Relevant and even prescient commentary on news, politics and the economy.

This week’s Greek tragedy

This week, the single most important event in global bond markets was the S&P downgrade of Greece’s long-term debt obligations, A- to BBB+. Moody’s is the last of the major rating agencies to hold Greek debt in the A-category of investment grade (currently at A1); but a major decision from Moody’s could come within weeks. This would make Greece the lowest-rated country in the Eurozone, and the only one with 6-B status.

Since the beginning of the month, the Greek 5-Yr government bond jumped over 1% to 5% by Friday.

The chart illustrates comparable 5-yr government bonds across the Eurozone. Interestingly, the region (ex Greece) remained rather resilient to the news. However, Greece is not alone; and its growing government financing problems are in good Eurozone company.

According to the European Commission’s autumn 2009 Economic Forecast, only 5 of the 16 Eurozone countries are expected to remain below the 60% debt limits of the Treaty on European Union in 2010, while just 3 will satisfy the 3% deficit limits.The most imminent issue for Greece, with its new BBB+ status, is eligibility for ECB’s collateralized loans. In October 2008, the ECB dropped the minimum credit rating for eligible collateral on its credit facilities from A- to BBB-. However, Greece’s downgrade to the next tier of investment grade status (BBB+ by S&P) now makes it ineligible for the ECB’s credit programs if the temporary measure is repealed. Obviously, this is a problem for Greece; but it is a growing problem for the ECB as well.

I see two problems forming. First, the pressure to drop deficits and leverage will be overbearing in Europe, especially in the UK. Dropping debt levels will be important after the recovery is well underway; but before that, and a fledgling economic recovery may be cut short. Second, if investors do start to question the ability of governments to service debt (recently in Greece), financing costs in other struggling countries, like Spain, Portugal, or Italy (and some of the others circled above), could rise swiftly and pressure budgets further.

The Wall Street Journal wrote a nifty little article about the time spent trying to regain a higher rating after a downgrade occurred:

Sovereign upgrades, meanwhile, can take a long time: Greece’s rating took nine years to move one notch upward to triple-B in the 1990s; Australia lost its triple-A rating in 1986 and saw 17 years pass before it was restored.

Years, that’s how long it will likely take Greece to “implement a credible medium-term fiscal consolidation programme”. And it is very possible that Greece will see further downgrades before upgrades.

This is a problem for the ECB – it will be interesting to see the ECB push a credible exit with Greece’s credit rating squelching the expiration of the temporary collateral requirements. Fun times ahead!

Rebecca Wilder

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Household leverage: US vs. UK

Households in the US and the UK are members of the “most levered club”. But put their balance sheets side-by-side, and the outlook for the US economy looks a little brighter than that for the UK. Why? Both are dropping debt burden, but a qualitative analysis suggests that the UK household leverage (probably) should be falling at a more accelerated pace.

The chart illustrates leverage in the US and UK, or household debt (loans) as a percentage of disposable income (DPI) through Q3 2009 and Q2 2009, respectively (the UK releases Q3 Economic Accounts at the end of December). By Q2 2009, UK and US households dropped leverage rather coincidentally, -4.8% and -4.4%, respectively. However, the debt bubble was bigger in the UK than in the US, peaking at 160% of DPI compared to 131% in the US. Why isn’t leverage falling more quickly? Spending.

To be fair, UK Q3 statistics may paint a very different picture. However, that is unlikely, given that real retail sales continue to grow, 3.2% at an annualized rate in the three months ending in October.

Oh, it all makes sense now: UK retail sales remained firm in 2009, and real home values hit a (probably local rather than global) cyclical low much earlier than in the US.

This is an ominous sign for the UK economy. Households are kicking the can down the road: de-leveraging – paying down debt by dropping consumption and saving a relatively higher share of income – is inevitable.

Rebecca

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Sit back and relax: the US and China, this is gonna take awhile

China exported its way to a $2 trillion dollar fortress of F/X reserves ($USD mostly), while the US borrowed its way into a hole deep enough to spark a vast global recession. Who’s to blame?

Given the symbiotic relationship in the chart above, it’s hard to blame any one individual, group, or even country. But blame we do. Martin Wolf, at the Financial Times, wrote an interesting article about the need for a “co-operative adjustment” of global current account deficits and surpluses. He argues the following:

China’s exchange rate regime and structural policies are, indeed, of concern to the world. So, too, are the policies of other significant powers. What would happen if the deficit countries did slash spending relative to incomes while their trading partners were determined to sustain their own excess of output over incomes and export the difference? Answer: a depression. What would happen if deficit countries sustained domestic demand with massive and open-ended fiscal deficits? Answer: a wave of fiscal crises.

It sounds so imminent: re-balance now, or else. Sure the tides of portfolio flows must change; structural current account imbalances are now proven to cause economic catastrophe, as illustrated by the 2-yr case study of late. But it’s not going to happen over night. It takes a long time for re-balancing of any kind to fully pass through. Just look at Japan in the 1990′s.

Data note: you can download Japan Flow of Funds data here, and US Flow of Funds data here.

The chart above illustrates the debt bubbles in the US financial crisis and in 1990′s Japan. In Japan, the households didn’t accumulate as much debt relative to the non-financial business sector; however, both sectors dropped leverage. And notice, that it took about a decade for households and firms to do so.

What’s overly obvious is that the Chinese will not be bullied into revaluing the yuan just because the US says so. And also evident is that there is a (very lengthy) de-leveraging process underway in key economies. By default, the debt-reducing developed world will force the Chinese to focus policy more inward (domestic demand) and less outward (export demand), as US consumers drop debt levels. But sit back and relax, it’s gonna be a while.

Rebecca Wilder

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Too efficient NOT to consolidate

Cross-posted at News N Economics blog, by Rebecca

Here’s yet another historical record broken in 2009:

“Only three insured institutions were chartered in the [third] quarter, the smallest quarterly total since World War II.”

This fact is from the FDIC’s latest Quarterly Banking Profile. There are probably non-economic reasons for this, i.e., the application process to qualify as a new charter institution (see the types of charters here) is likely much more stringent than in previous years; but nevertheless, this fact reiterates the trend in the number of banking institutions, most definitely down.

The FDIC is awash in problem institutions. The well reported number of bank failures jumped to 132 in 2009 (as of November 20, and you can find the data here). However, that’s just share of the much larger “problem”. According to the same quarterly profile, there are now 552 “Problem” institutions in the FDIC charter system holding $346 billion of assets on balance – that’s 2.4% of nominal GDP.

As such, it seems that consolidation is all but a foregone conclusion. But watch out, because the new 4-letter-style phrase, “too big to fail”, is heavy on the tongues of US policymakers. Senator Bernard Sanders (Vermont) introduced the “Too Big To Fail Is Too Big to Exist” bill last month, which defines such an institution as (see the bill here):

“any entity that has grown so large that its failure would have a catastrophic effect on the stability of either the financial system or the United States economy without substantial Government assistance.”

Ahem, so how big is that? Peter Boone and Simon Johnson at the Baseline Scenario define “too big to fail” as bank liabilities amounting to 2% of GDP (roughly):

“So to us, 2 percent of G.D.P. seems about right. This would mean every bank in our country would have no more than about $300 billion of liabilities.

A large American corporation would still be able to do all its transactions using several banks. They would even be better off — competition would ensure that margins are low and the banks give the corporates a good deal. This would help end the situation where banks take an ever-increasing share of profits from our successful nonfinancial corporations (as seen in the rising share of bank value added in G.D.P. in recent decades).”

But there are economic efficiencies, like scale economies, that need to be considered. David C. Wheelock and Paul W. Wilson at the St. Louis Fed find statistically significant increasing returns to scale (i.e., bigger banks, lower costs) in the US banking system. They use a non-parametric estimator to estimate a model of bank costs and find the following (link to paper, and bolded font by yours truly):

“The present paper adds to a growing body of evidence that banks face increasing returns over a large range of sizes. We use nonparametric local linear estimation to evaluate both ray-scale and expansion-path scale economies for a panel data set comprised of quarterly observations on all U.S. commercial banks during 1984-2006. Using either measure, we find that most U.S. banks operated under increasing returns to scale. The fact that most banks faced increasing returns as recently as 2006 suggests that the U.S. banking industry will continue to consolidate and the average size of U.S. banks is likely to continue to grow unless impeded by regulatory intervention. Our results thus indicate that while regulatory limits on the size of banks may be justified to ensure competitive markets or to limit the number of institutions deemed too-big-to-fail, preventing banks from attaining economies of scale is a potential cost of such intervention.”

Better put: the cost of consumer and firm loans will be higher in the long run if too much intervention prevents the banking system from capturing scale economies. Furthermore, they suggest that even the largest institutions experience increasing returns (i.e., these).

I should say that I have absolutely no experience in non-parametric estimation and cannot vouch for the econometrics. However, the results are timely; and furthermore, the Federal Reserve Bank of St. Louis’ economics research is well-regarded. Point: I trust it.

As a note, David Wheelock wrote a very interesting piece a while back about the inefficiencies of mortgage foreclosure moratoria during the Great Depression …interesting stuff (paper link here).

Rebecca Wilder

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Are exporters in Asia real-ly losing their competitive edges?

by Rebecca

Central banks across Asia are concerned and actively engaged in some kind of currency manipulation – direct intervention, quasi-capital controls, and/or public speech (I will refer to this later, but RGE published a great article to the fact) – as investors flock to global capital markets seeking the “risk-on” trade. Central banks are attempting to stem the sometimes sharp currency appreciation, however, real exchange rates remain competitive.

Over the last three months, the $USD has dropped 3.6% against the Singapore dollar, 4% against the Malaysian ringgit, 6.1% against Indonesian rupiah, 1.9% against the Thai baht, 3.6% against Indian Rupee, 6.8% against the Korean won, and 1.8% against the Taiwan dollar.

The chart illustrates the trend in key Asian (not including China, whose exchange rate is explicitly pegged at 6.83 since July 2008) nominal exchange rates (measured in local currency units per $USD) – appreciating , which has Asian export industries worried. Central banks are intervening (in some cases through direct $USD purchase), where further intervention is a near certainty as many of these countries see export growth as the impetus to recovery. As such, and according to RGE last week, Asian central bankers are faced with a dilemma:

Despite a flood of portfolio investments into many of the region’s asset markets since early 2009, Asia still needs foreign capital to stimulate investment and finance its current accounts. Therefore, facing a sluggish export recovery and a pegged Chinese renminbi, most countries have opted to contain currency appreciation via verbal and actual interventions to avoid losing competitiveness. Intervention in the foreign exchange market has led to record reserve growth of over US$70 billion in Q3 alone in emerging Asia ex-China. Although most Asian countries are expected to keep intervening amid some currency appreciation, several countries may impose restrictions on foreign currency transactions. Given buoyant equity markets, attractive carry trades and the U.S. dollar weakness, policy measures will not contain the impact of capital inflows on Asian currencies, meaning that some appreciation from the least trade-dependent countries is to be expected. Taiwan is the country where capital controls or new restrictions are most likely to be implemented.

True, Asian nominal exchange rates are appreciating (sharply in some cases); but what one needs to consider is the real effective exchange rate. Actually, real effective exchange rates (taking also into account relative prices) remain rather competitive. In fact, only Indonesia and South Korea are experiencing any substantial real appreciation, and South Korea’s coming off of a very low base.

The chart above illustrates the real exchange rate: the nominal exchange rate defined in units of home currency per unit of foreign currency * (foreign price level)/(home price level). A movement up indicates a real appreciation of the local currency against the country’s trading partners.

Real exchange rates in Malaysia, Thailand, Taiwan, and India fell in the latest monthly data point; and furthermore, some are seeing the downward trend intact. Indonesian policymakers are worried – the sharp appreciation of its currency is growing the real exchange rate quickly.

It’s a complicated policy world out there – a hodgepodge of monetary stimulus, capital controls, and fiscal deficits. Something’s gotta give; and my bet’s that it will not be the currency. Direct intervention and further capital controls are on the way in Asia in spite of the need for foreign-sponsored domestic investment.

Rebecca Wilder

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LABOR’S SHARE

By Spencer (2009)

 

The issue of a jobless recovery is getting a lot of attention recently.

I’ve found the best way to look at the issue is to compare the change in real growth and productivity over the long run. There have been three periods of different productivity trends in modern US economic history.

Prior to about 1973 productivity growth averaged 2.8%. In the second or low productivity era, running from 1974 to 1995, productivity growth slowed to 1.5% before rebounding to 2.4% since 1995.

But real GDP growth also slowed over this period. As a consequence, the ratio of real GDP growth to productivity growth fell from 68% in the early strong productivity to 50% in the weak productivity era before rebounding to over 80% in the most recent era. Basically, real GDP growth equals productivity growth plus hours worked or employment growth. A consequence of stronger productivity in an era of weaker GDP growth this suggests that each percentage point increase in real GDP growth generates a much weaker increase in hours worked or employment. Currently, a percentage point increase in real GDP growth now generates under a 0.2 percentage point increase in hours worked versus 0.3 in the pre-1974 era and 0.5 percentage points in the low productivity era.

But to a certain extent comparing productivity and real GDP is comparing apples to oranges. To be accurate one should look at productivity versus output in the nonfarm sector. GDP includes the farm sector of course, but also the nonprofit and government sectors where productivity is assumed to be zero.

If you look at what happened in the 1990s and early 2000s recoveries in the nonfarm business sector, you see that productivity growth significantly outpaced output growth in the early recovery phase of the cycle. As a consequence hours worked or employment fell, generating the jobless recoveries. It looks like the problem in these two cycles was much weaker growth rather than strong productivity.


This shift to an environment of stronger productivity and weaker real growth generated an interesting development that has received little attention among economists or in the business press.

This development was a secular decline in labor’s share of the pie. Prior to the 1982 recession there was a strong cyclical pattern of labor’s but it was around a long term or secular flat trend. But since the early 1980s labor’s share of the pie has fallen sharply by about ten percentage points. Note that the chart is of labor compensation divided by nominal output indexed to 1992 = 100. That is because the data for each series is reported as an index number at 1992=100 rather than in dollar terms. So the scale is set to 1992 =100 rather than in percentage points. But it still shows that labor payments as a share of nonfarm business total ouput has declined sharply over the last 20 years and prior to the latest cycle we did not even see the normal late cycle uptick in labor’s share.


If this chart gets a lot of attention it will be interesting to see how the libertarian and/or conservative analysts who keep coming up with all types of excuses to explain away the weakness in real labor compensation in recent years explain this away. If you really want to raise a stink you could look at this as a great example of the Marxist immiseration of labor that Marx believed was one of the internal contradictions of capitalism that would eventually lead to its self destruction.

additional chart in response to comments.

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Big week for currency intervention measures

by Rebecca

Policymakers across Latin America are announcing measures to stem currency appreciation against the $US. Since March 2009, the $US depreciated 25% against the Colombian peso, 28% against the Brazilian real, 14% against the Mexican peso, 12% against the Peruvian nuevo sol, and 11% against the Chilean peso.

Much of the $US’s lost value is due to a renewed risk appetite as the “flight to (US) quality” unwinds somewhat. Even so, emerging market policymakers are worried; and governments across the region are stepping up to halt the appreciation either directly (Peru) or with quasi-capital controls (Brazil).

The Brazilian government announced a 2% tax on foreign capital flows into the domestic fixed income and equity markets. And to Brazil’s northwest, the Colombian central bank on Friday announced plans for direct intervention in the foreign exchange market to the tune of 3 trillion pesos (only after lesser and indirect measures announced the previous week proved only transiently effective). And Peru’s central bank has been purchasing $US on a regular basis since September 2009.

As the chart above illustrates, the Banco Central de Reserva del Perú has been very successful in stemming the appreciation. Colombia’s initial efforts (like halting the repatriation of foreign dollar holdings) were successful but only to a point – the peso fell almost 4% against the $US; but since then, the peso has settled to around 1917 Peso/$US. Brazil’s efforts, however, did little to break the trend of the real: the $US appreciated roughly 2% in the wake of the capital tax announcement, but the BRL (the real) gained back every bit of value that it lost in about 2.5 days. As one of my colleagues said, “you can’t submerge a beach ball”.

I suspect that Colombia’s direct intervention announced on Friday will successfully drive down the value of the peso, as the foreign capital inflows are primarily from $US-denominated government bond issues (little equity flows). It’s kind of interesting that the government is concerned about the appreciation of the peso but issuing debt denominated in $US…….

Brazil’s capital markets are too big and too enticing to foreigners right now (see charts below) – more direct measures are needed to stop the BRL’s appreciation. We will see if the Banco Central do Brasil goes there – Asia’s certainly doing it!

Text added: The charts illustrate the EXTERNAL bond and equity issuance by country as a share of total issuance in Latin America from the IMF Global Financial Stability Report.

Rebecca Wilder

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Foreign exchange reserves are hot hot hot

by Rebecca

The G7 G20 Leader’s statement, number 20., regarding the IMF’s mission and governance (bold font by yours truly):

The IMF should continue to strengthen its capacity to help its members cope with financial volatility, reducing the economic disruption from sudden swings in capital flows and the perceived need for excessive reserve accumulation. As recovery takes hold, we will work together to strengthen the Fund’s ability to provide even-handed, candid and independent surveillance of the risks facing the global economy and the international financial system.

Last week I was in New York talking with Emerging Market strategists and economists. Most of them attended the IMF meetings in Istanbul, Turkey – according to them, the monster takeaway from the meetings was that the sky’s the limit in terms of FX reserve accumulation (in EM economies). Put this way, the IMF is unlikely to be successful in its aforementioned goal of preventing the “need” of excess reserves, at least over the near term.

Key markets in Asia (China, or South Korea) and Latin America (Brazil) remained rather resilient to the credit crunch late in 2008 due to sufficient (even excessive) reserves holdings. Brazil, for example, was able to supply private-sector financing needs by draining FX ($USD) reserve holdings. South Korea and other Asian economies, too.

The chart below illustrates reserve holdings across key countries in LATAM (Latin America) and Asia – notice the sharp drop at the end of 2008.


It’s an incredulous thought: that policy makers in EM countries – whether the reserve accumulation was for precautionary reasons (LATAM) or stemming from export-led growth (Asia) – won’t be filling the reserve coffers at increasing rates; the process is already underway.

Reserves in Brazil are now 230% higher than they were in 2007 (January), 197% in China, 190% in Thailand, and 163% in Hong Kong. Hong Kong is interesting; amid their strict dollar peg, the Hong Kong Monetary Authority is accumulating reserves faster than most countries (Hong Kong will be the country to watch as the peg against the dollar is sure to result in some inflationary pressures, given that Hong Kong’s economic fundamentals are stronger than those in the US at this time – another post).

Record inflows of late into EM financial markets (bonds and equities) are providing plenty of liquidity and contributing to reserve accumulation of late. However, having sufficient FX reserves has proven to be the best insurance out there against a stoppage in external financing. And as long as inflation pressures remain muted, acquiring reserves is not too costly economically (there are administrative costs, though, from sterilization when US Treasury rates are near zero).

The Treasury recently released the Semiannual Report on International Economic and Exchange Rate Policies; it states that officially no foreign central bank has explicitly manipulated their currency since 1994 but pointed the finger at China for their currency policies that inhibit the unwinding of global current account imbalances. An excerpt from page 3:

Although China’s overall policies played an important role in anchoring the global economy in 2009 and promoting a reduction in its current account surplus, the recent lack of flexibility of the renminbi exchange rate and China’s renewed accumulation of foreign exchange reserves risk unwinding some of the progress made in reducing imbalances as stimulus policies are eventually withdrawn and demand by China’s trading partners recovers.

It’s farcical to think that the G7 can browbeat EM countries into curtailing excessive reserve accumulation. To be sure, export growth is simply not going to grow China at rates sufficient to maintain jobs growth (9% or so) and reserve balances are likely to be increasingly focused inward domestically (supporting the financial system, local governments, etc.). However, what seems to be very real is that targeted reserve accumulation, in whatever currency but still heavily weighted in $US, buffered EM countries from catastrophe and is not going away.

Rebecca Wilder

P.S. for those of you who want to know a bit more about reserve accumulation in China, Brookings wrote a nice topical piece earlier this year.

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The Fed’s attempt to assuage inflation fears that don’t need assuaging

by Rebecca

There is no shortage of speeches by US central bankers these days. The following is an excerpt from a NY Times article that highlights the debate among key Fed officials about the speed and method of stimulus withdrawal once the decision to exit has been made:

Mr. Bernanke and other officials want to see evidence that the economic recovery is self-sustaining, strong enough to generate jobs without the crutch of extremely low interest rates.

But Mr. Warsh, as a Fed governor, has begun arguing that the central bank cannot afford to wait for irrefutable evidence of a solid expansion. Mr. Warsh recently argued that the Fed should take at least some of its cue from stock prices and other financial indicators, which turn around earlier and more quickly than the underlying economy.

Mr. Warsh and some other Fed officials also argue that when the time does come to change gears, the central bank may have to raise rates almost as fast as it slashed them when the crisis began.

We are far from seeing “irrefutable evidence of a solid expansion”. This debate is likely confusing the public more than anything else, or as my title puts it: the Fed is attempting to assuage inflation fears that don’t need assuaging. There is simply no measured inflation concern at this time, not even over the next ten years.

The chart illustrates the 30-day moving average of expected inflation for the next 5, 7, 10, and 20 years. Expected inflation, roughly speaking, is the nominal Treasury Security rate minus the associated Treasury Inflation-Protected Security (TIPS) rate, the real rate of return or the break-even rate. Technically this break-even rate is not a perfect measure of inflation expectations; but it’s close and measured daily (see this SF Fed article for more on TIPS).

The “inflation problem” is way overstated in the media. Roughly speaking, markets have priced in just 1.3% annual inflation each year over the next five years, 2% over the next ten years.

By giving speech after speech (Bernanke’s latest), the Fed is attempting to keep inflation expectations in check. However, the Fed is walking a fine line between alleviating concerns about long-term inflation prospects and overemphasizing the short-term disinflation (deflation) risks.

Rebecca Wilder

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The Fed called a mulligan

by Rebecca

Ex post, it is obvious that the Fed was way too tight in the second half of 2008. To be sure, the FOMC was actively engaged in its standard easing policies; however, the Fed got the Treasury to aid in its sterilization efforts, and later the Fed fast-tracked the interest on reserves (IOR) program (originally set for an October 1, 2011 start). The Fed was misguided in its sterilization efforts, as aggregate demand was already collapsing.

Something was afoot well before the collapse of Lehman Brothers. David Beckworth at Macro and Other Market Musings backs up Scott Sumner’s (TheMoneyIllusion blog) theories with an intuitive analysis using the equation of exchange (MV = PY):

Below is a table with the results in annualized values (Click to enlarge):

This table confirms what we saw in the levels: a sharp decline in velocity appears to be the main contributor to the collapse in nominal spending in late 2008 and early 2009 as changes in the monetary base and the money multiplier largely offset each other.

… (And a little later)

Unfortunately, though, it appears the Fed was so focused on preventing its credit easing program from destabilizing the money supply that it overlooked, or least underestimated, developments with real money demand (i.e. velocity). As a consequence, nominal spending crashed.

This line research essentially posits that the Fed got it terribly wrong in the second half of 2008. As David shows in the table above, the velocity of money was dropping with households clinging to cash under heightened economic uncertainty.

If this theory is true, then one could view the $300 billion Treasury buyback program (see the NY Fed’s Q&A here) as the Fed’s equivalent of “calling a mulligan” in an attempt to take back its sterilization efforts in 2008.

The $300 billion buyback of Treasuries will restock about 75% of the Fed’s Treasury holdings (focused in notes and bonds rather than bills, but there is a contemporaneous objective to pull long rates down) that dwindled previous to the onset of the SFP account. Unfortunately, though, it was already too late.

(The Treasury issued short-term notes and deposited the proceeds with the Fed in order to aid in the Fed’s sterilization efforts – see an old post of mine for a more thorough explanation of the SFP, or the Supplementary Financing Program.)

Another event recently occurred that would support the view that the FOMC is backpedaling: the Treasury’s Supplementary Financing Program (SFP) is going bye bye.

The Treasury started this week to unwind its account with the Fed (the SFP listed on the liabilities side of the Fed balance sheet). This is almost surely going to end up as excess reserve balances in the banking institution, as the Fed is unlikely to sterilize these flows. (Note that one could see if the Fed was sterilizing the flows if its Treasury holdings started to fall again.)

I guess that the real question is: where would we be now if the Fed had pushed harder on the money supply in 2008? I imagine that Angry Bear readers have many thoughts on this.

Rebecca Wilder

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