Everything you wanted to know about the ECB's latest monetary policy (but were afraid to ask)

Once again, a great deal of confusion surrounds the European Central Bank's current policy objectives as well as the nearterm action expectations. Let's try to tackle the subject in a Q&A format.

Q:  Since the policy change announcement back in June, what has the ECB accomplished?
A:  In addition to lowering short-term rates, the ECB has launched the TLTRO program (4-year cheap loans to banks) and began its third covered bond buying program (these bonds are issued by banks and secured with loans).

Q:  What has been the impact of the ECB's interest rate reductions?
A:  The overnight benchmark rate has been set to near zero and the excess reserve rate has been moved to negative 20bp to incentivize banks to deploy capital. This has resulted in negative overnight interbank rate - banks pay each other to park their cash (which is still cheaper than parking cash with the ECB).

Overnight interbank rate in the euro area (source: emmi)

Furthermore, the euro's decline that resulted from negative rates and a possibility of further easing is expected to provide support for the export-dependent euro area nations.

Q:  Has the rate action resulted in more lending in the euro area?
A:  The immediate reaction of the area's banks to the negative deposit rate was to buy massive amounts of sovereign debt, including periphery bonds. This has resulted in unprecedented declines in government bond yields across the yield curve.

There is evidence however that credit conditions in the euro area are beginning to ease. Growth in broad money supply measures for example has improved markedly.

M3 YoY (source: ECB)

However, it remains unclear whether monetary policy had much to do with this development. Instead the banking system deleveraging cycle, which started a few years ago, is gradually ebbing. Moreover, the conclusion of the ECB's stress tests should help banks deploy more of their balance sheets in the private sector without the uncertainty surrounding the stress testing process hanging over them.

Q:  How much in TLTRO loans has been taken up by the banking system thus far?
A:  About €90bn - see story. This is well below some of the more conservative projections.

Q:  How much ABS (asset backed securities, such as credit card and auto loan receivables) and covered bonds has been purchased since the announcement of the program?
A:  The ECB has acquired a small amount of covered bonds but no ABS thus far - see schedule.

Q:  What has been the impact on the Eurosystem's (ECB's) balance sheet?
A:  The impact has actually been a net decline, as banks continue to repay their MRO and the original LTRO loans.

Eurosystem total balance sheet (source: ECB)

Q:  Why hasn't the ECB been able to buy more covered bonds and ABS in order to have a visible impact?
A:  According to Credit Suisse, the total amount of qualifying ABS and covered bonds the ECB could purchase is around €140bn. The volume is insufficient for the ECB to accumulate substantial amounts of paper without massively overpaying and disrupting this market. And even if the ECB did purchase that whole amount, it would take too long and have only a limited impact on the balance sheet expansion (note: this is roughly the amount of paper the Fed would buy in 2 months during QE3).

Q: There has been some talk of the ECB buying corporate bonds as well. Couldn't that help grow the balance sheet?
A:  Corporate bond purchases are a possibility, given the ECB can no longer afford to wait for the banking system to act as the area's policy transmission mechanism. According to Credit Suisse however, only about €100bn of corporate bonds would qualify/ be available for such a program. While it sounds like a large amount and would certainly cut borrowing costs for companies, the amount is insufficient to restore the Eurosystem's balance sheet to the 2012 levels.

Q:  How much then does the ECB need to expand its balance sheet in order to be credible?
A:  As discussed back in September, the ECB should probably grow the balance sheet by about €1 trillion. And the only way to achieve that is to augment existing programs with a more traditional QE effort that includes buying government bonds. Up to now there has been resistance from some Governing Council members (particularly) Germany, but supposedly Mario Draghi has been able to build consensus for such expansion - see story. That is why we had a rather sharp market reaction to the latest ECB press conference (see chart). Yet Draghi continues to downplay the €1 trillion balance sheet "target".

Credit Suisse: - ... ABS and covered bonds add up to €140bn-odd of potential purchases. Adding a (putative) €100bn of corporates is wildly insufficient to achieve the "target" [€1 trillion]. This target therefore has to be downgraded, in our view, to "something I believe I might have mentioned" while the much more thorny issue of "proper" (government) QE is addressed.

Q:  Why do many of the Governing Council members all of a sudden are convinced that such a drastic action (€1 trillion expansion) may be needed?
A: The persistently weak inflation readings have convinced them that Japan-style deflation risks in the Eurozone are quite real.

Source: ECB

Q:  When (if at all) will the ECB begin to purchase government bonds?
A:  The ECB is likely to wait on any traditional QE for some time, even though it has started to prepare for it (some ECB employees have been asked to dust off the old Securities Markets Program - SMP). The goal is to see if another round of TLTRO will meet with more demand and if inflation stabilizes on its own.

Q:  Will all this monetary activity by the ECB stem the declines in inflation?
A:  The technique used thus far has been to talk down the euro by hinting that a "bazooka" monetary event is on its way. That approach has worked. Whether the weaker euro will ultimately end up generating a higher sustainable inflation rate remains uncertain.

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Distinguishing the Fed's securities purchases from monetary expansion

There has been a bit of confusion about what today's FOMC announcement means with respect to Quantitative Easing. The statement says that " the Committee decided to conclude its asset purchase program this month". It's important to point out that while this is the end of the Fed's bond purchases (for now), the US monetary expansion has ended this past summer. The outcome is visible in the the banking system's excess reserves, which flattened out around July.

That in turn resulted in the US monetary base leveling off at just below $4.1 trillion, as the so-called "money printing" effectively ended in July.

This begs the question: How is it that the excess reserves and the monetary base stopped growing this summer while the securities purchases and the balance sheet expansion continued through October? The answer has to do with some other balance sheet items that offset ("absorbed") reserve creation. The key item to consider here is the Fed's reverse repo position, which became more impactful as the securities purchases ebbed.

While the Fed's securities program is just ending now, the US monetary expansion was finished months ago. Therefore, other than its psychological effect, today's announcement should have a limited impact on the economy.

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PBoC joins other major central banks with unconventional monetary policy action

Softer than expected economic growth in China (see discussion) has finally spurred the PBoC into action. However, rather than undertaking asset purchases that would inject reserves into the overall banking system, the PBoC forced liquidity directly into state-owned banks.

NY Times: - With industrial production growing at the slowest pace since the worst of the global financial crisis and foreign direct investment in a tailspin, China appears to have taken the unusual step of using monetary stimulus in an attempt to forestall further economic weakness.

China’s central bank has lent 100 billion renminbi, or $16.2 billion, to each of the country’s five main, state-controlled banks, bankers and economists said Wednesday, although the central bank and the five banks involved stayed silent. The seemingly stealthy decision to inject a total of $81 billion into the banking system this week came as the Chinese economy, like many economies in Europe, has slowed over the summer, although still expanding at a pace that would be the envy of most countries around the world.

This is probably the least effective QE-style action, as state-owned lenders are unlikely to efficiently deliver capital into the private sector. But the fact that the PBoC has taken this action tells us this could be the start of a longer monetary stimulus effort. The markets are not expecting a near-term economic improvement and instead pricing in a prolonged battle to accelerate growth. China's SHIBOR rate swap curve has become more inverted than a month ago with expectations of further rate declines.

Some form of stimulus was already being priced in, which is in part what generated the recent stock market rally.

Source: Investing.com

Now the PBoC joins other major central banks in expanding "unconventional" monetary policy efforts. The impact of such actions on economic growth however remains highly uncertain, particularly in the face of softening property markets and weaker corporate balance sheets.

Source: Reuters

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What has been supporting gold prices?

As the chart from Reuters shows, gold has outperformed all the major asset classes this year.

Most explanations for these results point to the various geopolitical risks that have generated jitters across a number of markets. However there is another explanation. Expectations that monetary policy will remain loose across major economies longer than originally anticipated have been driving gold higher. Here are some key indicators supporting this thesis:

1. As discussed earlier (see post), China's monetary policy continues to be quite supportive for credit expansion.

2. Japan's growth will likely fall short of BOJ's projections (see chart), prompting the central bank to accelerate QE or at least maintain it over a longer period. Credit Suisse: "We see additional BoJ easing coming in November."

3. The Australian unemployment rate has been considerably higher than expected (see chart), suggesting that the risk to the RBA rates is to the downside (or at least low for a longer period of time).

4. Economic reports from the euro area continue to point to a slowdown (chart below), and while the ECB is unlikely to undertake outright QE or other such measures, the expected period of accommodation has clearly been extended. This is particularly true with inflation rates in a number of member states at dangerously low levels (see chart).

Source: Centre for European Economic Research (ZEW)

5. While the US recovery remains stable and the Fed continues to taper securities purchases, the "effective" monetary policy has become looser that it was a year ago. One can gauge this by looking at longer-term real (as opposed to nominal) rates. The 10-year real rates in the US for example have been declining, now below 20bp. That is clearly an accommodative trend.

6. Even in the UK where we had some saber rattling from the BOE about potentially raising short-term rates in 2014, real yields of government bonds remain deep in the negative territory across the curve.

The level of monetary accommodation in world's major economies remains quite high, with little indication of near-term withdrawal. That has provided substantial support for gold prices and may continue to do so in the near future.

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5 reasons the ECB will act in the months ahead

It may be something symbolic such as a small rate cut or possibly a more substantial move such as a new LTRO program (discussed here), but the European Central Bank will be forced to loosen monetary policy in the near future.  Here are the reasons:

1. Liquidity:  The ECB's (technically the consolidated Eurosystem's) balance sheet is stll declining - down 28% since the middle of 2012. Excess reserves of the euro area banks are down nearly 80% over that period.

2. Credit:   Private lending in the euro area continues to fall - see chart.

3. Monetary aggregates:   Lack of loan growth has resulted in progressively weaker growth in the broad money supply. Most recent M3 print came in significantly below expectations - see chart.

4. Disinflation:  The euro area's price index growth is at the lowest level since the Great Recession and significantly below the ECB's target. Moreover, the growth rate seems to be deteriorating.

Furthermore, this disinflationary trend is not limited to the Eurozone periphery nations. Even Germany is showing signs of a slowdown in its inflation rate.

The last time Mario Draghi spoke on the topic, he hinted that this extraordinarily low inflation rate is an aberration. But that explanation is starting to get old. 

5. Emerging markets mess: While the ECB officials are denying that EM contagion will spread to the Eurozone (see story), the recent selloff in European equities says otherwise. Knock-on effects are inevitable, given the vulnerability of the Eurozone's recovery combined with the area's significant exports to emerging market nations.

Aside from these 5 reasons, the short term rate markets are now reflecting a policy change by the ECB, though the timing remains unclear. The June Euribor futures have spiked - indicating a lower implied Euribor rate -

Source: Eurex

... and German short-term government yields fell materially. These are signs of the markets' expectation of lower short-term rates going forward.

Over the next few meetings we should see a shift by the ECB toward a looser monetary policy. Otherwise the central bank will be toying with deflation risks.

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5 years of QE and the distributional effects

As we approach the fifth anniversary of the start of the first quantitative easing program, some are asking the thorny question about the so-called "distributional effects" of these unprecedented programs. Who really benefited since the first QE was launched? There is a great deal of debate on the topic, but here are a couple of facts. Financial asset valuations, particularly in the corporate sector have seen sharp increases. For example the S&P500 index total return (including dividends) has delivered 144% over the 5-year period. Those who had the resources to stay with stock investments were rewarded handsomely.

Source: Ycharts

But what about those who didn't have such an opportunity? For example savers, particularly retirees who had to stay in cash? They were hurt severely by record low interest rates (negative real rates - see post). And those who had neither the savings nor significant stock investments, relied on house price appreciation or growth in wages. The housing recovery has certainly been helpful (for those who kept their homes), but according to the S&P Case-Shiller Home Price Index, US housing is up less than 5% over the past five years. Not much of a "wealth effect" for those without stock portfolios. And when it comes to wage growth, the situation isn't much better. The chart below shows hourly earnings growth of private sector employees.

It therefore shouldn't be a surprise that the three rounds of quantitative easing over the past five years rewarded those who had the wherewithal to hold substantial equity investments. Everyone else on the other hand - which is the majority - was not as fortunate.

Perhaps the best illustration of these distributional effects is in the chart below. It shows the relative performance of luxury goods shares with wealthier clients vs. retail outfits that target the middle class. The benefits of QE are clearly not felt equally by the two groups.

Source: JPMorgan

So as we prepare for the Janet Yellen's ultra-dovish Fed (see story), it's worth thinking about the past five years and the cost of growing distributional effects in the United States. For now there is plenty more cheap money to help those with large stock portfolios.

JPMorgan: - There are debates about whether a 0% cost of money helps anything except financial asset prices ... All we know is that the Fed has a story to tell (“cheap money is good”) and they are sticking to it.

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QE3: the act of doing the same thing and expecting different results

As we approach the first anniversary of the Fed's monetary expansion effort (QE3), it's worth comparing the success of the current program with that of 2010-11 (QE2). At this stage the two are roughly equivalent in growing bank reserves.

Note: The official start dates were a bit different but the announcements took place around the same time

In fact just in the past few weeks the QE3-induced reserve growth exceeded that of QE2, as the total bank reserves (commercial banks' deposits with the Federal Reserve banks) move above $2 trillion (and the US monetary base moves above $3.2 trillion).

The key to these programs' effectiveness is their impact on credit growth. Here is the comparison. One could presumably argue that QE2 resulted in stemming the credit contraction taking place in 2010. It's hard to make that argument for QE3.

Given this result, why would any central bank want to continue on its current path? Some would argue it is to keep longer term interest rates low. But the 30-year mortgage rate is now some 60+ basis points higher than it was when QE3 was announced. So if it's not credit growth or interest rates, what is the mechanism to transmit this "unconventional" monetary policy into the economy and job growth?

You hear economists talk about how the Fed should continue buying securities at the current pace because the US economic growth remains tepid. But isn't this simply doing the same thing (now for a year) and expecting different results?

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Other central banks impacting US money supply

Guest post by Lee Adler (The Wall Street Examiner)


When the Fed prints reserves by buying MBS and Treasuries with money that did not exist previously, this increases bank deposits (liabilities) and cash assets pretty much dollar for dollar. I have run charts showing this relationship, but something went wrong beginning in January.

That something was the breakdown in Treasuries holdings, as Eurozone banks began to unwind the LTRO trade at the first opportunity in January.

The Fed is not the only actor in this game. All the major central banks conduct operations with the Fed’s 21 Primary Dealers. US money supply data represents not just the US but is a pretty big slice of the whole world and reflects other central bank policies and the flows of capital between nations and banking systems.

Treasuries were liquidated to pay down the LTRO. At the same time we saw the echo of that in US commercial bank repo lending and other securities lending to nonbanks, extinguishing the offsetting deposits.

The forced March liquidation of leveraged holdings by big Chinese shadow institutions also showed up here. The BoE has also been running tighter policy.

So the Fed and BoJ are fighting an uphill battle to keep money supply inflating. US money supply would still be increasing dollar for dollar with the Fed’s purchases, but their friends, the other central banks, are no longer cooperating.

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JGB yields spike in spite of all the BOJ bond buying

Japanese government bonds experienced a spectacular sell-off in the past few days, with the 10-year JGB yield rising by a half of its value.

Source: Investing.com

This is taking place in spite of BOJ's pledge to keep on buying paper (see post). Anyone who doubts the central bank's resolve, need only look at its JGB holdings. The Bank of Japan is now buying over 70% of all new government bond issuance.

Source: BOJ

The spike in JGB yields - in spite of all the central bank buying - is quite troubling.  It is precisely the opposite of what the BOJ had intended. It means that liquidity in JGBs is disappearing, as the market is increasingly controlled by a single buyer. And with most speculative players positioned long, what started as a small sell-off, quickly became amplified - as bets are unwound.

WSJ: - On Monday, Japanese yields moved higher even as the BOJ scooped up ¥1.2 trillion of JGBs maturing in one to 10 years at three separate operations—exactly the opposite effect the BOJ had been hoping for, strategists said.

With liquidity deteriorating, "a risk-free investment has now become risky," said Manabu Tamaru, senior investment manager at Baring Asset Management (Japan). "Thus investors are demanding a risk premium under the BOJ's buying program."

As of 10:30 EST (5/14) the sell-off continued.

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From our sponsor:

Bernanke signals the Fed is uneasy with "reaching for yield"

As Merrill's junk bond index yield crossed the historical low of 5% on Thursday, some senior Fed officials are clearly becoming uneasy. Corporate credit markets are entering bubble territory (see discussion) and up until recently very little has been said on the topic by the US central bank. On Friday Ben Bernanke sent a signal to the markets that the Fed is watching the "reaching for yield" situation "particularly closely".

Ben Bernanke (May 10, 2013) - ... We follow developments in markets for a wide range of assets, including public and private fixed-income instruments, corporate equities, real estate, commodities, and structured credit products, among others. Foreign as well as domestic markets receive close attention, as do global linkages, such as the effects of the ongoing European fiscal and banking problems on U.S. markets.

Not surprisingly, we try to identify unusual patterns in valuations, such as historically high or low ratios of prices to earnings in equity markets. We use a variety of models and methods; for example, we use empirical models of default risk and risk premiums to analyze credit spreads in corporate bond markets. These assessments are complemented by other information, including measures of volumes, liquidity, and market functioning, as well as intelligence gleaned from market participants and outside analysts. In light of the current low interest rate environment, we are watching particularly closely for instances of "reaching for yield" and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals. It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices. For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move. Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves.

The chart below must give at least some US central bankers a reason to reflect on the current pace of monetary expansion. What "unusual patterns in valuations" will another $1.5 trillion of securities purchases create? The FOMC is likely to have at least some debate on the topic at the next meeting.

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From our sponsor:

With deflation in BOJ's crosshairs, the yen is sure to weaken further

In spite of all the recent stimulus talk, Bank of Japan continues to battle deflation.

NY Times: - Deflation remains firmly entrenched in Japan, figures showed Friday, as the central bank projected that its targeted level for inflation was still some years off, underscoring that there are no quick fixes for one of the world’s largest economies.

Prime Minister Shinzo Abe, who took office last December, has made the fight against deflation — the damaging fall in prices, profits and wages that has dogged Japan for most of the past 15 years — a main part of his economic policy. He pressed the central bank to commit to a target of 2 percent annual inflation, considered by many economists a healthy level.

The yen strengthened by over a percent today, driven mostly by weak US first quarter GDP reading of 2.5% (vs. 3.1% expected). But this yen strength is unlikely to persist. Given Japan's deflationary pressures and the government's commitment to address the situation, the BOJ will press the pedal on monetary expansion. And in a race against the Fed, the BOJ is ultimately expected to "win" (see discussion). It's only a matter of weeks before USD/JPY breaks above 100 as the yen continues to march along its weakening trend.

Yen per one dollar

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From our sponsor:

Low money multiplier does not justify ultra easy monetary policy

An number of readers responded to the post (here) on growth in US monetary base with "so what?" After all the so-called "money multiplier" has been at historical lows - meaning that the Fed's monetary expansion has not made its way into the broader economy. The argument is that all this new liquidity is "trapped" in bank reserves, as lending remains tepid.

According to this traditional school of thought, you need sharp growth in the broader money supply to generate inflation - a major threat to the economy. But there is a problem with this argument.

Greenspan's Fed also believed that as long as the money multiplier was at historical lows, loose monetary policy is justified. And in 2002-2005 the money multiplier was indeed at historical lows. This is what the trend looked like to economists before the crisis.

Inflation of course was not a major issue at the time - at least not by historical standards. And the Fed continued with loose monetary policy, as fed funds target rate hit 1% during 2003-2004. The fed began to raise rates in the second half of the decade, but by that time it was too late. Rate increases ultimately served to burst the housing bubble in 2006.

What many economists failed to realize - and many continue to do so today - was that the risk of excessive liquidity is not necessarily the overall price inflation. With US wages stagnant, those looking for a 70s-style inflation will not find it. Instead liquidity manifests itself in asset bubbles, which is exactly what was happening in the housing market at the time when the money multiplier was at the lowest levels in recent history (chart above). Plus in a global economy, inflation (including wage inflation) was simply exported to emerging markets nations.

Economists and market participants however find ways of rationalizing asset bubbles - just as they did with the housing market in the US and China's double digit growth (among other bubbles) during the first half of last decade. That's why using the traditional money multiplier as a rationale for an ultra loose monetary policy is not prudent.

As an example of where this excess liquidity may be ending up today, consider the fact that the average US corporate junk bond yield ended up at an all-time low of 5.93 last week (chart below). Of course market participants have dozens of ways of rationalizing this trend - just as they did with other markets many times before.

Therefore before dismissing the expansion in the US monetary base as inconsequential, consider the fact that in spite of low money multiplier, excess liquidity will find ways to distort markets right under our noses. And you don't need to generate headline inflation in order for these distortions to damage the economy when the correction finally takes place.

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From our sponsor:

Precious metals hit by the Evans’ Rule

There seems to be a great deal of confusion about why gold (and silver) sold off in response to yesterday's announcement from the Fed.

Source: Barchart

The Fed will be undertaking an even more aggressive expansionary policy than originally announced in September. Balance sheet will expand dramatically and so will the reserves and the monetary base. Treasuries sold off again today with higher inflation expectations (see discussion).

Dow Jones Credit Suisse 30-Year Inflation Breakeven Index (source: S&P)

So what's up with gold?

Clearly there is no single explanation. But the main thrust of the selling has to do with the introduction of the Evans’ Rule. Now that the end of this ultra-accommodative policy is linked to the unemployment rate, some gold investors are beginning to think the date is much closer than people had originally anticipated (as discussed here). The Fed has been known to be "behind the curve" and investors were betting the Fed will "overshoot" as usual (maintaining the policy of zero rates and extreme liquidity for much longer than necessary.) But with the Evans’ Rule in place, some funds involved in precious metals (including silver - silver March futures are down 3.5% today) think the exit is now much closer - simply because now the Fed will effectively be "forced" to exit based on their own rule.

Reuters: - Gold fell 1 percent on Thursday as fears the Federal Reserve might withdraw its economic stimulus if the job market improved dramatically prompted funds to reduce their bullish bets.

The metal fell below $1,700 on Thursday for the first time this week on economic worries about the U.S. "fiscal cliff," overshadowing its safe-haven appeal. Liquidation by large institutional investors in gold futures on fears of tax hikes in the new year also pressured prices, traders said. Silver dropped 3 percent for its biggest one-day decline in a month.

Gold's drop came a day after the U.S. central bank adopted numerical thresholds for its monetary policy. It said it would keep interest rates near zero until the U.S. unemployment rate fell to 6.5 percent.

Analysts said the move stirred fears that the U.S. central bank could put an end to its loose monetary policy which has boosted the metal's inflation-hedge appeal.

"With the economy showing some signs of recovery, we may see a 6.5 percent unemployment rate sooner than previously anticipated, so longer-dated funds that are heavily invested in metals are looking to reduce their gold positions," said Phillip Streible, senior commodities broker at futures brokerage R.J. O'Brien.

This effect is visible in the currency markets. The dollar index initially sold off after the treasury purchases announcement, but then recovered as soon as the Evans’ Rule was brought up. And dollar's stability is a negative for precious metals - even if inflation expectations are picking up steam again.

Dollar Index (DXY) futures (source: Barchart)

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From our sponsor:

Trendline on the unemployment rate projects the Fed ending zero rate policy by late 2014

The Fed's new approach to targeting a specific unemployment rate (called the "Evans’ Rule") may shed some light on how long the monetary easing may continue. Credit Suisse did a simple linear extrapolation from the peak unemployment rate in 09. Such approach sets the end of the program for late 2014. That of course assumes the unemployment rate will continue declining in a linear fashion (which may be unrealistic given the structural shift in employment). It also assumes that labor participation (something the Fed is tracking closely, though it's not part of the official target) will improve with falling unemployment - another "leap of faith".

Source: CS

This extrapolation gets to the "target" considerably faster than the FOMC's "middle of 2015" projection or even the Fed Funds futures curve market expectation (Feb-2015 contract now implies full 25bp).

Fed Funds futures implied rate

The new unemployment targeting program (combined with inflation tolerance level) is expected to make for a more flexible policy tool because the FOMC would be less reluctant in adjusting its rate expectations. CS researchers think both the FOMC and the futures markets will adjust to an earlier date as the unemployment rate continues to decline (some comments in brackets [ ] ).

CS: - The Fed’s date guidance by no means “nailed down” the markets expectations but certainly made them stickier as innovations to the Fed’s rate guidance would not be costless. On the margin the Fed would have traded some credibility for flexibility at some future date when an inward shift in the date became necessary. [English: with the old approach, changing the expected date of the end to zero rates would have been harder, though not impossible.]

In the final analysis we think the market will realize the Fed can and will move the thresholds if unemployment continues to fall rapidly on the back of lower unemployment. But that will take time to sink in. In the meantime we think the blue eurodollars [2015] are free to trade.

Still, a linear trendline fitted to the unemployment rate since the peak in 2009 would suggest reaching 6.5% in late 2014. A continuation of the more recent pace of declines would imply and even earlier date. 

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RBA's Glenn Stevens takes on major central banks

RBA's Governor, Glenn Stevens today took a jab at the four major central banks (Fed, BOJ, EBK, BOE) without naming any names. Here are two key points summarized by Goldman:

1. The rapid expansion of the balance sheets of many central banks has "blurred the distinction between fiscal and monetary policy" and therefore the future exit from these policies which "provide cheap funding for governments may prove politically difficult". Ultimately, while central bank actions have bought government's time to put public finances back on track, central banks cannot solve these longer run challenges.

This is an excellent point. Central banks are called upon to fix structural problems, but all they can do is make sure governments have access to cheap funding for some period of time. At some point these central bank actions become counterproductive, yet any exit from these strategies may prove politically difficult (effectively creating a trap).

2. The expansion of central bank balance sheets has created disquiet in the global policymaking community as it has led to spillovers and distortions at the international level via an acceleration in cross-border flows of capital in search of higher returns. Although central banks are effectively factoring-in these flows into their policy decisions, there is not a consensus on how this should be done and there is an argument that central bank mandates would need to be changed to appropriately account for these spillovers. At the very least, increased global cooperation is optimal on this front.

Here he is referring to the persistent strength in the Australian dollar, which is killing the nation's export sector. He is attributing this strength to other central banks keeping incredibly high liquidity levels and near zero rates - forcing capital to flow to assets like the AUD.

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Fed lowers mortgage rates without "printing money"

The Fed remains in a holding pattern. Just as comparison, take a look at the pace of MBS purchases during QE1 in 2009 versus the current pace of expansion.

$bn, source: St Louis Fed

More importantly, bank reserves are basically holding flat...

Reserve balances with Federal Reserve Banks (source FRB)

... and so is the overall monetary base (effectively no new base money has been created since the start of the QE3 program).

$bn, source: St Louis Fed

Just the "threat" of open-ended MBS purchases by the Fed has created demand for agency MBS (see discussion), pushing MBS yields to new lows. That in return has sent mortgage rates to record lows as well.

Source: Bankrate

In fact today even as the 30y fixed rate hovers above absolute lows, the 15y fixed and the 30y jumbo both hit records.

Source: MortgageNewsDaily.com

If lowering mortgage rates was what the Fed intended to accomplish with the latest monetary expansion, the central bank has succeeded. And so far they have done it without a significant change in bank reserves. Whether this will translate into improved economic activity and job growth remains to be seen (see discussion).

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QE3 update: modest increase in bank reserves

US bank reserves at the Fed grew about $27bn, with the "other" category showing up in reserves this week (as Lee Adler discussed earlier). Overall the pace of reserves growth is still quite modest on a relative basis (currently reserves are at the level of early September.) Further increases are expected in December as more MBS purchases settle.

Bank reserves (source: FBR)

Moreover, the Fed's balance sheet unexpectedly shrunk by $20bn this week. Part of the decline has to do with MBS paydown from all the mortgage refinancing activity. Certainly there is some noise in the balance sheet measures and reserves on a week-to-week basis, but the Fed is definitely being cautious. We may see a more aggressive approach to bank reserve expansion after Operation Twist (see discussion) winds down - likely early next year. There is about $50bn of short-term notes left to sell (chart below).

$bn

A number of economists continue to argue that increasing bank reserves is not productive at this point in the cycle because it will not stimulate further credit expansion (while risking inflation).

SoberLook.com

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