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The Street: More QE Would Be a Reward to Banks

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https://realmoney.thestreet.com/articles/10/22/2015/more-qe-would-be-reward-banks

More QE Would Be a Reward to Banks

By Roger Arnold

Oct 22, 2015 | 4:00 PM EDT

In the past few months, I've written several columns concerning the recessionary trajectory the U.S. is on and how the Fed would respond if that continues.

Although a recession is not yet inevitable, the preparation for how the Fed will respond, if required, has begun.

On the recession issue, the Chicago Fed National Activity Index (CFNAI) released this morning validates the recessionary trajectory with the opening remarks of:

"The Chicago Fed National Activity Index ticked down to -0.37 in September from -0.39 in August. Two of the four broad categories of indicators that make up the index decreased from August, and all four categories made nonpositive contributions to the index in September" (emphasis is mine).

On the monetary response issue, as I discussed earlier this week in the column, "When Bad News Is Exactly That -- Bad," the San Francisco Federal Reserve Bank has already indicated that a probable response by the FOMC will be negative short-end rates coupled with another round of quantitative easing (QE).

As I discussed in 2011, monetary and fiscal policy come in two basic forms, pull through and push through, which may also be considered reward and punishment.

In that context, the implementation of another round of QE may be considered the pull through; a reward provided to the banks for agreeing to accept the push-through punishment of negative short-end rates.

The first issue to deal with is the potential structure of what another round of QE would involve and when it would be supplied.

The last round of QE involved the purchase of agency mortgage-backed securities. The idea was to allow the Fed to purchase what had become illiquid mortgage securities from the banks in order to provide the banks the capital necessary to make new mortgage loans and in the process drive the mortgage rates down to stimulate consumer demand for home purchases.

As I've noted previously, that structure required approval by the U.S. Treasury, and the next round of QE will, too, because the Fed's mandate has not been expanded by Congress to allow it the opportunity to purchase other than Treasury securities without first getting approval from the Treasury secretary.

The next round of QE will likely require the Fed to go beyond mortgage securities and into purchasing other kinds of bank loans that will likely become illiquid as a result of the economic deterioration.

Those loans will likely be concentrated in autos, commercial real estate mortgages and commercial and industrial.

This, too, will require Treasury secretary approval.

However, it is also likely the Fed will use the potential for it to expand into those areas by requesting that the executive and legislative branches coordinate and supply a fiscal response this time that is complementary to the goals of the monetary efforts.

In addition to requiring the fiscal support, the Fed will require the banks to agree to accept negative short-end rates in order for a round of QE targeted at these other kinds of loans.

The next issue concerns the timing of the Fed moving forward with a round of QE structured this way.

Until the bankers agree to accept the negative short-end rates and the government agrees to provide a complementary fiscal response, the Fed will wait to implement the next round of QE, even if the Treasury secretary approves.

The executive and legislative branches won't have the political support necessary to coordinate and respond with a complementary fiscal stimulus package, however, until there's been enough of a deterioration in economic activity and capital markets to afford for such.

That's a normal part of the political process, though, as there is too much risk to the continued viability for re-election faced by individual legislators to warrant even attempting a pre-emptive fiscal stimulus measure.

A fiscal package is only politically viable as a reaction to economic and market events that have already caused the electorate to not only acquiesce to the necessity of it, but request it.

The most important part of this process for investors, as I wrote about earlier this week, is that the current expectation of a pre-emptive monetary response to market instability or weak economic reports indicating an imminent contraction in private-sector activity is imprudent.

The Fed is telegraphing its willingness to supply a monetary response as the legislative mandate requires, but the experience of the past seven years has also proved that a monetary response provided in the absence of complementary fiscal measures is not just inviable but actually counterproductive.

At this stage, the most likely catalyst for encouraging the required response by bankers and fiscal authorities will be a decline in oil prices, but it may instead first be evidenced by continuing deterioration in the biotechnology and technology sectors.