Crunch time for the Fed

A shy, retiring, conservative central banker he is not. Frequently in his reign as Fed Chairman, Ben Bernanke has been prepared to explore and implement bold policy responses in the face of immense financial and economic challenges. Witness his response to the 2008 financial crisis; his preparedness to allow the Fed’s balance sheet to expand almost exponentially (through both QE1 and QE2); and, his decision to maintain the funds rate at essentially zero for two years at the last FOMC meeting.

As such, given his track record, simply expecting the Fed Chairman to acquiesce to a twist operation today may be underestimating his ambition. In the first instance, it is questionable how much value a twist would actually be in terms of addressing the lack of aggregate demand in the economy. Also, with short term interest rates essentially zero and long-term rates below 2%, it is not clear that an operation designed to further reduce the cost of long term borrowing will succeed against the backdrop of a private sector still intent on deleveraging.

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Those with substantial borrowings will likely be thankful for even lower debt servicing costs, but amidst enormous uncertainty this extra cash flow is unlikely to induce much in the way of extra spending. If a twist operation is regarded as too timid, then what other measures might the Fed Chairman be contemplating? There are numerous possibilities, including another dose of QE, reducing/eliminating the interest rate on excess reserves, and an explicit target for any of bond yields/nominal GDP/inflation/the unemployment rate. Alternatively, there is also the more radical suggestion that the Fed could lend indirectly to the private sector using the banks as the conduit.

Utilising the discount window, the Fed could lend at virtually zero interest rates to the banks, in turn accepting collateral on quality private sector assets such as corporate bonds, commercial paper, bank loans, etc. This in turn would potentially significantly lower the cost of capital for both banks and the non-financial private sector. Almost a decade ago, the current Fed Chairman mentioned this particular policy option in a speech on countering deflation which also contained his reference to helicopter drops of money. It is entirely possible that indirect lending to the private sector is being examined by the Fed Chairman right now, and that this two-day meeting has been called specifically to convince FOMC policy hawks that the Fed must again be adventurous.


Finally, some good news from the UK. Amidst the pervasive gloom in the UK that led Business Secretary Vince Cable to declare at his party’s annual conference on Monday that ‘we now face a crisis that is the economic equivalent of war’, finally we have spotted some good news that is worth sharing (partly because it is so rare). In a survey of business executives undertaken by the Economist Intelligence Unit, the UK was regarded as one of the world’s potential manufacturing hotspots in the future, behind China, the US and India. Quite healthy company. According to the survey, the volatility in commodity prices and rapidly rising transport costs in many emerging economies rendered the UK an attractive place to source production. The weak currency and the enormous uncertainty about the future of Europe also helped perceptions of the UK as a manufacturing destination. Separately, Debenhams announced healthy revenues after a respectable sales performance during the summer.

Greece considers a referendum on the euro. Despite denials yesterday morning, there is growing speculation that Prime Minister Papandreou is considering a referendum on Greece’s continued participation in the euro. According to Kathimerini, the Greek people will be asked specifically whether they should tackle their debt crisis by exiting the eurozone or remaining within the single currency. The article claims that Papandreou hopes to obtain a stronger mandate for the crippling austerity measures required to satisfy Greek creditors. Apparently, a bill is to be submitted to Parliament in coming days, as a prelude to announcing the referendum. Also under consideration by the Greek cabinet is a snap election, again with the intention of forging a stronger political consensus around the need for drastic change. No doubt this was discussed at Monday night’s emergency cabinet meeting. The Finance Ministry in Athens claimed that last night’s second conference call with the troika was positive and productive. The EU subsequently confirmed that a full delegation will descend on Athens next week following the dialogue between Greek Finance Minister Venizelos and the IMF in Washington over coming days. With Greece still on a knife-edge and Italy being downgraded by S&P overnight, there was plenty for the euro bears to get their teeth into yesterday. The Wall Street Journal reported that the Bank of China had put a halt to trading fx swaps in their local market with both BNP and UBS, and the FT claimed that Siemens had pulled up to EUR 6 bn of deposits out of French banks. Interestingly, the single currency is actually a little higher today, with some shorts probably closing their positions on signs that the troika might just give Greece their next loan instalment after all.

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