Saturday, September 24, 2011

The futility of monetary expansion

Given the strong opposition to any further expansion of its balance sheet, the US Fed has not gone ahead with a third round of quantitative easing but settled for the next best option of recalibrating its existing portfolio towards the longer end of the tenor spectrum.

The Fed's FOMC cited "significant downside risks" and announced that over the next nine months, it would sell $400 bn worth securities (treasuries and mortgage backed securities) with maturities below 3 years and purchase those with maturities longer than 6 years. With this, it hopes to twist the yield curve on longer term securities downwards without printing any more money and thereby further expanding its balance sheet.

While there is little doubt that it will have some impact in flattening the yield curve and lowering long-term rates, it is more or less certain that its impact is likely to be marginal. In fact, as witnessed by the steady flattening of the yield curve in the build up to the announcement, the markets may already have factored in its impact.

As an FT article suggested, though the lower long term rates will benefit home mortgage holders, their ability to take advantage of it remains questionable. It is estimated that about a quarter of borrowers have a mortgage worth more than their home and a half do not have the 20% of home equity needed to refinance at a lower rate. This effectively means that the two worst affected categories of mortgage holders will not be able to benefit from the flattening of the yield curve.

The lower long-term yields will also affect the profitability of banks, which traditionally borrow short-term and lend long. The flatter yield curves will dent their arbitrage margins. This will act as a further disincentive for them to lend in an uncertain economic environment.

Small businesses, the traditional engines of economic growth and job creation, especially in the aftermath of recessions, are badly credit constrained. Risk averse banks and financial institutions have been generally loath to lend to small businesses. As the plight of mortgage holders mentioned earlier shows, the battered household balance sheets have some distance to go before consumption can recover.

Most importantly, like the earlier quantitative easing programs, "operation twist" too will come up against the biggest problem facing monetary authorities and governments today - how to translate the dramatic expansion in monetary base and the resultant ultra-low long-term interest rates into increased credit ioff-take. In other words, monetary policies have not been able to make much headway with getting banks to lend, consumers to borrow, and businesses to invest. Except for a handful of the largest firms and financial institutions, credit remains squeezed.

This brings us to the fundamental issue which Paul Krugman and others have been higlighting, about the difficulty of squeezing much out of monetary policy when the economy is stuck in a liquidity trap and where aggregate demand is also in a deep slump. In a liquidity trap, since interest rates are touching the zero-bound (and therefore people do not have to sacrifice interest earnings to obtain liquidity), people are hoarding money not because of its liquidity value, but merely as a store of value. Worse still, since interest rates are close to zero, money and short-term treasuries become interchangeable and mere stores of value. This in turn means that conventional monetary policy actions that involve open market operations by swapping money for treasuries or expanding the money supply become ineffectual.

The graphic below highlights the near complete lack of responsiveness of monetary aggregates to the massive expansion in monetary base. Though the monetary base has exploded, the M2 money supply and its velocity have hardly budged, just as inflation has remained anchored to the bottom.

Clearly, as the graphic below shows, this massive infusion of money has found its way into the safety of bank's reserves.

It is amply clear that the present economic problems cannot be solved just by increasing the supply of money. Nineties Japan and Depression era US provides ample evidence of the futility of such expansion. In the circumstances, the solution lies in boosting aggregate demand. Monetary policy can only work at the margins in preventing the situation from getting worse.

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