“Of these effects, the first only is immediate; it manifests itself simultaneously with its cause — it is seen. The others unfold in succession — they are not seen…”
--- Frédéric Bastiat
Hulk Smash: The Endgame?
Last week, we discussed QE. An even more momentous event is the recent passage of the CARES Act. Unlike QE, which relies solely on the Fed to create cash and bank reserves, the Cares Act relies on the US Treasury to contribute $454 billion in “equity”. By providing as much as 10x leverage, the Federal Reserve can create as much as $4.5 trillion in “dry powder” for various programs (business loans, primary market debt purchases, secondary market debt purchases).
What does the CARES Act mean for the Fed’s balance sheet?
LIABILITY: The Fed creates non-interest bearing cash and bank reserves. The US Treasury equity is placed directly in various SPVs (special purposed vehicles). The Fed balance sheet does not show Treasury equity.
ASSET: The Fed buys “AAA” rated debt market securities created via securitization. The underlying collateral has credit risk. The magnitude of Fed leverage is constrained so that there is a “sufficient” level of credit enhancement (enough Treasury “equity”) to rate the securities “AAA”.
So it is like QE?
Yes, it is an asset swap, but with an additional caveat…
Under Section 13(3) of the Federal Reserve Act, assets purchased by the Fed must be (a) guaranteed by the U.S. government or (b) secured by collateral “sufficient to prevent losses” to the public. The Fed’s argument is that “AAA” rated debt securities from a securitization have sufficient collateral. In this situation, collateral is provided in the form of Treasury equity and leverage provided by the Fed is restricted to a level than ensures the securities are rated AAA.
What is the joint Fed / Treasury game plan?
Presumably, the Fed will hold the securities until maturity, not reinvest the proceeds, and take the currency from the proceeds out of circulation. The hope is that the Fed experiences no losses.
What if it turns out that Fed is wrong about the level of collateral needed, and the Fed suffers losses?
First, is quite likely that the US Treasury will suffer some losses on the $454 billion that it is providing as “equity” / “credit enhancement” unless the economic recovery is robust. The Fed could conceivably suffer losses and impair its balance sheet if the Treasury “equity” is not sufficient to cushion losses. At 10x leverage, a 10% decline in value of the underlying securities would wipe out the Treasury equity cushion. Declines beyond 10% would impair the Fed’s balance sheet.
Any losses borne by the Treasury and the Fed would put downward pressure on the value of the US dollar. Dollar depreciation will manifest itself domestically as inflationary pressures.
But hasn’t the US dollar been rising recently? And isn’t the near-term risk an economic depression, with associated deflationary pressures?
Yes, the US dollar has been rising, as it is the world’s reserve currency. The initial panic from a global crisis exerts upward pressure on reserve currencies (a topic for a future post) and a sharp economic downturn initially creates deflationary pressure.
However, the long-term impact is likely the opposite, i.e., inflationary pressure. Inflationary pressure results from the growth in the quantity of government liabilities that do not expand the productive capacity of the economy. Similar to a business which destroys value by engaging in projects where ROIC < WACC (return on invested capital < weighted average cost of capital), government interventions often destroy price signals, inhibit innovation, and impede value creation. The government liabilities are, of course, government debt and the monetary base. Many economists will argue that central banks must offset the deflationary effects of a contraction of bank credit with the inflationary effects of central bank policies. Unfortunately, central banks always seem to find a way to ensure that their stimulus is greater, so inflation, not deflation, is the ultimate outcome.
Why don’t supply and demand in the economy adjust to mute the inflationary pressure?
The natural adjustment to increasing inflationary pressure would be higher long-term interest rates, impeding the ability of the government to continue to increase its liabilities via debt issuance. The Fed has short circuited that adjustment by seizing control over interest rates. The adjustment will then occur over time via the exchange rate.
Alternatively, the government could reduce fiscal deficits and allow creative destruction via private sector debt restructuring. The government could also increase productivity via less regulation, better incentives (e.g., simpler tax structure, tax structure favoring long term capital investments over short term investment trading), and better use of human capital.
Once the crisis passes and the world economy rebounds, the consequences of government intervention will become more visible. USD depreciation (smashing of the green currency) is likely to occur. Inflation will not appear immediately, and the process will likely be nonlinear. Inflation will be similar to a business failure…it will happen gradually, we will not notice it, and then it will appear suddenly, with a huge bang.