RECOVERING FROM DISASTER RECOVERY

By Annaly Capital Management:

The challenge confronting the Federal Reserve is unusual in the history of central banking. How do you tighten when the blunt instrument of monetary policy—the overnight lending rate—has been rendered ineffective. Fed-watchers recall the 2002 speech by Ben Bernanke in which he enumerated the unconventional policy options that “a sufficiently determined” Fed could utilize in the event that it had brought the Fed Funds rate down to zero. The tools he covered showed a central banker more than willing to think and act outside of the box in the right set of circumstances. Once lowering the Fed Funds rate was no longer an option, he envisioned bringing down long rates through purchases of Treasuries and Agencies, directly lending to banks and the private sectors using a wide range of assets as collateral, buying foreign government debt or supporting tax cuts and other fiscal stimuli. And it could inflate. In the phrase that earned him the sobriquet Helicopter Ben, he famously said, “The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”

The speech was the central bank’s version of its Disaster Recovery (DR) plan, a plan that every business has and hopes it never has to use. What he didn’t know at the time was that the deflation he and others feared was imminent wouldn’t be the precipitating factor for turning this theoretical discussion into a massive and revolutionary crisis response playbook. (In his speech, he acknowledged that “for the foreseeable future, the chances of a serious deflation in the United States appear remote indeed.”) Instead, it was a financial crisis that nearly destroyed the global financial infrastructure.

As it turned out, the Fed pretty much followed the DR plan laid out by Chairman Bernanke. It lowered rates to zero, bought over $1.5 trillion in Treasuries and Agencies, established a number of direct lending facilities, set up exchange swap facilities for foreign central banks, backed fiscal stimulus and TARP, and injected massive amounts of excess reserves into the banking system. It also got into the M&A and investment management business along the way. It is no wonder that the discussion around the removal of accommodative monetary policy involves putting all of the tools back in the toolbox before the Fed Funds rate can once again be effective. This is now happening. The purchase programs are completed. The lending programs—the PDCF, TAF, TSLF, TOP, CPFF, AMLF, MMIF—have all been closed. (In an effort to keep our word count down, we will NOT be spelling out these acronyms. It is our version of linguistic tightening.) TALF is winding down. The discount rate has been raised to its historical 50 bp premium over Fed Funds. The massive excess bank reserves are targeted for draining, as the Fed has been testing out tri-party repurchase programs and term deposit facilities. And they are considering other wind-down options, such as raising rates paid on excess reserves, and outright asset sales.

We imagine that in their heart of hearts the Fed is upset about having to re-open the controversial swap lines to the ECB and other central banks. It is a setback in their process. Nevertheless, the Fed is trying to put the tools back in the box. Look no further than the decline in the monetary aggregates for proof of that. As the graph below shows, our own monetary aggregate, M-2 plus institutional money market funds, is dropping like a rock. Who needs to raise the Fed Funds rate to tighten?

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