Markets make prisoner of the Fed

October 22, 2010

“Market participants should not direct policy,” Kansas City Fed President Thomas Hoenig warned listeners at a town hall meeting in Lincoln, Nebraska, back in August. Unfortunately that is precisely what is now happening.

Hoenig noted that Wall Street’s clamour for cheap money was not disinterested: “Of course the market wants zero rates to continue indefinitely … they are earning a guaranteed return on free money from the Fed by lending it back to the government through securities purchases.”

Now the same pressure groups want the Fed to launch a second round of asset purchases so they can sell U.S. Treasury bonds to the central bank (in effect back to the federal government) at inflated prices.

A new round of securities purchases provides investors with an exit strategy from what might otherwise be a dangerous bubble in the bond market. Every bubble needs a “greater fool” prepared to pay a higher price for the asset to keep the bubble inflating. In this case, the guaranteed sucker is the Fed itself.

Meanwhile quantitative easing (QE) has pushed up the value of all the risk assets institutions and investors hold, giving the market a highly desirable insurance policy.

Set aside the question of whether the Fed should socialise investors’ risks and losses in this way. Set aside also the issue of moral hazard — whether by bailing out investors the Fed will encourage more excessive risk-taking behaviour in future. Most officials admit recent actions have increased moral hazard but believe it is a problem to be solved in the long term by appropriate supervision.

The immediate policy question is whether the prospective QE programme is contributing to stability in the financial markets and an environment likely to encourage more long-term investment by businesses and job creation. In other words, is QE succeeding in its own terms, meeting the objectives set by the central banks themselves?
There are several reasons to be extremely doubtful.

BROKEN LEVER?
Proponents of QE argue massive asset purchases undertaken by the Federal Reserve and the Bank of England cut long-term interest rates and credit spreads in 2009, and prevented the economies of the United States and the United Kingdom tumbling into a much deeper recession and deflationary spiral.

Reviewing UK experience earlier this month, Bank of England Executive Director Paul Fisher claimed its 200 billion pounds of asset purchases kept broad money growth higher than expected given previous contractions in nominal gross domestic product (GDP); lowered long-term rates by 100 basis points; cut credit spreads; supported equity and debt issuance; and lowered interbank borrowing rates sharply.

Speaking about the same time, New York Fed Executive Vice President Brian Sack claimed the Federal Reserve’s own programme lowered long term rates about 50 basis points. Sack admitted diminishing returns would eventually set in but insisted “the tool appears to be working, and it is not clear that we have yet reached a point of diminishing effects”.

All these estimates focus on the financial impact of QE. No one doubts QE has profoundly affected prices for financial assets. The problem is that the impact on real assets (homes, factories, spending and jobs) is harder to discern.

The Bank of England and the Fed acted much earlier and more aggressively than the Bank of Japan. In proportionately the largest easing anywhere in the world, the Bank of England bought assets amounting to 14 percent of GDP in just ten months; the Bank of Japan bought assets worth 13 percent of nominal GDP over a period of 5 years.

But all this activism has bought only a tepid recovery in output and jobs. In the United States inflation is still below the Fed’s desired level. It’s a lot of dollars for a small measurable effect, leading some observers to wonder if the monetary transmission mechanism is broken. Sack disputed that as “overstated” but admitted certain aspects were “clogged”.

One remedy for a clogged pipe is to apply overwhelming force to clear the blockage and restore the free flow. Presumably, if the Fed and other central banks do enough QE, even a clogged transmission mechanism will eventually pass on some of the effects to the real economy in the form of inflation, output and jobs.

Interviewed by the Financial Times, Harvard Professor Kenneth Rogoff likened the Fed’s predicament to a golfer stuck in a sand bunker. “Tap lightly and the ball will not get out of the hazard. I would say: I am now going to slam the ball and I don’t know where it is going to go but if ends up on the fairway I am going to hit it towards the hole”.

Rogoff admitted inflation could easily overshoot the desired level, but said the Fed could commit to act aggressively to rein it in again should that happen.

INDUCING INSTABILITY?
This blunderbuss approach is not entirely comforting. The collateral damage could be worse than the disease. It might not even work. PIMCO Chief Executive Mohammed El-Erian warns in the same FT interview “any quantitative easing will go straight out of the U.S. and into the rest of the world” via the carry trade.

It points to a deeper problem: Fed policy, especially its increasingly aggressive flirtation with unconventional measures, risks becoming a source of instability and uncertainty for investors. It may actually be harming rather than promoting a sustainable recovery in output, employment and prices.

Sack has already admitted the Fed’s balance sheet expansion works in part because it “adds to household wealth by keeping asset prices higher than they otherwise would be”. But this divergence between “fundamental” values and market prices is inducing the sort of self-validating behaviour and reflexivity that billionaire hedge fund owner George Soros has identified at the root of every bubble.

Former Fed Chairman Alan Greenspan and his colleagues have been criticised for cheap money policies that inflated a string of bubbles, first in dotcom stocks then in the bond market and housing. But bubbles were the accidental effect of policy. Sack’s discussion of QE suggests inflating a new financial bubble is now the deliberate target of policy.

Why should that matter? The central problem is that it introduces a massive policy contingency into asset prices. Equities, bonds, currencies and commodity prices are now only valued at their current prices on the assumption the Fed will undertake and continue massive QE for an indefinite period.

But that expectation is predicated upon failure and is not time consistent. If QE works, the Fed will quickly end it. If QE fails, the Fed would come under pressure to do more. Either way, the policy-dependent future path for asset prices is increasingly unstable.

In the face of so much uncertainty rational investors have shown a strong preference for highly liquid (financial) assets over less liquid investments in new buildings, factories and expansion plans that would be costly to reverse.

Unfortunately the Fed cannot now easily reverse course. Substantial QE has been priced in. “Increased expectations for balance sheet expansion in response to the September FOMC statement also generated a substantial response,” according to Sack. The Fed dare not risk disappointing those expectations now.

The market has successfully taken the Fed prisoner. But officials do not want to make an open-ended commitment to using the blunderbuss.

Hence the arcane (illogical) debate about whether a gradual discretionary approach to asset purchases to preserve the Fed’s policymaking flexibility can be coupled with a hint but not a formal commitment to a large overall total to validate market expectations. If these two approaches appear contradictory, it is because they are.

The solution is not blunderbuss QE to unblock the clogged monetary pipe, but applying a solvent in the form of carefully calibrated measures to unglue the credit markets and promote a stable outlook for investment. Confidence, not panic-driven liquidity, is what investors need now.

- The views expressed are the author’s own -

12 comments

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This is no less than a disaster in the making.

Posted by yr2009 | Report as abusive

Ah, the Fed, the Fed..what did we do to deserve these characters ? We need a national bank whose charge it is to support the American economy instead of enriching it’s member banks.

Posted by gramps | Report as abusive

Anyone reading this article just use in your mind the words PRINTING MONEY when ever you see the words QUANTITATIVE EASING or QE,and you will understand all these finance articles a lot better. When they use SOCIALISE that means our taxes prop them up

Posted by diddums | Report as abusive

Thank you for this blog post. The commenter, then, becomes the critic who shapes the writer’s next content. So I want to encourage you to keep on blogging in the same style as you writing style is really perfect.
SEO Armenia

Posted by tatushik | Report as abusive

I don’t see the author’s name on this page, but I’d like to offer congratulations on his/her concise depiction of the QE problem.

I was looking forward to the conclusion that such an astute author would supply at the article’s closing.

I have to say that the last paragraph of the article is a disappointment. The author points out what IS NOT the solution, then slips out the back, Jack by supplying an plumbing analogy as to what IS the solution.

What exactly would that “solvent” consist of? What “carefully calibrated measures” will unglue the credit markets and promote a stable outlook for investment?

I’m not just being flippant. I agree with yr2009 and diddums that QE2 is a dreadful idea.

I have some ideas of my own, but I’m genuinely interested in what this author might suggest and how he/she thinks those measures might play out.

Posted by breezinthru | Report as abusive

BTW, murfster could well be right about this, but I like to think that a less destructive solution exists.

Posted by breezinthru | Report as abusive

This is all about forcing (trying to force, hah, instead of balancing a budget) China’s currency to trade by un-pegging (destroying) the dollar, which is a much bigger source of instability. Don’t think for a moment that monetary policy is being driven by Fed ‘mandates’. It is being driven by geo-politics. Mexican standoff.

For those Chinese not steeped in North American lore, a Mexican standoff is a slang term defined as a stalemate or impasse, a confrontation that neither side can foreseeably win. The term is most often used in lieu of ‘stalemate’ when the confrontational situation is exceptionally dangerous for all parties involved.

In the end, there will be a global deal and global, commodity-backed ecurrency – and a lot of damage getting there probably. Sooner the better…

Posted by McBurney | Report as abusive

@breezinthru

The quality of a solution depends on the quality of the definition of the problem. Poor definition leads to poor solutions, and often to none.
Bad solutions lead to second and third generation problems that can be worse that the original ones.

If you wrongly define a problem, you cannot find a good solution, because you’d be looking in the wrong place, and using the wrong tools.
The ongoing recession / depression is not a problem in itself – It is the manifestation of a problem, i.e. a symptom.
Similarly, the bubble that preceded it is not a problem in itself, but the manifestation of a problem, i.e. a symptom too.

So what is the underlying problem that so far has manifested itself in a housing / financial bubble, then morphed into a recession, and is now is being transformed into a catastrophe?

Clearly, this problem is inefficient allocation of capital across the US economy, and apparent growth (pseudo growth, bubble) morphing into negative growth, in the form of a recession with chronic high unemployment.
What’s been causing this efficiency problem is the political manipulation of markets, through subsidies, discriminatory taxation, bailouts, and other distortions imposed by legislators from both parties in the past decades.
The problem is basically a social and political one.
As long as laws favor one economic sector (i.e. Housing & Mortgage, through tax laws) or activity (financial markets) over another, there will be severe distortions in the US economy in the form ‘credit crunch’ for many businesses that can create real (i.e productive) jobs and healthy economic growth, and on the other hand, ‘bubbles’, i.e. inflated prices in the subsidized markets, such as the Housing / Mortgage markets.
What the Fed and this Administration have been doing so far is applying extreme measures to solve a problem they have erroneously defined. Doing so is further weakening the US economy, instead of healing it, and putting it on the right track.

Posted by yr2009 | Report as abusive

Back 100 years ago we would have had a tar-and-feather party for Bernanke and Geithner, the two Administration snake oil salesmen.
Today because we are civilized and socialized we let them go on their merry way, strewing financial ruin in their wakes.
Make no mistake. Those two are waaay out of their depth and if they continue their misguided policies we will look back on this year as the good old days…

Posted by stanrich | Report as abusive

QE or purchasing of longer term bonds as a method of injecting money and liquidity into a faltering, no growth economy is perhaps the last tool left in the Fed’s basket to stimulate the economy. The Fed controls only Monetary tools to affect economic growth and inflation pressures.

Fiscal policy tools are largely controlled by Congress and its tax and spend initiatives and legislation. Inconsistent and growth counter-productive fiscal initiatives by the Congress, including anti-growth marginal tax increases, health care cost increases foisted on businesses and consumers, non-productive regulatory changes that amount to ‘closing the barn door after the horses have left the barn’ have created uncertainty which prevents or disincents rational business and consumer spending from energizing GDP and job growth. GDP growth and job creation would also increase Federal tax revenues without increasing marginal tax rates, which is a well recognized by eonomists as counter-growth tax policy. Politicians largely ignor the reality of such economic realities as they seek quick fixes which sound good to some voters but have adverse effects on the economy. Bernanke is doing his best to stimulate growth with his available tools. Congress now focuses on budget cutting and tax increases which stiffle growth. Spending control and deficit cutting is a great goal, but must come second to growth initiatives in a very weak economy. Economic growth will produce tax revenues and jobs and therefore help the deficit problem, and also take pressure off the dollar.

Posted by Dan-SF | Report as abusive

The race is not for the swift

Posted by COOKRconsultant | Report as abusive

The trade of QE causing intense inflation harming primarily the poor and further QE to keep the S&P alive is a hard choice.

The Poor, rationing between food and fuel, now reaching to the lower middle class, which Mr. Bernanke when addressing food & fuel doesn’t consider as real inflation conflicting with Europe’s measurements; or propping up the S&P and Dow by maintaining a cheap dollar and pushing exports.

Unfortunately his positive arguments for QE is weakened by the Large corporate entities going rapidly offshore to avoid paying American Corporate taxes. It’s tough when your chosen constituents stick it up your rear.

Posted by kenezen | Report as abusive