Sunday, November 30, 2008

Will Quantitative Easing Crater the Dollar?

When the Federal Reserve announced on November 25 that is was spending around $600B on bailing out agency debt and MBS and around $200B on bailing out ABS, many worried that a new program of quantitative easing will sink the dollar and raise interest rates. At RGE Monitor, Nouriel Roubini referred to "desperate actions" and said the the Fed was implementing:

an effective policy of aggressive quantitative easing as the balance sheet of the Fed – already grown from $800 billion to over $2 trillion – will be expanded further as most of the new bailout actions and new programs will be financed via injections of liquidity rather than issuance of public debt. ...

Effectively the Fed Funds rate has been abandoned as a tool of monetary policy
... the Fed is now relying on massive quantitative easing and direct purchases
of private sector short term and long term debts to try to aggressively push
down short term and long term market rates.

Although these moves have reduced ABS and MBS spreads, Roubini believes as others do that there are negative longer-term implications:

... These policies – however partially necessary – will eventually leads to much higher real interest rates on the public debt and weaken the US dollar once this tsunami of implicit and explicit public liabilities and monetary debt driven by rising twin fiscal and current account deficits will hit a world where the global supply of savings is shrinking – as most countries moves to fiscal deficits thus reducing global savings – and foreign investors start to ponder the long term sustainability of the US domestic and external liabilities.

When will this "eventually" occur? In an article titled Ricardian Equivalence, Macro Man commented on the markets' immediate reaction to put the dollar under pressure. To summarize his arguments:

The past few decades, but particularly the past few years, have seem enormous rise in private sector leverage....both through traditional lending and derivatives contracts.
At the end of 2007, Citigroup had more than $2 trillion of assets on their
balance sheet. That number will be a lot lower by the time all is said and done. ...

So in Macro Man's view, any dollars "created" by the Fed to expand its balance sheet (and let's not forget, they have yet to really crack out the printing presses by not sterilizing their asset purchases) will merely partially offset dollars lost through de-leveraging and the implosion of the shadow banking system ...

The impact of these programs will, in Macro Man's view, only submarine the dollar once the crisis is resolved and domestic demand begins growing organically again. That seems likely to be several years away, for there is another kind of Ricardian equivalence at work- the ballooning of the US budget deficit should be offset by a sustained rise in the US private sector savings rate.

This is an important point for investment strategies. If the resolution of the crisis is several years away, perhaps we can expect a relatively stable dollar for some time.

And if the dollar remains stable, and the Fed's actions are offset by private sector deleveraging, perhaps we can expect a deflationary environment to continue for some time.


"Ricardian Equivalence"
Macro Man, Nov 26, 2008

"Desperate Measures by Desperate Policy Makers in Desperate Times: the Fed Moves to Radically Unorthodox Policies as Economy Is in Free Fall and Stag-Deflation Deepens"
Nouriel Roubini's Global EconoMonitor, Nov 26, 2008

Press Release on MBS
Board of Governors of the Federal Reserve System, Nov 25, 2008

Press Release on ABS
Board of Governors of the Federal Reserve System, Nov 25, 2008