Tag: Federal Reserve

The Fed’s New Round of Quantitative Easing

Last Thursday, the Fed announced its intention to proceed with another round of quantitative easing, or QE3. To summarize my reactions:

  1. By introducing another program to buy MBSs, to the tune of $40 billion per month, the FOMC is supporting the long-standing federal policy of special aid to housing, real estate and mortgage interests. These federal policies were the largest single contributor to the financial crisis. Why would the Federal Reserve want  to encourage continuation of these federal policies? Almost every economist, except those allied with housing interests, agrees that the mortgage-interest and real-estate tax deductions in the federal tax code should be eliminated or scaled back. I’ll wager that almost every Federal Reserve economist shares this view. The Federal Reserve says that it is apolitical but this decision is directly supportive of continuation of the current status of Fannie Mae and Freddie Mac. This action is not monetary policy but fiscal policy, extending credit to a favored industry. This policy is crony capitalism, whether practiced by the federal government or by the Federal Reserve.
  2. The FOMC’s decisions create yet another exit problem for the Fed. If job growth picks up, or inflation rises, before every future FOMC meeting the market will wonder if the Fed will stop buying MBSs. The Fed has refused to offer any genuine guidance as to when the policy will end. Conversely, if job growth remains weak, market participants will wonder before every FOMC meeting whether the Fed will do more, or introduce some new and untried policy.
  3. In his press conference, Chairman Bernanke appropriately emphasizes the need for fiscal policies to stabilize federal finances. Yet, he is promising that the Fed can make a material contribution to bringing down unemployment. That promise reduces the pressure on Congress to act. Why should Congress deal with the tough political issues if the Fed can do the job, even if more slowly than if Congress acted?

Dimon on NY Fed Board a Distraction, Solution Is to Remove the Fed from Bank Regulation

It is not surprising that the recent losses at JP Morgan have resulted in calls by current and would-be politicians to remove bankers from the boards of the regional Federal Reserve banks, as JP Morgan CEO Jamie Dimon currently sits on the board of the New York Federal Reserve. There’s even a petition for the “public” to demand Dimon’s resignation. Setting aside the irony of having senators call for keeping bankers off the regional Fed boards just days after they voted to place a former investment banker on the Federal Reserve board, the real question we should be debating is: Should the the Federal Reserve even be involved in banking regulation?

As I’ve noted elsewhere, a recent paper by economists Barry Eichengreen and Nergiz Dincer suggests that separating monetary policy from banking supervision would yield superior outcomes, both for banking stability and the economy more generally. While there is a very real conflict-of-interest when bankers sit on the boards of their regulators, there is an even bigger conflict-of-interest when those setting monetary policy are also responsible for bank safety. Rather than let institutions they supervise fail, and face public criticism, there exists a strong incentive for the monetary authority to mask bank insolvency by labeling such a liquidity crisis and then injecting easy and cheap credit. The result is that the rest of us are left paying for the mistakes of both the bank and regulator. A far better alignment of incentives would be to separate the conduct of monetary policy from bank supervision.

Like anything, such a separation would not be without its costs. I am the last to go around claiming a “free lunch” when it comes to banking and monetary policy. The current Boston Fed President made a strong case over a decade ago for keeping the two combined. The Richmond Fed has also offered a useful discussion of the pros and cons of such consolidation, as well as consolidating regulators more generally. These costs aside, I believe having the Fed focus solely on monetary policy would improve both.

The ‘Dodd Rule’ on Nominations

Obama’s recent nomination of Jeremy Stein and Jerome Powell to the Board of Governors of the Federal Reserve System raises an important question: How should the Senate treat nominations whose terms are likely to run beyond the term of the current president? If confirmed, Stein could serve until 2018 and Powell until 2014. Of course this pales in comparison to current governor Janet Yellen, whose term runs until 2024.  With or without Stein and Powell, Obama nominations will have control of the Federal Reserve for years to come.

The long terms of Federal Reserve governors are meant to insulate them from political pressure. But that’s after they’ve been confirmed.  This structure tells us little about how to handle such appointments during their nomination phase.

In the absence of strong policy or theoretical rationales, we often look to precedent. In this case we have at least one. In December of 2007, almost a year before the November 2008 election, then Senate Banking Committee chair Chris Dodd (D-CT) said, in relation to the nomination of Randall Kroszner to the Federal Reserve, “We’re frankly getting down to less than a year away from the election. On nominations of that length, I’m fairly reluctant.” Senator Dodd acted (or rather failed to act) on that reluctance, and blocked the nomination of Professor Kroszner.  His nomination was not an exception, as the nominations of Larry Klane to the Federal Reserve and a couple of nominations to the Securities Investor Protection Corporation were also blocked, for apparently this same reason. Dodd also delayed nominations to the President’s Council of Economic Advisers, although those positions would have ended with the term of President Bush. Also worth noting is that these important economic policy positions were being blocked in the middle of a recession and financial crisis, when one would think you need “all hands on deck.”

Is this “Dodd rule” the correct position? It’s hard to know. I can say I didn’t think it was appropriate at the time. And I am usually not one to believe that “two wrongs make a right.” The correct solution, in my view, would be to have the Senate decide upon the appropriate length of time before a presidential election that it will no longer consider nominations that run beyond the president’s term and incorporate that decision into the Senate rules.  Until then operating under the “Dodd Rule” strikes me as fair enough.

Bernanke’s Anti-Stimulus

One of the direct results of the Federal Reserve’s zero interest rate policies has been a massive reduction in interest income going to households. Since 2008, household interest income has fallen by about $400 billion annually. That’s $400 billion each year that families have not had to spend.

Now of course you can also argue that families interest expenses have also fallen, and that would be true, but that just serves to illustrate that much of monetary policy is not about creating wealth, but re-distributing it. Since interest payments are one’s person expense and another’s income, Fed driven changes in the interest rate should not increase household income in the aggregate.

As interest income/expense is not the only item on the household balance sheet, the Fed does try to make us feel richer via changes in asset prices. The problem, however, is that the change in many asset prices can also have little more than distributional effects. If owners feel richer because their house prices have gone up, or not fallen as much as they would have otherwise, then renters are poorer as they need to save more to by the same house. The same holds for commodity prices. Monetary driven increases in the price of food might be great for farmers, or speculators, but it makes households poorer by the same amount it increases the wealth of commodity holders. If the Fed truly wished to help our economy get back to “normal” then it would allow the free choices of individual borrowers and savers to determine the interest rate. It would also end its implicit practice of picking winners and losers in our economy. Unlike Fed driven changes in asset prices and interest payments, voluntary exchange between savers and borrowers increases the welfare of all parties involved.

It Was those Bad Speculators That Drove the Housing Bubble….

A recent report from the Federal Reserve Bank of New York examines the role of speculators in driving the housing bubble. Setting aside the fact that almost everyone who bought a house was “speculating” to some degree, the researchers focus on those who were buying homes they did not intend to live in.

Some have already tried to paint this study as proving the government had little to do with the housing crisis. To their credit, the study’s authors do not go that far. Others, Mark Thoma for instance, show no such constraint:

“This is pretty far away from the (false) story that Republicans tell about the crisis being caused by the government forcing banks to make loans to unqualified borrowers.”

Of course, I’m sure that even Thoma knows that he’s set up a straw-man. Does anyone really believe that the Community Reinvestment Act and the Government Sponsored Enterprises housing goals were the only factors behind the crisis? Perhaps if the New York Fed really wanted to understand the crisis, it should look in the mirror.  It would seem reasonable to me that three years of a negative real federal funds rate might have had some impact on the housing market, particularly in encouraging speculators. After all, the Fed was basically paying people to take money.

None of this takes away from the role that Fannie and Freddie played in the housing market. For mortgages they purchased directly, Freddie’s investor share increased from three percent in 2003 to seven percent in 2007. And this ignores the massive volume of private label mortgage backed securities purchased by Fannie and Freddie. I think its reasonable to believe some of those were investor loans. In addition, the FBI has reported that the most frequent form of mortgage fraud has been borrowers stating the loan was for a primary residence when it was not.  But then it would be impolite of me to suggest we actually prosecute borrowers who committed fraud.

As I argued over two years ago, the relatively high percentage of foreclosures that are driven by pure speculators should make us question the many efforts to slow or stop the foreclosure process. If so many of these foreclosures are speculators, then why do we continue to protect them from losing the homes? They gambled, they lost. It’s time to move on and let the markets continue to adjust.

Now, one can continue to blame private sector actors for following the perverse incentives created by government. After all, the banks didn’t have to make the loans and the borrowers didn’t have to take the money. But it should be the primary objective of public policy to get the incentives correct. It should by now be crystal clear that all of the massive speculation in the housing market didn’t “just happen”—it was the result of massive government distortions in our housing and financial markets.

 

Raising Interest Rates to Help the Housing Market

Last week I offered a few proposals to help move along the housing market. Given the need for brevity, the rationales for each were short. As almost all of them were counter to the conventional wisdom, they do merit a little more explaining, in particular the suggestion to raise interest rates.

Before I could offer a further discussion of the fact that the mortgage market is driven by both demand and supply, Daniel Indiviglio at the Atlantic was quick enough to provide much of that detail. Rather than repeat his analysis here, which I agree with, let’s focus on a few other points.

David argues that “at rates like 4 percent, those loans had better be pristine if the bank wants to ensure that its default risk is covered by the small amount of interest it receives.” Let’s dig a little deeper. What lenders care about are real rates. With inflation running approximately 2 percent, the real return on a prime mortgage today, before credit cost, is around 2 percent. But today about 3.5 percent of prime loans are in foreclosure. Assuming a 50 percent recovery rate, 1.75 percent is needed to cover credit losses. Even in good times, prime loans foreclosure at about a 0.6 percent rate. With subprime foreclosures running about 14 percent, you’d need to charge at least 9 percent to break-even in real terms. At today’s rates, lenders are barely breaking even on prime loans, they’d bleed money if they charge similar rates to subprime borrowers.

But then why don’t lenders just charge higher rates for the higher risk borrowers? After all that’s what they did during the bubble years.  Well a lot has changed since then. For instance, in 2008 the Federal Reserve, under the Home Ownership and Equity Protection Act (HOEPA), lowered the threshold for what is considered a “higher-cost” mortgage, from treasury +8 percent, which excluded much of the market, to prime mortgage +1.5 percent, which under current rates makes anything over 5.5 percent a “high cost” mortgage. When Congress passed HOEPA in 1994, it shut down that segment of the market, due to what is tremendous litigation risk. Now the Fed’s extension of HOEPA has done the same for much of the mortgage market. According to the Fed, 22 percent of the market was “higher-cost” in 2005. After the new regulation, that share had fallen to 2.4 percent in 2010. Yes the housing bubble and credit crisis would have shrunk that market, but by almost 90 percent? And yes, many of those loans we didn’t want to come back, but many we did.

The point here is that the Fed actually does impose, via legal risk, a de facto ceiling on mortgage rates. If we want to bring back housing/mortgage demand among higher risk borrowers, which were a significant source of demand, then the Fed would be wise to suspend its current HOEPA rules. If we don’t want to bring that demand back, then fine, just stop complaining about a weak housing market. As an aside, I was of the view in 2008 and still today that the Fed lacked legal authority for its 2008 HOEPA rule, but then the Fed has rarely let a lack of legal authority get in its way.

The Federal Reserve, the ‘Twist,’ Inflation, QE3, and Pushing on a String

In a move that some are calling QE3, the Federal Reserve announced yesterday that it will engage in a policy called “the twist” – selling short-term bonds and buying long-term bonds in hopes of artificially reducing long-term interest rates. If successful, this policy (we are told) will incentivize more borrowing and stimulate growth.

I’ve freely admitted before that it is difficult to identify the right monetary policy, but it certainly seems like this policy is – at best – an ineffective gesture. This is why the Fed’s various efforts to goose the economy with easy money have been described as “pushing on a string.”

Here are two related questions that need to be answered.

1. Is the economy’s performance being undermined by high long-term rates?

Considering that interest rates are at very low levels already, it seems rather odd to claim that the economy will suddenly rebound if they get pushed down a bit further. Japan has had very low interest rates (both short-run and long-run) for a couple of decades, yet the economy has remained stagnant.

Perhaps the problem is bad policy in other areas. After all, who wants to borrow money, expand business, create jobs, and boost output if Washington is pursuing a toxic combination of excessive spending and regulation, augmented by the threat of higher taxes.

2. Is the economy hampered by lack of credit?

Low interest rates, some argue, may not help the economy if banks don’t have any money to lend. Yet I’ve already pointed out that banks have more than $1 trillion of excess reserves deposited at the Fed.

Perhaps the problem is that banks don’t want to lend money because they don’t see profitable opportunities. After all, it’s better to sit on money than to lend it to people who won’t pay it back because of an economy weakened by too much government.

The Wall Street Journal makes all the relevant points in its editorial.

The Fed announced that through June 2012 it will buy $400 billion in Treasury bonds at the long end of the market—with six- to 30-year maturities—and sell an equal amount of securities of three years’ duration or less. The point, said the FOMC statement, is to put further “downward pressure on longer-term interest rates and help make broader financial conditions more accommodative.” It’s hard to see how this will make much difference to economic growth. Long rates are already at historic lows, and even a move of 10 or 20 basis points isn’t likely to affect many investment decisions at the margin. The Fed isn’t acting in a vacuum, and any move in bond prices could well be swamped by other economic news. Europe’s woes are accelerating, and every CEO in America these days is worried more about what the National Labor Relations Board is doing to Boeing than he is about the 30-year bond rate. The Fed will also reinvest the principal payments it receives on its asset holdings into mortgage-backed securities, rather than in U.S. Treasurys. The goal here is to further reduce mortgage costs and thus help the housing market. But home borrowing costs are also at historic lows, and the housing market suffers far more from the foreclosure overhang and uncertainty encouraged by government policy than it does from the price of money. The Fed’s announcement thus had the feel of an attempt to show it is doing something to help the economy, even if it can’t do much. …the economy’s problems aren’t rooted in the supply and price of money. They result from the damage done to business confidence and investment by fiscal and regulatory policy, and that’s where the solutions must come. Investors on Wall Street and politicians in Washington want to believe that the Fed can make up for years of policy mistakes. The sooner they realize it can’t, the sooner they’ll have no choice but to correct the mistakes.

Let’s also take this issue to the next level. Some people are explicitly arguing in favor of more “quantitative easing” because they want some inflation. They argue that “moderate” inflation will help the economy by indirectly wiping out some existing debt.

This is a very dangerous gambit. Letting the inflation genie out of the bottle could trigger 1970s-style stagflation. Paul Volcker fires a warning shot against this risky approach in a New York Times column. Here are the key passages.

…we are beginning to hear murmurings about the possible invigorating effects of “just a little inflation.” Perhaps 4 or 5 percent a year would be just the thing to deal with the overhang of debt and encourage the “animal spirits” of business, or so the argument goes. The siren song is both alluring and predictable. …After all, if 1 or 2 percent inflation is O.K. and has not raised inflationary expectations — as the Fed and most central banks believe — why not 3 or 4 or even more? …all of our economic history says it won’t work that way. I thought we learned that lesson in the 1970s. That’s when the word stagflation was invented to describe a truly ugly combination of rising inflation and stunted growth. …What we know, or should know, from the past is that once inflation becomes anticipated and ingrained — as it eventually would — then the stimulating effects are lost. Once an independent central bank does not simply tolerate a low level of inflation as consistent with “stability,” but invokes inflation as a policy, it becomes very difficult to eliminate. …At a time when foreign countries own trillions of our dollars, when we are dependent on borrowing still more abroad, and when the whole world counts on the dollar’s maintaining its purchasing power, taking on the risks of deliberately promoting inflation would be simply irresponsible.

Last but not least, here is my video on the origin of central banking, which starts with an explanation of how currency evolved in the private sector, then describes how governments then seized that role by creating monopoly central banks, and closes with a list of options to promote good monetary policy.

And I can’t resist including a link to the famous “Ben Bernank” QE2 video that was a viral smash.