Exit, Stage Right – Fed to Stop Bond Buying, Uncharted Waters Ahead
In just a few days the Federal Reserve is expected to officially announce that it will stop the program known as “quantitative easing,” that has been pumping $85 billion a month into the economy for the last several years. Some will then be saying that it didn’t work, while others will say that it did.
The truth is, however, that both perspectives are somewhat true, and I just don’t think answering the question as to which one is more right, really matters at this point. It is what it is, and we are where we are.
Okay, so first let’s briefly look at how the program worked and what it was supposed to do, then what it did or didn’t do and why… and finally, let’s look at what’s likely to happen in the months to come now that the program has ended. As Alan Greenspan was quoted as saying a couple of days ago, we’re in “uncharted waters,” but just because we can’t know everything about what’s to come, doesn’t mean we can’t all benefit from knowing more about what’s going on.
When an economy falls into a recession, or in our case, a deep, protracted recession such that might be called a depression, there are two types of policy that can be used to make things better again: monetary policy and fiscal policy. The latter has to do with taxes and government spending to stimulate economic growth, the former is what we’re talking about here and it has to do with increasing the money supply.
The first thing that’s done when economic conditions worsen, usually due to a speculative bubble popping or some sort of corporate malfeasance finally transforming into a mega-bankruptcy or slew of filings, the first thing that those in charge of monetary policy do is lower interest rates. You might remember all of this from the years after the dot-com bubble burst in April of 2000, or maybe you remember it as following 9-11.
Lower interest rates stimulate an economy by lowering the costs of borrowing for both businesses and individuals, which leads to higher levels of spending all around, which ultimately means economic growth. After dot-com days came to a close, we had lost over $7 trillion in consumer wealth ($7.3 trillion, as I recall), and so the Fed under Chairman Greenspan predictably dropped rates and, that time around, we all started buying houses, which fueled the bubble whose demise we’re still dealing with today.
However, if the economy hasn’t done much recovering as a result of rates nearing zero, as happened by 2010, then it’s time to bring out the big guns of quantitative easing in order to start firing mountains of money more directly into the economy.
In other words, if the low rates aren’t leading to higher levels of borrowing and therefore spending, then the Fed will simply start shooting the extra cash directly into our financial institutions. (Picture fire hoses on full blast shooting money into commercial banks and other private financial institutions.)
In case it’s not obvious, lower interest rates can only stimulate spending and hence the economy if people are: a) able to borrow, which means qualified borrowers in terms of FICO scores and existing debt-to-income ratios and b) willing to borrow, which means they are optimistic enough about their future prospects to take on additional debt. It also helps a lot if there is credit available in the first place, which means having financial institutions not flirting with insolvency.
If people have dramatically reduced their spending due to enormous losses resulting from a bubble’s demise and from which they haven’t recovered, as was the case this last time spent circling the proverbial drain, then it also should be obvious that you can shovel as much dough as you want into bank vaults and corporate coffers, but Best Buy isn’t going to expand its stores until people are shopping at Best Buy again.
Quantitative easing has meant that the Fed went on a bond-buying spree of unprecedented proportion, and by that I mean to the tune of $85 billion a month, as I read the other day. They buy short-term government bonds in order to lower short-term market interest rates, and once those rates near zero, they buy assets with longer maturities to lower longer-term interest rates.
So, that’s how they pump the money in. They purchase these short- and long-term assets from various kinds of banks, the thinking being that these banks will loan out the mountains of excess cash in order to earn a return on their assets greater than otherwise available.
What they’re doing is increasing the money supply… more money to borrow, more money to spend and presto-magico before you can say government stimulus, you’ve got the economy back on track and making stops at ‘The American Dream’ once again.
Why didn’t it work?
First of all, it worked to some degree, how could it not? It’s $85 billion a month for three years. I keep seeing different totals being tossed around in the press, but the number is $4 TRILLION on the Fed’s balance sheet, according to William Dudley, president of the New York Fed. And that’s a lot for any two or three economies.
It didn’t work because… well, because of what was said above. The banks got the money injected into their vaults, if you will, but they didn’t lend it out, instead they did things like making sure it was earning interest on deposit at the Federal Reserve.
It’s not that banks didn’t want to lend money out… that is how they make money after all. It’s mostly because there aren’t enough qualified or willing borrowers around. In addition to whatever else you might want to say, people either can’t or don’t want to borrow, and business is not going to borrow or expand until there’s demand… which means consumer spending.
Now, one would think that all of that was foreseeable, but quantitative easing went forward regardless of whether or not it would have its desired effect. In large part, I’m sure it was a case of “the only port in a storm.” They had no other tools left in the monetary policy tool box, and when $40 billion wasn’t cutting the mustard, they had to figure that $85 billion a month had to do something positive, especially if you did it long enough, right?
Well, that’s also, of course, right… it did have to do some positive things, and can be used for other purposes beyond lowering and holding down interest rates. Quantitative easing, thought of as monetary expansion, can also be used to help ensure that inflation doesn’t fall below its target rate, for example. If it works too well, it can cause higher levels of inflation… when it doesn’t work it’s because banks don’t lend the money out.
The problem has been that most obvious what it’s done for the already very wealthy. I’m sure it’s also done positive things for the country’s economy as a whole, so in that sense I’m sure it has benefitted all of us, perhaps not directly, but at least in the sense that it would have to have been somewhat worse without it.
The International Monetary Fund (IMF) along with a slew of economists would say that the quantitative easing undertaken over the last few years has mitigated some of the adverse effects of the crisis. I would respond that whatever those benefits have been, they were counterfactual in nature, and as such imperceptible by regular people… and then I start chewing them out for being obtuse, insensitive and incompetent… at least that’s how my fantasy of responding to the IMF and other economists ends.
However, I don’t think further discussions on that subject matter much at this point, except of course as historical analysis. That’s what it was, why they did it… … how it worked, why it didn’t… and also did. It’s over now. Based on what the Fed has said, November will be the last month of its foray into quantitative easing, and the market will be much more on its own for the first time in years.
What’s a market to do?
While speaking at the Council of Foreign Relations in New York last Wednesday, former Fed Chair Alan Greenspan was asked if the Fed would be able to avoid “sparking a crisis.” He replied that the Federal Reserve wouldn’t be able to stop its expansive monetary policy without causing the financial markets “turmoil.” He said he doesn’t like the word, “crisis.” Specifically, he said he preferred “turmoil.”
He also said, “I don’t think it is possible.” He doesn’t think it’s possible for the Fed to stop quantitative easing without causing turmoil… he doesn’t want to refer to what he sees as being inevitable as being crisis-like. But he’s okay with inevitable turmoil.
Greenspan declined comment on the optimal timing for the Fed to start raising short-term interest rates, but that is what’s coming at some point… soon. (And I don’t think there is optimal timing for raising rates in an economy this anemic.) He also confirmed that banks had just kept the money on deposit with the central bank, acknowledging that the program has failed to “spur demand,” and then he went on to characterize demand as being “dead in the water,” which makes inflation “dead in the water.”
All of those sorts of statements portend an economy that essentially continues to run along the bottom of a ditch.
The success part of the trillions in quantitative easing, beyond its effect on long-term interest rates, Greenspan described in terms of “boosting all income-earning assets.” And all one has to do is take a quick look at a stock market chart for the last few years to see what the former Fed Chair meant by that.
It’s also why the rich have done nothing but gotten markedly richer since quantitative easing began 37 months ago.
That’s the LAST THREE YEARS of our economy being supported by gargantuan monthly deposits of cash into our financial system, so the question on everyone’s mind is: How will our economy do on its own? Will it get out of its metaphorical wheel chair and walk under its own power straight out of the hospital doors, will it limp along in severe pain, or will it collapse onto legs whose muscles have atrophied?
Or, will it need to be dragged along by the Fed holding it up as if in “Weekend at Bernie’s?”
Greenspan readily admitted that we’re in “uncharted waters,” so the answer is that no one knows much of anything with certainty, although that doesn’t mean we can know nothing either.
I’d say it’s absolutely safe to assume that the Fed will do anything and everything to soften the blow to the economy to whatever degree possible. That doesn’t mean it will be a non-event… there will certainly be turmoil, as Greenspan said, but I have to think that whatever the scale is that’s being used to measure the turmoil, it will end up somewhat less than it might have been.
Not that whatever amount of such turmoil couldn’t do plenty of damage to your financial underpinnings mind you.
It’s certainly not going to make interest rates lower, I’ll say that… and it’s also not going to make the stock market shoot up to new highs, or anything like that, either. As a matter of fact, It’s going to have the opposite effect in both cases, the only real questions involve how much and when. And as to the answers to those sorts of inquiries, I’m afraid you’d need a crystal ball that’s actually operational, being run by someone we can trust and that knows how to use it.
Absent those things being in place, it’s nothing more than fodder for one of those office pools where you bet like $20 by buying a square on which is depicted the outcome of a sporting event, like the Super Bowl. Good luck!
The fear is deflation… the opposite of inflation… and a much more difficult problem to solve if you’re a central bank. Deflation occurs when people aren’t spending, so corporations cut prices, and that leads to reduced corporate profits, which means lay-offs and higher unemployment, which further reduces spending… and the cycle repeats and continues.
With the lowest interest rates in modern history having failed to stimulate demand it’s hard to imagine that deflation isn’t a possibility, and I’m sure it’s a major concern. But, I’m equally sure that the Fed will do things like very gradually reduce its holdings purchased as part of quantitative easing, so any effect will be spread over time. They’re not going to allow us to drive off a cliff.
No, I’m sure the Fed will issue soothing statements about how it will keep short-term rates low for quite some time. It may even delay its expected announcement until it figures out how to stop the easing without long-term interest rates spiking up like the hair on a 13 year-old boy. They might stop paying interest on deposits held at the central bank… that tradition only started in early 2009, when former Fed Chair Bernanke went to Congress to get permission to do so.
Eliminating the interest paid on deposits, the thinking would be, that the banks would want to put that money to work since it isn’t earning anything while parked at the Fed. I don’t know… seems like it’s a move that would be subject to more of the same problem we’ve had all along… “demand is dead in the water,” as Mr. Greenspan said.
I have to think it’s also possible that the Fed’s fears will compel it to announce less than is expected, perhaps they’ll just lay out some criteria for when quantitative easing’s monthly bond buying should be stopped, while not actually stopping it now. Central bankers are said to believe that long-term rates are already higher than they should be at this stage of the recovery.
But, regardless of the specifics, the Fed has unquestionably made it clear that quantitative easing is coming in for a landing, so get ready everyone. Buckle your seat belts because we’re going to experience some turmoil ahead. Fed Flight Attendants will be coming around to pick-up any drinks, and let’s get those tray tables back up right now… you wouldn’t want to be decapitated by one of those trays when we hit the bumpy air that’s just ahead.
“Excuse me, Flight Attendant?”
“Yes, sir, how can I help you? I am a little busy preparing for the crisis… I mean, the crash… no wait, I mean turmoil. I’m getting ready for the turmoil, sir.”
“I’m scared. Just how bad do you think it’s going to be?”
“Well, sir, I really don’t know, but between you and me, the captain said he pegs it somewhere between needing to keep your vomit bag close by, and having to use your seat cushion… as a toilet. Does that about cover it for you, sir.”
“Could I please have a few of those little bottles of vodka you guys have on the cart?”
“Sure, sir, how many would you like?”
How many are there in a… do they come by the case?”
VOICE OVER: “At Fed Air we realize that you don’t have a choice, but we appreciate you flying with us anyway. Fed Air… Where it may not be pretty and it may not be fun… but we will get you down.”
I hope this was helpful…
And remember… be careful out there.