No respite from hard realities

Earlier last week, as was widely reported, Ben Bernanke delivered a much heard speech to a community of sceptical Fed watchers. Bernanke acknowledged in that speech that economic recovery is slower than they anticipated.

The salient points of the speech are easy to summarise: (i) recovery is nowhere near done (ii) the rate of growth and employment is disappointing (iii) credit continues to be tight (iv) inflation is lesser than desired by the Fed.

Since Jackson Hole speech is much widely reported and talked about — the language is predictably "banker-ese".

One might be forgiven if, to use a Churchillian metaphor, the Bernanke speech is described as a policy-confusion cast in vagueness wrapped in euphemisms. Some have gone on to say, as Joe Wiesenthal does, the Fed doesn't have what it takes to fix the crises.

The irony is that Bernanke himself hints at this issue. He says, that Fiscal authorities need to step up as well — knowing very well that there is a move in Washington and academic circles that have increasingly made great attempts to paint the Fed the villain of the past decade.

The logic

All this said, what Bernanke has tried to do in this speech is articulate where-in is the Fed is headed .

While he has argued that the Fed will improve its communication (provide strategic guidance) and lower rates on the excess reserves that banks deposit with the Fed — the core policy-approach can be reduced to the inexorably simple two words — Quantitative Easing. What this means is that the Fed is planning on increasing, in Bernanke's words, "large-scale purchases of agency debt, agency mortgage-backed securities (MBS) and longer-term Treasury securities".

It is important to see follow through with the logic why the Fed thinks this large scale purchase of instruments will make a difference.

At it's heart — the Fed views that assets aren't "perfect substitutes". i.e., assets differ along various dimensions such the underlying credit risk, duration (the amount by which a bond's price changes when there is a change in interest rate), convexity (the amount by which a bond's duration changes when there is a change in interest rate) and so on.

So, if the Fed can affect the total supply of an asset that investors can buy or sell, then there ought to be a ripple effect. Other assets with similar, but not same characteristics, can thus be affected.

So, when the Fed purchases the Agency debt, Agency MBS, Treasury securities — it reduces the yield on them. Correspondingly, in order to ensure their portfolios continue to maintain some of the same characteristics as before the Fed intervention — private market players would choose to hold other assets available in the market.

This would in turn reduce the yield available on them. The whole idea is thus to reduce the cost of borrowing across various segments of the market.

Bernanke argues that this program of continued purchase of securities has "made an important contribution to the economic stabilisation and recovery".

Yet, the scepticism that this process works is justified on various levels. As Yves Smith noted, interest rates are not the primary decision factor when individuals decide to launch businesses. What matters is the perception that demand exists for ones' goods or services.

Asset inflation

In contrast, increased levels of quantitative easing often aids in asset inflation, but that arguably only helps banks who seek to mark up their books.

Credit flow into the ‘real' economy, however, is something beyond the scope of monetary policy, per se except through indirect measures. From the experience of Japan - increasing amount of literature stresses on making this crucial difference clear. i.e., One must recognize that keeping the financial system stable is different from ensuring the real economy can indeed take off.

In case of the Japan during its quantitative easing program in the early 2000s, what was clear is the following.

Typically as firms, who carried large amounts of non-performing loans on their books, went to raise funds in the market — due to the amount of capital sloshing around in the yen denominated capital markets — the market participants increasingly didn't demand a premium from firms with worse credit quality.

The result of this was an increasing level of false security regarding the quality of banks — which led to the decade of zombie banks.

In essence, neither history nor rationale seems to convince us that quantitative easing will spare the United States of hard decisions. The Fed seems to know this, but a foreknowledge that the show must go on?

The columnist works for a major European investment bank in New York City. You can follow his tweets at http://twitter.com/ks1729