Fed Monetary Policy: Easy In, Hard Out (Updated)

My view is that there is no such thing as a free lunch, not even for governments or central banks. Any action taken may have benefits, but also imposes costs, even if those costs are imposed upon others. So it is for the Fed. At the beginning of 2008, they had a small, clean, low duration (less than three years) balance sheet on assets. Today the asset side of their balance sheet is much larger, long duration (over 6 years), negatively convex, and modestly dirty as a result. Let me give you a few graphs created from the H.4.1 data, obtained via the poorly designed and touchy the last time I wrote on this is QE3. What has been the practical impact since then? The Fed owns more MBS and long maturity Treasuries, financed by more reserve balances at the Fed.

Banks use this cheap funding to finance other assets. But if they want to make money, the banks have to take credit risk (something the Fed is trying to stimulate), and/or interest rate rate risk (borrow short, lend long, negative convexity, etc). The longer low rates go on through interest on reserves, the greater the tendency to build up imbalances in the banking system through credit and interest rate risks. 1992-1993 where Fed funds rates were held at 3%, was followed by the residential mortgage backed security market melting down in 1994, not to mention Mexico. Sub-2% Fed funds rates from 2002 through mid-2004 led to massive overinvestment in residential housing, leading to the present crisis.

Fed tightening cycles often start with a small explosion where short-dated financing for thinly capitalized speculators evaporates, because of the anticipation of higher financing rates. Fed tightening cycles often end with a large explosion, where a large levered asset class that was better financed, was not financed well-enough. Think of commercial property in 1989, the stock market in 2000 (particularly the NASDAQ), or housing/banks in 2008. And yet, that is part of what Fed policy is supposed to do: reveal parts of the economy that are running too hot, so that capital can flow from misallocated areas to areas that are more sound. At present, my suspicion is that we still have more trouble to come in banking sector. Here’s why:

We’ve just been through 4.5 years of Fed funds / Interest on reserves being below 0.5% — this is a far greater period of loose policy than that of 1992-1993 and 2002 to mid-2004 together, and there is no apparent end in sight. This is why I believe that any removal of policy accommodation will prove very difficult. The greater the amount of policy accommodation, the greater the difficulties of removal. Watch the fireworks, if/when they try to remove it. And while you have the opportunity now, take some risk off the table.

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Written By: David Merkel