Tuesday, January 13, 2009

Bernanke Speech

Helicopter Ben's speech today was actually pretty good.  In it he distinguishes between what he calls "credit easing" from the quantitative easing that Japan did post 2001.

The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006.  Our approach--which could be described as "credit easing"--resembles quantitative easing in one respect:  It involves an expansion of the central bank's balance sheet.  However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental.  Indeed, although the Bank of Japan's policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves.  In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses.  This difference does not reflect any doctrinal disagreement with the Japanese approach, but rather the differences in financial and economic conditions between the two episodes.  In particular, credit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing.  To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally.

Of course, he makes believe that this spread targeting can do just what the market (theoretically) does, namely correctly price credit risk.  If he's right, and his pricing of spreads is smarter than the market's, then we will have no problem.  If he's wrong, and he's not as smart as the market, or even just dumb in a different way, then the Fed will end up owning a lot of securities that are not worth face value -- ie. the Fed will be taking credit risk.  In this case, they will either be able to unwind this risk before suffering losses on it by pushing it back into the private market at a moment when things look (deceptively) more normal, or they will stomach the losses themselves. 

Later on in the speech, he answers to critics who say that the Fed's dramatic balance sheet expansion may not be inflationary now, but must be down the road, and he discusses how they intend to shrink their balance sheet at the appropriate time in order to prevent this from happening.  The idea is simply to later un-print the money they are printing right now to make these loans and buy these assets, by calling in the loans or selling the assets back into the market. That works fine as long as the loans are short-term and the assets are liquid and money good.  If not, once again the Fed will be taking credit risk.  I suppose though that this is an inherent part of "credit easing".  If you were just quantitatively easing, then you could have your Central Bank Hand print money to buy up the government debt that your Federal Government Hand has just issued (what people call monetizing the debt).  This doesn't require any credit risk, but thereby prevents you from targeting spreads directly and thus doing an end-run around the broken financial intermediation system.

So the approach here is smarter than what Japan did, but also much riskier.  If they screw this up we will get the mother of all inflationary booms.

No comments: