Thinking about the Fed

Despite the announcement of ‘QE3’ by Mr Bernanke, the total assets of the Federal Reserve bank (FRB) have only increased by around $40bn since end August and within these assets, securities have risen by around $35bn, with the bulk of the increase within the mortgage backed (MBS) category. There has also been an increase in the FRB’s other assets, which have risen from $191bn to $208bn, but no breakdown is provided.  One significant issue is that the Treasury has been running down its holdings of deposits at the FRB over the last month or so, and the Treasury’s credit balance at the Fed is down by about $20bn over the last three months, and its total stock of deposits within the banking system is probably down by somewhat more.

This removal of deposits from the Fed in order to fund current disbursements by the Treasury should have led to a fall in the size of the FRB’s balance sheet but the fact that it has actually grown by $40bn suggests that the FRB’s true underlying ‘private sector’ balance sheet is really growing at a faster pace than the headline data suggest. This in turn implies that the FRB (and by implication the Treasury) are already being quite expansionary. This positive liquidity impact would help explain just why financial markets seem to have been ignoring bad news from the global economy, and permits a bullish near term view. However, it also means that with the Fed creating money, investors who are on the sidelines waiting for QE3 to provide a further boost to markets may be disappointed. This doesn’t mean that Mr Bernanke won’t do more, and the US consumer picture is really quite weak, with nominal retail sales growth having only averaged 0.3% month on month since the beginning of 2012 and sales growth (officially at least) has only been positive in three months since March. Even allowing for some of the statistical problems that plague summer data, this is hardly an impressive performance and in inflation adjusted real terms the retail data is only up 1.2% year to date. US household income growth is insipid at present, but interestingly the consensus expectation is that there will be a sharp acceleration (in some cases a trebling!) in real consumer expenditure growth in the economy in 2013 despite that fact that taxes are going to rise by some, as yet unknown, amount and, households are currently rebuilding rather than withdrawing home equity. This suggest that the US economy may well underperform expectations next year, and with fiscal policy constrained, it will the left to the Fed to attempt to provide yet more stimulus.

One problem is that it seems that Quantitative Easing is no longer working. This may reflect the relative shortage and high price of collateral, and the current move towards deleveraging in the investment banking world but naysayers also claim that there’s no hard evidence that QE programmes to date in the US, the UK and Euroland have been any more successful in creating sustainable economic growth than the Japan’s various efforts in years gone by.

Looking back, with its QE1 and QE2, the Fed not only boosted financial market liquidity through asset purchases directly, but also the liquidity that it created was recycled through the repo and other intra financial system credit channels to the investment banks and the leveraged fund community in general, where there were significant second round effects, and these second round effects may have been more significant than the Fed’s actual asset purchases themselves, but in the new more risk-averse financial world, we cannot expect these second round effects to be so large, or even to be there. If Mr Bernanke faces disappointing economic news in 2013, the only policy tool available will be yet more asset purchases in the domestic bond markets. This of course will have positive implications for asset prices in these specific markets and will also likely allow the boom in corporate bond issuance, and hence in private equity and equity buybacks and M&A to continue, and such developments should in turn provide some parts of the risk markets with support even as economic growth and in particular profits disappoint.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla