it’s by no means time to break out the daiginjo sake yet

TO BE NOTED: From Alphaville:

"Japan: Land of the rising (output) surprise Posted by Gwen Robinson on May 29 11:30.

Bikkuri shimashita (surprise, surprise), as they say in Japan.

What is going on there? In stark contrast to all the bleak news lately about plunging exports, factory closures and mounting lay-offs, official figures on Friday showed one of the biggest surges on record in second-quarter industrial output. Some commentators leapt on the figures to proclaim the worst of the current slump is over for the world’s second largest economy. At the very least, according to some analysts, companies are beginning to “normalise” activity after a period of aggressive inventory reduction (The Honda effect).

The FT reports that Japan’s industrial output bounced back 5.2 per cent in April compared with the previous month, a stronger rise than analysts expected and a boost to hopes. What’s more, with government stimulus spending starting to support demand and manufacturers starting to reverse the drastic cuts to production imposed by a collapse of demand since late last year, the Ministry of Economy, Trade and Industry said surveyed manufacturers expected their output to rise a further 8.8 percent in May and 2.7 percent in June.

However - and there is an important “however” - signs of looming deflation and government data showing that seasonally adjusted unemployment had hit 5 per cent (its highest level for half a decade) suggested that Japan’s economic woes are indeed, far from over.

Even so, the second consecutive monthly rise in industrial output comes amid a distinct lightening of the mood surrounding an economy that suffered record contractions in both of the last two quarters, notes the FT:

The Bank of Japan last week upgraded its assessment of the Japanese economy for the first time in nearly three years, saying exports and production were beginning to bottom out and the effects of state stimulus spending would soon be felt. A supplementary budget clearing the way for the government’s latest Y15,400bn economy boosting package of measures is expected to be enacted today (Friday).

However, (that “however” again) “prospects for final demand for Japanese products in key markets such as the US and China remain unclear and at least some of the current upswing in output is likely to be replenishing inventories depleted by drastic recent production cuts”.

Richard Jerram, economist at Macquarie Securities Japan, notes that the strong April output figures follow sharp cuts to output in the first quarter, due to companies taking production well below final demand in order to burn off excess inventory:

As this process runs its course, output needs to adjust higher in order to stabilise inventories, and this began in April. The trade data on Wednesday gave the first sign of this process, with export volumes up 7.8 per cent from March. Similarly, output rose 5.2 per cent month on month in April and METI is projecting further gains of 8.8 per cent in May and 2.7 per cent in June. As is often the case when the cycle is bouncing, the output data are beating firms’ short-term projections.

Having just seen the worst two quarters on record, quarterly growth in the second quarter of about 10 per cent will be the best on record, according to Jerram, although that will “probably be surpassed” in the third quarter.

Nevertheless, this will still leave output about 15 per cent lower than in the first-half of 2008, before the Lehman shock hit, he adds.

There are two key concerns: First, excess capacity, “with the bounce taking capacity utilisation rates (and profit margins) back only to levels typically seen at the troughs of previous cycles”. Second is that underlying deflation is worsening and set to persist for a prolonged period.

Indeed, the news might all look good today but it’s by no means time to break out the daiginjo sake yet. As Chiwoong Lee of Goldman Sachs writes in a research note on Friday: “We expect production to sustain growth until the autumn, but we note the potential for a downturn later in the fiscal year (starting April) given deteriorating employment conditions and weak consumption”.

Related links:
Japan factory output jumps 5.2% - FT
Japan’s factory output surges most in 56 years - Bloomberg
Japan’s export figures spur optimism - FT
Land of the Rising Sun - closer to the precipice - FT Alphaville
End of the yen’s safe-haven status - FT Alphaville

This entry was posted by Gwen Robinson on Friday, May 29th, 2009 at 11:30 and is filed under Capital markets. Tagged with japan."

Me:

Don the libertarian Democrat May 29 17:11

"Bikkuri shimashita (surprise, surprise), as they say in Japan"

In the US we say Holy S--- or J----- C-----!!! Just so you know.

when, if at all, carry trading would return as per function of declining volatility and appreciation of risky assets

TO BE NOTED: From A Fistful Of Euros:

"Japanese Housewives Back in the Game? by Claus Vistesen

I am sure all those deadly serious investors, analysts, and commentators we hear so much from have been hard at it of late, trying to keep track of the broadest possible range of indicators in an attempt to to discern whether all those shoots of green would continue sprout, or whether what we have been seeing was merely a blip on the horizon of what may well be a very long recession. Clearly, what we have been seeing in the economic data does now seem to be a bit more than a mere blip, although what actually happens next may well take many of the consensus analysts completely by surprise.

Interestingly we have been getting some pretty clear signals of late, and from one of the “usual suspects”, that something somewhere may well be changing. I am of course talking about the recent Bloomberg report (also here) that Japanese housewives are once again making their presence felt in currency markets by playing the carry wheel.

Individual investors in Japan increased bets to the most in six months that the yen will weaken as the economy stabilizes, jumping back into a trade that was all but wiped out last year.

Businessmen, housewives and pensioners held 153,326 margin contracts at the end of last month that will make money if the yen declines against currencies ranging from the euro to the Australian and New Zealand dollars, according to the Tokyo Financial Exchange. All told, they may have as much as $125 billion in yen so-called short positions, RBC Capital Markets strategists said. “Investors believe the worst of the global recession is over and higher-yielding currencies are bottoming out,” said Yoshisada Ishide, who oversees $1.8 billion as a Tokyo-based fund manager at Daiwa SB Investments Ltd., a unit of Japan’s second-biggest investment bank.

Now, I have had my eyes on the Japanese housewives on more than one occasion (especially here) because I think that the tendency of Japanese retail investors to scour the global economy for yield runs a bit deeper than a simple carry trade play. Well, it is of course a carry trade but the underlying impetus for Japanese retail investors to act as they do also has something to do with a decline in home bias due to a low domestic interest rate environment as a result of demographics and subsequent sluggish domestic demand. The point is simply that one of the only ways Japan can achieve sustained is to mobilize its large stock of savings and, more importantly, to mobilize it abroad (e.g. through the purchase of samurais) in order to get the yield which is not obtainable in the domestic capital markets.

In the current environment of financial crises, great depressions, and credit crunches Ms Watanabe et al. have of course, in line with most other risky asset punters, been pulling back their fangs. However, with the recent narrative of green shoots and second derivatives it was also always going to be the question of when, if at all, carry trading would return as per function of declining volatility and appreciation of risky assets. As I have suggested lately, tentative signs have emerged that carry trading activity has slowly been coming back.

Now, it can be debated whether the apparent return of the Japanese housewives to the carry trough represents evidence of a solidification of the green shoots or, as a friend suggested to me, a contrarian indicator that things will soon hit the fan again. This particular friend of mine is an investor, so you are probably better off listening to him than me. There is also the small question of the targets for Ms. Watanabe’s allure in the form of the usual, OECD, suspects such as the Kiwi, the Aussie, and the Euro.

Looking at the chart to the right the recent three months which have been marked heavily by the green shoots discouse, it is quite obvious to see that the JPY has depreciated accross the board against the usual suspects. It is difficult to say whether MS. Watanabe has had a hand in this, but more interestingly is also the fundamental question of where the carry trade activity is going to be conducted in the future?

Specifically, it will be interesting to see whether there is going to be a change in the game whereby the OECD economies currently engaged in QE and with subsequent credible commitments by the central bank to keep rates low become funding for a carry trade to exploit the potentially “low volatility” growth (yield) in places such as India, Brazil and Turkey - see Edward’s piece on India yesterday for a good example of how all this could work.

Clearly, the BOJ has the mother of all credible commitments here in the sense that nominal interest rates have hardly budged the zero bound for more than a decade even in the midst of booms. This last point need careful watching I think as well as of course we might as well get another bout of volatility which could fold the, after all, fragile green shoots.

So, it does indeed seem as if the Japanese housewives are back in the game, but another fundamental question is whether the housewives ever left the game. This is to say that we need to look at structural long term outflows as well as more short term punting in order to really understand the what drives MS Watanabe and her fellow Japanese retail investors."

survey results suggest that further tightening is becoming less widespread

TO BE NOTED: From News N Economics:

"The worst of the credit crisis is likely behind us, say key central banks

Friday, May 1, 2009

Together, global senior loan officer surveys tell the following story: the worst of the credit crunch, at least in commercial banking, is likely behind us. Key central banks - the Bank of Canada (BoC), the Bank of England (BoE), and the European Central Bank (ECB) - report that Q1 2009 credit conditions in their respective banking sectors are generally tightening; however signs of stabilization are emerging: fewer banks are reporting to have tightened. The Bank of Japan (BoJ) reports that credit standards are generally easing somewhat; however, the demand for lending is likely the limiting factor for credit flow in Japan.

The ECB: showing signs of stabilization for household and firm lending

From the ECB's survey report:

The results of the April 2009 bank lending survey show that in the first quarter of 2009 the net percentage of banks reporting a tightening of credit standards on loans and credit lines to enterprises was 43%, which – while still reflecting a pronounced further net tightening – was 21 percentage points lower than in the fourth quarter of 2008. This could point to some stabilisation of the current tightening cycle. For the second quarter of 2009, the banks expect a further reduction of the overall net tightening to 28%.

The BoC: Lending standards still tight, but less widespread

From the BoC's survey report:

Although overall lending conditions continued to tighten, the tightening was somewhat less widespread than in the preceding quarter.

The BoE: Seeing some light, overall standards on corporate lending actually eased...

From the BoE's survey report:

In the three months to mid-March, a net balance of lenders reported that they had reduced the availability of credit to households. Contrary to expectations expressed in the 2008 Q4 survey, a small net balance of lenders reported increased lending to the corporate sector over the past three months. As in previous surveys, concerns about the economic outlook, reduced appetite for risk and falling collateral values had borne down on credit availability.

And the BoJ: Easing somewhat across most loan types

The BoJ's survey report indicates that in the first quarter of 2009 net, lending standards to large firms tightened somewhat, while those to medium-sized firms eased somewhat. Small firm and household lending standards eased somewhat. However, the outlook for small firm and household loans suggests that less easing is on the horizon. Note: the BoJ information can be found in question 7. of the survey.

In Japan, the primary problem in the bank lending space - the limiting factor according to the survey - is not the standards, but the weakening demand for loans (see question 1 of the survey and my previous post).

Overall, banking standards remain tight and are tightening in net across key economies; however, the survey results suggest that further tightening is becoming less widespread. I imagine that the worst of the global credit crunch is now behind us. The Fed's senior loan officer survey report for Q1 2009 will release soon; and I expect it to tell a similar story.

Rebecca Wilder"

manufacturers increased production to replenish inventories

TO BE NOTED: From the FT:

"Japanese output shows surprise gain

By Michiyo Nakamoto in Tokyo

Published: April 30 2009 03:09 | Last updated: April 30 2009 03:09

Japan’s industrial production rose at twice the pace widely expected, climbing 1.6 per cent month-on-month in March and raising hopes the economy was over the worst of the recession.

Factory output in the world’s second largest economy rose for the first time in six months as manufacturers increased production to replenish inventories, following a run of sharp falls in previous months.

The better-than-expected result helped lift market sentiment, with the benchmark Nikkei average rising more than 250 points in morning trading.

Companies forecast that industrial production will rise further this month and next, as they step up production to make up for large inventory reductions made previously, suggesting output may be bottoming out after the sharpest decline on record in the first quarter of the year.

Exports also rose in March, from February while consumer sentiment has improved.

The Bank of Japan is likely to cut its economic forecasts on Thursday but will probably hold fire on monetary policy as it gauges the impact of recent steps to boost the economy.

The 1.6 per cent rise in industrial output follows a small rise in exports reported earlier in April, although shipments are still running around half the levels of a year ago.

The BOJ will likely assess the data at its policy meeting on Thursday, at which it is expected to keep interest rates at 0.1 percent.

With hopes high the global economy may be past the worst phase of recession, the BOJ is due to stay with its forecast that the economy will start picking up late this year or early in 2010."

adopt the stock-buying plan comes in spite of considerable opposition to government intervention in the market

TO BE NOTED: From the FT:

"Japan plans emergency share purchases

By Michiyo Nakamoto in Tokyo

Published: April 17 2009 05:41 | Last updated: April 17 2009 18:12

Japan’s ruling Liberal Democratic Party on Friday unveiled details of its proposed Y50,000bn scheme to allow the government to buy shares from the market if share prices fall to an extent that is seen as an economic emergency.

LDP lawmakers said the proposals would be submitted to parliament on April 27, the same day a supplementary budget to fund a record Y15,400bn ($155bn) stimulus package is put ­forward.

The stock-buying facility, which would run only until March 2012, highlights concerns about the impact of the sharp fall in Japanese share prices, which hit a 26-year low last month. The LDP’s plan is in addition to the stimulus package

Masaaki Shirakawa, the Bank of Japan governor, on Friday warned that fears about the fall in stock prices or a worsening economy could damage the ability of financial institutions to perform their role in financial intermediation.

“Commercial paper and corporate bond issuance is improving. But Japan’s financial environment remains severe as a whole with more companies, regardless of their size, saying funding conditions and banks’ lending attitudes are severe,” Mr Shirakawa told BoJ regional branch managers on Friday.

Since Japanese banks count a substantial level of stock holdings as part of their capital, a sharp decline in share prices hurts their ability to increase assets.

Under the LDP’s proposal, a new public body would be set up to buy the shares with funds raised from the Bank of Japan as well as private banks and guaranteed by the government.

Strict criteria would have to be met to trigger the buying of shares, and the prime minister would head a financial crisis committee responsible for giving the go-ahead.

For example, action could be triggered by the market’s price-formation function being seriously damaged or the price earnings ratio of companies dropping to below “normal” levels for an extended period. Panic selling could also trigger buying by the public body.

The decision to adopt the stock-buying plan comes in spite of considerable opposition to government intervention in the market.

Some sceptics see it as an election ploy by the LDP. “It appears to be a political gambit to make sure that the stock market doesn’t collapse during the election campaign,” said an equity salesperson at a western investment bank."

Taro Aso told Kaoru Yosano

TO BE NOTED: From the FT:

"Japan prepares record fiscal stimulus

By Michiyo Nakamoto in Tokyo

Published: April 7 2009 03:00 | Last updated: April 7 2009 03:00

Japan's prime minister told his government yesterday to prepare a record fiscal stimulus package to lift the world's second-biggest economy from its deepening gloom, with real spending exceeding 2 per cent of gross domestic product or more than Y10,000bn.

Taro Aso told Kaoru Yosano, the finance and economy minister, to work on a stimulus plan focused mainly on five key issues: a new social safety net for non-regular workers, full use of government financial institutions to ease the credit crunch, a big expansion of solar energy, improvements to healthcare and medical services, and subsidies to local governments for the revitalisation of regional economies.

The government plans to unveil details of the package on Friday, and aims to submit necessary legislation to the Diet before the Golden Week holidays in late April and early May.

Japan has already implemented a range of stimulus measures totalling Y12,000bn ($119bn) in actual government spending under Mr Aso to combat the impact of the global recession,as recommended by the International Monetary Fund.

However, the Japanese economy has remained under severe stress, with exports plunging by record amounts over the past few months.

GDP fell by 3.3 per cent quarter on quarter in the last three months of 2008, and the most recent business sentiment survey by the Bank of Japan, released last week, showed that optimism had deteriorated to a record low.

The measures come amid mounting suggestions that Mr Aso may be preparing for a general election.

The prime minister must call an election for the powerful lower house of parliament by the end of September. But popular discontent with his ruling Liberal Democratic party has made the timing of the election difficult for him.

The latest stimulus package "stops things from getting worse . . . [but] it doesn't necessarily make things better", said John Richards, head of research at Royal Bank of Scotland in Tokyo.

The gap between Japan's potential and actual output was about Y20,000bn, so the government was filling about half of that, said Mr Richards. "It's big [but] it certainly isn't too much."

The measures to provide a safety net for non-regular workers and to improve medical and healthcare services were likely to be effective in stimulating economic activity, although "the devil is in the details", he said.

However, measures to support local government to revitalise regional economies could end up simply increasing unnecessary public works projects, said Masaaki Kanno, the chief economist at JPMorgan in Tokyo.

"Japan has been doing the same things since the 1990s. They should do things that they can't normally do, which require strong leadership," said Mr Kanno.

In addition to the five pillars of the new stimulus package, the LDP is finalising proposals for a temporary relaxation of Japan's so-called gift tax, which is aimed at spurring a transfer of wealth from older to younger people.

The LDP is proposing to increase the amount that is exempt from the gift tax if wealth transferred from the older to younger generation is used to buy real estate.

www.ft.com/asia-pacific

Copyright The Financial Times Limited 2009"

This week, economic reports around the world tell the story of an ongoing economic contraction

TO BE NOTED: From News N Economics:

"Economic reports around the world (April 1-7): still scary

Wednesday, April 8, 2009

This week, economic reports around the world tell the story of an ongoing economic contraction. Overall this week's reports suggest that there is still a lot for global policymakers to worry about.

EXPORT GROWTH IS STILL IN THE RED ZONE

The chart below illustrates monthly exports through March for South Korea and Taiwan, and through February for Malaysia and Indonesia (export numbers are not seasonally factored and listed in $US). Over the year the annual growth rates show ongoing weakness.

INFLATION FALLS - STILL MOSTLY ON ENERGY AND COMMODITIES....

The chart below illustrates annual inflation rates through March for Thailand, South Korea, Switzerland, and Taiwan. Serious weakness in global demand has dragged down energy and commodity prices, taking inflation to deflation in some cases. However, eventually this will pass through to core prices (prices ex energy and food) at a lag, and core inflation (which is still very positive in the US) will fall, too. Switzerland is now negative, -0.4%, and Taiwan and Thailand have experienced deflation for two and three consecutive months, respectively.


UNEMPLOYMENT IS WEAK IN THE EUROZONE AND THE US

The chart below illustrates the annual change in the unemployment rate for the Eurozone through February and the US through March. Both registered 8.5% unemployment rates in each respective month, or a serious deterioration in labor market conditions over the year.

The labor market is generally lagged to overall economic conditions - it takes a while for firms to internalize the economic situation, firing late and hiring late. So these economies may be recovering well-before the unemployment rate starts to decline (jobless recovery).

BUT IT DOES LOOK LIKE THE ECB IS WAY LATE

The chart below illustrates the policy rates for the European Central Bank (ECB) and the Bank of Japan (BoJ). The ECB cut by 25 bps to 1.25%, and the Bank of Japan left its rate unchanged at 0.1%. Given the previous chart, which illustrates the sharp decline in labor market conditions across the Eurozone, it seems that the ECB started to ease too late. Perhaps it is because wages are a little stickier in Europe.


ANOTHER OMINOUS SIGN OF WEAKNESS IN CONSUMER SPENDING

The chart below illustrates annual retail sales growth through February for Germany and Hong Kong. Hong Kong sales are clearly tumbling, falling 13.9% over the year. German retail sales growth, however, are quite volatile; it's 5.3% decline does not show any weakness beyond normal activity since early 2007. Interesting.

THE LANDSLIDE IN UK INDUSTRIAL PRODUCTION CONTINUES

The chart below illustrates UK industrial production in levels and its growth over the year. Nosedive. According to jka online blog, the sector breakdown was:

Consumer non durables, (-5%), textiles (-5.4%) and food and drink (-4%) were relatively lightly hit. Fuel products, the only sector showing growth up by just 1%.

Auf Wiedersehen, Rebecca Wilder"

“The Bank’s actions are boosting the monetary base and ramping up its balance sheet, which is QE in all but name,”

TO BE NOTED: From the FT:

"BoJ ramps up purchase of government bonds

By Mure Dickie in Tokyo

Published: March 18 2009 12:52 | Last updated: March 18 2009 12:52

The Bank of Japan is to increase its purchases of Japanese government bonds by nearly a third, the latest in a series of increasingly assertive measures by the central bank to respond to the pressures created by the global financial crisis and a fierce domestic recession.

The BoJ said its decision to raise buying of JGBs from Y1,400bn a month to Y1,800bn was intended to ensure there was enough liquidity in the financial system to ensure its stability.

EDITOR’S CHOICE

Warning on fall in Japan’s R&D - Mar-16

BoJ drafts Y1,000bn of bank loan aid - Mar-17

However, the move will also help to hold down bond yields and smooth financing for Japan’s government just as it prepares to start drawing up a new package of fiscal measures to stimulate the world’s second largest economy.

The BoJ has been widely criticised by Japanese politicians and officials for what they see as its overly-conservative response to the current downturn, the country’s sharpest in decades.

Masaaki Shirakawa, BoJ governor, is deeply reluctant to return to the policy of “quantitative easing” that the bank used to try to boost growth from 2001 to 2006 and the bank’s policy board unanimously voted to maintain its current 0.1 policy interest rate.

However, the BoJ has become gradually more bold in its efforts to boost financial system liquidity and support financial institutions, this week unveiling a draft plan that would see it provide up to Y1,000bn in subordinated loans to large commercial banks.

The loan scheme is intended as a safeguard to be used if conditions worsen for local lenders that have so far been much less affected by the global financial turmoil that US or European counterparts but have seen their capital bases hit by falls in the value of their equity holdings.

By supporting banks, the BoJ hopes to encourage lending to the country’s corporate sector.

The bank, which is already buying corporate debt itself to help ensure companies can access credit, said on Wednesday that fundraising for the crucial financial year-end period through this month had “mostly been completed”.

However, the bank added markets could remain under stress, with economic conditions “likely to continue deteriorating for the time being”.

By increasing its JGB purchases and buying corporate debt, the BoJ is mirroring in a more cautious way the balance sheet expansions being undertaken by counterparts in the US and UK.

However, the BoJ has avoided describing its actions as marking a return to quantitative easing, which it defines as providing excess liquidity to the financial system by targeting the level of reserves held by banks along with a commitment to long-term low or zero interest rates.

Some analysts say the distinction is increasingly irrelevant. “The Bank’s actions are boosting the monetary base and ramping up its balance sheet, which is QE in all but name( NB DON ),” wrote Julian Jessop chief international economist at Capital Economics in a research note.

The increased purchase of government bonds will be welcomed within the administration of Taro Aso, Japan’s prime minister, who is currently preparing the ground for a new package of stimulus measures likely to be sent to the Diet early in the fiscal year that begins in April."

"If not read carefully, one might assume that the Fed is not engaging in a policy of quantitative easing, when in fact, it is."

Rebecca Wilder on News N Economics makes some sense about the issue of whether or not the Fed is engaging in Quantitative Easing:

"The Fed's message: We're not the Bank of Japan

The Fed is increasingly discussing its monetary policy goals, and it’s about time( I AGREE ). But I have noticed that the Fed is being very careful not to use the term quantitative easing (QE) when describing its current policy measures. If not read carefully, one might assume that the Fed is not engaging in a policy of quantitative easing, when in fact, it is. ( I AGREE. IF IT ISN'T, IT'S A KIND OF PRELUDE OR OVERTURE. )

What the Fed is trying to say is this: we are pursuing a QE policy, but differently than did the Bank of Japan earlier in the decade because; we are not growing the liabilities side of our balance sheet. This seems little silly, as the Fed may very well start printing currency if prices continue to decline. Note: See this post for a discussion of quantitative easing, the Fed’s creation of reserve balances, and the “printing of money.”

The Fed finally stated its intentions

1. The Fed had its big coming-out monetary policy party when it announced a near-zero interest rate policy on December 16. Before that, one could only speculate as to what the Fed’s intentions really were. In the Fed’s announcement of its intentions to use any means necessary to promote economic growth and price stability, the word quantitative was not used, except to refer to the purchase of “large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets”. No mention of quantitative easing, when in fact, that is exactly what the Fed is doing.

2. In a press conference directly following the Fed’s announcement, the Wall Street Journal reported:

But the senior Fed official said the central bank’s approach is distinct from quantitative easing and different from what the Japanese did. The Fed’s balance sheet has two sides, the official explained: assets with securities the Fed holds (including loans, credit facilities, mortgage-backed securities) and liabilities (cash and bank reserves). Japan’s quantitative easing program focused on the liability side, expanding cash in the system and excess reserves by a large amount. The Fed’s focus, however, is on the asset side through mortgage-backed securities, agency debt, the commercial paper program, the loan auctions and swaps with foreign central banks. That’s designed to improve credit-market functioning, the official said. By expanding the balance sheet by making loans, the official explained, the focus is not on excess reserves but on the asset side. That securities-lending approach directly affects credit spreads, which is the problem today — unlike Japan earlier, where the problem was the level of interest rates in general, the official said.
3. And then Janet Yellen, President of the Federal Reserve Bank of San Francisco, said this (hat tip, Mark Thoma):
On the surface, it may seem appropriate to equate the Fed's use of its balance sheet to stimulate the economy with the quantitative easing policy pursued earlier by the Bank of Japan. But as I noted at the outset, the differences outweigh the similarities in my opinion. The main similarity is that the Fed, like the Bank of Japan, has increased the quantity of excess reserves in the banking system well above the minimum level required to push overnight interbank lending rates to the vicinity of zero. The creation of such a large volume of excess reserves, in the Fed's case, results from the enormous expansion in the Fed's discount window lending, foreign exchange swaps, and asset purchases. In the Bank of Japan's case, the expansion in excess reserves resulted from the deliberate adoption of an explicit numerical target for them. The theory underlying the Bank of Japan's intervention was that banks might be encouraged to lend by replacing their holdings of short-term government securities with excess cash.
The Fed is pitching the same line: our policy is different from the Bank of Japan’s (BoJ) policy measures earlier in the decade. Janet Yellen went as far as to imply that the Fed is not engaging in a QE policy. But Bernanke himself defines QE as “providing bank reserves at levels much greater than needed to maintain a policy rate of zero” (page 5 of Bernanke, Reinhart, and Sack), whichis exactly what the Fed is doing.

The Fed IS engaging in QE policy, but somewhat differently than did the Bank of Japan.

Like the BoJ, the Fed is growing its balance sheet through reserve creation. The Fed has been quite explicit about this, citing the funding of the MBS purchase program and GSE debt through reserve creation.

This should be a familiar chart by now. It illustrates the Fed’s various lending policies listed in its balance sheet. The Fed has increased the credit extended to the commercial banking system by $1.35 trillion in just one year, mostly through the creation of reserves.

The Bank of Japan targeted commercial bank reserves – through the printing of currency and creation of reserves – to a level of 30-35 trillion yen. The Fed has made no such target.

Unlike the BoJ, the Fed's liabilities are falling.

The chart illustrates the liabilities side of the Fed balance sheet. As you can see, with the unwinding of the TSP account (see this post ), the liabilities of the Fed are falling rather than rising. And furthermore, the Fed is not growing its currency stock in bulk. The BoJ’s liabilities would have been rising precipitously, as it flooded the banking system with yen (printing currency).

So the Fed isn't printing hard currency. I find this to be a rather mute point, as the Fed would probably like to see a little inflation right about now. James Hamilton argues that the Fed should consider increasing bank cash holdings to create some inflation. Inflation would lower the real debt burden of households and firms, ensuring that debts at least could be paid off. In the Wall Street Journal, Kenneth Rogoff argues: that "a little inflation would be a good thing".( I AGREE )

The Fed said that it will “employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability"; that certainly doesn’t preclude the printing of currency. I wouldn’t be surprised if the Fed started to print currency soon (it has already increased the currency stock by $44.5 billion since October 8) to promote a little inflation.

Rebecca Wilder"

"I would not call this a pure "quantitative easing" a la BOJ or per Mr Bernanke's definition, which I think is a reasonable one."

A good resource to keep from Free Exchange. I find that both sides make a good point, and I myself feel that, strictly speaking, using Hooper's terms, it's not Quantitative Easing in the strict Bernanke sense, but it does feel like what is being done is a feint of Quantitative Easing. In other words, not quite Quantitative Easing, but close enough for now, and we'll go there if we have to:

"I WROTE in this week’s issue that unconventional monetary policy of the sort the Federal Reserve promised on December 16th "is often called 'quantitative easing' because its effect is felt through the quantity rather than the cost of credit."

The Federal Reserve has disputed that its actions are "quantitative easing", the term given to policies the Bank of Japan implemented earlier this decade once its interest rate had fallen to zero. I disagree. Here is my rationale:

The difference between quantitative easing and conventional easing is that the first occurs through the size of the balance sheet and the second through the level of the short-term interest rate (although a purist would note that changing the level of the interest rate ultimately requires an adjustment in the size of the balance sheet also). Growth in the balance sheet can occur through either the liabilities (that is, bank reserves and currency) or the assets (holdings of securities and loans); the two ultimately must equal. While a central bank can try to achieve its effects differently by targeting reserves versus targeting assets, I think they're both ultimately a way of achieving monetary stimulus through the quantity rather than the cost of credit( OK ). The fact that the Fed has not put specific figures on how much it will grow the balance sheet to me is not significant; until 1989 it didn't put specific figures on how much it was changing the federal funds rate, either, but that was still clearly the focus of its monetary policy.

I discussed this over email with Peter Hooper, the chief economist at Deutsche Bank Securities, and he disagrees. He writes:

I would quibble with the notion that what the Fed is doing now is, strictly speaking, quantitative easing, though I wouldn't say you are wrong. This is a matter of semantics. I just look at things, or at least define them, a bit differently. First, I wouldn't say that changes in the size of the Fed's balance sheet would necessarily signal the kind of special quantitative easing we are talking about. I will acknowledge that it is tempting to define any large increase in the balance sheet as quantitative easing, but I prefer to be more of a purist on this.

As you note, the purist would say that any time the Fed eases it is a "quantitative" easing. That is, when the Fed eases (reduces its rate target), it involves increasing the quantities of both the assets and the liabilities on its balance sheet (assuming demand for reserves at any given rate has not declined)—ie, it buys Treasuries and issues more reserves. I would define the special case of quantitative easing we are talking about the way Ben Bernanke did in a speech not too long ago: as the central bank pushing out more reserves than are demanded at a zero interest rate.( OK )

Prior to its recent move to paying interest on reserves, the Fed had to guess what quantity of reserves to issue to meet demand at the rate it was targeting. Now, with interest being paid on reserves at its target rate, in principle at least, it doesn't have to guess on the quantity, it simply supplies all the reserves that are demanded at that rate. I say "in principle", of course, because there is a glitch—the GSEs hold reserves but are not eligible to receive interest from the Fed, so they do indirectly through banks at a discount, and that discount has been significant because banks are unwilling to expand their balance sheets to take advantage of the full amount of this arbitrage opportunity. The discount is what has pushed the effective federal funds rate below the target rate and explains why the Fed has moved to a range rather than a point target. It could fix the problem by paying interest on reserves held by GSEs—this would raise the effective rate to the rate paid on reserves (25 bps currently). But this is taking us aside a bit from our debate.

The Fed is now supplying all the reserves that are demanded at a still positive price through its various liquidity facilities. To my way of thinking, this still differs significantly from what I think of as the more aggressive form of quantitative easing pursued by the Bank of Japan. The BOJ set an explicit target for reserves that it knew would be well in excess of banks' demand even at a zero interest rate. It did so in hopes that banks would begin to use the glut of reserves to expand their lending, but this was clearly a case of pushing on a string—the banks just sat on the reserves.

The Fed is now taking a quite different tack and, I think, potentially much more productive one. It is aiming to reduce elevated credit spreads by purchasing GSE MBS (as well as by offering non-recourse loans against ABS when the TALF gets going). (Note that the BOJ would not have considered this option because it was not facing the kind of elevated credit spreads we have today. They also were facing a much more severe deflationary situation and had fewer options than the Fed.) What the Fed is doing may look and feel like quantitative easing in terms of its impact on the balance sheet, and because it now involves outright purchases of securities, it looks more like what the BOJ was doing. But so long as the Fed is still paying positive interest on reserves (even with the GSE-related slippage), I think it is a different animal. There is also an important difference in motivation: It is an effort to influence market interest rates directly rather than an effort to increase bank lending via increasing the quantity of reserves being supplied.

It is true that the stock of excess reserves has soared, and that looks a lot like what happened in Japan, but I would maintain that in the US case, the stock of excess reserves is still a reflection of a tremendous increase in demand for liquidity on the part of investors and financial institutions. The cost of that liquidity obtained through the Fed's various lending facilities is nonzero, and to the extent that further increases in the stock reflect Fed purchases of MBS going forward, the move is aimed explicitly at reducing rates, not increasing quantity. Hence, I would not call this a pure "quantitative easing" a la BOJ or per Mr Bernanke's definition, which I think is a reasonable one. What I would call it is an aggressive application of unconventional monetary policy, and an appropriate one under the circumstances."

"Their mission is to provide liquidity to the system by acting as lender-of-last-resort "

Casey Mulligan:

"Flight to Quality( FLIGHT TO SAFETY ) -- Cause or Effect?

Professor Lucas is a strong advocate.

I agree that there is a flight to quality( I AGREE ). Professor Lucas says that one way that people attempt to buy safe securities is to spend less on consumption goods. That makes sense -- but the same logic implies that people should work harder (earn more) as another means to accumulate those securities. The facts show that people are working less.( WHY ? COULDN'T IT HAVE TO DO WITH EMPLOYERS CUTTING BACK? ) Barro and King (1984) explained it best -- the basic puzzle of recessions (this one included) is that consumption and leisure move in opposite directions. Wealth effect and intertemporal substitution effect explanations of recessions (Professor Lucas' story is one example) imply that they move together.

That's why I believe that the "flight to quality" is a symptom( HERE I AGREE ) rather than a cause.

Professor Lucas arrives at the conclusion that the Fed should print money. Despite the arguments above, I agree that such a Fed policy would do more help than harm( I AGREE )."

Now Lucas in the WSJ:

"The Federal Reserve's lowering of interest rates last Tuesday was welcome ( TRUE ), but it was also received with skepticism( THAT'S FINE ). Once the federal-funds rate is reduced to zero, or near zero, doesn't this mean that monetary policy has gone as far as it can go? This widely held view was appealed to in the 1930s to rationalize the Fed's passive role as the U.S. economy slid into deep depression.

It was used again by the Bank of Japan to rationalize its unwillingness to counteract the deflation and recession of the 1990s. In both cases, constructive monetary policies were in fact available but remained unused( TRUE ). Fed Chairman Ben Bernanke's statement last Tuesday made it clear that he does not share this view and intends to continue to take actions to stimulate spending( TRUE ).

There should be no mystery about what he has in mind. Over the past four months the Fed has put more than $600 billion of new reserves into the private sector, using them to discount -- lend against -- a wide variety of securities held by a variety of financial institutions. (The addition is to be weighed against September 2007's total outstanding level of reserves of about $50 billion.)

This action has been the boldest exercise of the Fed's lender-of-last-resort function( I AGREE THAT THIS IS WHAT IT IS ) in the history of the Federal Reserve System. Mr. Bernanke said that he is prepared to continue or expand this discounting activity as long as the situation dictates( I AGREE WITH HIM ).

Why do I describe this as an action to stimulate spending? Financial markets are in the grip of a "flight to quality"( FLIGHT TO SAFETY ) that is very much analogous to the "flight to currency"( I AGREE. IT'S LIKE A BANK RUN. HOWEVER, I SEE IT AS A FLIGHT TO EXPLICIT GUARANTEES FROM IMPLICIT GUARANTEES ) that crippled the economy in the 1930s. Everyone wants to get into government-issued and government-insured assets, for reasons of both liquidity and safety( TRUE. IT'S BOTH. ). Individuals have tried to do this by selling other securities, but without an increase in the supply of "quality" securities these attempts do nothing but drive down the prices of other assets( TRUE ). The only other action people can take as individuals is to build up their stock of cash and government-issued claims to cash by reducing spending. This reduction is a main factor in inducing or worsening the recession( TRUE ). Adding directly to reserves -- the ultimate liquid, safe asset -- adds to supply of "quality" and relieves the perceived need to reduce spending( TRUE. STILL THE FLIGHT TO SAFETY ).

When the Fed wants to stimulate spending in normal times, it uses reserves to buy Treasury bills in the federal-funds market, reducing the funds' rate. But as the rate nears zero, Treasury bills become equivalent to cash, and such open-market operations have no more effect than trading a $20 bill for two $10s. There is no effect on the total supply of "quality" assets.

A dead end? Not at all. The Fed can satisfy the demand for quality by using reserves -- or "printing money" ( GO FOR IT )-- to buy securities other than Treasury bills. This is the way the $600 billion got out into the private sector.

This expansion of Fed lending has not violated the constraint that "the" interest rate cannot be less than zero, nor will it do so in the future. There are thousands of different interest rates out there and the yield differences among them have grown dramatically in recent months. The yield on short-term governments is now about the same as the yield on cash: zero. But the spreads between governments and privately-issued bonds are large at all maturities. The flight to quality means exactly that many are eager to trade private paper for non-interest bearing (or low-interest bearing) reserves and with the Fed's help they are doing so every day( TRUE, ALTHOUGH IT SOUNDS FOOLISH ).

Could the $600 billion in new reserves be called a bailout? In a sense, yes: The Fed is lending on terms that private banks are not willing to offer. They are not searching for underpriced "bargains" on behalf of the public, nor is it their mission to do so. Their mission is to provide liquidity to the system by acting as lender-of-last-resort. We don't care about the quality of the assets the Fed acquires in doing this( WE DO CARE ). We care about the quantity of its liabilities( OK ).

There are many ways to stimulate spending, and many of these methods are now under serious consideration. How could it be otherwise? But monetary policy as Mr. Bernanke implements it has been the most helpful counter-recession action taken to date, in my opinion, and it will continue to have many advantages in future months. It is fast and flexible. There is no other way that so much cash could have been put into the system as fast as this $600 billion was, and if necessary it can be taken out just as quickly. The cash comes in the form of loans.( I'D PREFER SIMPLY PUTTING MONEY OUT AND LEAVING IT )It entails no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These seem to me important virtues( THAT'S A GOOD POINT )."

More or less, I agree.

"After one bubble bursts, the only way to get out of the resulting recession, and to avoid a depression, is to create another bubble."

Peter Coy on Business Week with a post I like:

"This is war. On Dec. 16, the Federal Reserve announced it was stepping up what amounts to a shock-and-awe campaign against the most dangerous economic downturn in decades. In an unprecedented move, the Fed cut its short-term interest rate target to essentially zero while committing to buy mortgage bonds and other assets on a massive scale. The goal: to provide cheaper credit to every part of the economy, starting with housing.

Fed Chairman Ben Bernanke initially underestimated the fast-moving crisis( TRUE ), but now he's deadly serious( TRUE ). As a student of the Great Depression, Bernanke does not want to go down in history as the Fed chairman who allowed the U.S.—and possibly the world—to slip into the worst slump since the 1930s( CORRECT ).

Will the new battle plan work? Most likely yes—eventually ( I AGREE ). The Fed's monetary weaponry, in combination with the fiscal artillery of the incoming Obama Administration, are so potent that if they are used to their full extent they can almost certainly generate an economic recovery, potentially starting in the second half of 2009 ( I AGREE ). The problem is that today's all-out attack on recession may well generate a surge of unwanted inflation in 2010 or after( A VERY REAL POSSIBILITY ). But the Fed seems to regard that as an acceptable price to pay to avoid disaster now ( IT IS ).

True, the Fed has finally reached the end of the line on cutting rates—they can't go below zero. But it remains essentially unlimited in how much it can stimulate the housing market and broader economy by buying up mortgage-backed securities, Fannie Mae (FMN) and Freddie Mac (FRE) corporate debt, and other assets ( TRUE ). The Fed's early efforts are already showing some success( TRUE ). Since it said in late November that it would buy such securities, 30-year mortgage rates have fallen to 5.2% from 6%, and refinance applications have more than tripled. The Dec. 16 announcement will greatly( MODESTLY ) expand these purchases.

What's more, starting in early 2009, the Fed will pump money into markets for student, auto, credit-card, and small-business loans in hopes of helping those parts of the economy. All told, the Fed's assets—a measure of how much the Fed has lent, directly and indirectly—could go as high as $5 trillion, says Ed Yardeni of Yardeni Research. That's up from $2.2 trillion now. And the range of assets the Fed is permitted to acquire in an emergency is almost unlimited( VERY TRUE ). "It could buy a herd of cattle in Texas if it so desired," says Paul Ashworth, senior economist in the Toronto office of consultant Capital Economics.

These moves are so sweeping that they almost overshadow what would ordinarily be the biggest news of all: the Fed's Dec. 16 cut in its target federal funds rate to a range from zero up to 0.25%, the lowest in its history. The funds rate is what banks charge each other for loans to meet reserve requirements. In fact, the Fed's target had become irrelevant in recent weeks because what banks actually charge each other for those loans had already fallen to almost zero ( TRUE ). That's because of the huge surplus of reserves that the Fed has injected into the financial system( TRUE ).

Critics of the Fed say the central bank is running unacceptable( ACCEPTABLE ) risks of losses by itself and ultimately by taxpayers while propping up an unsustainable reliance on debt. "It's 100% wrong. It's going to make the situation worse," says Peter Schiff of Euro Pacific Capital, a brokerage in Darien, Conn. "In the short run, it does postpone some of the pain, but the economy is going to be in worse shape a year from now. Eventually we will have hyperinflation, where the dollar loses almost all its value( THAT'S THE FEAR )."

That, however, is a minority view. Most economists think that inflation is the last thing the Fed needs to worry about right now( THEY SHOULD WORRY ABOUT IT ). According to New York University economist Mark L. Gertler, who collaborated with Bernanke on research during the Fed chief's Princeton years: "We are in an incredibly dangerous situation. Now is the time to be aggressive. There's no danger of inflation. It's almost insane that people are talking about it now." Even with all the Fed's heroic measures, predicts Merrill Lynch (MER) senior economist Drew Matus, "the recession is going to be a long one, and the recovery is not going to be a big one( WHO KNOWS? )."

One reason for optimism—mild optimism, anyway—is that Bernanke has learned from the mistakes committed by the Fed during the Depression and the Bank of Japan during that nation's Lost Decade of the 1990s. In 1999, when he could afford to be undiplomatic, Bernanke asked in a book he contributed to whether Japan's monetary policy was "a case of self-induced paralysis," and he praised President Franklin D. Roosevelt's "willingness to be aggressive and to experiment."

When the economy does begin to recover, perhaps in the second half of 2009 or possibly later, the Fed will have a very different problem on its hands: how to soak up all of the excess liquidity it has created so it doesn't stoke inflation or some new asset bubble ( TRUE ). In a Dec. 17 research note, Yardeni wrote: "After one bubble bursts, the only way to get out of the resulting recession, and to avoid a depression, is to create another bubble( SORT OF )." That's not what anyone wants, but it's certainly better than the alternative—a downturn that would rival the Great Depression( I AGREE ).

Coy is BusinessWeek's Economics editor.

"The dollar's fall, however, is making it far harder for Europe and Japan in particular to export their way out of recession. "

I posted a graph showing the recent rise and decline of the dollar. From the Washington Post:

"By Anthony Faiola

Washington Post Staff Writer
Thursday, December 18, 2008; Page A01

The dollar yesterday staged one of its biggest one-day drops against the euro and fell to a 13-year low against the Japanese yen as near-zero interest rates and the Federal Reserve's plan to print vast sums of cash dilute the value of the greenback.( Quantitative Easing )

The drops dramatically accelerated the dollar's reversal of fortune over the past three weeks after months of solid gains( THE FLIGHT TO SAFETY IN US BONDS ). The slide underscores the risks the Federal Reserve is taking to jump-start the U.S. economy through aggressive monetary policy( THERE ARE RISKS ).

On Monday, the Fed cut its target for the federal funds rate, at which banks lend to each other, from 1 percent to a target range of 0 percent to 0.25 percent, and effectively vowed to print as much money as it needs to try to pull the United States from a worsening recession ( I'M FOR THIS ).

While that policy may ultimately aid an economic recovery, it is robbing the dollar of value as investors anticipate less interest on their dollar-denominated investments and more bills in circulation, making each one worth a bit less. In response, investors are dumping the dollar and buying up other currencies ( I PREFER TO SAY THAT IF THEY BUY BONDS NOW, AND INFLATION ARISES, THEIR BONDS WILL BE WORTH LESS. ON THE OTHER HAND, SINCE THERE WILL BE MORE DOLLARS IN CIRCULATION, THE DOLLARS THEY ARE HOLDING NOW WILL BE WORTH LESS ( FROM QUANTITATIVE EASING ) ).

If the dollar's fall is unchecked, it could jeopardize the long-term faith of foreign investors in the value of the American currency and could cause foreign investors to dump U.S. stocks and other assets, whose value would be worth less in euros or yen( TRUE ). The Dow Jones industrial average fell 1.1 percent yesterday.

A sharp rise in the value of foreign currencies could slow economic recovery in Europe and Japan because it would make their exports more expensive in the United States ( TRUE ). A steep, sustained fall in the dollar could force the Fed to abruptly raise interest rates to prop it up( IN ORDER TO GIVE INVESTORS AN INCENTIVE TO BUY BONDS BECAUSE OF THE HIGHER INTEREST RATES, AND THEIR DOLLARS WOULD GAIN IN VALUE IF THE MONEY SUPPLY CONTRACTS ). That would drive up costs( BECAUSE IT WOULD BE PAYING MORE INTEREST ) for the U.S. Treasury as it seeks to raise cash for bailouts by issuing billions of dollars worth of new debt to investors.

"The risk is that the deceleration of the dollar could cascade, and push interest rates up as the rest of the world demands a higher return on U.S. investments," said C. Fred Bergsten, director of the Peterson Institute for International Economics.

But higher interest rates could weaken demand even more. The deteriorating economic outlook helped send oil prices down yesterday to $40.06 on the New York Mercantile Exchange, despite production cuts by the Organization of the Petroleum Exporting Countries, and the falling dollar, which should help drive up oil prices because they are denominated in dollars( AND SO WORTH LESS ).

The dollar shed about 3 percent against the euro yesterday, falling to $1.44. It lost 1.3 percent against the Japanese yen, dropping to 87.93, the lowest since July 1995.

The slide marks another turn on the dollar's roller coaster year, which it began at multiyear lows when the U.S. economy slowed even as much of the rest of world was still growing. But as investors began to grasp that Europe and Japan were facing recessions as bad, if not worse, than the one in the United States, the dollar staged a rally. Between July and November, the dollar climbed about 24 percent against a basket of six major world currencies( MAINLY THE FLIGHT TO SAFETY ).

The Fed's aggressive interest rate policy ( QUANTITATIVE EASING ), coupled with a sense that the United States may face dire problems in the auto industry( MORE EASING AND DEBT ), have erased about half those gains in the past three weeks. Up until recently, emerging market currencies were also losing ground against the dollar. The Chinese, analysts say, have been massively intervening in currency markets in recent months to weaken( KEEP IT CHEAP ) the yuan and make Chinese exports more competitive overseas( BY STAYING CHEAP ). But the yuan has jumped 0.7 percent against the dollar this month, despite continued Chinese intervention.

That is good news for U.S. exporters ( OUR GOODS ARE CHEAPER ). The cheaper dollar earlier this year had boosted overseas sales of American-made products from airplanes to soybeans, making exports a rare bright spot of the economy. In recent months, however, the export boom has faded as the dollar strengthened and the global economy waned. The suddenly weaker dollar may now help put U.S. exports back on track, just when the economy needs all the help it can get ( THEORETICALLY, EXPORTS SHOULD GO UP WITH A CHEAPER DOLLAR, AND, AT SOME POINT, AS THE ECONOMY DOES BETTER, THE DOLLAR WILL STABILIZE OR TURN AROUND ).

The dollar's fall, however, is making it far harder for Europe and Japan in particular to export their way out of recession ( THEIR GOODS ARE GETTING MORE EXPENSIVE FOR US ).

Japan, which already has near-zero interest rates, has little room to lower them further to weaken the yen. But analysts say Tokyo is likely buy more dollars ( THAT SHOULD STRENGTHEN THE DOLLAR, MAKE THE YEN CHEAPER ) in an attempt to drive the yen down in value.

The dollar's fall is putting particular pressure on the European Central Bank to follow the Federal Reserve and the Bank of Japan and dramatically cut interest rates ( WITH THEIR HIGHER INTEREST RATES AND RETURN, MONEY IS GOING THERE AND NOT TO THE DOLLAR ), according to analysts. The ECB has been reluctant to slash rates too deeply, partly because it fears that inflation will reemerge in major countries like France( THIS SHOULD BE EXPLAINED ) should rates fall too low.

Yet analysts say the weakened dollar may force the ECB to cut rates, fearing the steep climb in the euro could make it far harder for export-driven economies like Germany to stage a recovery. Some in Europe are responding aggressively. The Central Bank in Norway, which does not use the euro, dramatically slashed key interest rates yesterday by 1.75 percent to 3 percent.

"This really puts the Europeans in a corner," said Simon Johnson, former chief economist at the International Monetary Fund and an economist at the Massachusetts Institute of Technology. "They can't just sit there and watch the euro climb( EXPORTS WILL GO DOWN, HURTING THEIR ECONOMY )."

Other analysts argue that the dollar may surge again in the weeks ahead, particularly if the Fed's aggressive moves begin to show signs of lifting the U.S. economy ( IF QUANTITATIVE EASING WORKS ).

"I'm a little skeptical that this is the end of the dollar's rebound," said John Shin, currency strategist at Merrill Lynch in New York. "Investors are reacting to the anticipation and the actuality of the Fed's plan to flood the world with dollars. But the U.S. is not alone in its problems, and you're seeing particular stress on the European economy. You have to think that the Fed is ahead of the curve, and by the time the Europeans get there, the U.S. economy may be better positioned for recovery( OTHER COUNTRIES WILL END UP DOING WHAT WE'RE DOING, GIVING THEM NO COMPETITIVE ADVANTAGE WITH HIGHER INTEREST RATES, GIVING THE DOLLAR STRENGTH AGAINST THE OTHER CURRENCIES )."

The Dollar's steep rise was the Flight To Safety, the steep decline is Fear Of Inflation. Both are likely overreactions to actual conditions. I hope.

"All that matters is that both currency and reserves represent ultimate, unquestioned liquidity. And they do."

Willem Buiter on the Fed move:

"The Fed has joined the Bank of Japan at the (near) zero lower bound on the overnight risk-free nominal interest rate; the Federal Funds target rate is set between zero and 25 basis points. The rather strange vagueness of the new target - a 25 basis points range rather than a point target - is unnecessary. It is the product of the inexplicable inability of central banks everywhere (US, UK, Euro Area) to fix the overnight rate at any level (including zero) by accepting deposits (reserves) at that rate in any amount at any time and to lend (against appropriate collateral) at that rate in any amount at any time.

Being willing to buy or sell any amount at a price is the definition of setting a price. Central bankers want to both set the price (overnight interest rate) and keep some control over the quantity (reserves held by banks with the central banks and/or the stock of secured overnight lending). Except for a fluke, they will be frustrated. The overnight rate will, quite unnecessarily, depart from the official policy rate (the Federal Reserve’s Federal Funds target rate, the Bank of England’s Bank Rate, the ECB’s Main refinancing operations Fixed rate). It’s an unnecessary slight operational blemish - a minor badge of operational incompetence.

But this minor deficiency in the genetic code of central bankers and central bank officials charged with setting the overnight rate should not obscure the fact that the Fed’s decision to head straight for the zero lower bound on short nominal interest rates was the right thing ( HEAR HEAR ). At worst it will not help much to bring down the cost of private borrowing and increase its availability. But it won’t hurt.

The Fed and the Bank of Japan will soon have company on the floor. The Bank of England should get Bank Rate to zero late spring or early summer and even the ECB, the ultimate gradualist procrastinator, will get there before the middle of 2009.

Then what? Quantitative easing and qualitative easing are next. Quantitative easing is the expansion of the balance sheet of the central bank keeping constant the liquidity and (credit) risk composition of its assets, by increasing the stock of base money. It does not matter whether the increase in the stock of base money takes the form of an increase in the stock of currency (bank notes) or an increase in the stock of reserves held by the banks with the central bank. Currency does not bear interest, while reserves may bear interest, positive or negative. For ’seigniorage’ the interest paid on base money matters; it is a key determinant of the profits of the central bank, the solvency of the central bank and the payments made by the central bank to the Treasury.

But as long as the solvency of the central bank, its capacity to pursue its its mandate and the solvency of the sovereign are not dependent on a particular level of seigniorage earned by the central bank, the fact that reserves are interest-bearing and currency is not does not matter for the central bank’s ability to use quantitative easing and qualitative easing to bring rates and spreads down. All that matters is that both currency and reserves represent ultimate, unquestioned liquidity. And they do.

Qualitative easing is a change in the composition of the assets on the central bank’s balance sheet towards less liquid and higher risk assets. The Fed has made it clear that it does not have great ambitions for bringing down the long-term risk-free nominal interest rates on US Treasury bonds. These long-term yields are already rather low. Instead its main ambition is to reduce the spreads between official rates and private lending and borrowing rates. It will do so by increasing the amount of private securities held on its balance sheet.

Some of this increase in the share of private sector assets in the Fed’s balance sheet will represent the Fed’s acceptance of a wider range of private securities as collateral in repos, at the discount window and in its steadily growing number of special facilities. Increasing amounts will be the result of outright purchases of private securities by the Fed, something I recommended in August 2007. The Fed has already purchased large quantities of commercial paper and asset-backed commercial paper. It is also increasing its purchases of residential mortgage-backed securities issued by or guaranteed by Fannie and Freddie. It is planning purchases of a wider range of asset-backed securities. It may end up emulating the Hong Kong Monetary Authority by investing in the stock market, say by purchasing a suitable index of listed stocks, like the Wilshire 5000 Total Stock Market Index. I made such a proposal when deflation and the zero lower bound last threatened, in 2003.

One thing the central bank needs in order to engage wholeheartedly in quantitative easing and especially in qualitative easing, is the full backing of the Treasury/ministry of finance. Greater central bank exposure to private sector default risk is an inevitable result of quantitative and qualitative easing, unless the entire expansion of the balance sheet of the central bank is achieved by purchasing sovereign debt instruments. If the default risk materialises, the Treasury has to recapitalise the central bank immediately. Such automatic indemnification is necessary if the central bank is to be able to pursue its regular macroeconomic objectives. If it is not automatic and unconditional, it threatens the operational independence of the central bank in its rate setting decisions.

The need for fiscal backing of the central bank for the central bank to be able, without endangering its price stability objective, to engage in quantitative and qualitative easing by raising its exposure to private securities subject to default risk means that the Euro Area suffers from a handicap. At least 15 national Treasuries (of the 15 Euro Area member states) and possibly as many as 27 national Treasuries (of the 27 EU member states - all 27 EU member states’ national central banks are shareholders of the ECB) may have to be involved in a recapitalisation of the ECB/Eurosystem if it were to suffer a material capital loss as a result of its monetary and liquidity operations.

That would be a huge organisational, logistic, technical and political problem. It can only be solved effectively by creating the beginning of a supranational EU fiscal authority, with independent tax and borrowing powers ( WOW ). The alternative, interim solution, would be to create an EU fund (containing, say, €2.5 trillion or €3 trillion) which could be used to recapitalise the ECB/Eurosystem at short notice.

What else can be done by the central banks?

The spreads between interbank rates (Libor, Euribor) and either Treasury securities of the same maturity or the market’s expectation of the official policy rate over the same horizon (as reflected in the overnight indexed swap (OIS) rate) have been coming in but still appear excessive. In addition, very little interbank lending appears to take place at these interbank rates.

I propose that the Fed, the ECB and the Bank of England set themselves up not just as providers of a clearing platform for interbank lending, but as a market maker or universal counterparty in the unsecured interbank market. The central bank would set, say, 3 month Libor as follows. The central bank would offer to accept deposits from eligible banks at the 3-month OIS rate minus, say, 50 basis points or 75 basis points, and it would be willing to lend unsecured to eligible banks at the 3-month OIS rate plus, say, 50 basis points or 75 basis points. The rates offered for loans could be made to depend on the central bank’s assessment of the borrowing bank’s creditworthiness, with 50 or 75 basis points being the benchmark for a bank with a AA or A rating. The amounts lent at these spreads over Libor would not be open-ended. These facilities would be offered for unsecured loans to and deposits from banks at any maturity between overnight and, say, 2 years. The OIS markets now stretch to a 30-year horizon and are sufficiently liquid to provide useful benchmarks for pricing the corresponding unsecured interbank markets."

All good points, but I agree with Nick Rowe:

"Quantitative and qualitative easing would be more effective if the Fed liabilities were NOT backed by the fiscal capacity of the Treasury. That way an increase in the money supply would be more likely to be seen as permanent, and thus more likely to increase expected inflation.

Helicopter money is theoretically equivalent to buying assets which turn out to be bad (because you are then just giving away money).

In other words, the helicopter would be more effective if the Fed publicly threw away its vacuum cleaner (or at least locked it up for 10 years). Indeed, in a liquidity trap, the helicopter won’t work at all if people expect the vacuum cleaner to be brought into play as soon as there is an excess supply of money.

There is a trade-off between the effectiveness of fighting deflation now and being able to control subsequent inflation if the Fed overdoes it.

Posted by: Nick Rowe | December 17th, 2008 at 3:32 pm | Report this comment"

Here's my, deflation effected, - 2 cents:

I think that Nick is right. I believe that everyone should read this paper:

http://www.nber.org/~wbuiter/helijpe.pdf

I actually thought that you agreed with Nick.

Posted by: Don the libertarian Democrat | December 17th, 2008 at 5:57 pm |

"figures that suggest the need for a fiscal stimulus that’s enormous by historical standards": Were We In Our Old Universe

Paul Krugman on a Liquidity Trap:

"It’s a curious thing that even now, when we are clearly in a liquidity trap, we still have a lot of economists denying that such a thing is possible. The argument seems to go like this: creating inflation is easy — birds do it, bees do it, Zimbabwe does it. So it can’t really be a problem for competent countries like Japan or the United States.

This misses a key point that I and others tried to make for Japan in the 90s and are trying to make again now: creating inflation is easy if you’re an irresponsible country. It may not be easy at all if you aren’t."

One could ask the same question about the deficit and debt, but why bother?

"And once you realize that central banks may not be able to move expectations about future money supplies, it becomes a real possibility that the economy will be in a liquidity trap: if interest rates are near zero, money printed now just gets hoarded, and monetary policy has no traction on the real economy."

That's Japan. They're population is different than ours in their expectations and investing decisions, so that it's not obviously an apt comparison. For example, oddly, average Japanese investors are buying stocks now, while ours are shell-shocked.

"Back in 1998 I argued that the Bank of Japan needed to find a way to “credibly promise to be irresponsible.” That didn’t go down too well, but it was what sober, careful economic analysis prescribed.

Or as I said in the linked paper,

The whole subject of the liquidity trap has a sort of Alice-through-the-looking-glass quality. Virtues like saving, or a central bank known to be strongly committed to price stability, become vices; to get out of the trap a country must loosen its belt, persuade its citizens to forget about the future, and convince the private sector that the government and central bank aren’t as serious and austere as they seem. "

This sounds suspiciously like a policy of an elite fooling an ignorant public. Can't bother them with the truth. Isn't this the Paradox Of Thrift under a different guise? The answer is incentives.

"OK, so now back to Hatzius et al. They emphasize the role of the disruption of credit markets in pushing us into a liquidity trap. They then turn to an estimate of likely changes in the “private sector balance” — the difference between private sector saving and private sector investment. And it’s stunning:

The GS house price forecast combined with current equity prices and credit spreads implies a rise in the private sector balance from +1% of GDP in the second quarter of 2008 to +10% in the fourth quarter of 2009— - a rise of 9 percentage points, or 6 points at an annual rate.

What’s the answer? Huge fiscal stimulus, to fill the hole. More aggressive GSE lending. Maybe a “pre-commitment” by the Fed to keep rates low for an extended period — that’s a more genteel version of my “credibly promise to be irresponsible.” And maybe large-scale purchases of risky assets.

The main thing to realize is that for the time being we really are in an alternative universe, in which nothing would be more dangerous than an attempt by policy makers to play it safe."

Memo to Paul: We're still stuck here in the same old dustbin of a universe. This is a version of the Kitchen Sink Argument. If we are in a Lewis Carroll universe, mightn't the rules in it include printing money like it doesn't matter? And how would you judge that any more or less logical than an enormous stimulus and increase in the debt?

Funny thing about a Looking Glass Universe. It's devilishly hard to reason in.