The Real Effect of Debt – Rising Systemic Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The Real Effect of Debt (Federal Reserve of Kansas City Jackson Hole Economic Policy Symposium, Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli, Aug. 2011) Cecchetti et al, in a recent paper referenced below, looked at the debt levels and saw in moderate levels, it can improve welfare and enhance growth.  However, high levels can have damaging effects. 

The authors extend the work of Reinhart & Rogoff (2009) on government debt by including non-corporate and household debt.  Based on estimations that include government, corporate and household debt from 1980 to 2010, the authors find that excessive debt levels can have a damaging impact on economic activity.  The safe level for government debt is in a range of 80-100% of GDP.  This was consistent with earlier studies, but the study was limited to advance countries and looked at data from the last 30 years. 

The implication is that countries with high government debt levels must act quickly to address fiscal problems.  Otherwise, these countries can experience a sustained period of stagnation.  Long-term, a fiscal cushion is needed as a buffer for extraordinary events. 

Similarly, the authors find that moderate levels of corporate and household debt can enhance economic prospects.  The results suggest the threshold level for corporate debt is 90% of GDP and the level for household debt is 85% of GDP, although the result is less robust.  Total debt levels in all three sectors have increased from 165% of GDP to 310% of GDP over the last 30 years.  The most striking implication is that advanced countries are in worse shape than previously thought. 

The problem is compounded by future promises made to the people, an aging workforce and slower population growth, and lower long-term economic growth prospects.  As a result, debt rises faster, reinforcing its downward impact while raising the return demanded by investors.  The authors, economists at the Bank for International Settlements, conclude that advanced countries need to act decisively to address fiscal problems before the adjustment costs become prohibitive.

Systemic risk will be elevated for the immediate future until the debt overhang is addressed.  

 

For more information on this, follow the link:  http://tinyurl.com/3lwhww2  

 

Reflections on Mr. Bernanke’s Speech at Jackson Hole and Future Monetary Policy

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Unlike at his Jackson Hole speech in 2010 when QE2 was presented, Fed Chairman Bernanke did not pull a rabbit out of the policy hat last week.  The focus was not on the immediate outlook for the economy or monetary policy, but more on the structural headwinds facing the US economy and other long-term issues such as fiscal policy.  Mr. Bernanke made two surprises on short-term policy: the lack of discussion about further asset purchases or other easing options and that further policy options will be considered at upcoming FOMC meetings.     

 

He differentiated between the cyclical and structural/secular role of monetary policy, noting that the Fed is less effective when it comes to the latter role.  He reminded his listeners that the Fed alone cannot carry such a heavy policy burden and that fiscal policy was needed to promote growth and stability.  Fiscal policymakers face a fine balancing act “the need to place fiscal policy on a sustainable path” and to avoid “severe economic and financial damage” while noting the fragility of the current environment.  He noted reforms are needed in other areas of economic management, emphasizing the need for a better process for making fiscal decisions.  

 

Mr. Bernanke noted economic policies that support robust economic growth in the long run are outside the province of the central bank.  He implied in the President’s upcoming speech on needed fiscal stimulus and job creation – a constructive and collaborative approach by the Administration and Congress was required.  Another round of damaging policy dithering and political bickering would have strong adverse consequences on the economy.

 

The Fed continues to have a more optimistic view on US economic prospects than most private sector analysts.  The major difference is the Fed assumes that a number of temporary factors that depressed economic activity in the first half will not be present in the second half.  If this view is correct, it would imply that chances for QE3 are minimal.  However, if the Fed view converges to that of private sector, the chances for QE3 increase.  The most likely form would be through increased asset purchases of longer-dated maturities.

 

Other extreme measures would not be considered, unless the economy and financial markets substantially deteriorate below current prospects.  The Fed would have three possible policy options: the extension of the QE program into other markets such as corporate bonds, a sharp increase in the program that extends the Fed’s balance sheet and an explicit or implicit change in the Fed’s policy targets.  However, US economic prospects have not deteriorated enough to consider these options.

Preliminary Thoughts on Bernanke’s Speech at Jackson Hole and Fed Policy Options

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The most important event this week is tomorrow's speech by Fed Chairman Ben Bernanke at the annual Kansas City Fed Conference.  The speech is expected to focus on three elements: the downgrading of US economic prospects, a defense of past policy actions and an outline of Fed policy options.

 

Last year, Mr. Bernanke outlined details for QE II and Fed policy options: the purchase of long-term securities, communication and lowering the interest rate paid on excess reserves.  The Friday speech will most likely focus on:  the possibility of additional purchases of long-term securities and changing the composition of the balance sheet. 

 

The Fed will note the downgrading of US economic prospects, as mentioned in the recent FOMC minutes.  This view will be consistent with the lowering of US growth prospects done by a number of Wall Street (WS) analysts.  The most recent FOMC communiqué noted “a slower pace of recovery in coming quarters” and “downside risks to the economic outlook have increased”.  However, the Fed economic outlook has one key difference from WS analysts as evidenced in recent speeches by Fed officials “weakness in economic activity in the first half was due to temporary factors …” and “restraining forces have abated and thus, we should see stronger growth in the second half”.  This suggests the Fed takes the view that the slowdown was partially caused by temporary factors.  The Fed scenario is for weak growth followed by a modest recovery going into 2012.  This is slightly more optimistic than private sector forecasts.

 

The next point, to be addressed by Mr. Bernanke, is the defense of previous Fed easing efforts.  The combination of weakness in growth and downward revision to economic forecasts raise questions about effectiveness of recent policy efforts.  Previously, he argued that QE helped reduce deflation risk and raised inflation expectations.  Mr. Bernanke will most likely address these issues as follows: the first is that central banks (Fed) cannot be the sole source of stimulus in a global fiscal tightening environment; secondly, one way QE II was successful by avoiding another recession (to date) and deflation; and lastly there is evidence from economic studies that QE does have a positive impact on growth.  The jury is still out on QE II, but it has helped the economy – the question is how much?

 

As indicated earlier, the three options open to the Fed include: communication, asset purchases and balance sheet management and changing the interest rate paid on excess reserves.  The Fed has already implemented a variation of its communication policy by stating that rates will remain low for an extended period.  The Fed will not consider changing the interest rates on excess reserves due to technical aspects of implementation, potential damage to banks from already low rates and questionable impact on bank lending.

 

This leaves the last option of large-scale asset purchases and changing the composition of the balance sheet.  There are studies that suggest that selling short-dated treasuries and buying long-dated can have a significant impact on reducing real rates.  The reason why this option may be favored is that it will not change the size of the Fed balance sheet which would keep politicians happy.  The view among WS analysts is that Mr. Bernanke will present these options, but not pre-commit to any policy action except through the FOMC.  The recent rise in core inflation will keep policymakers cautious.  The use of any unconventional policy options such as a higher inflation target, price level targeting, a long-term interest rate target or option twist (used in the early 1960s) may be considered at a later date.

US Economic Developments & Conventional Fed Policy Options

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions,com 

 

Recent US Economic Developments

 

S & P has downgraded the US long-term sovereign debt rating from AAA to AA+ and kept the rating outlook as negative.  They noted a further improvement in the fiscal situation will be required to avoid further downgrades (reducing the deficit by $4tr not $2tr).  Moody’s & Fitch have not altered their AAA rating at the current time.  The US short-term rating remains intact at A1+, with no impact expected on money market funds.

 

US non-farm payrolls showed gains of a little over 115,000 with unemployment rate at 9.1%.  The gains in the private sector were partially offset by a decline in government employment.  The US economic growth was revised lower to 0.8% in the first half of the year.  Overall, a number of investment firms have lowered growth estimates through 2012 year-end to a little over 2%.

 

Conventional Fed Policy Options

 

Fed officials enter August with weaker than expected economic growth and projections of extended period of below trend growth increasing the pressure for further monetary easing.  This has a similar parallel to last year and if further downside risks persist, the Fed may implement QE III.  Currently, the Fed’s three conventional policy options: communication to investors & the public, asset purchases & sales and interest rate policy.

 

The first option the Fed might consider is “forward guidance” given the size of the Fed’s balance sheet.  This might have a minimal economic impact, but could be combined with a link to a specified period of low policy rates or an economic event.  Asset purchases or sales are a second policy option, but are limited by the size of the Fed’s balance sheet.  One application is to keep the balance sheet size the same, but to increase the duration risk by buying longer-term securities.  This could be combined with a reinvestment of maturing mortgage holdings.  Any proposed increase in the aggregate duration risk would be considered as policy easing.   The last option is to cut the interest paid on excess reserves left at the Fed.  This would have minimal impact since effective fed funds are already 0.08% and a zero rate on excess reserves could damage market institutions.  

 

Fed action would only be driven by increased downside risk.  Any change in communication or composition of the balance sheet would have at best a symbolic impact on the economy.  The US economy stands on the risk of falling into a double-dip recession; the Fed clearly lacks conventional policy tools to do much about it unless combined with other policy alternatives.

 

The (Forgetful) Dismal Scientists or “Yesterday’s logic is illogical today”

by Michael Arbow MBA

Partner, RSD Solutions Inc.

www.rsdsolutions.com

info@rsdsolutions.com

 

As the US Federal Reserve Chairman’s own version of the QE2 sets sail, commodity prices continue their upward move. The upward march in oil was initially caused by the increase in demand for product as world oil consumption moved from about 88 million barrels/day last year towards an expected 90 million this year. More recently, Brent crude has been pushed above $100 because of increased uncertainty of continued delivery from the Middle East.

Now those of us with long memories, say 12 months, will recall that the dismal scientists as economists are affectionately (?) known, predicting that the next recession would start when oil trades above $100 USD/bbl. Interestingly, the Street has not renewed their talking of this outcome but rather they focus on the renewed and continued strength of the US economy. It is strange that all the arguments Street economist gave about the effects of triple digit oil and $4.00/gallon gasoline 12 short months ago are no longer gain attention.

This blog raises 2 points:

1. It takes a paradigm shift for yesterday’s logic to be illogical or have reduced impact. Effective risk management must be dynamic but not at the expenses of forgetting the past.

1. It looks like price volatility will continue in 2011 and downside risk is starting to appear.For corporate risk managers: what are you doing now that the likelihood of downside economic risk is increasing or are you seeking safety in the crowd?

In fairness.  I caught the following (taken from the Globe and Mail) just prior to posting:

"The International Energy Agency’s (IEA) executive director Nobuo Tanaka said prices above $100 per barrel for the rest of the year could drag the global economy back into a repeat of the 2008 economic crisis."