Can Tightening Fight the Collateral Shortage?

Tyler Durden of Zero Hedge claims that any taper in QE will be a response to the collateral shortage — the fact that quantitative easing has stripped an important part of the market’s collateral base for rehypothecation out of the market. With less collateral in the market, there is less of a base for credit creation. The implication here is that quantitative easing is tightening rather than easing credit conditions. The evidence? Breakdown in the Treasuries market resulting in soaring fails-to-deliver and fails-to-receive:

20130621_fails_0

Tyler notes:

Simply put, the main reason the Fed is tapering has nothing to do with the economy and everything to do with the TBAC presentation (rehypothecation and collateral shortages) and that the US is now running smaller deficits!!!

I don’t disagree with this. The ultra-low rate environment (that is still an ultra-low rate environment in spite of the small spike in Treasuries since murmurs of the taper began) on everything from Treasuries to junk bonds is symptomatic of a collateral shortage. Quantitative easing may ease the base money supply (as an anti-deflationary response to the ongoing deflation of the shadow money supply since 2008), but it tightens the supply of collateral.

The evidence on this is clear — expanding government deficits post-2008 did not bridge the gap in securities issuance that the financial crisis and central bank interventions created:

assets

The obvious point, at least to me, is that it seems easier and certainly less Rube Goldberg-esque to fight the collateral shortage by running bigger Federal deficits until private market securities issuance can take its place. Unfortunately quantitative easing itself is something of a Rube Goldberg machine with an extremely convoluted transmission mechanism, and fiscal policy is not part of the Fed’s mandate.

But I am not sure that tightening can fight the collateral shortage at all. The money supply is still shrunken from the pre-crisis peak (much less the pre-crisis trend) even after all the quantitative easing. Yes, many have talked of the Federal Reserve inflating the money supply, but the broadest measures of the money supply are smaller than they were before the quantitative easing even started. This deflation is starting to show up in price trends, with core PCE falling below 1% — its lowest level in history. Simply, without the meagre inflation of the money supply that quantitative easing is providing, steep deflation seems highly likely. I don’t think the Fed can stop.

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Even After All The QE, The Money Supply Is Still Shrunken

Here are the broadest measures of the US money supply, M3 and M4 as estimated by the Center for Fiscal Stability:

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With the total money supply still at an absolute level lower than its 2008 peak, it is obvious that the Federal Reserve in tripling the monetary base — an expansion by what is in comparison to other components of M4 a relatively small amount — has been battling staggering deflationary forces. And with the money supply still lower than the 2008 peak and far-below its pre-2008 trend, the Fed is arguably struggling in this battle (even though by the most widely-recognised measure, the CPI-U the Fed has kept the US economy out of deflation). 

Those who have pointed to massively inflationary forces in the American economy based on a tripling of the monetary base, or even expansion of M2 clearly do not understand that the Fed does not control the money supply. It controls the monetary base, which influences the money supply but the big money in the US economy is created endogenously through credit-creation by traditional banks and shadow banks. The Fed can lead the horse to water by expanding the monetary base, but in such depressionary economic conditions it cannot make the horse drink.

What does this imply? Well, either the monetary transmission mechanism is broken, or monetary policy at the zero bound is ineffectual.

What it also implies is that hyperinflation (and even high inflation) remains the remotest of remote possibilities in the short and medium terms. The overwhelming trend remains deflationary following the bursting of the shadow intermediation bubble in 2008, and to offset this powerful deflationary trend the Fed is highly likely to have to continue to prime the monetary pump Abenomics-style into the foreseeable future.