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Friday, September 25, 2009

 

tim duy on liquidity withdrawal


following on today's earlier post, tim duy provides something of a window on the thinking behind these latest moves to threaten liquidity.

[G]iven the unemployment outlook is sad, wage growth continues to deteriorate, core inflation is falling, and we seem to lack an institutional arrangement to force higher prices, should they even emerge, into higher wages, what is the Fed thinking? Should they really be worried about winding down programs? Are they really confident enough that an inventory correction that will undoubtedly spike GDP numbers will also translate into sustainable growth? Even knowing full while that after the last recession, the US economy languished despite the inventory correction, only to be revived on the back of the housing bubble? In effect, the Fed looks to be putting much weight on the cyclical story playing out, while ignoring the structural story of the necessity of asset bubbles to fuel growth. Pondering this, a little noticed Bloomberg report jumped to mind:

Federal Reserve policy makers are concerned about making “a colossal policy error” leading to higher inflation if they don’t withdraw extraordinary monetary stimulus soon enough, said Laurence Meyer, vice chairman of Macroeconomic Advisers LLC and a former Fed governor.

“When you talk to committee members you see a little bit more angst than you’d expect,” Meyer said in an interview yesterday at the Kansas City Fed’s monetary policy conference in Jackson Hole, Wyoming. “In public they say they’re confident they’ll get it right, they’re confident they have the tools to get it right. But when you talk to them in private there’s some concern there.”


So, added to the Medley rumor, the pieces start to fall together. Internally, perhaps a wide range of FOMC members believe, in their hearts if not in the data, that they have gone so far that the balance of risks have shifted toward inflation. But this is troubling; the basis for the inflation story falls entirely on the Fed's expansion of its balance sheet. Just a meager $1.3 trillion expansion give or take in the wake of an over $11 trillion decline in household wealth? And the bulk of that expansion is sitting in excess bank reserves? Not really much of an inflation story. But why else are they so eager to withdraw? Just to prove to critics they can? With much fanfare, from Bloomberg today:

The Federal Reserve and U.S. Treasury said they’re scaling back emergency programs aimed at combating the financial crisis, reducing support for firms that now have an easier time getting funding.

The central bank today said it will further shrink auctions of cash loans to banks and Treasury securities to bond dealers, reducing the combined initiatives to $100 billion by January from $450 billion. The Treasury has “begun the process of exiting from some emergency programs,” the chief of the government’s $700 billion financial-rescue fund said separately.


Bottom Line. The Fed is moving toward the exit as they look toward the conclusion of their securities purchases programs. But it is not clear that such a move is justified by their own forecasts or the inflation/wage/employment data. There may be an internal fear they have gone too far, a fear that the hawks can exploit. To be sure, I see no reason to expect the Fed will raise rates for a long time. And the Fed maintains it has policy flexibility, claiming to be ready to revive asset purchases should economic or financial conditions justify. But I now suspect the bar for renewed expansion of Fed accommodation may be much higher than I had anticipated. And that the dominant push for expansion would have to come from financial market conditions, while they would be willing to tolerate persistently high unemployment rates so long as U. Michigan inflation expectations say elevated, regardless of the actual inflation data.


not only could we be seeing the popping of liquidity-fueled rallies in equity and credit; duy clearly fears this could be the onset of the second trough in an economic double dip. it should be said that the fed's alphabet soup has been unwinding for some time already, but has also been offset by quantitative easing in the form of mortgage-backed securities and treasury purchasing for the fed's portfolio. there's a strong implication here, however, that QE won't be expanded past the preset limits which the program will likely reach in the next week or two.

UPDATE: zero hedge forwards a bit more from moody's.

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Welcome back, GM--this whole issue goes back to the Fed being the Last Buyer. There is no one left to sell the Treasuries and MBS to--despite them being so confident a few months ago that the Treasury market was "liquid." Look at long Treasuries, for example. No real money buy-and-holders would buy a 3.5% ten-year or a 4.5% thirty-year coupon. The leveraged guys must have as much as they want--it's not so much that the spread is low, but that there is a lot of risk from short-end tightening and/or long end yield increases thanks to continued supply. The foreign central banks have stopped buying long Treasuries, opting instead for the one-night-stand T-bills.

Do the professors at the Fed really think that because they created Federal Reserve Notes and exchanged them for long Treasuries and MBS, some Wall Street sharpie is going to be willing to trade them back without making a substantial profit? The Fed was a big stupid buyer, and the only way out of that trade is to become even bigger and stupider or to find someone else who is. Good luck with that.

 
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