Brad Setser

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The Absence of Foreign Demand for Treasuries in the TIC data Is a Bit Misleading

by Brad Setser

A common explanation for low Treasury yields is that low rates outside the United States have piled into the U.S. market, as investors in Europe, Japan and elsewhere look to the United States for a reasonable mix of safety and yield.

That is part of what Gavyn Davies, in one of his typically thoughtful posts, argues that the Fed has learned over the past year. The United States is no longer a (monetary) island, the rest of the world matters. Of course, what Lael Brainard called the elevated sensitivity of exchange rate moves to monetary surprises is also a part of the global story. It isn’t just a flows story. An awful lot of the tightening in U.S. financial conditions that occurred in anticipation of the Fed raising rates came through dollar appreciation; too much in my view.

The apparent problem with this the “foreign demand is holding down Treasury yields” thesis: Foreign investors pretty clearly have sold Treasuries over the past 12 months. And not just a few Treasuries. Net foreign sales of long-term Treasuries over the last 12 months of data are around $250 billion.

So what is going on?


It is actually pretty simple, in my view. Treasury sales in the Treasury International Capital (TIC) data (and also, I suspect, most of the sales of U.S. equities) are linked to the fall in global reserves.

Over the last 12 months China has sold several hundred billion of reserves (though most of those sales were in the fall of 2015 and early 2016, recent sales are more modest), the Saudis have been selling and Japan—for reasons of its own—has been selling securities while increasing its deposits (Japan has reduced its long-term securities holdings by a bit over $100 billion over the last two years, while raising its short-term deposits by a similar amount, according to the SDDS data).

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Pot calling kettle black?

by Brad Setser

One thing that has puzzled me is that some of the countries that have — implicitly at least — been most critical of the expansion of the Fed’s balance sheet during the crisis long have had much larger balance sheets than the US Federal Reserve.

Before the crisis, the Fed’s balance sheet was around 6% of US GDP. Right now, it is around 15% of US GDP. A big increase no doubt. But the balance sheet of the People’s Bank of China (PBoC) is around 70% of China’s GDP. Foreign assets make up about 80% of the PBoC’s balance sheet — or around 55% of China’s GDP. And the PBoC’s estimated holdings of US treasuries and agencies are about equal to 30% of China’s GDP — a level that is far higher, relative to China’s GDP, than the US Fed is ever likely to achieve. The Fed expects its balance sheet to peak at roughly $2.5 trillion, or between 15% and 20% of US GDP.


China consequently presumably knows a thing or two about how to prevent rapid expansion of the central banks balance sheet — including rapid expansion from purchases of long-term US Treasuries and Agencies — from producing unwanted inflation.

The key, of course, is to sterilize the expansion of the central bank’s balance sheet. That means to offset the increase in the banks’ financial assets with an increase in the central banks’ financial liabilities, rather than increase in base money.*

Paul Swartz and Peter Tillman — my colleagues at the Council’s Center for Geoeconomic Studies — have plotted the growth in the balance sheet of the PBoC (relative to China’s GDP) and the growth in the Fed’s balance sheet (relative to US GDP). By China’s recent standards, the expansion of the Fed’s balance sheet isn’t particularly unusual.

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Today’s Fed statement speaks for itself

by Brad Setser

The Fed cut policy interest rates to zero, more or less. And it signaled that it hasn’t run out of ammunition even if it cannot cut rates further.

Not so long as there are still financial assets that it is willing to purchase. The Fed:

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity. (emphasis added)

Over the last few months, the Fed has more or less taken over a slew of functions previously performed by the private financial system.

Banks with spare cash (more deposits than loans) used to lend to banks that were short of cash (more loans than deposits). Now they lend to the Fed, and the Fed lends to the banks that are short on cash. That way no bank risks taking losses lending to a bad bank ….

Money market funds used to lend both to the financial sector and to firms with short-term financing needs. Now they (to simplify a bit) just buy Treasuries. The Treasury met this demand by increasing its issuance, and (to simplify a bit) putting the cash it raised on deposit with the Fed. That in turn allowed the Fed to lend to institutions in the US and abroad that previously relied on money market funds for financing.

Foreign central banks used to buy rather significant sums of Agency bonds, and in the process finance (indirectly) the extension of credit to American households. Now foreign central banks just want Treasuries. The Fed now plans to purchase rather significant quantities of Agencies, in effect making up for the fall off in demand from other central banks.

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by Brad Setser

The Economist — in the course of its analysis of the Fed’s response to the credit crisis — noted that only a few years ago the Fed got rid of its Agency holdings because it didn’t want its asset purchases to distort the allocation of credit in the US economy.

“Politicians have asked the Fed to favour certain industries or keep interest rates low almost from its birth. In 1921 the Fed rejected requests from Congress to buy long-term agricultural debt. In the 1940s and again in the 1960s, under pressure from the Treasury, it bought bonds to hold down long-term interest rates. In the 1970s, at the behest of Congress, it bought the debt of federal agencies such as Fannie Mae and Freddie Mac.

A 2002 staff study pointed out the risks of favouring particular assets or borrowers: it could result in too much investment in preferred sectors and too little in others, drag the Fed into arguments about fiscal policy and compromise its monetary policy. In recent decades the Fed largely extracted itself from anything resembling credit allocation. The last of its Fannie bonds matured in 2003.”

Obviously, the Fed has shed its inhibitions here over the past year — though helping the banks avoid forced sales of their existing assets into an illiquid market arguably has less impact on the allocation of future credit than buying securities other than Treasuries when times are good. still, there are concerns that the Fed is now shaping the allocation of credit in the US economy. The Economist writes:

“The central bank is lending to private companies on an unprecedented scale and is thus making decisions it long sought to avoid about the allocation of credit. It is also acquiring new powers of oversight. Politicians could chafe at the Fed’s power: why, they might ask, should unelected officials choose who benefits from taxpayers’ money? And they might press the central bank to pursue political ends—such as propping up favoured borrowers—that interfere with monetary policy ….

That brings up an interesting question: If Americans are uncomfortable having the Fed shape the allocation of credit in the US economy, shouldn’t they be equally uncomfortable when foreign central banks — notable China’s central bank — shape the allocation of credit in the US economy through their asset purchases?

The PBoC now has a larger dollar balance sheet (on the asset size) than the Fed. It holds around a trillion dollars of Treasuries and Agencies (over $950b can be identified using the TIC data, and the TIC data understates China’s holdings … ). The Fed has around $900 billion in assets — $940 billion, to be precise.

Moreover, the PBoC’s dollar balance sheet is growing far faster than the Fed’s dollar balance sheet. The Fed has responded to the credit crisis by changing the composition of the assets it holds, not by increasing its holdings. The PBoC by contrast is adding to its foreign assets at an extraordinary rate.

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The Gulf’s inflationary monetary-fiscal-policy spiral ….

by Brad Setser

The Gulf has — by virtue of its peg to the dollar — entered into an era of “single digit interest rates and double digit inflation.” So writes the Global Financial House in its report on the Gulf’s economic outlook:

the region would have to “live with the paradox of single-digit interest rates and high double-digit inflation”, said Ala’a al-Yousuf, Chief Economist at GFH.

Moreover, loose monetary policy is generating pressure to loosen fiscal policy, as it is hard to explain why real wages for government workers are falling when oil revenue is soaring. That too will add to inflationary pressure:

So far, the government response to spiralling inflation has been in the form of higher wages, increased subsidies and other cash incentives, the report said, in the absence of any relief from the currency effect of the dollar peg.

“In our opinion, the GCC is entering a phase of loose monetary-fiscal policy spiral, which, together with a wage-inflation spiral, have trapped the region between two impossible trinities,” said Hany Genena, Senior Economist at GFH.

Government spending is set to rise 25% this year, reaching $300 billion. That is roughly half of the Gulf’s likely oil export revenues, assuming roughly 15 mbd of exports, an average oil price of around $120 for the year and $5 a barrel production costs. And that total leaves out — I think — a lot of government sponsored investment projects.

No wonder the region is booming. Monetary and fiscal policies are both wildly expansionary. This will, over time, help to reduce the oil exporters surplus and thus facilitate global adjustment. But it also risks laying the ground for big problems if the price of oil turns down.

Letting the exchange rate adjust up — and down — with the price of oil still seems to me to be a better way of managing commodity price volatility.

One thing though is clear: at current oil prices, the small Gulf states are once again fabulously wealthy.

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Read the annual report of the Bank of International Settlements

by Brad Setser

International institutions usually put out reports filled with turgid and overly-qualified prose.

But not the BIS. At least not this year. The introduction and conclusion of its 78th annual report are a pleasure to read. The prose is clear and direct. An example:

“If asset prices are unrealistically high, the must eventually fall. If savings rates are unrealistically low, they must rise. If debts cannot be serviced, they must be written off. Trying to deny this through the use of gimmicks or palliatives will only make things worse in the end.” (p. 145)

Outgoing Chief Economist William White’s is unsparing in his criticism of both the big private banks and the major central banks. Central banks, in White’s view, held rates too low for too long after the equity bubble burst – creating asset bubbles that fueled excessive demand growth to offset what he views as the natural fall in prices associated with the integration of large new pools of labor into the world economy. Private banks ignored the risks building on their balance sheets

And central banks and private bankers alike failed to appreciate the risks created by the new world of securitized mortgage finance – particularly a world where a lot of exposure was held off-balance sheet in “vehicles” of various kinds.

“Recent innovations such as structured finance products were originally thought likely to produce a welcome spreading of risk-bearing. Instead the way in which they were introduced materially reduced the quality of credit assessments in many markets and also led to a marked increase in opacity. The result was the eventual generation of enormous uncertainty about the size of losses and their distribution. In effect, through innovative repackaging and redistribution, risks were transformed into higher-cost and, for a while at least, lower-probability events.”

It isn’t hard to get the impression that White thinks innovation increased the both the cost and probability of a crisis by contributing – along with low policy rates – to reduced credit standards and asset bubbles. He clearly thinks that the credit losses that followed the bursting of the bubble cannot be “cleaned up” easily.

“It is not clear where the losses [on “new financial instruments”] are, how they should currently be valued or how large they might grow given ongoing declines in the prices of underlying assets.”

The solution? In the first instances, the banks who originated and distributed (sometimes to their own treasury or internal hedge) the bad loans should take their losses.

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Does the Fed’s mandate now extend to Beijing, Moscow and Riyahd?

by Brad Setser

The Financial Times, in a leader, says yes.

If there were a Central Bank of the World its monetary policy committee would glance at today’s inflation rates and expectations of future inflation and then raise interest rates. There is no such bank, but there is something close: the US Federal Reserve, the monetary policy of which is mirrored by many countries in the Middle East and Asia. The Fed may not want that responsibility, but it would be wise to worry because, like it or not, low Fed interest rates are contributing to global inflation.

The Fed itself would — I suspect — argue that it has to worry about a fall in the dollar, a rise in commodity prices or a fall in the dollar that spurs a rise in commodity prices only to the extent that such developments risk prompting a rise in US inflation, and thus affect the Fed’s ability to guide the US economy. That is a formulation that doesn’t generate any conflict between the Fed’s domestic mandate and the dollar’s global role. The Fed only should care about the dollar’s external value to the extent it influences the Fed’s ability to meet its domestic objectives.

The FT leader goes much further. It argues that dollar pegs generates such large benefits to the US — namely cheap financing — that the US should be willing to adopt a monetary policy that is right for the entire dollar zone even if it is wrong for the US. The FT:

The Fed has another reason to worry as well. The greater the inflationary pressure, and the more Asian countries are forced to raise interest rates, the greater the risk that they dump their pegs to the dollar. The results for the US would be unpleasant: a currency crash and even higher domestic inflation. The US benefits from the dollar’s use as a reserve currency; the price is that the Fed cannot forget the effects of its policy on the wider world.

The Fed’s Vice-ChairDon Kohn seems to disagree. He argues, more or less, that if US monetary policy isn’t right for fast growing economies in the emerging world, they should importing US monetary policy. Dollar pegs — not US rates — should change. That at least is what Krishna Guha of the FT inferred from Kohn’s speech:

[Kohn] appeared to call on fast-growing emerging markets to drop their exchange rate pegs to the dollar and adopt independent monetary policies – so they no longer import Fed monetary policy. Mr Kohn said “in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability”.

The Fed vice-chairman did not specify what steps he thought should be taken to restrain demand in these overheating countries. However, he said economies “benefit from having independent monetary policies that provide room to respond flexibly” to different economic shocks. He added “these benefits could be increased if exchange rate flexibility were to become more widespread”.

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Does Chinese inflation now constrain the Fed?

by Brad Setser

Tim Duy, with rather impressive timing, says yes. Rising inflation in China and the Gulf, the key regions in today’s “dollar zone,” now have a large enough impact on prices in the US to limit the Fed’s ability to cut rates further. Rather than setting monetary policy for the US, Duy — who had an office next to mine at the US Treasury back when we were both very junior new hires ten years ago — claims the Fed has to set policy for the entire dollar zone. Duy writes:

Years of academic research led Bernanke to conclude that the Fed’s best response to the financial crisis is that which should have been deployed during the Great Depression. Fine on paper, but in practice he is using 1930’s monetary policy in the economy of 2008. And that 70+ year gap is exceedingly important in many respects, but perhaps none is more important than the current status of the US Dollar as a reserve currency, a status that allows the US to run a gaping current account deficit. The concern is that the Fed treats the external sector with something of a benign neglect when setting policy, effectively ignoring the reserve currency function of the Dollar. Hence, in a bow to Wall Street, policymakers unwittingly created an overly stimulative environment that feeds back to the US in the form of higher inflation.

This simply implies that the Fed does not sufficiently consider the reaction functions of other central banks when setting policy. Should they? In a world with limited capital flows, no. But in today’s globalized financial environment, the answer is increasingly yes. In effect, by encouraging open capital flows, the US has ceded some amount of domestic policy control.

It is an intriguing argument.

Once upon a time, Nouriel Roubini and I postulated that central banks would be unwilling to add ever increasing sums of depreciating dollars to their portfolios, and that the need to attract international capital to finance the (large) US external deficit could become a constraint on US macroeconomic policy autonomy. In such a scenario, US long-term rates would rise — and the Fed might need to raise short-term rates — even during a US slowdown. Rather than being able to adopt counter-cyclical policies designed to support domestic economic activity during a slowdown, the US might be forced to adopt pro-cyclical policies designed to assure access to sufficient external financing.

This scenario hasn’t materialized. US fiscal policy is now expansionary and the fiscal deficit is rising rapidly. US monetary policy is also expansionary. US policy rates are low, especially in real terms. Long-term rates are low too — though no longer quite as low as they once were. All this has been possible, in some sense, because of an absolutely extraordinary increase in central bank reserve growth (supplemented by big flows into sovereign funds). My analysis suggests central banks and sovereign funds are on track to add over $1.5 trillion dollars to their portfolios this year (after adjusting for valuation gains). The huge rise in custodial holdings at the New York Fed strongly suggests that central banks remain the key sources of financing for the US.

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