The Impasse of Monetary Policy Part 3 - food for thought

Why The Fed, by itself, cannot deliver a sustainable recovery?

 Part 3 : food for thought 

2.3   What should the Fed worry about now?

·      Life after QE:  The Fed’s QE program had different goals and outcomes all along.

The successful QE1, which bought about $1.7 trillion worth of mortgage-backed securities and Treasury bonds between Nov 2008 and March 2010, helped banks as house prices started to crawl back from the depths of the recession.

By comparison, QE2, a $600 billion program which lasted until June 2011, targeted to lower long-term interest rates, with a view to “promote a stronger pace of economic recovery”.  This one was viewed as failing to meet its objective.

QE3, which was announced in September 2012, was a lot more audacious and targeted: having observed the tight correlation between the size of QE and stock market appreciation it was going to bet boldly in that direction. By levitating the values of financial assets while spending a monthly $85 billion for an open-ended period, it was banking on the “wealth effect” of investors to serve as a catalyst for economic growth and job creation. Two years and over $1.8 trillion later, the results are in: the stock market climbed another 40% in that period but the “trickle-down” economics experiment failed. The recovery is still tentative and more QE could have precarious and unintended consequences, including speculative extremes. 

The question now is what other kind of unconventional monetary tools the Fed can employ if and when the economy relapses again: more QE is clearly not the answer and relying on forward guidance (“talkware” as I call it) does not look overly promising.

·       Size of its balance sheet: The Fed’s balance sheet had almost quintupled to over $4.5 trillion in assets in Q3 2014 when compared to its pre-recession size of seven years ago. The financial press continues to suggest that, should interest rates rise faster than anticipated, the Fed – which now controls assets 80 times larger than its own equity capital – cannot completely ignore the risk posed by such unprecedented leverage. Just a mere 1.5% drop in the value of its bonds would wipe-out the capital on its books.

Although the Fed is better equipped than anyone to deal with the technicalities of potential balance sheet impairment, it would undoubtedly be at the expense of public confidence, the most valuable asset it has. So the question of how to gracefully unwind or shrink that balance sheet cannot be ignored, even when considering that, at 20% of nominal GDP, its scale is comparable to the ones used by most central banks in Europe or the U.K. That being said, it is noteworthy that the only time the Fed’s balance sheet attained financial leverage close to this proportion was during the Great Depression.

The issue finally boils down to whether any central bank can indefinitely suppress interest rates in a “market-based” economy. If unlikely, then how to shrink that balance sheet becomes not an option but a strategic choice to be made as part of a master plan.

·       Monetary velocity:  This measures the force with which money is put to work in the economy and is a key metric the Fed relies on to gauge inflation. According to recent research published by the St. Louis Fed, the velocity index was hovering around 4.4 for most of 2014, significantly below the 17.2 measured just prior to the recession. The inference here is that the private sector is holding more cash, or hoarding money, instead of spending it either for consumer consumption or industrial investments.

Households alone are reported to be sitting on well over $2 trillion in savings - about 50% higher than five years ago, despite negligibly low interest rates on their deposits. This implies that far more people than before have chosen cash over interest-bearing assets such as government bonds -- let alone equities -- from a risk/reward perspective. Increased thrift is an undesirable drag to the credit-multiplier-effect that the Fed wants; but, overheating asset prices made more savers hold cash despite repressive interest rates encouraging to do just the opposite.

·       Soaring stock markets: QE1 alone was behind the first 70% appreciation in the S&P 500 index which went on to triple in value between March ’09 and August ’14. In about 5.5 years the S&P has indeed climbed from 700 to 2000 as a majority of yield-starved investors embraced both stocks -- and bonds -- as the least bad of all alternatives.

But it would be a mistake to think of the stock market as a “leading indicator” of economic recovery. It is indeed that misplaced sense of confidence in the inflated value of stocks which preceded the crashes of 2001 and 2008. No, increased investor wealth does not easily translate into more jobs and rising incomes– both largely considered as indispensable for economic growth in a consumption society like the US. The “trickle-down” theory of supply-side economics is again proving to be unreliable at best.

What looks more certain however is that the next recession, most likely associated with a severe stock market contraction, will be attributed to the prolonged period the Fed maintained its ZIRP and QE policies. Artificially low interest rates have a history of conditioning investor psychology to overlook the inherent risks with capital allocation: how can the Fed forget that cheap credit, maintained for a period longer than necessary, was directly linked with the real-estate bubble that led to the Great Recession of 2008?

·    Adverse global cross-currents: To-date only the US, Japan and the UK have chosen QE to flatten the yield curve -- or overtly control long-term interest rates-- through the massive swapping of cash with tradable bonds. The ECB has stayed clearly behind, up until now.

But, as the US starts withdrawing QE while Japan continues to expand its own program, we have already witnessed abrupt exchange-rate dislocations -- harbingers of disruptive capital flows and potential trade conflicts. If and when the EU decides to embrace QE, because it is out-of-synch with the US, it will cause a similar except much larger instability in exchange rates and capital movements. The impact on the US of such instability is not clear yet.  Stalling, if not reversing of the potential US recovery with external forces capable of enlarging the trade deficit and adding to deflationary risks (coming from lower import prices) should be a concern for all American economic policymakers, including the Fed.