All in. The Fed and the US Treasury are now throwing everything into the battle to eliminate dislocations in the financial system, avert a deflationary spiral, and generate growth again over the medium term. Their reasoning is that the US remains mired in a deep recession.
Initiatives. This week, the US Treasury fleshed out its Financial Stability Plan. The core of the scheme is a Public-Private Partnership Investment Program, now also providing funds and guarantees for “legacy loans". And the Fed had already announced last week that it would step up its purchases of long-dated securities including Treasuries (pages 2-5).
Risks. These plans are, however, not without problems. This year, for example, the budget deficit will likely balloon to 12½% of GDP, and debt will rise to over 100% of GDP over the medium term according to the IMF. In addition, the Fed is quadrupling its balance sheet (cf. chart).
Fed. That harbors substantial inflation risks further down the road. Our analysis shows, however, that the Fed has the instruments to siphon off excess liquidity again. The question remains, however, whether it can also do this in a timely manner and on an adequate scale and avoid Congressional criticism (pages 6-9).
Hope. The latest initiatives, however, were greeted by equity markets, which chalked up strong gains. That, combined with the initial rays of hope on the data front, underpins our expectation for economic stabilization in the course of the second half of this year.
ECB. Contrary to the Fed, the European Central Bank still has scope to lower its key rate. Next Thursday, we expect the ECB to lower the refi rate by 25, possibly even by 50 basis points. At the same time, it will announce further "unconventional measures", but not switch to a Fed- or Bank of England-style quantitative easing (pages 10-11).
Further topics: – Data outlook: US & EMU economic climate to stabilize (page 12). – Market outlook: EUR in demand, govies to tend sideways (p. 20).
Geithner plan to help cleanse bank balance sheets but is no cure-all
Treasury Secretary Tim Geithner unveiled long-awaited details of his Financial Stability Plan to the acclaim of a number of major institutional investors as well as of the stock market.
The core of the scheme is a Public-Private Partnership Investment Program, PPIP, through which the US Treasury will co-invest with private sources of funds to buy socalled “legacy loans and securities” from banks.
The Treasury essentially has pasted together two entirely different schemes, with differing mechanics and sources of financing: (1.) A legacy loan program to auction off troubled loans, overseen and financed by the Federal Deposit Insurance Corporation, FDIC; and (2.) a legacy security acquisition program that will be partially financed through the just-launched Fed-Treasury Term Asset-backed Securities Loan Facility, TALF.
Notwithstanding the strong vote of confidence of the stock market and some investors, the ultimate success of the initiative is not assured. It depends on whether banks are ready and willing to sell illiquid assets at prices below where they are currently marked on bank balance sheets.
