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.

 

Damned if you do and damned if you don’t

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

U.S. politicians are playing roulette with that country’s AAA debt rating with their inability to agree raising the debt ceiling along with meaningful deficit reduction measures.

 

Last year the UK enacted meaningful deficit measures with a harsh austerity program and received plaudits from certain international institutions including the IMF for its actions.  The AAA debt rating was thought to be secure and medium term growth prospects bright.  However, Tuesday’s Daily Telegraph reports that this rating is now in jeopardy due to [1] lower than expected growth.  It is rumoured that the Prime Minister wants the Chancellor to stimulate the economy somehow although he also says that further stimulus is unaffordable.  What would change of course do to the market perceptions of the country and its credit rating?  Probably nothing positive!

 

Of course, the cause of all this is mass irresponsibility on the part of politicians in many countries over several years.  They can’t resist spending other peoples’ money.  Furthermore, they only have a short-term vision (if any at all) - their outlook generally stretches until no further than the next but one election, which usually means an absolute maximum of 8 years.  That usually leaves someone else to pick up the mess with those that caused it are often hailed as wonderful and visionary.

 

Personally, having lived in Canada during the deficit and debt ridden years in the 1980’s and 1990’s and coming to London in 2000, I was horrified by Gordon Brown’s 2001 budget that turned the spending tap wide open and set the UK’s fiscal health on course to where we know it ended up.  The opposition was too timid to mount any significant attack and essentially ended up buying into the big spending – until the political mood changed and they changed with it.  I remember telling anyone who would listen that this was fiscal madness and would end in tears sooner or later.  However my audience was small as nobody listened.  Good times were rolling along on a sea of debt, both public and private.

 

There is no easy solution and no painless solution to all of this.  Deficit reduction (let alone any thought of debt reduction) reduces growth at a time of moribund growth.  Stimulus might provide short relief at a cost of higher future interest costs and higher inflation and result in more difficult decisions later.  In fact, as fiscal situations worsen, decisions are taken away more and more from politicians and dictated more and more by the market.

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[1]  www.telegraph.co.uk/finance/economics/8660752/Weak-UK-growth-puts-AAA-rating-at-risk-experts-warn.html

Unquestioned Assumptions

By Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Does your company revisit assumptions upon which your approach to risk is based?  Are assumptions challenged?  Is there a dynamic process to do this?  Throughout most of my career, U.S. government obligations have been considered to be the definitive risk free debt.  No longer, now that S&P has placed it on negative outlook.  Willem Buiter, a former member of the Monetary Policy Committee and now chief economist at Citigroup, told the CFA Institute annual conference in Edinburgh[1]: “S&P’s negative outlook (on the US) is likely to be followed by a negative watch and then a downgrade early in 2013, unless a miracle happens …”.

 

Should this have been foreseen some time ago?  I would argue that this assumption about U.S. government debt should have been questioned several years ago.  In fact, perhaps it should never have been taken as an assumption. 

 

Nothing is risk free and no assumptions are valid beyond the moment they are made.  That is why a risk management system must be dynamic, and not imposed statically and left to apply until someone new comes in and decides to do an update, perhaps years later.

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[1] As reported in the Herald www.heraldscotland.com/business/markets-economy/us-economy-may-face-debt-downgrade-1.1100695