Wednesday, September 21, 2011

21/09/2011: Fed's QE3 and why it will fail

Markets catalysts for today (barring unexpected news from the euro area) will be the US Fed statement expected at 19.15. Following the FOMC two-day meeting consensus expectation is for the FED to announce new, but relatively modest - compared against QE1-2, easing measures labeled in the media Operation Twist.

These will attempt to boost consumer and corporate borrowing and spending, as well as ease longer-term debt constraint for the Feds and local authorities (states and municipalities). The Fed is likely to attempt flattening the longer-term yield curve in a hope that restarting borrowing will cut US elevated 9.1% unemployment rate.

To do this, the Fed will probably sell short-term debt (Treasuries) to buy out longer term debt - in effect the cost of borrowing will rise in the short run, while longer term financing costs will decline. Short-term consumer credit will take a hit, as will less liquid financial services providers. Operating capital for businesses is also likely to become more expensive. Just how exactly this is going to help US economy - anyone's guess, but it will provide some breathing space for the US Government, put pressure on the Republican opposition to debt ceiling hikes (pressing the argument forward that short-term financing is getting relatively more expensive) and will encourage banks to load up on maturity mismatch risk via incentivising shorter bonds loading).

Simultaneous selling of short term maturities and buying of longer term debt will in effect sterilize Fed intervention when it comes to its balance sheet, but it will also encourage cutting back the entire maturity profile of banks asset books.

The core problem, of course, is that these measures are likely to fail to deliver anything meaningful to the economy. The cause of stalled consumer and producer demand for credit is not the cost of financing - especially in the short run, since mortgage rates are currently at historically low levels. The real cause is the fact that the US is suffering from debt overhang.

Back in 1980, US Household, Corporate and Government debt as percentage of nominal GDP amounted to 151% - 3rd lowest in G7. By 1990 this rose to 200% - 4th lowest. With Bill Clinton's (or rather Republican Congress) heroic efforts to cut that, 2000 level of debt was 198% - the lowest in G7. In 2010, the US combined public and private non-financial debt was 268% - the second lowest in G7.

Meanwhile, household debt rose from 52% of GDP in 1980 to 95% of GDP in 2010. Thus US households have gone from being 4th most indebted in G7 back in 1980 to being second most indebted in 2010. In the mean time, corporate debt remained relatively low, compared to G7 states - rising from 53% in 1980 (3rd lowest) to 76% of GDP in 2010 (lowest in G7).

Public sector debt rose from 46% of GDP (3rd lowest in G7) in 1980 to 71% of GDP in 1990 (3rd highest in G7), declined to 58% of GDP in 2000 (second lowest) and rose to 97% of GDP in 2010 (3rd lowest in G7).

In a recent paper, presented at Jackson Hole, WY meeting this year, S. G. Cecchetti, M. S. Mohanty and F. Zampolli (paper titled "The real effects of debt") reported that thresholds for debt levels that are damaging to economic growth (under the baseline case that covers presence of the financial crisis) are:
  • 96% for Government debt to GDP ratio (US was already at 97% in 2010)
  • 73% for Corporate debt to GDP ratio (US was at 76% in 2010) and
  • 84% for Household debt to GDP ratio (US was at 95% in 2010)
Spot the problem, folks, for Ben clearly can't see it. (Hint: of all three debt heads, household debt is further out of trigger range).

Thus, the only meaningful stimulus the US Government can put forward is the set of measures to deliver meaningful reductions in household debt. About the only tool for that is a broad-based middle and upper-middle classes income tax cut.

Everything else, including Ben's financial re-engineering of the yield curve, is not much different from what the EU is doing with Greece. Kicking the can down the road is not the proverbial elephant the Fed is ignoring. The can itself - household debt - is.

1 comment:

Plainview said...

Absolutely spot on Doc. You nailed this. Instead of an (unlikely) broad-based tax cut, perhaps a wide and generous refi program could be reasonably effective.

Unfortunately you are completely wrong on your other article re. the EUR/CHF floor but I'd imagine you are already (like the funds who took it on) realising the error of your ways with that position.