The Path to Recovery

The key variable in the economic outlook is the pace at which the Fed purchases private-sector assets.

By David Malpass

David Malpass

The economic and financial-market events of late 2008 can be boiled down to this: The surprise Lehman bankruptcy froze credit markets, the U.S. economy hit a brick wall, and the global economy tumbled into a deep recession — one that many predict could last until 2010 or beyond. However, credit markets and confidence could still be repaired in time for economic recovery to take hold in 2009.
The decisive moment in this recovery scenario occurred late last November when the U.S. Federal Reserve announced it would purchase mortgage-backed securities (MBS) originated by Fannie Mae and Freddie Mac, as well as the debt of these government-sponsored enterprises. The Fed reinforced this position a few weeks later when it announced it would continue using its balance sheet to support credit markets, a process known as quantitative easing.

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In a traditional quantitative easing, the central bank buys (or repos) government bonds from banks, crediting the banks’ reserve accounts held at the central bank. The theory is that the banks will increase their lending by a multiple of the extra reserves. (Banks today are reluctant to increase their lending while deflation risks persist.) Another part of the theory is that an increase in central-bank purchases of government bonds (such as Treasuries) will lower the yields of those bonds, which in turn will push down yields in the private sector.During a credit freeze, however, the more powerful aspect of a quantitative easing comes from the asset side of the Fed’s balance sheet, rather than the liability side, and from the Fed’s choice of purchases. In particular, by purchasing credit instruments, the Fed lowers the yields on those and similar instruments. Meanwhile, through arbitrage, the yields on slightly riskier and longer-duration instruments also fall, a process that works to gradually reopen the credit markets. 
This is powerful medicine, even before it is aggressively applied. In the weeks following the November 25 announcement that it would buy mortgage-related securities, the Fed made only small purchases of agency paper totaling less than $10 billion. But the announcement itself caused an immediate decline in MBS and agency yields and, within days, mortgage rates themselves. Yields fell by a percentage point in multi-trillion-dollar markets, which is no small feat.
On January 5 the Fed began actual net purchases of private-sector assets (i.e., MBS). From here, if the Fed accelerates the pace of its asset purchases, broad credit markets will thaw, liquidity will push deeper into the financial system, and private-sector risk-taking will resume. In the process, the Fed can choose safe, high-yielding credit instruments with some duration and still make a profit.
And the Fed’s expansion will not necessarily be inflationary. The Fed is temporarily using its balance sheet to repair credit markets and counteract some of the paralysis in the banking system. And when banks start lending more, the Fed can stop lending and shrink its balance sheet, thereby avoiding inflation.
Note: The Fed is not “printing money.” There is no sign that extra dollar bills are being disbursed. Instead, the Fed is creating excess reserves for banks, which aren’t using them. The traditional money supply is going up, but that’s not a good measure of inflation risk given the slower velocity of money during the credit freeze. So unless the dollar weakens or the Fed keeps rates low after the recovery starts (as it did by mistake in 2004 and 2005), there shouldn’t be an inflation impulse.
There is more the Fed, and regulators in general, can do to curtail the financial crisis. One positive step would be for Washington to address the harmful interplay of regulatory capital, the credit-default-swap (CDS) market, bond regulators, and the strict mark-to-market accounting process. The interaction of these factors has contributed to and fueled the credit crisis by causing bond downgrades and forcing sales of equity capital into a falling market.
The Treasury also could assist matters by substantially lengthening the maturity of the national debt. This would lock in currently low Treasury yields, improve the government’s long-term financial picture, and make clear that the government will be in a position to tolerate Fed rate hikes when they become necessary.
But the key variable in the recovery outlook has become the pace at which the Fed purchases private-sector assets. The plan is solid. But with jobless claims likely to rise and GDP deteriorating, the Fed needs to buy assets, or plan to buy assets, fast enough to catch up with the economic free fall.