The second round of quantitative easing has started quietly before two weeks when the FED announced that it will invest the proceeds the payment from mortgage portfolio into buying treasury bonds increasing the liquidity in the markets.
The second phase of quantitative easing may proceed in a different way compared to the first. The central idea behind the first phase of quantitative easing was to reduce the risk in bank's balance sheet. Federal bank bought the mortgage portfolio worth 1.7 trillion from banks. This reduced the risk in banks balance sheet replacing the risky assets in the form of mortgage securities by the so called risk free treasuries. This innovative step taken by Fed went to a long way in freeing up the intra bank lending market which froze up after collapse of Lehman Brothers and AIG. The solution was very effective and within six months the banks started working normally and a global financial meltdown was averted.
The current circumstances are seemingly different from what existed in September 2008. The current macroeconomic scenario is marred by high unemployment, rising home foreclosure and falling consumption. These three factors are interrelated and feed each other. Let us first look at consumption.
The anemic consumer demand is the result of over leveraged consumer. The Debt to GDP ratio for US household is more than 132%. Around 17% of working age population is either unemployed or under-employed. This has reduced the personal disposable income which reflects into anemic consumer demand. Therefore consumer demand will remain anemic unless the unemployment rate goes down and their net worth increases.
To add to the disaster home prices are low and they may start falling. Home is the largest investment of US household and accounts for over 40% total house hold net worth. The total net worth of US house hold has fallen from 65 trillion to 54 trillion USD which is 21% lower. Current house prices are 25% lower than the peak prices and the fear is that they may resume their down ward journey.
It is estimated that 4 million homes are currently lying vacant and are up for sale with more than 5.3m households are currently delinquent on their mortgage. Add 2.5m that are already going through the foreclosure process, and a total of 7.8m households are in danger of losing their home. This is more than 11.8 million house hold up for sale, which is equivalent to more than 2 years of inventory.
It is the simple law of economics that when the supply is more the prices will fall. If home prices fall further, it will erode net worth of US house hold which will further inflate their debt burden. Therefore the US government is trying its best to clear the inventory by providing tax incentive to new buyer which recently lapsed in April 2010.
At the same time the banks are following the policy of extend and pretend i.e. trying to extend foreclosure over a period of two to five years and pretending that Home prices will rise during this period which will reduce foreclosures and home inventory. The house hold net worth will rise only if the home price rise which won’t happen unless excess home inventory is cleared. To clear excess housing inventory we need unemployment to come down which won’t happen unless consumer spending and demand increases.
The third problem is that of unemployment. When the housing industry was booming it employed 8 million workers. This has now fallen to less than six million. With demand for commercial and residential property decreasing and inventory increasing the demand for new construction is at all time low. Therefore it would be very difficult for people who got laid off to adapt to other industry and find jobs. Therefore the current level of unemployment is structural rather than cyclical. This structural unemployment will persist until people are able to retool their skills and get absorbed in other industry.
It must also be noted that in 7 out of last 8 recession housing was the leading sector in bringing US economy out of recession. This time is going to be different. There is no way that construction activity will pick in near term due to the excess inventory which is equivalent to next two years of demand. Since we have realized that the problems concerning US economy are structural, it would be difficult for Fed to cure them with monetary policy.
In the second phase of quantitative easing may take one of the three forms or a combination of all three.
Firstly, Fed will purchase US Treasury there by flooding the bank balance sheet with excess cash. The US banks are currently holding excess cash reserves of over 1 trillion dollar but these excess reserves have failed to translate into new lending. This has happens primarily due to two reason.
1) The banks are already sitting on unbooked loss in assets they are holding in their balance sheet. The government has allowed the banks to value assets as per their valuation model instead of marking them to market. But the intrinsic value of these assets (Commercial backed mortgages) etc has declined significantly in last two years. The banks are holding excess cash to cover for their future loss.
2) As we have already seen that the consumers are over leveraged and they are facing unusually uncertain time they are reluctant to take more loans which is perfectly logical.
Therefore any further easing by increasing the banks reserve will be only marginally effective. The banks may resume taking some more risk by lending to risky borrowers but that can only have a marginal impact on the consumption.
Secondly, the fed may again choose to buy more mortgage securities from the market which have marginal impact on housing mortgage market. At present the visibility of this action seems to be low as Fed's balance sheet is already cluttered with these high risky investments.
Thirdly, the fed may also reduce rates it pays to bank on cash deposited by these banks in order to induce them to lend more. Since this is not the reason why banks are not lending this will not cure the problem.
Lastly, the fed may keep the rates low for an extended period of time. This will help banks to recapitalize their balance sheet. As we all know that banks borrow form FED at 0.10% and invest them in treasury securities at 2.5% which helps it to recapitalize their balance sheet at taxpayer’s expense. Therefore by keeping rates low FED will enable bank to repair their balance sheet, but this may not induce banks to lend aggressively.
Therefore we can see that monetary policy is largely ineffective in current environment. No matter what the FED does it cannot force the banks to lend nor, it can force consumer to take more debt and spend. It will take years for the market to digest the current excess and resume on a normal growth path. I think further monetary easing in the form of QE - II will prove to be futile.
The only policy option which is left is of Fiscal stimulus options. The government may embark on a massive subsidization program by giving subsidy to home owners to prevent them from foreclosing homes or induce them into buying cars. US government has already tried this approach and it has only been able to generate a temporary bump in the market which eased away as soon as these programs expired. The subsidy given was completely insignificant to cover the damage done by falling net worth.
Only if the government attempts these programs on massive scale which are 20X higher than the current scale they may have substantial impact on the economy. Such a transfer will result into government taking more debt to subsidize house holds which will ultimately benefit banks as will get full value of loans which are currently impaired. This may be the biggest wealth transfer in the history if undertaken.
But given the precarious fiscal situation of US government and already high deficit to GDP ratio it would be impossible for the government to increase the fiscal stimulus to such an extent.
In absence of any policy decision by the government the economic growth will keep on swinging between growth and de-growth. We will see a phase of what we call a muddle through economy where structural unemployment will remain high, debt will remain high and equity markets will have sharp rallies and sharper pull back while overall going nowhere in next decade.
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