Looking Beyond Quantitative Easing

| May 22, 2013

During the past several years, the Federal Reserve has engaged in a historic market intervention through its quantitative easing (QE) programs. Early on in the process, Federal Reserve Chairman Ben Bernanke indicated that the intent of the intervention was to inflate the stock market and thereby spur a “virtuous cycle” through which the economy would be reinvigorated. Predictably, the economy has failed to respond meaningfully to QE as it continues to be constrained by excessive debt. However, the stock market has responded to artificially low interest rates and the cyclical bull market from 2009 has accelerated into a highly speculative advance that exhibits the characteristics of a prototypical bubble.

As an academic, Chairman Bernanke has exhibited the tendency to expect markets to behave rationally throughout his career. For example, many years ago, he argued that excessive debt would almost certainly not become a problem in the US because allowing debt to reach excessive levels would be irrational. Yet, here we are. Similarly, he probably did not expect the recent QE programs to create a speculative bubble in the stock market, but that is precisely what has occurred. As with all such highly speculative advances, the inevitable correction will be equally violent in character. It is only a question of when.

Additionally, it is important to reflect upon the extremely difficult task that will face the Federal Reserve when the time comes to reverse the QE process. How will this historic amount of monetary stimulus be withdrawn from the system without engendering significant economic disruptions? In a recent weekly commentary, fund manager John Hussman reviewed the unpleasant consequences of Federal Reserve policy that will need to be addressed after QE ends.

Over the past three years, the U.S. economy has repeatedly approached levels that have historically marked the border between expansion and recession. There is little question that massive quantitative easing by the Federal Reserve has successfully nudged the economy away from this border for a few months at a time. But as I’ve noted before, the belief that monetary easing solved the 2008-2009 financial crisis is an artifact of timing. The Fed was easing monetary policy throughout 2008, and while it is tempting to view the recovery as a delayed effect, the more proximate factors were a) the change in FASB accounting rules to dispense with mark-to-market accounting, which relieved banks of insolvency concerns even if they were technically insolvent, and b) the move to government conservatorship and Treasury backstop of Fannie Mae and Freddie Mac, which reduced concerns about default risk among mortgage securities.

The Pavlovian response of investors to monetary easing – as if it has anything more than a transitory and indirect effect on the economy – fails to distinguish between liquidity and solvency; between economic activity and market speculation; and between investment value and artificially depressed risk premiums. The economy is not gaining anything durable from these policies, and the conditions for the next bear market are already established. Meanwhile, the chart below updates the extreme that monetary policy has already reached (data points since 1929).

The 3-month Treasury yield now stands at a single basis point. Unwinding this abomination to restore even 2% Treasury bill rates implies a return to less than 10 cents of monetary base per dollar of nominal GDP. To do this without a balance sheet reduction would require 12 years of 6% nominal growth (which is fairly incompatible with sub-2% yields), a more extended limbo of stagnant economic growth like Japan, or significant inflation pressures – most likely in the back half of this decade. The alternative is to conduct the largest monetary tightening in the history of the world.


Category: Commentary, Market Update

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