You Get What You Pay For

By: Michael Ashton | Wed, Sep 29, 2010
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I am not sure if it is encouraging that Fed officials are not singing from the same hymnal, or frightening.

On the one hand, the occasional dissonance helps dispel any worries that the FOMC is succumbing to groupthink. Given the number of crazy ideas that are being floated, it is highly important that the Committee not come to some sort of ill-considered consensus on one of them (for example, the recent proposal that the Fed should raise rates to help the economy). Indeed, in this sort of environment the plethora of wild suppositions might be taken as a positive sign, that policymakers are brainstorming the situation - one cardinal rule of brainstorming, as we all know, is that you don't immediately reject any idea no matter how crazy it is.

On the other hand, if the metaphor you favor for the economy is of a great and stately ship being steered through the water by the steady hands of policymakers, it is disquieting to picture a dozen hands on the wheel all pulling it in different directions.

I am not entirely sure which hand I favor, but the fact of the dissonance is clear. Today, three Fed speakers held forth, and they sounded three different notes.

Philadelphia Fed President Plosser focused on the "downside" of further easing, and expressed his opinion that there is "a very limited amount of things we can do at this point." While he said that he would back further easing if deflationary expectations began to emerge, we clearly are not at that point. (I would note that since consumer expectations are usually a couple percent above actual inflation, such timing would arguably be a couple percent too late. Unless, that is, he is talking about economist expectations, but who the heck would rely on economist expectations?) Plosser specifically said that he doesn't support further asset purchases by the Fed (Large Scale Asset Purchases, LSAP, or simply QE2).

Plosser is one who believes that economies generally heal themselves if given enough time, and if left alone the healing will generally be more durable than if the government distorts the recovery process (as, for example, Greenspan routinely did). He argued quite reasonably that "we should not overreact" to economic data that can be volatile. As far as he is concerned, the Fed has used all of its bullets, but fortunately will not need the bayonet.

In contrast, Boston Fed President Rosengren said that the Fed still has plenty of bullets and should use them "vigorously, creatively, thoughtfully, and persistently, as long as we have options at our disposal...And we do have options, despite having pushed short-term rates to the zero lower bound." He is worried that inflation is currently so low that it wouldn't take much to tip the economy into outright deflation, and that this risk is one reason the Fed needs to keep firing. He is certainly not singing from the same hymnal as is Plosser. It's not even clear he's in the same congregation!

Providing a confusing middle ground (not to mention comic relief, which is starting to become routine for him), Minneapolis Fed President Kocherlakota seemed to lean a bit more towards Plosser. He pointed out that about $1trillion in excess reserves still sit on bank balance sheets (recall that the Fed bought about $1.7 trillion in securities in QE1), and said "banks are not using a lot of their existing licenses to create money. QE gives them new licenses to create money, but I do not see why they would suddenly start to use the new ones if they weren't using the old ones."

I find it hard to believe that a Fed official can say things like this. It is all fine and dandy for weekend economists to moan about the "money multiplier being broken," but as I said in my speech last night we know who broke it and we know how to fix it. The chart below (source: Federal Reserve H.3) is directly from my presentation last night, and I think makes pretty clear by itself why banks aren't using their "licenses to create money."

Excess Reserves of Depository Institutions
Pay Interest On Excess Reserves (IOER), get Excess Reserves!

Is this confusing? If you pay interest on reserves, you get reserves. If you want banks to use their licenses to print money, stop paying them to not print. It's like paying farmers to leave land fallow, and then wondering "why are we having corn shortages?" I continue to think that a necessary precondition to LSAP is to set IOER to zero, or to a penalty rate (negative), and then see what happens. I suspect that QE2 will not be needed if we finish QE1.

When the first quantitative easing happened, of course, the goal was not to increase inflation but rather to reliquify the banking sector. The Fed was more than happy to have banks holding surplus reserves in that circumstance. That circumstance has passed, however, and the FOMC ought to either take back those reserves or release them into the wild.

As it stands now, in any case, it seems to me that if the Fed were to vote on QE2 today the proposal would lose. The economy does not seem to be plummeting, and plenty of Fed officials are skeptical. Core inflation, ex-housing, has been at 2-3% all year; there are no meaningful deflationary pressures. Yet. This may all change if fiscal policy tightens as it is scheduled to do, but as things stand today I think QE2 is growing less likely just as the market seems to be believing in it more and more each day. The dollar went to an 8-month low today, and it is probably not a coincidence that this happens while the chatter about QE2 is increasing.

Incidentally, speaking of the speech I gave last night: I want to thank my hosts - the NY Investing Meet-up chapter - and especially Daryl Montgomery (also a Seeking Alpha contributor) for arranging it. I enjoyed meeting the group, but I was remiss in not giving the link to my blog (, indicating my handle on Seeking Alpha ("The Inflation Trader"), or noting that my Twitter moniker is inflation_guy. Hopefully, some of those in attendance will come across this column and track me down!



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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