Sunday, November 30, 2008

OPEC supply cuts will not match demand declines

OPEC did not agree cut production this week-end. The cartel members could not find common ground and decided to wait until December. OPEC cut production quotas in October by 1.5 million barrels or 5.2% of daily demand. That has had little impact on the oil price decline.

There are two major problems. One, the demand decline has taken the market by surprise. The global economies are falling faster than expected and look like they will continue to decline in 2009. Second, and more importantly, OPEC countries have been aggressive with their economic expansion plans and they do not feel like cutting production to stabilize prices. will help with increasing revenues.

The classic problem of cartels is that you have cheaters. And there are some major cheaters in the world. Venzeula gains 90% of its export revenue from oil. The majority of government revenue is tied to oil and President Chavez needs every last cent to stay in power. Russia was planning for $95 a barrel oil so they will have to produce flat out to meet revenue targets. Iraq needs the revenue for capital building. Iran has internal economic problems which need more money. We have not even started to discuss the other Arab countries.

Right now there is little reason to see prices going up. Let's not forget that oil was $10 a barrel ten years ago.

Non-standard monetary policy is becoming our new standard

It is now evident that the Fed is flowing a policy of quantitative easing. Unfortunately, they have not been willing to be explicit in announcing there policy change. Now, some may argue that we are premature about making this announcement since the Fed funds rate is still at 1% bu the latest round of Fed announcements of buying commercial paper and MBS and GSE debt is all but stating the obvious.

This should not be surprising given that Chairman Bernnake has researched this issue extensively all the way back in 2004 in "Monetary Policy at the Zero Bound: An Empirical Assessment" with Vincent Reinhart and Brian Sack. In that important paper, Bernanke and company discusses the policy alternatives when rates start to reach zero. There are three major policy alternatives, communication, quantitative easing, and balance sheet policies. It could be argued that the Fed is engaged in all three of these alternatives right now.

First, the Fed has made clear that they will provide significant funds through a number of programs to provide the market with liquidity. They have also made clear that they are will to provide funds even if this lowers the Fed funds rate below the target.

Second, the Fed has engaged in actively increasing their balance sheet through providing lending facilities. It has provided more repo lines, the dealer lending facilities and other programs which have increased the Fed balance sheet to above $2 trillion. They have been providing funds to offset the delevering by private sources.

Three, the Fed has been willing to take on credit risk in order to provide liquidity and to affect the yield curve. The outright purchase of GSE debt and MBS is similar to earlier policies like Operation Twist to use its buying power to affect longer-term rates and rates that seem to be out of line relative to historical relationships.

The good news is that three prong attack to affect the economy is right out of their policy choices discussed in the 2004 paper. Unfortunately, the bad news is that the impact of these policies may take some time so no one should expect monetary miracles over the next few weeks. The size of the liquidity problem outstrips the impact that was modeled in the 2004 paper.

Global monetary policy zero limit bound problem

Most of the G7 central banks will have policy meetings in the first half of the December. All of the central banks are facing slowing economies and lower inflation. In fact, there is a growing concern about deflation. The key issue will not be whether there will be easing but how much. This leads to the bigger question of what will happen when you force rates closer to the zero limit bound (ZLB).

Now we will not dwell on the deflation issue. Core inflation for most countries are still within their targeted zone after excluded food and energy. Much of the decline in CPI and PPI is a reversal of the short-term commodity spike. The spike was not an inflation problem as much as a price shock issue. It now seems obvious that inflation taregtting is out the window and economic stimulus is the problem.

The issue for many central banks is that we still are relatively early within the recession cycle and interest rates are falling to extremely low levels. Major cuts in many of these countries will take short rates down to levels where there will a concern about what some have called the ZLB problem. What are the policy choices of the central bank if we you are or approaching zero interest rates?

The problem is facing a number of central banks this month. Japan has seen a growing decline in economic growth. Rates are at 30 bps and have limited room for further decline after rates were cut 20 bps in October. The Fed has rates listed at 1% but another Fed cut is expected to bring the Fed funds target down to 50 bps. The Fed funds rate is already trading below one percent. The Fed seems to have changed to a quantitative easing policy. The Swiss National Bank has a target rate set at 1% but will meet again in December under a declining environment. Bank of Canada has argued earlier that the economy is still doing ok, but the tight relationship with the US and its commodity focus will place further pressure to lower rates. Bank of England is behind the curve with an economy that is growing worse every month. The same could be said for the ECB.

Expect to see further rate cuts across the board but there will be more discussion about quantitative easing and non-standard monetary policy. We know the global economies are in recession so there will be more focus on what will be the monetary and fiscal stimulus alternatives in the coming weeks. The equity markets will sell-off on anything other than strong easing.

Bank of Japan quantitative easing - lessons for the Fed

In the depth of the Japanese "lost decade", the Bank of Japan changed monetary policy to try the radical approach of quantitative easing. It actually was the only alternative to a liquidity trap from a deflationary environment where rates were at zero. The Bank of Japan had moved to zero interest rates in March 1999, but the policy of just keeping rates at zero was not enough.

The BOJ Quantitative easing set current account balances, the equivalent of excess reserves, to a quantitative target which would be maintained until CPI was greater than zero on a year over year basis. The policy started on March 2001 and lasted until March 2006. The current account balance initially moved from 1 trillion yen to 5 trillion yen, but the target was increased nine times from from March 2001 to December 2004 for a target pf 35 trillion yen.

The Fed seems to be on similar path so it seems important to discuss whether the BOJ quantitative easing was a success. The answer is that its success was only marginal. First, the size of the increases was much larger than anticipated and the impact of trying to stop deflation took longer than expected. Investors in the US should recognize that there will not be an quick fixes even if we have started quantitative easing much sooner than the Japanese.

Studies of the Japanese financial markets show that the the BOJ easing was able to effect longer rates and bring them down slightly. However, empirical studies suggests that a 10 trillion yen expansion was able to only bring down three and five years interest rates by less than 20 bps. There will not be a significant reduction in US rates if we use the Japanese case as a benchmark.

The BOJ found that there was no overall stimulation of lending from their quanttitive easing. Research did find that the easing policy reduced the standard deviation of CD rates across Japanese financial institutions. That is, the lower quality financial institution were able to reap a benefit from the increased reserves. However, some have concluded that the lowering of risk for those firms of lower quality actually delayed structural reforms. Poor institutions lasted longer than they would have until normal policies.

The Fed is moving to quantitative easing but it is not clear that this will be a panacea for all what ails the US economy. Now there may be limited choices and quantitative easing may be the only alternative, but this alternative does not mean that we will have a quick cure to our problems.

Saturday, November 29, 2008

Monetary policy and credit quality cross purposes

The Fed has taken steps to directly buy up corporate assets through the high quality and ABS commercial paper markets and through GSE mortgage debt. The Fed rationale is to unlock the liquidity crisis in the short-term lending market and try and push down mortgage rates. The objective of the Fed is to provide liquidity while taking a minimum of credit risk. We thought the mortgage purchases were going to be a TARP objective but things change but that is another issue.
These purchases, which promote the quantitative easing Fed policy, could lead to unintended consequences. If the Fed is willing to finance all of the good quality assets which are rated A1/P1 how is poorer quality paper going to be financed? There are only two choices. The firms of lower quality will have to go under or they will have to find a price that will entice buyers of the paper. The Fed will crowd out the banks for higher quality paper which will have serious portfolio balancing effects.
So who are the potential buyers of lower quality financial paper? They will either be money market funds or banks. Both these groups have either a back-stop or deposit insurance but it comes at a cost. Deposit insurance does not mean that banks and money funds are going to take on riskier credits. Money funds will take on any asset which has the potential to break the buck for the funds.
So what are the alternative scenarios for the banks? They could buy this lower quality paper and have it become a larger portion of their loan portfolio or they could walk away from the market and take deposit reserves at the Fed at the Fed funds rate. The first alternative could hurt earnings and equity. This will force banks to take capital from the Treasury and thus loss control of their firms. The second alternative allows for positive earnings while still maintaining control of their institutions. Credit risk is limited.
The choice seems simple. There will be less lending to those who may need it most at any price. A two-tiered system of Fed lending to high quality firms and no lending to those that do not meet the Fed criteria will further develop. There is no solution in the short-run for this problem if the objective is to solve the liquidity crisis as quickly as possible.