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Sunday, July 26, 2009

Ease the tension!

How do you put toothpaste back into its tube? Ask Chairman of the United States Federal Reserve, Ben Bernanke. He has a plan to tame inflation, after the U.S. banking system and the economy, on the whole, received massive dollops of capital heaped onto it. Good luck, Uncle Ben!

But, what tools does he have, truly, if any, to tame inflation in the short term and long term? In order to answer that question, we don't have to look back at the beginning of the credit crisis, but only at the response and its intended impact.

The first and foremost thing should be to undo what you did, if there really is a huge concern. But, things have changed since the state intervention. Least of which, is that a few banks and credit institutions, went out of business. Also, more importantly, producers and businesses also have scaled back production or have gone out of business as well. In addition, no one is quite sure-- well some of us are sure-- which way the U.S. stimulus package would create a bubble, or if whether or not international markets, for particularly oil and gold, would create a situation where trying to tamp inflation would be ineffective, coupled with the idea that it may, at this time, do more damage to growth.

Forget about your inflation target range and, perhaps, put on your output gap caps! The U.S is in for the third phase of this crisis. The first being the actual credit squeeze, the other in combating deflationary pressure and the other, now, managing inflationary expectations.

Due to the reality of 2008, with regard to blocked credit markets, the Federal Reserve, with the acceptance of the U.S. Treasury under both president's Bush and Obama, implemented two plans: The Target Asset Relief Program (TARP) and a strategic monetary tool, Quantitative Easing (QE).

TARP was supposed to, by all intents and purposes, inject credit back into the market, through the Fed. purchasing troubled assets that, under then present circumstances, could not have been sold. In addition, this was also supposed to induce banks to lend to businesses and home owners again, once the risk of writing down or the loss of those troubled assets, mostly home securities and collateralised debt obligations (CDO's), were removed from balance sheets.

The critical issue of contention are the warrants- stock options- the US government took in companies that sold their troubled assets to the government. These warrants are essentially equity the US government bought into banks in exchange for expunging the current market value of the troubled asset from the bank sheets.

The premise for this policy, with regard to spurring banking activity while creating stability and security within the market, with the aid of a sub-program, the public private investment program (P-PIP), was for the government to be able to make a profit on these assets, when the market gets back to normal as well as for the private investors, who participated in the program.

Herein lay the major issue. Banks don't want to buy back those troubled assets, or, in other terms, recoup their warrants from the Fed.. They are more than willing to allow the government to own these assets, and resume banking activity under a new slate- even though the US government, in essence of those warrants, owns stakes in those companies. So, the Fed is stuck with these assets for a time, which it will have to sell at below what ever the future the market value is, even though they should make a profit with all things considered, but at the same time rewarding the banks that failed by absolving their losses.

This may be a good thing. For one, the US government does not have to inject as much credit, at a time that is of their choosing if they wish to do so, and over-inflate the US economy. The second issue is that, through this mechanism, the government can control the price of those assets and ease them back into the market, while still making a considerable profit for the tax payers, for it to go back into useful public projects. The only concern is if traditional investors hold out for a lower than fair market price for the assets and create a bottom market, only to over-heat on the real market when the government winds up TARP.

The second policy response, as said, has been with QE.

QE, quite simply, allows central banks to increase the amount of credit into an economy, by purchasing government bonds in the open markets, and in effect, increasing liquidity to private banks.

The U.S. Fed, in this case, created money to purchase these government securities held by private banks, in order to free up credit markets after traditional policy responses, interest rate cuts, were proven ineffective.

Princeton University Professor, Paul Krugman, suggests that the U.S. is in a liquidity trap of sorts, where it does not matter if whether or not QE or the interest rate remain at or cut below 0%. His premise rests on the then obvious fact that the rate cuts didn't work and, hence, QE was made an additional tool. But, while that may be true and while confidence has crept back into the markets, the issue now; is if whether or not it worked too well for the private sector?

I say this, under the premise that the Fed. bought these government bonds at a time when the market was looking for credit, and the Fed. bought their securities at a nearly rock bottom market price and interest rate. The plan would be to, now, implement a reverse repurchase agreement with the banks that sold government bonds to the Fed., which may or may not be bought back by banks at a relatively high rate. Leaving the Fed. with assets on its own balance sheet, which it may find difficult to sell at a higher price, which would absolutely sop credit out of the market if welcomed by the banks, while at the same time, leaving banks with the capital the Fed. injected, with no guarantee, unless we were to have lending restrictions through the U.S. Treasury- which may be counter-productive to the recovery effort- in order to stave off inflation.

The good and bad thing about the amount of liquidity through QE, is that the U.S. dollar is weak compared to other currencies. This may encourage, seeing that the worst is over, international investors to buy the dollar in hopes of making an appreciable profit. This would mean dollars would exit the U.S. market, to, let's say, China.

While no plan is fool proof and having no plan at all, can, in some cases, be better than a bad plan. Any plan for inflation however, should take into consideration some of the things that have been done to increase inflation as aforementioned in this article. Don't assume that the interventions are 180 degree undoable either.
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