Koo and Gross on what Bernanke will do next

Posted by John McDermott on Jun 22 17:54. 2 comments | Share

Apologies for the public school levels of surname chicanery in the title but a couple of big hitters have weighed in before the Fed Chairman’s special appearance on US Markets Live on Wednesday.

Richard Koo, chief economist at Nomura Research Institute and analyst-in-chief of “balance sheet recessions”, More…

Apologies for the public school levels of surname chicanery in the title but a couple of big hitters have weighed in before the Fed Chairman’s special appearance on US Markets Live on Wednesday.

Richard Koo, chief economist at Nomura Research Institute and analyst-in-chief of “balance sheet recessions“, writes in his latest note that the Fed’s lack of options today is reminiscent of the BoJ’s predicament a decade ago.

Koo argues that although its consumers are deleveraging and its house values are declining, it’ll take the US longer than generally assumed to return to trend growth. Especially since, if Japan’s balance sheet recession is any guide, the adjustment in asset values may overshoot on the downside.

So what’s a Fed Chairman to do? Well, according to Koo, apparently Bernanke has to do something, even though he knew all along that quantitative easing doesn’t do much in these situations.

The paucity of policy options is reminiscent of the situation facing the BOJ ten years ago.

Fed chairman Ben Bernanke understands that monetary accommodation during a balance sheet recession has little impact apart from the portfolio rebalancing effect. After all, neither employment nor the money supply has grown meaningfully despite aggressive quantitative easing and two and a half years of zero interest rates.

The portfolio rebalancing effect did lift stock prices and commodity prices initially, but there has been no corresponding recovery in the economy or corporate earnings.

Unfortunately, that means the increase in equity and commodity prices was little more than a bubble created by central bank actions. Some of those assets now appear to be correcting, as it is difficult to justify current share prices on a discounted cash flow basis without a full-fledged economic recovery.

I suspect the Fed chairman, who must do something despite his awareness of the limitations of quantitative easing, is in asimilar predicament. While this is just speculation on my part, I think he may be considering leaving the $600bn in liquidity in the market as long as possible while, on a microeconomic level, seeking a way to better target the funds supplied by the Fed.

By “on a microeconomic level” Koo means that Bernanke may look at recapitalising smaller US banks, which would be yet another bold move by the Fed into the world of fiscal policy.

According to the Fed chairman, the Troubled Asset Relief Program (TARP) that was first applied to the large banks in November 2008 was extremely unpopular because it was caught in a political cross-fire and the authorities failed to convince the public that the program was actually needed. As a result, little was done to address the shortage of capital at smaller banks.

But the problems in the US banking sector will continue until this issue is dealt with. When the BOJ faced exactly the same problem in 2009, it had banks issue subordinated loans that were then underwritten by the BOJ in order to address a capital shortage and overcome the credit crunch. This highly unusual policy came about when the Aso administration’s proposed injection of capital into the banks, designed to resolve the credit crunch that followed the Lehman-inspired financial crisis, was largely ignored by banks. The banks ignored the policy because they had developed a strong distrust of the FSA following the drastic changes that began during the Koizumi administration.

Ultimately, few banks took advantage of the BOJ’s program, as Japanese banks were not deeply involved in the subprime mess and were therefore able to recover quickly from the subsequent financial crisis. In the US, in contrast, many smaller financial institutions continue to suffer from a shortage of capital.

I suspect that initially the Fed intended to discontinue QE2 as the economy gradually recovered, but was forced to reconsider after the gloomy jobs report released at the beginning of June. With the usual macroeconomic monetary measures proven to be ineffective, the Fed now needs to come up with new microeconomic policies for the post-QE2 era. Here it all depends on the kinds of ideas that emerge. In this area, it will not be surprising if the Fed begins providing assistance to smaller financial institutions, which it has been concerned about for some time.

QE 2.5, anyone?

Meanwhile, another big hitter is conveniently out in front of Wednesday’s Bernanke presser. This is from today, not 2010:

Nor is it related to Gross’ froggy Treasuries strategy, of course.

Koo note in the usual place.

Related links:
Richard Koo goes unconventional on China – FT Alphaville
Richard Koo: Trying to Warn Bernanke & Goolsbee – Washington Note

Advertisements
Post a comment or leave a trackback: Trackback URL.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: