Erwan Mahe submits:

As the exit-strategy debate continues to pick up steam, we must be careful to distinguish between those entailing monetary and fiscal policies, because their relative priorities vary according to the economic zone.
This phenomenon was on full display this past weekend at the G20 meeting. At the meeting, the developed countries reiterated their plans to continue their stimulus spending, given the risk of “W,” as in 1937.
At the same time, India’s Prime Minister, Manmohan Singh, declared that his country will next year wind down the “significant” stimulus set up to contend with the crisis, due to “clear signs of an upturn in the economy."
This statement comes in the wake of the Indian central bank’s move last 27 October to hike certain obligatory reserve ratios on commercial banks, with the aim of withdrawing part of the liquidities from the system.
As for the United States, the debate remains open, although the first available indicators suggest that monetary policy will surely lead the “exit,” since the persistent growth in unemployment will impede the government from ending its stimulus measures for some time to come.
Just consider President Obama’s decision to sign the bill to extend the unemployment insurance payment period, thus bringing it close to the European model, and the publication of the hike in unemployment – not just the 10.20% — but, above all, the U-6 rate of 17.5%, which includes the entirety of under-employed employees. (Alternative measures of labor underutilization).
The Fed will thus have to lead the way, once it determines, as announced following its latest FOMC, that the output gap has narrowed enough for it to pull back from its highly accommodating monetary policies.
The interesting point is just how the Fed will carry out this tightening without necessarily having the same impact on the interest-rate curve as in past situations of this type, given the colossal bloating of the Fed’s balance sheet today
Several scenarios have been put forward:
  • Hiking the Fed Funds rate via an increase in the interest rate on bank reserves, which today stands at 0.25%.
Aside from the impact on interest rates, this presents the advantage of keeping the 0 billion of commercial bank liquidities in the Fed’s coffers, thereby, preventing them from dispersing into the real economy and enabling the American central bank to bolster the liability side of its balance sheet and sleep on the assets recognised on its balance sheet (MBS, treasuries, etc.). But it would then have to manage two risks: credit quality of assets and that of the rate curve.
As for credit risk, it is reasonable to think to that if it has to raise short-term rates, it is because the economy is doing (much) better, which would considerably reduce this risk.
As for curve risk, everything depends on how long it succeeds in financing at 0.25% these assets which bring a yield of between 2% (T-bills) and 5% – 6% (MBS). This would give it a certain edge in terms of carry, enabling to even hike short-term rates above the entry rate on this paper, if need be. The Fed does not really have a mark-to-market problem.
This approach has been highlighted by San Francisco Fed President, Mrs Yellen, the dove on the Fed board.
Another solution would be to set up huge reverse repo operations, for which certain tests have been performed in recent weeks, but it seems that the initial plan to address all concerned investors in order to avoid being limited to just primary dealers has been harder to implement than expected.
As such, the latter have demanded a slackening of their regulatory ratio restrictions in order to absorb such large reverse repos, should the Fed decide to go all the way with this project.
This ‘mechanist’ solution appears, like that of the 1-year term deposit, to have lost its place at the top of the list.
Another way of dealing with the liquidity situation is that defended by St Louis Fed President, Mr Bullard, who advocates simply re-selling the assets bought by the Fed during its QE. This approach presents the advantage of bringing its balance sheet in line with orthodoxy, and would surely please regional hawks (e.g., Bullard, Plosser, Lacker).
The major handicap of this technique is that, given the Fed’s stake on certain market segments (e.g., MBS), a move on these assets could push up their interest rates sharply and thus drag down further a real estate market which, in the best of cases, is in deep convalescence.
As such, we see that the impact on the interest-rate curve (bear steepening or flattening) will depend on the method finally decided upon, and I think it would be highly imprudent to guess which way Mr Bernanke will go on this issue.
For those who are passionately interested in this subject (ah yes, they exist!), let me suggest this interesting work by WSJ journalist, David Wessel: In Fed we Trust. It contains lots of juicy anecdotes on the decisions made by the Bernanke-Paulson-Geithner trio between 2007 and 2009 and gives a fascinating look at the internal debates within the Fed at the time.
But do not forget that, before considering the method to be employed, the main question to which investors all over the planet must respond is the timing of any exit strategy and the precise meaning of “extended period of time.”
We have long argued and bet that short-term rates would remain low much longer than the consensus was willing to acknowledge, given our fears of a Japanese-style deflationary spiral spreading to the US and the eurozone. We consider this risk to be very much alive today, as long as the Chinese currency remains pegged to the US dollar, leaving the US protected from inflation importation while heightening the deflationary trends on the eurozone.
Even the Brazilian Finance Minister says the Chinese peg to the dollar is a problem.
However, the statement by PBoC Governor, Mr Zhou, at the end of the G20 that “there is little international pressure to re-value the yuan” means that we are likely to suffer from Chinese-driven deflationary pressure for some time to come.
As for the Fed’s view of the output gap (i.e. the margin existing before an economic rebound creates inflationary tensions), I have attached a graph tracing the evolution of U-3 unemployment, including that published last Friday at 10.20%, and the currently more useful U-6 at 17.5%.
If we take into account that the number of hours worked by week is stuck at a record low of 33 hours, we can see the wide latitude companies have before coming under upward wage pressure, even if there were to be a V-shaped recovery.
And the 9.5% hike in productivity on an annual basis of American workers in Q3 also tallies with the total absence of inflationary pressure.
Moreover, the persistent and major credit contraction, illustrated by Friday’s publication of a new .8 billion decline in consumer credit in the US for September does nothing to bolster the arguments of proponents of a V-shaped recovery.
U-3 and U-6 unemployment rate in the US. What an output gap!

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