Ben’s still dancing…

At first I thought I misheard… or that some charlatan journalist was trying to make headlines.

But no. Ben did say he’s thinking of buying long-term Treasuries. His speech last Monday is crystal clear: “[T]he Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities […]”

Treasuries! Of all things! It’s like going to your favorite pastry shop, everything is at a discount, and you get a diet coke!

What’s wrong?

What is wrong is that this is the wrong solution to our problem, which is three-fold:

First, there is a huge hole in the balance sheets of banks, because a large amount of the assets in their books are either illiquid or junk or illiquid because they are junk.

Second, as a result of the first problem, there has been a brutal disruption in the availability of credit, as financial institutions hoard cash out of fear of each other, of nonbank firms and of their own ability to meet future obligations.

Third, the economy is on freefall, with the latest payroll numbers attesting to this (I’m looking for the superlative of “abysmal”).

So given these three aspects, what are the Fed’s priorities and objectives and what instruments will it use to achieve them?

Let’s start with the second, which is, ironically, the easiest part. By now, the Fed has established an entire infrastructure of facilities to address shortages of liquidity—the TAFs, CPFFs and ABCPMMMFs of this world. These are designed to be temporary, since the underlying assumption (and prayer) is that financial conditions will normalize.

That’s all good, only that along with praying, Ben’d better do something too. Like, deal with the first part of the problem, which is to plug the hole of the banks. What is he doing on that front?

It’s probably the Nth time I will argue “very little.” Yes, we had the use of part of the TARP (by the Treasury) to recapitalize some banks. Yes, we had the rescues of the selected few (AIG, Citi etc), partly with Fed money, to avoid a repeat of the Lehmans aftershocks. Yes, we had the announcement of the TALF, which was certainly a step in the right direction. But it has been very (very) patchy.

Take the rescue of Citi. It was last-minute. The modalities (fate of creditors, shareholders, etc) were a work in progress. No rationale was offered behind the amount of assets carved out of the bank (with the Fed’s and the Treasury’s help), including whether it would be sufficient.

Don’t get me wrong, it was the right “idea,” i.e. carving out assets on one hand, and plugging a potential hole with new capital on the other. But why not apply this approach uniformly and across the board of (systemically important) institutions, and clean up the system once and for all? And at the same time, prepare for the failure of institutions that (given our limited resources) we simply cannot rescue?

So let’s go back now to Ben’s idea of potentially buying long-term Treasuries. Clearly Treasuries are not really “toxic” (at least not yet!) and, as such, they’re not the kind of asset banks would like to see carved out of their books. So the purchases would do nothing to address problem #1 and, by extension, #2.

But then again, Ben really meant it as a potential means to address #3. Indeed, in his own words “This approach might influence the yields on these securities, thus helping to spur aggregate demand” (my emphasis).

Even here, this is not the most efficient use of Fed cash: First, long-term Treasury yields are super low already, so they don’t exactly need support.

Secondly, if there is any fear among investors that yields will go up in the future, that’s because of uncertainty over how inflationary of the Fed’s easing is going to be—an uncertainty that is building fast, I should add, and which is not really dealt with by promising to, urh, print money to buy Treasuries!

Third, yields of, say, mortgages or loans to companies are high largely because banks currently demand a sizeable premium for liquidity (i.e. they’d rather hold cash or liquid Treasuries than lock their money on a long-term loan). This is not going to go away no matter how many Treasuries the Fed buys–unless the problems at banks get fixed.

So I’ll go back to my perennial call for the Fed to step in and buy a large chunk of the “troubled” assets in banks’ books. Like in the case of Citi, this should come in conjunction with a potential “refill” of bank capital, if the carve-out results in a new hole.

Buying toxic assets is better than buying Treasuries for another reason: IF the Fed is successful in revitalizing the economy, long-term Treasury yields are bound to go up (as growth expectations rise) and their prices would go down. This will translate into a large capital loss for the Fed.

On the other hand, if it buys the troubled stuff, success in rejuvenating financial markets will likely bring the yields of these securities down—at the very least because the “liquidity premium” will go down. Translation: The Fed could actually make a gain on at least some of these “toxic” assets.

Finally, let me throw another bombshell here–food for thought, you might say. This may be the time to revisit the desirability of an inflation-targeting regime for the Fed, of which Ben is a famous fan. Why?

Because uncertainty about future inflation is rising, as people get iffy about the expansion of the Fed’s balance sheet (which, by the way, is (still) non-inflationary for the reason I mentioned here). So this would be precisely the point where an explicit commitment by the Fed to a medium-term inflation target would help reign in inflation expectations.

Ultimately, what has been lacking all along is communication. Communication of the Fed’s (and the Treasury’s) accurate understanding of the size of the problem, their priorities and end-objectives, and the tools that will be employed to achieve them. We got one step forward last week, but Ben has now switched to foxtrot.

No offence, Ben, but it doesn’t look good! So why don’t you stick with the forward steps and let us do the dancing!

Glossary: troubled assets, cash hoarding, liquidity premium, communication, foxtrot.


Originally published at the Models & Agents blog and reproduced here with the author’s permission.