The calls for QE3 continue to rage.
But as FT Alphaville has discussed at length, QE3 in its conventional guise — freshly minted base money in exchange for US government bonds — might not really be an option due to the squeeze it causes in the US Treasury market.
Indeed, Fed purchases are the equivalent of hoarding the system’s supply of safe assets on the Fed’s own balance sheet, and in so doing preventing private investors — especially money market investors — from investing in the assets on favourable terms.
While this is mostly the point of QE — the idea, after all, is to stimulate risk appetite and cause investors to change their portfolios — a continued lack of risk appetite means the money created, rather than flowing into risky securities as hoped, is only crowding out the last remaining safe securities in the market instead. The consequences are negative rates and principal destruction — a lethal combination that is arguably far more dangerous and deflationary than no QE at all.
Indeed, unless QE3 is accompanied with more Treasury bond issuance, and a larger national debt — and we know there’s no political appetite for that — there’s a very good chance that such liquidity measures could do more harm than good.
The interesting thing, however, is that we may be able to look to history to see how this situation plays out.
According to this 2010 paper by the St. Louis Fed, the Fed and the Treasury were faced with an almost identical dilemma back in the 1930s, with the Fed equally concerned about the impact of large asset purchases on short term rates:
During the summer of 1933, as excess reserves reached $500m, Fed officials’ reluctance increased. Nevertheless as Meltzer (2003) reports, President Roosevelt wished purchases to continue. On October 10, 1933, hoping to avoid a political confrontation, Fed officials decided to continue purchases. Yet, on October 12, these officials unanimously approved a statement to the president noting that (i) the System’s holdings of government securities exceeded $2bn, (ii) bank reserves had reached a record high, and (iii) short-term money rates had dipped to record lows.
Not wanting to put further pressure on interest rates, the Fed thus halted purchases in November 1933.
But as the St Louis Fed’s Richard Anderson notes, quantitative easing did not end there. It instead shifted to the Treasury and the White House through gold purchases:
The Fed’s reluctance could be overcome with gold. President Roosevelt controlled both the nation’s gold stock and monetary policy, so long as the Federal Reserve remained inactive. The president’s most effective tool was the Gold Reserve Act, passed on January 30, 1934, which raised the value of gold from $20.67 to $35 per ounce. The mechanism by which the Treasury gained control was elegantly simple. On August 28, 1933, Roosevelt called all outstanding domestic gold into the Federal Reserve Banks; on January 30, ownership was transferred, before revaluation, to the Treasury from the Federal Reserve Banks in exchange for (paper) gold certificates. When gold’s price increased to $35 per ounce from $20.67, the Treasury realized a windfall profit of more than $2 billion. The Treasury, Meltzer (2003) reports, began purchasing gold “immediately” via the issuance of additional gold certificates — bank reserves and the monetary base expanded when the gold certificates later were received by the Federal Reserve Banks.
During 1934-36, the Treasury purchased $4 billion in gold in international markets, sharply increasing bank reserves and the monetary base. The effect on bank reserves is displayed in the table. In 1936, as today, concern arose regarding inflation. Then, the Fed’s exit strategy was higher statutory reserve requirements, infeasible today. Today, the Fed’s exit strategy includes increasing the remuneration rate on deposits at the Fed, offering banks term deposits at the Fed, and the use of repurchase agreements.
The idea that the Treasury could once again become the gold buyer of last resort, in exchange for liquidity, is interesting to say the least. Not only would such a strategy ease the squeeze in the Treasury market, it would do so without compromising the liquidity effects of QE.
What’s more it could help to support and stabilize the gold price, while taking zero-yielding safe assets out of the system in favour of yield bearing ones — giving money markets a fighting chance for survival in terms of yields.
While gold purchases have never been communicated as official central bank policy, there’s no denying that a shift in this direction is taking place. Be that wittingly or unwittingly.
Not only have central banks become net buyers of gold over the last year, there is a lot of anecdotal price evidence to suggest that gold prices have stabilised as a result. It’s also important to note so-called gold swaps — what might otherwise be called gold repos, similar to the concept of the LTRO, but instead of pledging debt collateral for liquidity you get cash in exchange for gold. These became extremely popular in the period before central banks became outright net buyers of gold (i.e. between 2009-2010).
We, ourselves, have already speculated about the role central banks may be playing in propping up gold prices via their current gold absorption and purchasing activities.
Propping up the gold price – FT Alphaville
The cost of global central bank balance sheet expansion – FT Alphaville
On the perils of plunging repo rates – FT Alphaville