HELICOPTER BEN GOES ZIRP, QE, AND MORE... WHILE THE GLOBAL ECONOMY ENTERS STAG-DEFLATION
By Nouriel Roubini
REG Monitor
Original source: RGEM Monitor
The Fed decision yesterday to cut the Fed Funds range to 0-0.25% formalized the fact that, over the last month, the Fed had already moved to a ZIRP (zero-interest-rate-policy) -- as the effective Fed Funds rate was already close to zero -- and started a policy of QE (quantitative easing) as its balance sheet has surged over the last few months from $800 billion to over $2 trillion. And -- as discussed below -- the Fed is now undertaking even more unorthodox policy actions.
These Fed policy actions are occurring while the U.S. and the global economy is now risking a protracted bout of stag-deflation, a disease that I first discussed as early as January 2008 when I warned about the risk of a global deflation and stag-deflation. While it is now fashionable to talk about such deflationary risks –- and the latest U.S. CPI figures confirm that we are entering into deflation -– some of us were worrying about the coming deflation well before the mainstream –- concerned with short-run and unsustainable increases in commodity prices –- discovered the deflationary risks in the global economy.
It was clear to those of us that saw early on the risks of a severe U.S. and global recession that, once that recession would emerge, deflationary rather than inflationary pressures would emerge as slack in goods markets, slack in labor markets, and slack in commodity markets would emerge. So now we need to worry about stag-deflation, deflation, liquidity traps, and debt deflation. Welcome to the world of stag-deflation or, as Krugman would put it, to the world of “depression economics.”
So what is the outlook for the
The outlook for the
The recession in other advanced economies (the euro zone, the
There is now also the beginning of a hard landing in emerging markets as the recession in advanced economies, falling commodity prices, and capital flight take their toll on growth. Indeed, the world should expect a recession (growth in the -1 to -2% range) in
Other emerging markets in
How is the policy response in the
The Fed decision yesterday to cut the target for the Fed Funds rate to a 0% to 0.25% range is just underwriting what was already obvious and happening in reality: while the target Fed Funds was -- until yesterday -- still 1% in the last few weeks -- following the massive increase in liquidity by the Fed -- the actual Fed Funds was already trading at a level literally close to 0%.
So the Fed just formalized what was already happening for weeks now, i.e. that the Fed Funds rate was already zero and that the Fed had already moved to quantitative and qualitative easing (QE) in the form of massive increase in the monetary base and aggressive use of monetary policy -- via a range of new facilities and tools -- to reduce short term and long term market rates that are stubbornly high in a sign that the credit crunch is severe and worsening.
I predicted early in 2008 that the Fed Funds rate "would be closer to 0% than to 1%" in the midst of a severe recession. Now 12 months into this severe recession (that officially started in December 2007) -- a recession that will last at least another 12 months (if not, as possible, much longer) -- the Fed Funds rate is already down to 0% (the beginning of the zero-interest-rate-policy or ZIRP for the U.S.) and the Fed has moved into uncharted unorthodox monetary policy as a severe stag-deflation is taking place.
And, as predicted here over a month ago, the Fed is now committed to keep the Fed Funds rate close to zero for a long time (as a way to push lower long term Treasury yields), is purchasing agency debt and agency MBS in massive amount; and is even considering purchasing long-term Treasuries as a way to push lower long term government bond yields that are already falling sharply.
More aggressive policy actions may be undertaken by the Fed as a severe credit crunch shows no signs of relenting. In his 2002 speech on deflation the Bernanke spoke even of helicopter drops of money, monetizing fiscal deficits, and even buying equities. The latter actions have already been partially undertaken: the Fed is effectively already monetizing the U.S. fiscal deficits as the purchase of markets assets (agency debt and MBS and other facilities) is financed with the Fed printing presses rather than the TARP program; and now with the Fed considering the purchase of long-term Treasuries, such monetization of deficits will be made more formal. Also, since the TARP has been turned into a program to recapitalize financial institutions (and thus boost their capital and market value), the U.S. has already effectively intervened indirectly in the equity market (by partially nationalizing a good part of the U.S. financial system); once the Fed starts to buy the U.S. long-term Treasuries financing the TARP program, this indirect Fed purchase of U.S. equities will be even more clear.
While Fed actions to reduce mortgage rates -- via purchases of agency debt and agency MBS -- are partially successful, as long-term mortgage rates are falling, most of Fed purchases of private assets have been so far limited to very high-grade securities. Thus, the gap between the yield on high-grade commercial paper purchased by the Fed and the one that the Fed is not purchasing is sharply rising; ditto for the gap between agency MBS and private label MBS; also, while long-term Treasury yields are sharply falling, the spread of corporate bonds -- both high-yield and high-grade -- relative to Treasuries remains huge, as a sign of a severe credit crunch. Thus as a next step the Fed may be soon forced to walk down the credit curve and start buying private short-term and long-term securities with lower credit rating. That would mean that the Fed will take on even more credit risk than is already taking on today while purchasing illiquid private assets. But desperate times lead to desperate actions by desperate policymakers.
In the rest of the world, monetary and fiscal easing is also occurring as global policymakers are trying to prevent a global stag-deflation; but the policy response in most countries is more limited and constrained than the aggressive one of the
In the Eurozone the policy response has been extremely slow. First, the ECB is behind the curve and cutting rates too little and too late. Second, the ECB has been much less creative and aggressive than the Fed in creating new facilities to unclog the liquidity and credit crunch that is becoming as severe in Europe as in the U.S. Third, the fiscal policy stimulus in the E.U. is weak: those countries that need a stimulus the most (Italy, Portugal, Greece, Spain, U.K.) are the ones that can afford it the least given their large fiscal deficits and debts; and those who can afford it the most -- Germany -- are least willing to have it. Fourth, the recapitalization of financial institutions in
While the
In the many emerging-market economies at the risk of a financial crisis, aggressive monetary easing and fiscal easing are not likely. Indeed, many of these countries start with large fiscal deficits and debt, thus requiring fiscal discipline rather than easing. Moreover, many of these countries have large stocks of foreign currency liabilities whose real value would sharply increase if easy monetary policy leads to a sharp depreciation of their currency. Thus, there is less room for monetary easing. Also, many of these countries don’t have the fiscal resources to provide liquidity and capital to their financial institutions that are now facing a sudden stop of capital inflows. The international community -- IMF programs, World Bank [and] other IFIs' financial support, and the Fed/ECB with their swap lines -- can help countries under distress as long as they implement appropriate policy changes, but the risks of outright financial crises remain in some of the weakest economies.
In
Could fiscal policy rescue the day and prevent a Chinese hard landing? The optimists argue yes by pointing out that fiscal deficits and public debt are low in
In summary, with traditional monetary policy becoming less effective, non-traditional policy tools aimed at generating greater liquidity and credit (via quantitative easing and direct central bank purchases of private illiquid assets) will become necessary in many advanced economies. And while traditional fiscal policy (government spending and tax cuts) will be pursued aggressively, non-traditional fiscal policy (expenditures to bail out financial institutions, lenders, and borrowers) will also become increasingly important in these advanced economies.
In the process, the role of states and governments in economic activity will be vastly expanded. Traditionally, central banks have been the lenders of last resort, but now they are becoming the lenders of first and only resort. As banks curtail lending to each other, to other financial institutions and to the corporate sector, central banks are becoming the only lenders around.
Likewise, with household consumption and business investment collapsing, governments will soon become the spenders of first and only resort, stimulating demand and rescuing banks, firms, and households.
The long-term consequences of the resulting surge in fiscal deficits are serious. If the deficits are monetized by central banks, inflation will follow the short-term deflationary pressures; if they are financed by debt, the long-term solvency of some governments may be at stake unless medium-term fiscal discipline is restored.
Nevertheless, in the short run, very aggressive monetary and fiscal policy actions -- both traditional and non-traditional -- must be undertaken to ensure that the inevitable stag-deflation of next year does not persist into 2010 and beyond.
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