The unthinkable

Posted by Tracy Alloway on Oct 27 08:03.

Signs of resistance to treasury issuance are causing Deutsche Bank analysts to think the “unthinkable” — Japan-style quantitative easing in the US.
Resistance to treasuries is something of a problem given that supply is about to shoot up — by about $2.5 trillion, according to DB estimates. See the, rather scary, chart from DB, below left.
We think that most - about $2.3 tn - will likely be financed in bills, while the remaining $1 tn would be in coupon Treasuries. Of course, all but $1 tn of the $3.3 tn net issuance would be reversed in subsequent years, as liquidity facilities are reduced and assets are sold back into the private market, thus leading to paydowns further down the road. But in the near term, the large supply volume into an illiquid market with a diminished capacity of the dealer community to hold inventory could spell trouble for the orderliness of the issuance process.
There’s also the problem of excess reserves on deposit with the Fed. In the week ending Oct. 22, these reserve balances averaged $301bn, DB says, up from $11bn at the beginning of last month.
The Fed now pays 1.15 per cent interest on excess reserves. While that has partially sterilised its liquidity program it’s also had an adverse effect — reducing the incentive for banks to lend their reserves to err, other banks (i.e. inflamed the credit crisis), but we’ve made that point before.
In any case other than lower rates and bail-out banks en masse, the US’s options are limited. If traditional rate cuts aren’t working, America’s financial authorities may have to look at something else:
This raises the issue of whether the Fed might ultimately embark on a course to not sterilize the effect of its balance sheet growth. For example, instead of SFP bills that are issued to the public with the proceeds deposited at the Fed, the Fed might simply buy the bills directly from the Treasury, and credit the balance in the Treasury’s general account for use in its fiscal initiatives, in effect monetizing the debt. In addition, the Fed might limit the sterilizing impact of the excess reserves held on its balance sheet. Significant quantitative easing can happen even if the fed funds rate is not brought down to zero.
In otherwords, the kind of quantitative easing initiated by Japan in 2001, when the country’s central bank started targeting excess reserves (”current account balance”) and added whatever reserves were necessary by buying Japanese government bonds to keep the balance high.
While this engendered a decent degree of enthusiasm from the market (see for instance, Pimco’s explanation and appraisal of the policy, here), it can also be a risky move. In effect, the central bank is risking inflation to keep liquidity levels high (and perhaps decrease nominal debt levels?) I.e. good for gold bugs, bad for your run-of-the-mill (voting) American.
Deutsche Bank for one, thinks the Fed is unlikely to pursue a QE course:
We think there is a decent chance that it can be avoided. In particular, the receptivity of global investors to financing the pickup in Treasury issuance over the next year is a crucial factor. If the government is unable to finance the debt through regular issuance, the temptation would rise to monetize it instead. However, our sense is that this radical path is less likely, particularly as we have seen lately that the US dollar currency, as well as Treasury securities, are increasingly seen once again as attractive global flight-to-quality instruments. The successful funding of the government’s rescue plan, combined with a revival in the economy, could mitigate the need for a shift to quantitative easing, in our view.
Charts like this, of the Fed’s balance sheet, and some pundits, are already suggesting the central bank may already be embarking down the QE road. What then, was one of the biggest complaints about Japan’s quantitative easing (other than rampant inflation)? — just that it ended up postponing the structural change that many argued was necessary for the country’s banking system…
From a Federal Reserve Bank of San Francisco paper:
In strengthening the performance of the weakest Japanese banks, quantitative easing may have had the undesired impact of delaying structural reform.