Fed Conference on Central Banking on Mar 23 2012


Reserve Requirements as a Tool for a Fed Exit Strategy
March 30, 2012

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at www.cumber.com.  He may be reached at Bob.Eisenbeis@cumber.com.


At the March 23 Federal Reserve Board conference (Conference on Central Banking: Before, During and After the Crisis, http://www.federalreserve.gov/newsevents/conferences/central-banking-conference-before-during-after-crisis-program.htm), three prominent central bankers – Jean-Claude Trichet (former head of the ECB), Masaaki Shirakawa (governor of the Bank of Japan) and Jaime Caruana (BIS) – argued that policy makers needed to be aware of the unintended consequences and risks associated with their easy-money and quantitative-easing policies, put in place to address the financial crisis.  How to craft an exit from those policies and engineer a gradual and non-distorting shrinkage in central bank balance sheets is a prime concern as economies gradually improve, as illustrated most recently in John Taylor’s op-ed in the March 29th WSJ.


The Federal Reserve has been struggling with some of those issues.  One consequence of those deliberations is the Fed’s new coordinated communications strategy.  Unfortunately, the change in communications has still left financial markets with considerable uncertainty.  For example, most recently the FOMC has explicitly stated that it intends to hold the target Federal Funds rate within its current 0-.25 percent range well into 2014.  But at the same time, the FOMC released for the first time participants’ assumptions as to when the first rate move might take place.  Interestingly, notwithstanding the 2014 date contained in the FOMC’s policy statement, 6 participants assumed that the first rate increase would not occur until 2015 or into 2016, while 6 assumed that it would occur before the aforementioned 2014 date.  The wide distribution of policy views, this long into the recovery, was surprising, at least to this author.  The large dispersion reflects considerable uncertainty within the FOMC about the path of the recovery.


To complicate matters, the chairman and other participants, in their speeches, rightly state that the 2014 consensus date for the next policy move is not a firm commitment but is contingent upon the actual path of the economy.  Not to be outdone, market participants and media pundits keep raising the possibility of another round of quantitative easing.


With each speech and/or piece of congressional testimony, longer-term interest rates have moved either up or down, depending upon how the comments are interpreted.  All of this is insignificant, however, compared with what will happen when the FOMC actually begins withdrawal of the extreme accommodation it has been pursuing.  Bond investors, in particular, will not want to be subject to large capital losses on their portfolios as rates rise; and so the probability of a sharp rate shock due to market reaction to even a modest change in the policy rate is extremely large as investors run for the door, all hoping to be first out.


Right now the three key indicator variables of where policy effectiveness sits from policy makers’ perspective are unemployment, inflation, and a measure of economic slack in the economy.  We know that many FOMC participants are first and foremost concerned about employment and are willing to keep rates low until the unemployment rate drops to an “acceptable” level, whether that is 7 to 7.5% or some lower number.  This preference will make it especially difficult to justify a policy move to stave off inflation until it is actually observed.  But because the long and variable lags in the effectiveness of policy, waiting until inflation actually occurs will be too late.


But what will happen if the economy takes off, and inflation breaks out and is fueled by a sudden increase in bank lending as the high volume of excess reserves are converted into required reserves, with the associated multiplier effect on the money supply and stimulus to aggregate demand?  This is behind the concern of John Taylor in his March 29th op-ed, especially if the FOMC is behind the curve.  Is there a way for the FOMC to hedge against a too-rapid increase in bank credit, thereby tempering a potential rapid expansion of aggregate demand until unemployment improves, without shocking markets and long-term investors with an aggressive increase in the policy rate?


Such a hedged policy may be possible.  What if the Fed were to increase bank reserve requirements to, say, 90 percent?  The appropriate number may be a bit larger or smaller than that, but for the moment follow the logic of this proposal.


While this might come as a shock to banks, that shock could be mitigated by coordination with the banking industry.  The fact is that, given the current level of excess reserves, banks are voluntarily holding a much higher level than what is being proposed.  Before the financial crisis, banks holdings of excess reserves were less than 4% of their total reserve holdings, whereas today they are 96%.  So an increase in required reserves to even 90% would not be binding, and there would be little or no impact upon bank lending costs, nor would it affect in any way the 25 basis points the banks are receiving for holding those reserves at the Fed.  At the same time, as the economy improves, there would be no effect on the increase in the opportunity cost of holding reserves instead of accommodating demands for funds.


The high level of required reserves could also function as a speed bump, limiting the pace at which lending could increase without the need for the FOMC to abruptly and rapidly increase its policy rate to prevent the economy from overheating.  But most importantly, the policy would give the Fed substantially more flexibility in how it managed the shrinkage in its asset portfolio.  Right now, its two main options are to either hold assets to maturity or to sell them into the market.  Holding assets to maturity would be virtually impossible, if it has to rely solely on increasing its policy rate as the main tool for tempering what might otherwise be an overheating economy, since selling assets would the main tool the Fed would have to push rates up.


Selling assets to raise interest rates would also require the Fed to recognize capital losses and reduce its book-value capital, of which it has precious little.  It would also avoid having to use the accounting gimmick it put in place to defer recognition of those capital losses – in other words, eliminate having to employ phony accounting to pretend it was book value solvent when it was not.  Raising reserve requirements to the suggested levels effectively sterilizes the bulk of the excess reserves on the Fed’s balance sheet, and by implication the assets in its portfolio, and would permit it to hold to maturity most if not all of the assets it has acquired as a result of its liquidity policies, quantitative easing, and efforts to support the housing market.


Some policy makers follow the absorption rate of excess reserves into required reserves as an important indicator of how quickly bank credit and the money supply are increasing.  Use of that indicator would not be affected, since there would still be ample excess reserves that could be employed to accommodate needed bank credit as the economy begins to pick up, while at the same time tempering the speed at which the banking system in the aggregate could expand credit and the money supply.


The real benefit of the policy being suggested, however, lies in the use of both a quantity-limiting policy tool (reserve requirements) and a price tool (the Federal Funds rate) to control the pace of the recovery and limit the acceleration in inflation.  Furthermore, it would enable the Fed to explicitly articulate an exit strategy for reducing its portfolio over time and commit to financial markets that it will phase down reserve requirements at a pace that is in accordance with a rule or formula that will not unduly constrain bank lending and that is geared to both the maturing of its portfolio and the pace of the recovery.  One could envision, for example, a pace of reduction that allowed for a larger amount of excess reserves initially but that gradually declined as the economy expanded, so as to use increases in market rates and bank lending rates to dampen what might otherwise be an overheating economy and an undesired increase in inflation.  The FOMC could then reduce the interest rate paid on only excess reserves to lower the attractiveness of holding the residual excess reserves as a marginal stimulus for banks to begin lending without impacting the total volume of reserves.  The FOMC would still also have the ability to employ changes in the target Fed Funds rate, but in this case using two policy instruments rather than one solves many problems that would otherwise be associated with the strategy that was put forth last year, which placed almost exclusive reliance upon manipulation of market expectations and a gradual increase in the funds rate.



Bob Eisenbeis, Chief Monetary Economist



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GIC in Paris

Message from my friend David Kotok in

Paris au Printemps – 2
March 26, 2012

Words cannot capture the weather in Paris during these past five days.  Every day was sunny, with a morning temperature reaching 50 degrees Fahrenheit and an afternoon high of 75 degrees.  After a decadent lunch, glass of wine, and pleasant conversation, the prime location to enjoy springtime in Paris was in the shade, where the light breeze wafted its way through the bustling cafés.

Approximately 150 participants have converged on Paris for the GIC meeting at the Banque de France, beginning on Monday.  Some have traveled thousands of miles; some came from just a few blocks away.  The public conversations intensified with the discussions concerning monetary policy, actions of central banks, and how to deal with sovereign debt.  Other issues included: What is the distortion in the yield curve of the world telling us?  How do we confront negative output gaps in the OECD countries?  Lastly, the final public panel addressed the issue of how to invest.

My colleague Peter Demirali wrote a recent piece on the direction of interest rates.  He captured points of view, and readers who missed it may find it on Cumberland’s website, www.cumber.com.  Peter presented a perspective on state and local government debt.  That $3.8-trillion-dollar asset class is of profound importance to American investors and financial institutions.  It is also important to Europeans.  There is an issue involving cross-over buying of state and local government debt.  The interest rate on the tax-free portion of that debt is higher than the interest rate on the corresponding maturities of US Treasury debt.

In Europe and other places in the world, the structure and nature of the credits backing state and local government debt are little-known, and therefore Europeans are reluctant to take on risk without gaining more understanding.  Peter has enlightened them during his presentation at the Banque de France.

Our private meetings here involved bankers, central bankers, investors, and money managers – the gamut of those interested in financial markets and economics.  We find that one theme persisted.  All of them were watching the credit spreads involving Portugal and Spain.  They realized the market was sending a message of concern.  The market was saying that the episode with Greece is not over, and the contagion could spread in spite of the massive liquidity injections of the European Central Bank.  They observed and discussed the use of collective action clauses and how they have to adjust their portfolios now that a government has inserted itself in a retroactive forced alteration of a debt structure.  In public, they were polite, but they dissected the risks strenuously.  In private, the debates became fierce.

We now look forward to the discussions at the private round table on Tuesday.  The round table is now fully subscribed and there is a waiting list.  The conference was full as well.  This was the largest and most successful foreign conference in the history of the Global Interdependence Center.  The GIC is most appreciative of the assistance and cooperation from the Banque de France in providing such support and a marvelous venue.

One final note about Paris.  One of the great museums in Paris is the Museé de l’Orangerie.  Virtual tours are available on their website, http://www.musee-orangerie.fr/index_u1l2.htm.  The museum sits on the Place de la Concorde at the end of the Jardin des Tuileries.  On this wonderful spring day in Paris, a walk across the gardens presents you with an array of budding trees, a wonderful outdoor experience as Parisians enjoy their weekend in the gardens.  I also hear a dozen languages being spoken, as this city attracts 20 million tourists every year.

L’Orangerie is mostly known for its collection of Monet panels, Les Nymphéas.  I have seen those panels on several occasions.  However, I have found the museum’s exhibits located downstairs to be its true jewel.  There, one can view a collection of Impressionist and modern works from Modigliani, Monet, Manet, Derain, Soutine, and Gauguin, among others.

The l’Orangerie also prepares special exhibits.  They are currently celebrating the musical work of Claude Debussy.  For details, follow the link: http://www.musee-orangerie.fr/homes/home_id24797_u1l2.htm.  And on the ground floor of the museum one can view a collection of great Impressionist works celebrating Debussy.  Famous French artists, among others, painted Debussy, attempting to depict the moods of his music through oils and pastels.  They illustrated how water and its condition, whether stormy or calm, evening or dawn, allowed the viewer of a painting to experience the sensations that are aroused when one hears the music.

We walk along the streets of Paris.  Our gaze passes over the Seine.  We reflect on the music of Claude Debussy.  We think about the paintings that were inspired by his ability to translate the notes into a message and how the message influenced these famous artists in such diverse, powerful ways.

It is springtime in Paris.  The serious issues have to do with Spain, Portugal and debt, and banks, capital and financial markets.  Those discussions were private and intense.  I relish the few minutes of an interlude – a budding tree, a scooter flying past, a young couple sharing a kiss, oblivious to everyone around them in the Jardin de Tulieries.  All the while, Debussy’s La Mer floats along in my mind.

A bientôt.


David R. Kotok, Chairman and Chief Investment Officer


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Twitter: @CumberlandADV



March 3, 2012

“Oil prices could soar to $440 a barrel if Strait of Hormuz closed.”  Tehran Times—five hours ago.

The worst part of writing this missive is that I remember every one of the events in the list below.  Maybe that is the best part, too.  At least I can still remember them.

We thank BCA Research (March 1 Special Report) for compiling this list of oil/energy shock events.  Every one of them led to a temporary spike in the oil price.  I will add personal comments on the older items in the list, since many readers may be younger than I am.  Note that in each case there was an oil-price spike, followed by some economic shock and then a period in which oil normalized to a supply/demand-balancing price.

November 1956 – March 1957 Suez Crisis.  This marked the first time Egypt attacked Israel and was decisively rebuffed.  Egyptian President Gamal Abdel Nasser triggered the event by nationalizing the Suez Canal, closing the canal and the  Straits of Tiran to Israeli shipping, blockading the Gulf of Aqaba,  and putting  the Israelis in a “no other choice but war” condition.  Britain and France reacted against Egypt.  Israeli forces rebuffed the Egyptian army, crossed Sinai, and reached the canal.  Nasser had fought against Israel during its 1948 War of Independence.  He had then led the overthrow of the previous Egyptian government in the early 1950s.  He consolidated power in 1955 and 1956.  Then he launched the attack.

Kotok comment: I remember the Suez crisis because it was a subject of intense discussion in my household.  As a teenager in a community where many had family in the Middle East, it was impossible to avoid daily conversation and attention to the national news.  Half a century later, I realize that the Middle East does not change much.  Only the characters change.  The story of strongman after strongman and war after war is an ongoing saga.

June-August 1967 Six-Day War.  Israel was attacked on all sides and in a fight for survival.  The result was a massive defeat for the attackers and the establishment of the Israeli armed forces as the dominant power in the region.  Syrian, Egyptian, and Jordanian forces were repelled.  Jordan fought bravely but lost to the military superiority of Israel.

Kotok comment: Jordan’s King Hussein changed his strategy after that war, which is why he did not participate in the next war against Israel.  The Jordanian-Israeli nonbelligerency continues to this day.  It gets strained at times; however, neither side wants war and both sides realize that war with each other is a losing proposition.

October 1973 – March 1974 Yom Kippur War and Arab Oil Embargo.  On possible advice of the United States, Israel waited until it was attacked by Egypt and Syria.  Jordan did not participate in the attack and Israel did not attack Jordan.  That allowed Israel to fight a two-front war instead of a three-front war.  The attacking Egyptian and Syrian armies made a strategic blunder: they waited until the holiest day in the Jewish calendar to launch the war.  Businesses were closed and families had gathered for the holiday, and that allowed rapid mobilization.  Had the attack been on a mid-week business day, the outcome could have been different.  Israel again showed its determination when its back was to the wall and it had no choice but to fight.

Kotok comment:  Iran may ignore history at its peril.  Israeli leaders’ patience is not a sign of weakness.  My first visit to Israel and to the Syrian frontier was in 1974.  Images of war were fresh and remain indelible.  We were allowed to go to the cease-fire lines, to understand the battle of the Golan Heights and to see how close this war came to threatening the survival of the country.

November 1978 – April 1979 Iranian Revolution.  Jimmy Carter’s presidency was undermined by the images of American hostages in Tehran.  Oil and the Straits of Hormuz were the dominant themes.

Kotok comment:  The late 1970s showed how monetary policy could be easy enough to allow an oil-price shock to morph into a broader and more vicious inflation.  Oil gapped from 3 dollars a barrel to 12 in the Arab embargo period.  It reached $30 a barrel at the peak in 1980.  By 1979, inflation was headed to double digits.  It took decisive action by new Fed Chairman Paul Volcker to attack it.  Under Volcker (1980-1981) interest rates reached the highest levels in American history.  Volcker broke the inflation cycle and started a 30-year disinflationary trend that has lasted until today.  He positioned a platform for Fed Chairman Alan Greenspan to preside over 18 years of this trend.  Ben Bernanke is the inheritor of that platform.

October 1980 – January 1981 Iran-Iraq War.  Saddam Hussein showed his true colors.  The enmity between Iran and Iraq continues to this day.  Later in 1981, the Israeli air force destroyed the fledgling nuclear facility at Osirak, Iraq, weeks before it was to start operating.  Years of Iraqi-focused diplomacy by the US and the Western powers had failed.  Israel again found itself with a “no choice” decision.

The rest of this list is in the recent memory of most readers, so we will not add comments.  Observations about oil and markets come after the list.

August 1990 – January 1991 Iraqi Invasion of Kuwait.  June-July 2001 Iraqi Oil Export Suspension.  December 2002 – March 2003 Venezuelan Strike.  March-December 2003 War in Iraq.  September 2005, Hurricanes Katrina and Rita.


BCA closed its list with this question about the future:  “2012:  Will there be ‘Closure of the Straits of Hormuz?’”

Take out the hurricanes and all the oil-price shocks have a common theme.  There is a strongman.  There is a shooting war or a threat of a shooting war.  Diplomacy and sanctions and negotiation have failed.  The final few days leading to the spike and the shock are impossible to forecast in advance.  Probabilities of outcomes are meaningless.  Tell me how anyone is to make a decision based on some geopolitical forecast of a 50-50 probability that Iran will mine the Straits of Hormuz.  Or alternatively, a 50% chance Israel will attack Iran’s nuclear facilities.

History also shows that oil prices have an upward trend during the period leading to the final spike.  In every case, the peak in price only came after something was seen as a terminal event or final action.  Subsequently, prices plummeted.

At Cumberland, we are overweight oil and energy in our ETF portfolios.  We can only guess at the geopolitical risk premium built into the oil price.  Last May we took the energy weight down to minimum.  This year it has been in overweight for months.  Energy stocks are now about one-eighth of the total market value, if you use the S&P 500 index as your guide.  At the peak of the oil shock in 1980, the energy component of the stock market was close to 25% of total market value.  Long-run forecasts with economic models argue for oil to be $175-200 per barrel by the end of this decade.

Add to that the failure of the United States to form a cohesive energy policy.  We consume nearly 19 million barrels of oil a day.  The world, including us,  consumes about 89 million each day.  We could be fully independent if we put our minds to it.  Our politics do not let us do that.  Shame on both parties in Washington for allowing us to be in this position.

For investors the issue is simple.  If you are strategically oriented, it is too soon to sell your oil and energy investments.  As to how to trade it on a day-by-day basis, we cannot be of much help.  There is a high correlation between the oil price per barrel and prices of oil stocks.  Track it closely.  If that correlation starts to fail, it may be warning you.

We could be overweight oil and energy ETFs for quite a while.  On the other hand, we could see changes that would lead us to sell as early as next week.  Nobody said this was an easy business.

David R. Kotok, Chairman and Chief Investment Officer

For Cumberland Advisors Investment Portfolio Styles: http://www.cumber.com/styles.aspx?file=styles_index.asp
For personal correspondence: david.kotok@cumber.com

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