of being problem banks.  And, this is with large numbers of home foreclosures in the future along with a continued weakness in the commercial real estate area.  Bank failures along with bank consolidations still proceed at a relatively rapid pace.   

Whether we get another round of quantitative easing or not, we will see the “stuff” around for some time yet.  Excess reserves in the banking system of around $1.6 trillion!  My guess is that we won’t see this declining by much until the banking system gets a lot healthier.

What is there not to understand about what the Fed has done and is doing?

Mr. Bernanke seems to feel that it continually needs explanation and justification.  I believe that this feeling is just Mr. Bernanke’s problem.