Markets make prisoner of the Fed
“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.
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.
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 –