The Impasse of Monetary Policy - Part 2 : the achievements

Why The Fed, by itself, cannot deliver a sustainable recovery?

Part 2 : the Fed's achievements

     2.2   Spotlight on the Fed’s accomplishments 

·       Rescuing banking: One of the greatest – but still relatively underappreciated – achievements of the Fed was saving our largest banks from bankruptcy and our financial system from more chaos. Endangered by overleveraging, these banks were effectively rescued by confronting their devastating risk of insolvency with overpowering doses of monetary liquidity – initially with the Toxic Asset Relief Program, promptly followed with rate cuts and QE – in spite of their management’s astonishingly persistent denials that disastrous conditions were present.

After the trauma that Lehman’s bankruptcy caused to the banking system, a pressing priority was the need to recapitalize the surviving banks. But with all the preoccupation around their “toxic” assets perceived as infesting their balance sheets, finding investors to lend them equity capital was a practically insurmountable obstacle.

The Fed anticipated that problem swiftly and initially lowered interest rates in a move euphemistically referred to as ZIRP (zero interest rate policy) with the expectation to bolster bank profitability, therefore reducing the need for capital injections. But, just as quickly, it also came to the conclusion that this was unlikely to suffice as the illiquid or problematic assets in these banks’ balance sheets could still precipitate insolvencies. That is when it decisively embarked on a series of Quantitative Easing (QE) programs as complements for shoring-up banks’ balance sheets but, also, encourage lending.

By purchasing fixed-income securities from targeted commercial banks, QE bolstered the cash reserves of these entities while reducing their financial leverage which was unquestionably linked with the Great Recession. That injection of liquidity, combined with very-low interest rates for boosting bank profits, prevented insolvencies while also encouraging increased lending considered so critical to jump-starting economic revival.

FIGURE 1

The rescue initiatives were unquestionably successful: six years later banks were sitting on almost $2.8 trillion in reserves, and the ratio of financial debt relative to GDP had dropped from a treacherous 120% to a more reasonable and sustainable 85%. Although bank lending still remains way below historic norms, especially to smaller companies, there is little doubt that America’s largest banks are on firmer footing than before, especially when compared to their still vastly under-capitalized European counterparts.

In Europe, by comparison, countries like the UK or Switzerland are still exposed to big financial risks by harboring outsized banks whose massive assets dwarf their GDP.

·       Household Deleveraging: The second most significant achievement is that by keeping interest rates so low and for so long it allowed consumer debt-reduction to take hold. Household debt has been reduced from 98% of GDP in 2007 down to 81% now. Consumers are no longer overleveraged.  Yet, they don’t seem hurried to ramp-up consumption to historic norms: a much needed requirement for economic revival.

·       Housing recovery: There is one scary indicator which used to illustrate the “bubble” in housing associated with sub-prime lending: the ratio of housing wealth to GDP. That ratio which measures the relationship between the worth of household real-estate and the economic output hit a vertiginous high of 2.1 in 2006 -- compared to only 1.4 in 2001 -- driven by profuse and cheap mortgages fueled with reckless lending practices. Not anymore.

The good news is that after having flirted with a low of 1.2 in 2012, it is now near its historical average of 1.4 measured over the last 40 years. The bad news is that, according to the real-estate firm Zillow, about 1 in 5 of all mortgaged homes still owe more on their mortgages than the market value of their homes. Although there is still some ways to go for declaring normalcy, it is still a lot better than a couple years ago.

·       Price stability: Prices for the basket of goods used to measure inflation have remained remarkably stable over the last six years. This achievement is controversial however because it ignores inflationary pressures building on the periphery with either bubbling financial assets or rising real estate prices. Furthermore, achieving such narrowed price stability is not indicative of attaining broader financial stability. The latter is still at risk by the aggregate US debt load (public & private combined) which still sits at the treacherous level of 320 % of the GDP, as the chart above illustrates.

·       Fiscal respite:  Lower interest-rates helped the government too, especially in reducing the interest burden on its gross public debt now near $18 trillion. This is more like a good news/bad news story since the net interest payable on that debt, currently lowered to a relatively modest $234 billion per year (less than 1.5% of GDP), could become a crippling obstacle for budget deficit reduction when interest rates start going higher. This is what should keep Washington worried as a most likely scenario.

The realization that the Fed’s QE has just bought them only more time -- and that QE is not an alternative for the badly needed fiscal policy reforms for inevitable tax revenue increase -- is politically just too painful to reach.