What can a Central Bank do when it can not lower the interest rates anymore, because the rate is already too low or even at zero? Ben Bernanke tried to answer that question in a 2004 paper (pdf).
Central banks usually implement monetary policy by setting the short-term
nominal interest rate, such as the federal funds rate in the United States. However, the
success over the years in reducing inflation and, consequently, the average level of
nominal interest rates has increased the likelihood that the nominal policy interest rate
may become constrained by the zero lower bound on interest rates. When that happens, a
central bank can no longer stimulate aggregate demand by further interest-rate reductions
and must rely instead on “non-standard” policy alternatives.
There is a point where interest rate manipulation is ineffective and for that situation Bernanke looked at three alternative 'non-standard' instruments:
- (1) using communication
to shape public expectations about the future course of interest rates - (2) increasing the
size of the central bank’s balance sheet, or “quantitative easing” - (3) changing the
composition of the central bank’s balance sheet through, for example, the targeted
purchases of long-term bonds as a means of reducing the long-term interest rate.
The first 'non-standard' policy is just talk. It may influence market expectations but is unlikely to have any real effect in severe situations.
To understand the second and third option we need to take a look at the Fed's balance sheet.
Like any balance sheet the Fed's has two columns of positions that should always sum up to the same amount. One column lists assets and the other one lists liabilities. Assets should be in balance with liabilities, thus the name of the sheet. Currently the Fed has about $925 billion in liabilities and the same amount in assets.
The main liabilities of the Fed are the US-dollar notes in circulation. The main assets the Fed pledges against these liabilities are treasuries, essentially future obligations of the United States' taxpayers to work a certain amount of hours to be able to pay the principal of the treasuries and some interest.
Bernanke's option two is to increase the size of the central bank's balance sheet. When the Fed prints more US-Dollar bills (or the electronic equivilant) and uses these to buy more treasuries both sides of the balance sheet, assets and liabilities, increase. The amount of money in circulation, the Fed's liabilities, increases as well as its assets, i.e. the amount of treasuries it buys for those dollars.
But bringing more money into circulation has a drawback. Here is the simplified case. If there are 1,000 units of money in circulation and 100 units of goods, each unit of goods has a price of 10 units of money. If the units of money increase, for example to 1,100, but the units of goods stays constant, the price for a unit of goods must increase, in this example to 11 units of available money for each unit of goods.
The effect of increasing the size of the Fed's balance sheet is inflation. More money chasing a constant amount of goods.
For people who saved units of money this can be very negative. Their saving's purchase power, the ability to buy a number of goods, decreases with inflation. 100 saved units of money will buy less units of goods if the amount of money inflates.
For people who are in debt, the effects of inflation are welcome. Debt is denominated in units of money. In the above inflationary case, to pay back 100 units of money in debt, will suddenly require less than ten units of goods, i.e. less work.
Higher inflation usually hits the masses more negatively than the privileged and can lead to severe social unrest. It is therefore not welcome. The ability of the central bank to use Bernanke's option 2 is limited.
This leaves option 3 – changing the composition of the central bank’s balance sheet.
The liability side of the Fed's balance sheet are U.S.-Dollar bills. The Fed can not change the composition of those. But it can change the asset side.
The business banks are currently in problems because many of the assets on their balance sheets are frozen. Right now nobody trust the value of the debt obligations (like mortgages) these banks are holding as assets. There is currently no market for these and their value is thereby uncertain.
Who knows if Joe Sixpack will really work, or can work, the hours he promised to do to pay back the mortgage loan he got to buy that big house? He may, or he may not. Unless there is some certainty to this, Joe Sixpack's debt obligation is not marketable.
In option 3 Bernanke suggest that the Fed changes the composition of the asset side of its balance sheet. It may sell treasuries to the business banks in exchange for a number of Joe Sixpack promises to work a certain amount of hours to pay back the loan the Joes borrowed to buy those big houses.
The Fed offers to exchange treasuries for mortgage backed security (MBS).
For the banks this means exchanging currently non marketable papers for ones that are immediately exchangeable for cash, Starbuck's Latte or whatever they want or need to have.
The Fed takes the banks' MBS papers with some 'haircut', i.e. it values the individual promise of Joe less than the general promise of all U.S. taxpayers, a treasury, and leaves the banks with some of the risk. The Fed may calculate that of 100 Joes 10 will not pay back as they promised and leave the risk of those 10 non-payers with the banks.
But what happens if 20 of 100 Joes are unable or unwilling to pay back their mortgage?
The banks' owners may decide that they don't want to take that loss and default. Then the Fed will have 'assets' on its balance sheet that are less in value than assumed. The asset side of its balance sheet, now filled with MBS instead of treasuries, will suddenly shrink and be lower in real value than is assumed for the liability side.
That risk is not small. Merrill Lynch says this is the worst recession since the 1970s, which makes any payment promise dubious. As Steve Waldman calculated, the Fed has committed half(!) of its assets to the risk-exchange scheme. If the Fed has calculated the risk wrong (which I have reason to believe) the exchange of secure treasuries for somewhat dubious MBS papers will have very serious implication for its balance sheet.
At that stage the Fed would have two options to bring the two balance sheet columns back into real balance
- decrease liabilities by reducing the float of U.S-Dollar in circulation, i.e. deflate (and increase real value of debts)
- let people know that a greenback with a $1 imprint is only worth $0.90 of asset equivalent. i.e. inflate the value of the U.S.-Dollar (and decrease real value of debts)
As the U.S. in total is a debtor nation, the second option, inflation, will be preferable. The value of the dollar will sink and thereby devalue any U.S. obligation and any U.S. asset, i.e. your saving or 401k deposits.
Yesterday the Fed ignited fireworks in the stock market with its announcement to commit another $200 billion of a $800 billion balance sheet to bad debt. But how can that be sustainable?
In my view it can not. So I am betting on an inflationary U.S.-Dollar environment.
Like Marc Faber I expect some imminent technical pull backs in metal and other commodity markets. But these are mere technical reactions and their prices, in U.S.-Dollar terms, will increase much more before there is some kind of resolution to the underlying Fed balance sheet problem.