On The Money

Heads of central banks usually resort to grey, bureaucratic prose to make their thoughts and intentions known to the great unwashed, who then have to pore over every word to try and decipher the true meanings hidden behind them.

Of recent date two very interesting things have been said by two very powerful central bankers: Ben Bernanke, chairman of the US Federal Reserve, and Mervyn King, governor of the Bank of England.

In Mr King’s case, at a media conference on the BoE’s August inflation report, he broke with the tradition of blandness and startled the audience to say of excess capacity in the UK economy:
“The big message today from this - I'm tempted to say – it’s levels, stupid”
“It's not growth rates, it's levels that matter here.”

This comment has set off a flurry of interpretation that still continues.

An insighful attempt was written by US bond manager Mohamed El-Erian in an analysis entitled “Return of the old ways of thinking threatens recovery” (Financial Times, 28 September, 2009).

According to Mr El-Erian, what Mr King was getting at was that “the absolute levels of income, debt, wealth and unemployment, not just the rates of change, are what matter today.”

Mr El-Erian’s decipherment of Mr King’s message is that investors and others are on the wrong track when they get excited about reports of short-term growth trends in economies.

“Confusing temporary factors for sustainable ones,” writes Mr El-Erian, “a growing number of analysts have extended the ongoing stimulus/inventory bounce to a V-like recovery next year and beyond.”

Rather, what will weigh on recovery prospects are the absolute levels of key economic variables.

“Analysis of key levels in the global economy points to important deviations between desired and actual levels.”

“The outlook for major countries will continue to be driven by the levels of key variables, not their rate of recovery.”

Four examples are given by Mr El-Erian.

First, consumer indebtedness remains too elevated in relation to credit supply and income growth expectations, most noticeably in the US and the UK.

Second, many banks are still too highly geared, which will inhibit their lending just when refinancing is required for commercial and residential property borrowings, and consumers need a grace period to cut down their debt burdens.

Third, unemployment has shot above expectations and will take a lengthy period to scale back down again.

Fourth, public debt levels have skyrocketed to the point where many uncertainties have been created surrounding future fiscal stimulus effectiveness and exit strategies, and the medium-term stability of the US dollar and financial markets.

In each of the four cases, the actual levels of the key variables – consumer indebtedness, bank gearing, unemployment, and public debt – grossly exceed their desirable levels.

Working these variables back down to what is desired will be a slow and ugly grind very likely to ensure that the rapid rates of rebound being seen in indicators such as gross domestic product growth projections turn out to be false friends in the medium to longer run.

So much for Mr King’s comment. What of Mr Bernanke’s?

On 23 September the Federal Open Markets Committee (FOMC) stated in a press release signed off by Mr Bernanke and his committee colleagues, “As previously announced, the Federal Reserve’s purchases of $US300 billion of Treasury securities will be completed by the end of October 2009.”

One interpreter of Fedspeak, Graham Summers, senior market strategist at US wealth advisory company OmniSans Research, pounced on the reaffirmation of the Fed’s intention to stop bulk-buying US Treasury bonds in an early October blog piece entitled “The next major crisis brewing”.

According to Mr Summers, the announcement heralds the end of the Fed’s quantitative easing program, in which it exchanged newly minted cash for US Treasury stock.

Termination of this program means the biggest buyer of US Treasury bonds will sharply diminish its market activities in a few weeks’ time.

“This particular development is key,” writes Mr Summers.

“A little known fact (and one totally ignored by the mainstream media) is that the Fed accounted for nearly half of all Treasury purchases in the second quarter ($US164 billion out of $US339 billion).

By Mr Summers’s reckoning, in the second quarter of 2009 the Fed bought more US Treasury stock than the next three largest purchasers taken together, and more than foreign governments, US households, and the primary dealers of major US banks did in total.

By contrast, foreign governments cut their purchases of US Treasury bonds by 40% from $US159 billion in the first quarter of 2009 to $US101 billion in the second quarter.

Were it not for the Fed’s stand in the market, many US Treasury bond auctions would have failed, claims Mr Summers.

When the Fed stops playing the role of market maker for US Treasury bonds, he argues, it is inevitable that yields on these securities will have to rise in order to tempt big buyers like the Chinese and Japanese governments to increase their purchase orders again.

With that rise in yields, pressure will go on to increase US interest rates, reasons Mr Summers, which will hit US banks through their huge holdings of interest rate sensitive derivatives.

To judge by the long list of reader comments at the end of Mr Summers’s blog, not everyone agrees with his version of the facts and interpretation thereof.

But at least he has put his finger on a major change set for the end of this month: the Fed will stop buying US Treasury bonds under its $US300 billion quantitative easing (“printing money”) strategy.

Of course, the Fed still has another trick up its sleeve.

In the same press release Mr Summers took exception to, the Fed announced:
“To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $US1.25 trillion of [federal] agency mortgage-backed securities and up to $US200 billion of [federal] agency debt.”

“The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010.”

This announcement marks a change in that it extends the duration but not the amount of the Fed’s agency-related (Freddie Mac, Fannie Mae, Ginnie Mae, and Federal Home Loan Bank) debt security purchases from their previously planned termination by the end of this year.

The Fed can “print money” to pay for these purchases, which foreign governments and other parties can take advantage of to sell US agency-related debt securities and buy US Treasury bonds instead should they be so minded.

According to the New York Fed’s website, the Fed’s System Open Market Account (SOMA) holdings as at September 30, 2009, were $US1.587 trillion dollars worth of debt securities, of which $US700.5 billion (44.1%) were US Treasury notes and bonds, $US131.2 billion (8.3%) were federal agency debt securities, and $US692.4 billion (43.6%) were federal agency mortgage-backed securities.

On the web: http://www.ny.frb.org/markets/soma/sysopen_accholdings.html