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Since the FOMC meeting,
there has been a noticeable silence over the Fed’s monetary policy following
QE2. But there is some evidence that the funding of government debt at low
interest rates will shift to the repo market, rather than a new round of
quantitative easing.
The silence on this subject may be partly
explained by the monetary focus shifting to Europe. However, it is likely
that the Fed has no intention of introducing QE3, given that the expansion of
narrow money so far has led only to a degree of price inflation, without much
benefit to asset prices. And with the ECB still reluctant to print euros, QE3
would probably collapse the dollar/euro rate and propel gold considerably
higher, putting unwelcome strains on the financial system. The Fed also finds
itself having dramatically expanded the monetary base for little economic
benefit: against all its expectations, the economy is sliding into recession
again. Perhaps it is a case of all the people being no longer fooled all of
the time with respect to what QE actually is. No, another approach is called
for.
To the Keynesian mind the obvious alternative
must be to expand bank credit, particularly when there is an accumulation of
non-borrowed reserves sitting on the Fed’s balance sheet. The NBRs
represent the excess capital owned by the commercial banks, which have not
been drawn down for use as the capital base for the expansion of bank credit.
They currently stand at about $1.76 trillion while in normal circumstances
NBRs would be no more than a few tens of billions. High levels of NBRs
reflect the reluctance of banks to lend and bankable borrowers to borrow:
they are symptomatic of an economy that refuses to expand.
It is against this background that Ben
Bernanke announced at the recent post-FOMC meeting press conference that
interest rates would be held at current levels (close to zero) for the next
two years. This could be the basis for shifting the funding of government
debt from printing raw money to expanding bank credit. The public do not
understand the inflationary implications of expanding bank credit as easily
as they do that of printing money: switching to bank credit as a funding
route for government debt allows the Fed to fool all of us a while longer.
The logical way to do this is by developing
the repo market, where the buyer of government securities conducts a reverse
repurchase agreement, or a reverse repo. In a reverse repo an investor buys
securities with an agreement to sell them back to the seller at a fixed price
at a future date. For the seller of the securities, the deal is defined as a
simple repurchase agreement and is the mirror-image of the reverse repo. If
the cost of financing a reverse repo is profitable then the transaction can
be highly geared to give a substantial return on the underlying capital. By
encouraging this market for short-term government debt, the Fed can exercise
tight control over short-maturity government bond yields with benefits
extending to medium maturities, irrespective of the quantity issued. The key to it is to get the
banks to lend to the institutions on the Fed’s
Reverse Repo Counterparty List, and the key to that is reducing the interest rate
paid on non-borrowed reserves to slightly below the targeted government bond
yield rate.
The development of the repo market is the
way to getting the NBRs put to constructive government use. Given that
short-term US government paper is seen as the lowest investment risk and the
highest quality collateral, gearing up a reverse repo fifty or even a hundred
times is a no-brainer. Theoretically, that $1.76 trillion of NBRs could fund
nine times that amount of government debt, or more than doubling it to $30
trillion. The point is that the successful development of the repo market in
this way is an obvious and more powerful solution than extending quantitative
easing.
We know from FOMC minutes last year that the
Fed have been assessing the repo market, so it is a
definite possibility. All that is required is interest rate certainty, and
that is what the Fed gave the market in its announcement that it would peg
rates at close to zero for the next two years. The probability that the repo
market will be developed in this way has been increased by the inclusion on
the 27th July of both Fanny Mae and Freddy Mac on the Fed’s
Reverse Repo Counterparty List. We should be interested in this development,
because it allows these government-owned entities to gear up their
fast-accumulating cash for certain returns, and using government entities
allows the Fed to exercise further controls on the development of the repo
market.
The apparent disadvantage is that reliance
on the repo market will shorten the overall debt maturity profile. But
successful funding at the short end of the yield curve will have the effect
of keeping yields down for longer maturities, and the Fed can also use
derivatives to extend its control to the longer end. Correctly managed, the
Fed will believe that it can keep the cost of government borrowing low and at
the same time manage the overall debt maturity profile.
We cannot be certain the Fed will use the
repo market in this way, but the problems with a new round of quantitative
easing, the studies of the repo market admitted in FOMC minutes, and the recent entry of Fannie Mae and Freddie Mac
to the Reverse Repo Counterparty List are strong evidence they will.
Furthermore, the establishment Keynesians and monetarists will be unconcerned
by inflationary consequences. To them, the greater danger is still a
1930’s style deflationary depression, the result of not enough
government economic stimuli. Unlocking the NBRs and gearing them up through
the repo market gives them all the room for manoeuvre they could wish for.
And if the Fed unlocks bank credit in this
way, other central banks will want to follow. This will not be so simple,
since most banks in other jurisdictions operate under Basle rules, which
require them to maintain a minimum level of risk-adjusted capital, instead of
keeping reserves at the central bank. Basle rules are being tightened,
forcing most banks to increase core capital as a percentage of loans, so
there is less capital available to back a dramatic expansion of repo markets
for government debt. Other central banks will have to use more imagination to
expand bank credit to finance government deficits.
In the short run, this may not matter too
much. All currencies are on a de facto dollar standard, so they will benefit
from the dollar’s extended low interest rates. Furthermore the
expansion of bank credit as a means of government funding in the US will
reduce demands on the global savings pool, easing the imbalance between
government deficits and funding availability.
So we have a workable monetary solution for
all the world’s ills. There are market benefits, too. Extended low
interest rates should help place a floor under asset prices, and the
resolution of the immediate uncertainties over US sovereign debt and less
pressure for government spending cuts will be seen as a confidence
restorative. But expanding bank credit to finance increasing government spending
merely allows that spending is no solution to the underlying causes of the
real economic difficulties.
Importantly, it guarantees yet more price
inflation down the road: bank credit expansion always has in the past, and it
always will in the future. Above all, it guarantees the next leg upwards in
the precious metals bull market.
Alasdair
McLeod
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