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| The Queen Elizabeth II |
The Federal Reserve made its long-expected announcement earlier this week regarding "QE2", the name investors have given to his program of buying assets other than short-term Treasuries in an attempt to spur economic growth.
What is "QE2"?
The "QE" stands for "quantitative easing", and the "2" denotes that this is the second (the first being in late 2008-early 2009) round of the Fed implementing this type of policy.
Traditionally, the Federal Reserve attempts to manipulate short-term interest rates by buying and selling short-term Treasury Securities, in it's Open Market Operations:
When the Fed wants to reduce interest rates, it buys short-term Treasuries, which puts cash into circulation and pushes their price up and interest rates down. This policy is known as monetary "easing", and is seen as a catalyst to spur economic activity.
Conversely, when the Fed wants to raise interest rates, it sells short-term Treasuries, which removes cash from circulation and pushes their price down and interest rates up. This policy is known as monetary "tightening", and is seen as a brake on potential economic overheating which would lead to inflation.
Breaking out our graphs, the increase in the Money Supply is intended to work as follows:
The Fed applied traditional Monetary stimulus as the financial crisis proceeded, culminating on December 16, 2008, when the Fed
dropped its target interest rate to zero (0 to 0.25%), where it has been ever since.
Once rates are near-zero, the Fed's traditional policy tools are of no use, as rates have nowhere to go down from zero. [For an interesting discussion on why, see
this post from Greg Mankiw].
If the Federal Reserve believes that economic conditions warrant further action, it has many rarely used tools at its disposal, designed primarily to encourage economic activity by bringing down longer-term interest rates. Here is where non-traditional policy comes into play.
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Ben Bernanke
Federal Reserve Chairman |
Chairman Bernanke presciently outlined his playbook on this in a 2002 speech before the
National Economists Club. Highlights (the entire speech is well worth reading):
"Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no longer has the power to expand aggregate demand and hence economic activity."
"However... a central bank... retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is zero.'
"To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys."
On November 25, 2008, the Fed announced that it would purchase $100 Billion in GSE debt, and up to $500 Billion in Mortgage Backed Securities.
NON-TRADITIONAL POLICY
This was a significant departure from traditional policy. Prior to the financial crisis, the vast majority of the Fed's Assets (which on its balance sheet support its Debt – which is the currency in circulation) were shorter-term Treasuries.
However, this was not the first instance of new and unusual actions by the Fed – these began with Liquidity-related actions as the Financial Crisis unfolded starting in the Spring of 2008. A summary of these actions follows, by way of background:
EMERGENCY LIQUIDITY POLICIES – A SUMMARY
The first radical departures from traditional policy related to Liquidity – providing credit for otherwise-solvent* institutions which found themselves holding assets that were hard to sell during a crisis. (*This description of Citibank, et al. as otherwise-solvent at the time may be questioned; we are simply describing the Fed's policy).
During the financial crisis, the Fed undertook a number of controversial actions and instituted a number of unusual emergency lending programs to provide liquidity to financial institutions.
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Federal support programs as of November, 2008
Federal Reserve Programs at top of chart
[Click chart to expand] |
These included:
* The guarantee of $30 Billion of Bear Stearns' (BSC) worst assets, provided to J.P. Morgan as incentive for it to acquire BSC. This pool remains on the Fed's balance sheet as "Maiden Lane I".
* TSLF (Term Securities Lending Facility) – created in March, 2008 to support Primary Dealers with $200 Billion in Mortgage-Backed and other securities
* Loans to AIG collateralized by (at par value):- $40 Billion in RMBS (Residential Mortgage-Backed Securities), under "Maiden Lane II"- $60 Billion in CDO's (Collateralized Debt Obligations), under "Maiden Lane III"
* CPFF (Commercial Paper Funding Facility) – designed to bail out companies (primarily GE) who rely heavily on Commercial Paper for their financing, with a commitment theoretically in excess of $1.5 Trillion, instituted in the Fall of 2008
* ABCPMMMFLF (yes, that's Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility – thankfully shortened to AMLF in common usage) – supporting Money Market Funds which were threatened by a run in September 2008 with the collapse of Lehman, a commitment theoretically exceeding $1 Trillion
* TALF (Term Asset-backed securities Loan Facility) – the purchase of securities backed by consumer loans (such as credit cards and auto loans) designed to revive the stagnant market for these securities in November, 2008, a commitment of up to $200 Billion
* Foreign Currency swaps exceeding $700 Billion with Central Bank counterparties at the height of the crisis in the Fall of 2008
* Nearly $150 Billion credit extended through the Primary Dealer Credit Facility in the Fall of 2008, which extended the Fed's Discount Window to all qualifying Financial institutions (not only the Primary Dealers who normally are the only entities which may access the Discount Window)
* Guarantee of up to $300 Billion to support Citibank's toxic Tier III Asset portfolio.
* Guaranteeing over $100 Billion of Merrill Lynch's (ML) assets to support Bank of America's September 2008 purchase of ML
The total liquidity commitments ran into the several trillions by early 2009, and the Fed's balance sheet ballooned with a hodgepodge of unusual assets (including, among other things, empty shopping malls).
These actions were designed to stave off what the Fed saw as the imminent collapse of the Financial system itself.
We discussed these actions in earlier articles, click to link:
What's that Smell? September, 2008
The Garbage Barge October, 2008
The Garbage Mega-Ship February, 2009
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The Mobro, the original "Garbage Barge", in 1987
Did the Fed's balance sheet become the new Garbage Barge? |
These policies do not fall under a narrow definition of "Quantitative Easing", as their purpose related to the emergency provision of liquidity, but we outline them to give a sense of the Fed's willingness, prior to its initiation of Quantitative Easing, to embark on bold and unusual policy initiatives.
NON-TRADITIONAL MONETARY POLICY
At the height of the crisis, with interest rates already at zero, the Federal Reserve perceived that the "real economy" (as opposed to its financial plumbing, which was addressed through its liquidity measures) was in danger of a severe and deep contraction.
As noted above, with rates already near-zero (during the crisis, rates actually fell below zero as terrified investors around the world scrambled to hold Treasuries, the one asset considered universally safe), the Fed found itself without access to the policy levers it normally uses to prod economic activity (the purchase of short-term Treasuries to lower short-term rates).
QE1 (and QE 1.5)
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| The RMS Queen Elizabeth, launched in September 1938 |
QE1 -
The November 2008 announcement of $600 Billion in GSE and MBS securities indicated that the Fed would now target interest rates further out on the yield curve – that is, it would attempt to encourage economic growth by lowering medium- and long- term interest rates through the purchase of large quantities of longer-dated bonds. This is the "quantitative" in "quantitative easing": the injection of quantities of money into the economy that takes place through the process of buying longer-term bonds and securities.
QE1.5 - The November 2008 announcement was followed in March 2009 by the announcement of
massive ($1.2 Trillion) additional purchases of:
* Up to $750 billion of additional agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion
* Up to $100 billion of additional agency debt bringing the total up to $200 billion
* Up to $300 billion of longer-term Treasury securities
The March 18, 2009 Federal Reserve statement included the dismal report that:
"Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession. And despite almost two years of near-zero interest rates, economic conditions have remained poor."
By way of explanation for its now $1.8 Trillion quantitative-easing program, the Fed stated that;
"In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability."
And so it did!
The effects of QE1 are controversial, but if it is true that "Bonds Don't Lie", the effects are visible in the path of the yield curve leading up to and after QE1, but are more muted after QE1.5:
QE2
A year and a half after the last round of QE1, with the economy still in the doldrums, the Federal Reserve has determined to take additional action with
a new round of Quantitative Easing.
Citing ongoing adverse economic conditions:
"…the pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed."
The Fed has determined to:
* Purchase
$600 Billion in longer-term Treasury securities, and
* Reinvest what analysts indicate is approximately
$300 Billion additional from principal repayment on existing securities held by the Fed into the purchase of new securities.
The total Quantitative Easing between QE1 (and QE1.5) and QE2 thus falls in the range of
$2.8 Trillion. For perspective, going into 2008, the Fed's balance sheet consisted of between $800 and $900 Billion of Assets, primarily short-term Treasury Securities.
The recent and projected expansion of the Fed's balance sheet is illustrated by the following graph, from
Zero Hedge:
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Past & Projected Federal Reserve Balance Sheet
Source: Zero Hedge |
WILL QE2 "WORK"?
To answer this question we must go back to the question of whether QE1 "worked".
+ THE POSITIVE ARGUMENT
Certainly the yield curve responded across the board at a time coincident with the original policy, and it is not unreasonable to assign causation to the Fed's actions.
This allowed homeowners facing rate resets to refinance at more beneficial rates than would otherwise have been the case, and also permitted companies to refinance their existing debt also at favorable rates, perhaps ameliorating an incipient funding crisis.
- THE NEGATIVE ARGUMENT
However, there are several criticisms which must be considered:
* It is reasonable to note that the real economy has only returned to anemic growth, which may or may not be ascribed to Monetary policy, and of late has stalled and remains below the threshold at which employment can stage a meaningful recovery.
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| Data Source: Bureau of Economic Analysis |
Real economic activity remains below the level of three years ago, with the only increase among the components of GDP (aside from a small reduction in the trade deficit) being Government Spending:
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Real GDP and components, Fourth Quarter 2007 versus the most recent Third Quarter 2010
Data Source: Bureau of Economic Analysis |
One criticism aimed at Monetary Policy as a means of stimulus is that it does not, in fact, promote real economic growth at all.
If business conditions are such that firms are unwilling to expand, then there will be no demand from "Main Street" for the excess funds provided by the Federal Reserve to the banks.
However, these funds must go
somewhere.
Where have they gone?
* The lack of demand for credit from businesses can be seen by the large buildup of bank reserves during this period. While the Fed can make credit available, it cannot force unwilling entrepreneurs to take risks by borrowing.
* The yields on Junk bonds have shrunk to levels generally last seen near their peak prior to the crash. Money is obviously flowing to these higher-yielding, and risky, assets instead of its intended target of business expansion, as investors who are facing negligible returns on Treasuries chase higher yields. The chart of Barclay's junk bond ETF (NYSE: JNK) illustrates the effects:
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| Barclay's high-yield bond fund (NYSE: JNK) Nov 2008 through Nov 2010 |
* One also must note that the Stock market bottom roughly coincided with QE1.5 in March 2009. Here also, one might reasonably conclude that the money not being borrowed by individuals and businesses is instead inflating a risky asset class.
SO, QE2…
Evidence that the excess money will inflate asset bubbles rather than real economic growth has accumulated in advance of and immediately following QE2:
* Stock prices surged through the fall in anticipation of, and accelerated in the two days following, the Fed's November 3 announcement
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| S&P500 ETF (NYSE: SPY) Aug-Nov 2010 |
* Commodity prices have skyrocketed, with Gold reaching all-time highs, and many other basic commodities up 30% or more year-over-year
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| Gold Prices Jan-Nov 2010 |
* Emerging market economies are facing hot capital inflows – as evidenced, by way of one example, by the boom in Indian equities. The financial officials of these countries have
expressed concerns.
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| The India Fund (NYSE: IFN) 1-year Nov '09 through Nov '10 |
In a remarkable moment of candor for a Central Banker, Federal Reserve Chairman Ben Bernanke actually confirms that it is targeting Stock prices (emphasis ours):
"…And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."
Here Chairman Bernanke is referring to the "Wealth Effect", by which consumers and investors who feel their wealth increasing will be more likely to spend and invest.
There are two poignant counterarguments (among many) that may be offered against this notion:
1) The "Wealth Effect"
The most recent manifestation of the "Wealth Effect" led to homeowners using their houses as ATM's, withdrawing home equity to spend on consumer items and actually saving at a negative rate (why save when your home value is growing by leaps and bounds?).
This did not end well.
The Wealth Effect works both ways - on the way up, and, in reverse on the way down.
2) Stock prices
Consider a share of IBM stock. A share is essentially a claim on a company's long-term stream of cash flows. These cash flows are determined primarily by industry conditions, the company's competitive position, and its sales, marketing, operating, and financial policies.
Fundamentally, a share is "worth" only the present value of its long-term stream of cash flows.
The
price of the share, however, is determined entirely by investor sentiment. If you bought a share of IBM in August at $125, and today, thanks in large part to easy Fed policy, the bid is $146, Chairman Bernanke would like you to feel more wealthy and spend some of that extra $21 on… well on pretty much anything except your savings account or your credit card bills.
However, while the
price of the share has changed, IBM's long-term stream of cash flows have changed not at all. The fundamental drivers of IBM's long-term success are the same as they were. The share still represents the same claim that it did before.
All that has changed is that there is more money chasing risk – driving the premium for risk down (and the price of stocks and high-yielding bonds, up).
Post-crash, investors are painfully aware of the potential for a reversal. And so with many analysts already viewing share prices as overvalued by fundamental metrics, encouraging them higher may reasonably be questioned as a proper goal of the US Federal Reserve.
Is QE2 a dangerous and potentially hyperinflationary "Monetization"?
This concern has been articulated loudly by many critics.
The answer is: Yes and No.
Yes, the Federal Reserve is directly buying Treasury securities, which is the definition of Monetization.
No, in that the Monetizations that precede Hyperinflationary episodes generally occur when the Central Bank buys Government Debt
that no-one else will buy. The Fiscal authorities go to the Central Bank as a last resort when their creditors desert them, which leads to a hyperinflationary spiral. This was the case in Weimar Germany, post-war Hungary, and most recently, Zimbabwe.
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| Hyperinflation in Zimbabwe, 2008 |
In the case of today's Federal Reserve, the Central Bank is purchasing the debt with the explicit goal of lowering interest rates and
deliberately triggering some level of inflation. There has yet been little evidence of a serious slackening of demand for US Government securities among the usual buyers (although concerns have been expressed).
And, the Fed has repeatedly indicated confidence in its ability to ultimately withdraw the excess Money Supply from circulation in an orderly manner. (This claim also has come under criticism.)
CONCLUSION
Some have argued that QE2 amounts to a deliberate, competitive debasement of the currency with the goal of manipulating a change in the USA's current account imbalances (by increasing exports), and/or an attempt to inflate away the value of the national debt. We take the Federal Reserve at its word that these are not its
deliberate intentions.
But the question remains:
Will QE2 create the inflation desired by the Federal Reserve, and will this inflation spur economic growth?
Both parts of this two-part question are subject to a high degree of uncertainty.
Will QE2 create the inflation desired by the Federal Reserve?
Fine-tuning the transmission of Monetary growth to inflation is a risky enterprise. Very often, inflationary forces build up for a period of up to two or more years unseen, only to explode with a vengeance – too late to put the Monetary genie back in the bottle.
If so, will this inflation spur economic growth?
And the question of whether inflation spurs economic growth was in the United States most recently answered "no" in the 1970's Stagflation episode.
So what should the Fed do to spur growth?
"What is do be done?", you ask?
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| Lenin asked: "What is to be done?" in his seminal 1902 pamphlet |
This is the eternal question raised by bureaucrats, central planners and central bankers of all stripes ever since the rise of the modern state. The underlying premise, of course, is that
something must be done – the question precludes the notion that
doing nothing is an option.
Here, several schools of economists diverge:
* Keynesians would argue that something must indeed be done, and would support precisely the sorts of Monetary policies that the Federal Reserve is undertaking (indeed, they are currently running the show), as an increase in Money will boost economic growth.
* Supply-siders would concur that something must be done, but would argue that Monetary policy is ineffective at promoting real growth and instead only creates inflation, and that Fiscal and (De-)Regulatory policies to encourage business activity are the way to go.
* Classical Economists would follow the advice of President Hoover's Treasury Secretary Andrew Mellon, whose counsel on what to do about the Great Depression was:
"Let the slump liquidate itself. Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate... It will scourge the rottenness out of the system. High costs of living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people".
* Austrian Economists might suggest that instead, doing nothing is indeed an option, and that the best thing the Federal Reserve can do (besides
disband!) is to simply preserve the value of the currency, providing some certainty to businesses and individuals as they make economic decisions.
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| Andrew Mellon: Liquidate Everything! |
The results of QE2 will unfold over time, although as with all economic policies, the extremely complex nature of the system will likely allow advocates of all points of view to plausibly claim vindication. Such is the nature of the "dismal science"!
In any event, QE2 is underway. "ALL ABOARD!"
[Click here to play]
- Peter T. Murphy, November 5, 2010
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