Monetary Policy Explained For The Layman

Courtesy of the Federal Reserve (click on pic for the link):

QE2: Confusion And Chaos Reigns

I’m struck by the extent of the divisiveness of opinions that the Fed’s announcement last week about a further US$600 billion in asset purchases has raised. And then there’s the fact that the FOMC’s vote on the matter was not unanimous.

But to illustrate the chasm between opinions on the Fed’s “quantitative easing” (aka printing money) program, have a look at these two articles in Bloomberg:

Bernanke Can’t Use ‘Poison as the Cure,’ Burry Says

Nov. 5 (Bloomberg) -- Michael Burry, the former hedge-fund manager who predicted the housing market’s plunge, said Federal Reserve Chairman Ben S. Bernanke is trying to use “poison as the cure” by pumping more cash into the economy to spur growth.

Bernanke’s Fed pledged this week to use $600 billion in additional Treasury purchases to help lower a 9.6 percent unemployment rate, close to a 26-year high, and to avert deflation.

The attempt to bolster growth is reminiscent of Alan Greenspan’s actions to revive the economy after 2001, Burry said in a telephone interview from Cupertino, California. The former Fed chairman helped create an unsustainable boom in U.S. property prices with his policies, leading to the worst global financial crisis since the Great Depression, he said.

Boosting the economy “was the point of inflating the housing bubble,” Burry said yesterday. “It was the intent that the house would become the ATM machine, and help us through those rough times, post-dot-com, -Enron, -WorldCom, -Iraq and - 9/11. That’s why I say they’re using the poison as the cure.” …

Currency Wars Part VII: Jim Rogers Gets It Wrong Again

Well-known economist, academician, theorist, investor and author Jim Rogers says Ben Bernanke doesn’t know what he’s doing:

Bernanke ‘Doesn’t Understand’ Economics, Rogers Says

Nov. 5 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke’s decision to pump a further $600 billion into the economy shows his grasp of economics is weak, said investor Jim Rogers, chairman of Rogers Holdings.

“Dr. Bernanke unfortunately does not understand economics, he does not understand currencies, he does not understand finance,” Rogers, 68, said in a lecture at Oxford University’s Balliol College yesterday. “All he understands is printing money.”

“His whole intellectual career has been based on the study of printing money,” said Rogers, who predicted the start of the global commodities rally in 1999. “Give the guy a printing press, he’s going to run it as fast as he can.”

Fed Rate Hike? Not Yet

You can read the Fed statement here. In meaningful terms, the 50bp increase in the discount rate, and change in tenure from a max of 30 days to overnight, doesn’t amount to much although Asian markets are running a little scared right now. The discount rate only affects banks wanting to borrow direct from the Federal Reserve System, and doesn’t impact market interest rates at all. Like central banks the world over, the Fed is preparing the ground for “normalisation” of the domestic monetary environment. Since nobody needs to borrow (even the Term Auction Facility is being closed next month), the move is more a case of signalling FOMC intentions as the US economy recovers, rather than a substantive move towards tightening monetary policy.


Update:
If you want to read a fascinating and highly informative discussion on the Fed’s exit strategy, particularly the use of interest on bank reserves, you can do worse than to read these two blog posts: here and here.

One Good Reason Why Central Banks Should Be Independent: Politicians Don't Understand Monetary Policy

This article on Bloomberg caught my eye yesterday. The relevant passage is:

"Representative Alan Grayson, a Florida Democrat, questioned what authority the Fed used to lend hundreds of billions of dollars through currency swaps to central banks around the world.

'One of the arrangements is $9 billion for New Zealand -- that works out to $3,000 for every single person who lives in New Zealand,' Grayson said. 'Wouldn’t it have been better to extend that kind of credit to Americans rather than New Zealanders?'"

Here's Bernanke's reply:

"Bernanke countered that 'we are lending to all U.S. financial institutions in exactly the same way' and that 'we have a longstanding legal authority to do swaps with other central banks.'"

...which is a nice way of saying Rep. Grayson doesn't have a clue of what he was talking about.

What happens when central banks do a swap? Using the NZ example, the Fed loaned the RBNZ US$9b. Can the RBNZ use this to increase credit in the NZ economy? How so when the USD is not legal tender in New Zealand? Getting that USD into the NZ banking system in NZD form implies a contraction of the domestic portion of the money supply, not an expansion, unless it's fully sterilised. So why do the swap?

Because NZ, just like everybody else in the aftermath of the Lehman collapse, faced a flight to safety of foreign investment and domestic capital which caused a spike in USD demand. There was a currency mismatch between the foreign currency assets and liabilities of the banking system. If the central bank's international USD reserves were also insufficient, then NZ banks would have failed to meet their international obligations. This would have an impact not only on NZ's credit standing, but also on the counterparties on the other side of the transactions.

Not so bad if you're domestic: all that happens is that your capital can't leave. But what about foreign creditors? And all those hedge funds and banks who played the forex carry trade (remember NZ's high deposit rates? Was it only last year?)? The swap lines the Fed engineered allowed US firms to call back their foreign-based capital and bolster both cash and capital reserves right when they needed it most.

Failure to meet USD obligations would have greatly exacerbated the liquidity and credit crunch of late-2008. The NZ swap line of US$9b was relatively small - the ECB got US$200b.

The net actual effect is that the Fed and participating central banks transformed private sector USD liabilities into official sector USD liabilities, with the corresponding increase in credit worthiness. It also meant that any USD the Fed actually lent out through the swap lines came right back to the US.

Having Congress overlooking the Fed's shoulders gives me the willies. If Rep. Grayson is any example of the average level of economic competence there, politicians and monetary policy shouldn't mix - and that goes double for BNM and Parliament.

Update
Mark Thoma at Economist's View has a video and a nice discussion going on about the same subject of Bernanke's testimony. Plus a correction: RBNZ's swap line was $15b (of which none was actually utilised!), and the ECB got $300b not $200b.