So says Goldman Sachs’ US economist, Andrew Tilton.
As a reminder, having lowered the US target rate to its absolute minimum, the Fed is now pursuing unconventional monetary policy in an effort to increase available credit and decrease its cost. This is what Fed chairman Ben Bernanke likes to call credit easing, but is more or less a form of quantitative meets qualitative easing — changing the composition and increasing the liabilities of the Fed’s balance sheet, via things like emergency liquidity measures, direct lending to private sector borrowers, asset purchases and so on.
In Tilton’s opinion, such unconventional easing is likely to be the primary focus of Fed policy until at least 2010. So we should know what we’re getting in return for the Fed’s ballooning balance sheet. As he puts it:
With both policymakers and investors operating in uncharted territory, it is much more difficult to gauge the stance of Fed policy. What does it mean if the Fed announces a plan to purchase $500bn of agency mortgage-backed securities, as it did in late November? The Fed is transparent about the size of its balance sheet and the nature of the interventions it is pursuing, but there is no obvious way to translate the results of those interventions into metrics that investors can easily understand—e.g. the federal funds rate.
Goldman is therefore attempting to bridge the gap, using their Financial Conditions Index (GSFCI), a measure of monetary and market conditions’ impact on GDP, and the fed funds rate as an indicator of the cost of credit. We’ll spare you the technical details (if you’re really interested you can read them here) and go straight for the results.
Our preliminary assessment of the agency debt/MBS purchase programs and CPFF is that it takes between $1 trillion and $1.6 trillion of balance sheet expansion to generate a funds-rate-equivalent easing of 100bp. These are clearly huge numbers, especially when compared with the Fed’s current balance sheet ($1.9 trillion, of which securities held outright make up roughly one-third), and we expect them to meet with some skepticism. However, they should be considered in the context of the more than $50 trillion of credit market debt outstanding in the most recent Flow of Funds report from the Federal Reserve.
Indeed, there are a lot of caveats attached to that analysis including, for instance, the fact that all the positive spillover effects might not be included in the calculation. Also, the marginal cost of the Fed’s QE exercise is unlikely to be constant. As the Fed expands its purchase programmes, fewer assets will be left in private hands, meaning incremental purchases could have a greater effect on prices and spreads — more bang for the buck.
Perhaps the biggest problem with this analysis is that it only deals with the cost of credit, as measured by the Fed funds rate, not the quantity. And QE is aimed at increasing the amount of available credit as well as its cost. But this is a point not lost on Tilton:
The Fed’s Term Asset-Backed Securities Lending Facility (TALF), to begin lending imminently, is explicitly designed to increase the volume of available credit as well as decrease its cost. So if it works as designed, the TALF’s ultimate impact on credit and financial conditions could be considerably larger than implied by our calculations. But this should not obscure the fundamental conclusion: it takes massive balance sheet expansion to generate a significant easing in financial conditions.
And on the wider point of QE in general, Tilton says:
In light of the apparent cost of unconventional easing, it is easier to understand Fed Chairman Bernanke’s desire to draw a distinction between “credit easing” and the “quantitative easing” approach pursued by the Bank of Japan. In essence, Bernanke is arguing that the Fed’s approach of targeting specific credit spreads and/or borrower groups will generate a better bang for the buck—more effective FCI easing for dollar of balance sheet expansion—than untargeted quantitative easing. We hope he is right.
Related links:
Understanding US Economic Statistics - Goldman Sachs
The pictorial quantitative easing - FT Alphaville
Quantitative and qualitative easing again - Willem Buiter’s Maverecon, FT
