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Euroland A Much Deeper Recession United States Will the Fed Buy Treasuries? View GEF Archive

		The Global Economics Team

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Due to a run of very disappointing activity indicators, we are aggressively lowering our 2009 GDP growth estimates for the euro area.  We are cutting our 2009 GDP growth estimate for the euro area to -3.3%, from -1.6% before.  This would imply a contraction in activity that is considerably larger than any experienced since the end of World War II. The downgrade reflects both a lower-than-expected 4Q GDP outcome as well as coincident monthly indicators pointing to a further acceleration in the rate of contraction in early 2009.  At the same time, our outlook for quarterly growth dynamics in the remainder of this year has only changed marginally.  On the back of tentative signs of stabilisation in a range of business sentiment indicators, we continue to look for gradual stabilisation in activity over the coming quarters and hope to see a return to positive GDP growth rates towards year-end.  Hence, the change to our 2010 forecast is considerably smaller, bringing the full-year GDP estimate down to 0.5%, from 1.1% before. Over the whole forecast horizon, we are lowering our estimates by 2.3 percentage points.

Reason for Cutting Our Numbers Is Not Difficult to Find...

The main reason for cutting our growth outlook for the euro area is that incoming economic activity and sentiment indicators have essentially been in freefall as of late.  Not only did 4Q show a larger-than-expected decline of 1.5%Q in non-annualised terms, but also the incoming industrial production data for the month of January pointed to a further acceleration in the rate of decline in early 2009.  As a result, we now expect euro area GDP to fall nearly 2%Q between January and March.  In addition, downgrades to GDP growth estimates elsewhere in the world, notably in Central and Eastern Europe, cast further dark clouds over the outlook for export demand. 

…it Is the Unprecedented Sharp Fall in Activity Indicators

At the same time, our outlook for activity in the remainder of year and for next year has not changed dramatically.  We continue to expect gradual stabilization in activity over the coming quarters and hope to see a return to positive growth rates towards year-end.  For this conjecture to come true, the tentative signs of stabilization that we have seen during the recent rounds of business surveys, where companies have stopped revising down their production plans, need to become more definite.  In addition, it would help if the bleak projections by companies for their own output would turn out to be overly pessimistic, in light of order demand not falling to the same extent that production plans were cut.

Mind the Alternative Explanation for Plunge in Activity

One reason for the sharp fall in activity indicators around the world could also be the profound changes in the production chains on the back of the ICT revolution, which have caused production chains to become much more closely integrated across sectors and countries over the last 10-15 years. This has potentially caused negative demand shocks to be transmitted along the global production chains much faster than in the past (see Euroland Economics: Inside the Inventory Cycle, February 23, 2009).  Together with much tighter control of inventories of finished products on the back of working capital concerns, this could have caused production to become more volatile. We find some indication that inventories have become more pro-cyclical over time and believe that euro area companies (outside the car sector) have likely been effective in limiting the rise in unwanted inventories of finished goods.  This implies there would be less of an inventory backlog standing in the way restarting production again once final demand stabilises.

A Lot of Demand Stimulus Is on the Way Already

Despite our new rock-bottom growth estimates, we believe that a 1930s-style depression can be avoided in the euro area.  In our view, the 1930s-style depression was primarily caused by a rather rigid macroeconomic set-up, characterised by the gold standard (including a fixed exchange rate regime) and a strict balanced budget doctrine.  Today’s macroeconomic set-up could not be more different, with flexible monetary policy, which has already taken aggressive action, including non-conventional measures such as QE, and good-sized fiscal stimulus programs and widespread bank rescue packages.

•           First, monetary policy has been eased substantially as the ECB cut official interest rates by 275bp since October, bringing the refi rate to a new record low of 1.5% in March. In addition, ECB President Trichet hinted at further easing at the March press conference. We expect the ECB to ease at least by a further 50bp before summer.

•           Second, the ECB has made significant changes to its open market operations, notably the move towards fixed refi operations with guaranteed full allotment of all bank bids. The fixed-rate tenders effectively remove all refinancing risk for eligible counterparties. They will remain in place beyond the end of this year. As a result, the ECB has massively expanded its balance sheet, pumped up the monetary base and boosted narrow M1 money supply growth.

•           Third, governments across the euro area have put together very substantial bank rescue packages. These packages comprise bank guarantees amounting to around €1.700 billion (around 18% of GDP), capital injections amounting to more than €200 billion (some 2.3% of GDP) and asset purchase programs worth more than €100 billion (a good 1% of GDP).

•           Fourth, governments have committed to considerable fiscal policy stimulus for this year and next, totaling €154 billion (1.7% of GDP).  In addition, automatic fiscal stabilisers, which tend to be bigger in Continental Europe than they are in the US, will help to offset some of the negative repercussions of the recession on incomes and demand.  The Stability and Growth Pact does not stand in way of effective fiscal stimulus, as a rising number of countries will likely be able to refer to one of the escape clauses.

•           Finally, lower oil prices will likely boost national income noticeably (see Euroland Economics: Good Deflation Isn’t a Cause for Concern, February 4, 2009). On our estimates, the sharp fall in oil prices reduces the transfer of income from the euro area to oil-exporting countries by more than 0.8% of GDP this year. Notably, consumers will enjoy a cushion of 1.1% of real disposable income against faster job losses, lower wage inflation and tighter financing conditions. Companies should also benefit from lower energy costs.

Sharing the Benefits of Lower Oil Prices

In the long run, the division of the benefits of lower oil prices between consumers and corporates depends on the adjustment in wages.  In the extreme case of full wage indexation, where lower consumer price inflation eventually translates fully into lower nominal wage increases, consumers would only temporarily benefit from falling oil prices.  Over the long haul, real wages would be completely stable and corporates would see their profits boosted considerably. The short-term rigidity in nominal wages implies that, in the near term, corporates won’t be benefitting as much though.  We estimate that of the €73 billion windfall from lower oil prices, eventually about €48 billion (c.60%) will accrue to consumers, while the remaining €24 billion will fall to corporates. 

Exports Dynamics Likely to Weigh on Euro Area

We expect export demand to be a significant drag on the euro area economy this year.  Direct exports of goods and services are hit hard by the slump in overseas economic activity. We now expect net exports demand to dent overall GDP by 1.4pp this year, the largest negative growth contribution seen since the start of EMU.  In addition, foreign affiliate sales of multinational companies headquartered in the euro area, which, given the surge in FDI over the last decades, tend to be nearly as large as direct merchandise exports, will likely take a major hit, we estimate.  The extent to which this dent in overseas sales will affect corporate profits in the euro area will also be determined by exchange rate developments, which in many regions of the world would reinforce the impact via a negative translation effect.

Investment Spending Estimates Cut Further

In light of the slump in global trade, corporate profits and tighter financing conditions, investment spending is likely to be hit very hard. This holds true in particular for investment in machinery and equipment, although construction investment will likely also feel the pain, especially in commercial structures and residential buildings.  We now expect a gross fixed investment spending plunge of 7.9% this year, led by an almost 10% slump in investment in machinery and equipment.  Construction investment is unlikely to be far behind, we think, even though government-sponsored public works will act as a boon.  We are projecting a 7.2% drop in overall construction investment this year.  Given the cooling housing markets and the construction overhang in a number of countries, we expect it will be quite some time before the construction sector will see an improvement.

Consumer Spending Relatively Resilient

Contrary to many Anglo-Saxon countries, euro area consumer spending will likely hold relatively steady over the forecast horizon, we think. While mounting job losses and lower wage increases will dent income meaningfully, part of this will likely be offset by much lower consumer price inflation and lower interest rates. In addition, the erosion of household wealth due to the equity and housing market corrections will likely be more limited in Continental Europe.  Here, Euroland consumers benefit (on a relative basis) from being homeowners to a lesser extent, from having a more conservative asset allocation and from being members of pay-as-go rather than funded pension schemes.  In addition, they are considerably less indebted on the whole and hence less likely to deleverage going forward.  Income tax cuts and beefed-up income support measures sponsored by governments will also help to stabilise spending.  Much will, of course, depend on consumers’ savings behaviour.

Mind the Dynamics in the Savings Rate

In our forecast, we assume that the savings rate will ease slightly as consumers continue to view the recession as a cyclical, not structural phenomenon. A potential risk to both the near-term and the long-term outlook is that consumers could conclude that they are hit by a structural crisis, revise down their long-term income and wealth expectations and raise their savings rate in the midst of the downturn. In this event, consumer spending growth could trail disposable income growth by a considerable margin.  In our view, such a prolonged phase of voluntary deleveraging would still remain a risk during the recovery in 2010 and beyond.  In the event, consumers across Europe would start to behave like German consumers, who have kept their purse strings tight for most of the last 10 years as they have tried to reduce leverage.

Inflation Will Dip into Negative Territory Temporarily…

On the back of the much deeper recession, we are also lowering our inflation forecasts, especially for next year.  Regular readers of our research will remember that we lowered our inflation estimates quite substantially as a result of a new set of commodity price assumptions (see Euroland Economics: Good Inflation Isn’t a Cause for Concern, February 4, 2009).  But due to more pronounced under-utilisation of resources and the resulting loss of pricing power, we are lowering our average 2010 inflation estimate to 1.2% from 1.6%.  Our estimate for this year remains unchanged at 0.5%.  This implies that headline inflation rates in the euro area will likely turn negative between May and July.  At margin, the deeper slump in activity increases the deflation risk in the euro area, but we still don’t view prolonged deflation as the most likely outcome.  A significant delay in the start of the recovery could potentially change this assessment though.

…but Prolonged Deflation Still Not the Most Likely Outcome

The most externally caused deflation of this year could become a concern if the fall in the overall price level starts to spill into lower wages, profits and incomes.  The likelihood of this happening is a function of the length and depth of the recession, not of the near-term inflation dynamics.  There is no mistaking that a drop in overall GDP of 3.3% this year will lead to a very marked under-utilisation of resources.  Notwithstanding some structural improvements in the labour market over the last two decades, we now expect the unemployment rate to reach double-digits by the mid-2010.  However, in the euro area there is typically a rather long time lag of around two years between a rise in the unemployment rate and a decline in wage inflation.  Pay packages agreed on in 2H08 will still drive wage inflation in most of 2009.  A sharp cyclical slowdown in labour productivity growth will likely send unit labour costs higher, limiting the decline in core inflation.  While falling steeply, the capacity utilisation rate in the industrial sector has only just dropped its long-term average.  Together with an unemployment rate that has thus far remained below the natural unemployment rate, this suggests that the downward pressure on inflation is only just beginning.  Due to the structural rigidities, this downward pressure is typically very moderate in the euro area, as any 1% shortfall in GDP eventually shaves 0.15% off the HICP (see Euroland Economics: The Long Shadow of the Energy/Food Spike, May 19, 2008).

ECB to Cut Refi Rate to 0.5%, Let EONIA Drift Towards Zero

Against this backdrop, we expect the ECB to lower the refi rate by 100bp in the coming months. While rate cuts beyond 1%, would not make much of a difference in terms of the EONIA overnight rate, further rate reductions would still be an important policy signal. We would highlight the possibility that a lower refi rate would coincide with a renewed narrowing of the corridor, as there seems to be reluctance on the part of the ECB Council with respect to a zero-interest rates policy (ZIRP).  The debate about additional non-conventional policy measures – notably targeted quantitative easing (QE) – would likely heat up too.  Given the controversial nature of this debate within the ECB Council, we believe that extending the existing refi operations to maturities beyond the current six-month period could be a good starting point.

Before embarking on targeted quantitative easing… As an intermediate step towards ‘targeted’ quantitative easing, the ECB could consider extending the time scale of the refinancing operations beyond the six-month horizon.  Refi operations have a number of advantages over outright purchases of financial assets, we think. 

•           First, refi operations are easier to reverse than outright purchases.  This should help to reduce the risk of an abrupt market reaction to the beginning of the next tightening campaign, the risk of feeding new asset price bubbles and the risks of, eventually, having to tolerate higher inflation, concerns which some Council members have with respect to QE. 

•           Second, a refi operation has considerably lower information requirements in the context of what financial assets to ‘acquire’ on the part of the central bank.  In a world of asymmetric information, these requirements are crucial to the success of an operation. Acting as a price-setter, during the bidding process of a refi operation the ECB can establish how much funding the banking system actually needs over a given period.  In addition, the ECB can leave it to the banking system to decide which financial assets banks are willing to hand over. 

•           Third, in terms of the financial assets underlying the transaction, refi operations offer more flexibility in terms of the collateral that is being pledged.  In an outright operation, the risky assets will have been sold for good to the ESCB at what probably are distressed levels, if current market prices are anything to go by.  In a refi operation, the banks can always adjust the collateral pool and, thus, would benefit directly from a recovery in risky assets.

…the ECB has other options, notably extending its refi operations. We continue to see a number of reasons why the ECB would be less enthusiastic about targeted quantitative easing than the Federal Reserve, the Bank of England or the Swiss National Bank (see EuroTower Insights: ECB to Enter ZIRP? January 7, 2009).  Its reservations might start with the bank-based nature of the Euroland financial system, which makes bypassing the banking system via direct purchases less useful, the assessment that the transmission mechanism is still largely functioning and the view that there is no widespread credit crunch in euro area.  They extend to the swift reversibility of such measures in the next tightening cycle and concerns about causing abrupt market reactions and thus creating additional havoc in financial markets.  Last, but not least, they include the question of incurring potentially rather sizeable losses on a purchased portfolio of financial assets in the course of monetary policy tightening.  Even though these losses would be shared between countries according to the national capital contributions to the ECB, they would likely hit public finances in a situation when these are virtually at their weakest point in this cycle.

United States
Will the Fed Buy Treasuries?
March 18, 2009

By Richard Berner & David Greenlaw | New York

As Fed officials meet this week, they face several challenges.  Courtesy of credit restraint and a global recession, the economy continues to contract sharply.  Although aggressive monetary and credit easing have yet to help the economy, and officials are just starting to implement the Term Asset-Backed Securities Lending Facility (TALF), neither those actions nor massive fiscal stimulus have yet to offset the adverse feedback loop from the credit crunch to the economy and back.  And the threat of deflation, while low, is rising as slack in the economy continues to grow.  Standard guides to monetary policy like the Taylor Rule suggest that the appropriate nominal funds rate should be negative.  While that cannot happen, it underscores the fact that, by conventional measures, monetary policy is not easy.  Even with our 2009 inflation forecast, Taylor Rule calculations yield a funds rate of -2.4%, and the lower the inflation forecast, the lower the appropriate funds rate; with inflation of -1%, the appropriate rate sinks to -5%.

Fed officials can’t afford to take chances with those risks.  As a result, the Fed will probably buy Treasuries if 10-year Treasury yields approach 3.25%, a level that could begin to threaten credit-sensitive demand like housing.  While the Fed will continue to focus on buying MBS and getting the TALF running, it will probably want to keep all options on the table.  That’s especially the case if global investors become skittish about Treasury debt.  As a first step, the Fed could authorize the manager of the System Open Market Account to buy Treasuries at this week’s FOMC meeting.

The case for buying Treasuries isn’t open and shut, but the arguments for buying under certain circumstances are persuasive.  First, the level of interest rates – mortgage, consumer borrowing rates and corporate yields – is what really matters for credit-sensitive demand, and buying Treasuries could reduce them.  The Fed’s MBS program has brought down mortgage rates by enough to dramatically increase housing affordability, MBS coupon yields have dropped to around 4%, and those declines have brought conventional 30-year mortgage borrowing rates to just over 5% – down 150bp since October.  Recently, however, concerns about counterparty and credit risk have increased the spreads of those rates over Treasuries by 10-30bp, and heavy Treasury supply has put a floor under Treasury yields; 10-year notes have hovered at 2.9%.  Fed officials will want to keep open the option of pushing down the level of Treasury yields if the spreads of mortgage or other borrowing rates over Treasuries stay high or widen, or if Treasury yields rise further.  Historically, the spread between 10-year Treasury yields and the 30-year fixed mortgage rate offered to consumers is around 160bp during ‘normal’ times.  This means that it will be difficult for the Fed to drive mortgage rates much below 5.0% – even if it successfully narrows the spread to a ‘normal’ level – should 10-year Treasury yields rise above 3.25%.

A second argument for buying Treasuries advanced by some Fed officials is that it is the least bad option for quantitative or credit easing.  They reason that buying Treasuries does not distort relative pricing, avoids market dislocations resulting from the support for one asset at the expense of another, and does not risk compromising the Fed’s independence.  For example, Federal Reserve Bank of Richmond President Lacker recently objected to the Fed’s credit facilities like the Commercial Paper Funding Facility and the TALF as intrusions into private sector lending decisions.  He noted that “this risks entangling the Fed in attempts to influence credit allocation, thereby exposing monetary policy to political pressure”.  Philly Fed President Plosser appears to share this view.  Lacker’s and Plosser’s objections are legitimate, but there is a trade-off between those risks and the effectiveness of targeted credit easing versus quantitative easing by buying Treasuries.  Moreover, the arguments about pricing distortions are relative; massive buying of Treasuries will create other distortions in market pricing.  Generally, however, the majority of Fed officials probably want both weapons in their arsenal, given the uncertainty over policy effectiveness and the need to be nimble to address the crisis.

The Bank of England’s gilt purchase announcement in early March shows that such actions can be effective.  The Bank of England announced an asset-purchase program with a ceiling of £150 billion, with £75 billion of purchases to be made within the coming three months.  In total, the BoE aims to buy at least £50 billion of private assets such as corporate debt, as envisaged in the existing Asset Purchase Facility. But it acknowledges that the large majority of the first £75 billion will have to be government bonds, given the three-month timeframe (see Quick Comment: Quantitative Easing (and a Rate Cut) and “An Arch-QE in the UK”, UK Interest Rate Strategist, March 5, 2009).  The BoE’s £75 billion amounts to about a third of all conventional gilts outstanding in 5-25-year maturities, or about 5% of UK GDP.  Using either metric, an equivalent US Treasury purchase program would scale up to about US$700 billion.

The key aim of the BoE’s QE plan is to boost money and credit supply and restart lending.  From its standpoint, declines in gilt yields are a subsidiary effect, as longer-term yields matter less for the UK economy than they do in the US.  But on that secondary metric, so far the plan looks successful; 10- and 20-year gilt yields tumbled 50-70bp in a few days after the announcement, and UK longer-term private yields have come down in tandem.  The BoE is formally committed to implement this plan, so gilt yields aren’t likely to back up significantly for now; of course, if gilt yields back up because the BoE achieves its goals, that would be a mark of success rather than cause for alarm.  Such a UK experience would contrast with what happened in the US, where 10-year Treasury yields plunged following strong hints from the Fed that it might buy Treasuries, only to reverse when action wasn’t forthcoming. 

Buying Treasuries can be implemented quickly to bridge the gap until other programs are in place.  Backstopping liabilities, restarting the securitization markets with the TALF, and helping to clean up and recapitalize lenders’ balance sheets are key to alleviating the credit crunch, but they’ll take time to implement and work.  The TALF is especially important, but it appears that it will start slowly.  The TALF process has been fraught because the facility is complex and because TARP funds are used to provide capital to its Special Purpose Vehicle. Using TARP funds involves Congressional oversight.  While the Fed dealt with some issues related to eligibility of collateral and oversight of hedge funds’ books last week, suspicions over executive compensation limits and intrusive oversight are making would-be participants reluctant to participate. 

What about the arguments against buying Treasuries?  First is the question of manageability; another US$700 billion on the Fed’s balance sheet might not be nearly enough, and purchases in the trillions would balloon the Fed’s balance sheet.  The Fed is already committed to the high-priority TALF and MBS programs, which will expand the Fed’s balance sheet by US$1.5 trillion or more.  A US$4-5 trillion balance sheet might not be easy to manage under current circumstances.  And unwinding such large purchases might pose balance-sheet management challenges when the ‘exit strategy’ will inevitably be required. 

Second, any future backup in rates would eventually inflict capital losses on the Fed if it held Treasuries acquired at low yields.  Moreover, notwithstanding the Bank of England’s success so far, some may even doubt the short-run effectiveness of Treasury purchases, because term premiums are low and there is no guarantee that riskier private rates will follow.  Just as intruding in credit decisions could jeopardize the Fed’s independence, so too could monetizing deficits over any period of time.  And pushing Treasury yields below what fundamentals dictate could set the stage for a sizable snapback when the economy turns.

In our view, such objections ring hollow.  The Fed intends to address the need to manage its balance sheet by asking Congress to give it additional flexibility.  A recent joint statement noted that “Treasury and the Federal Reserve will seek legislation to give the Federal Reserve the additional tools it will need to enable it to manage the level of reserves …”  As we’ve noted elsewhere, in practice, such legislation is likely to involve one or more of the following: 1) authorize the Fed to issue its own bills; 2) extend the Supplementary Financing Program and devise a way to avoid debt ceiling constraints; and 3) expand payment of interest on reserves to include non-bank institutions (such as the GSEs).  One or more of these changes should allow the Fed to eventually start to hike the target rate for fed funds – even with a bloated balance sheet.  The other risks noted above pale by comparison with the risk that the financial system remains impaired and that recovery remains elusive.  Given the ongoing seriousness of the financial crisis, Fed officials will continue to use all tools at their disposal to mitigate the impact on the economy.  Buying Treasuries is one of those tools, and the potential benefits seem to outweigh their costs, especially given the Fed’s need for flexibility.

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