It’s the (REAL, not the financial) economy, stupid!


“Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook…

…To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.”
-Federal Reserve Press Release, September 13, 2012.

The Federal Reserve, in its own words, has a dual statutory mandate to foster maximum employment and price stability. That is part of the reason the following statement (from Chairman Bernanke during the Q&A session when he unleashed the latest round of quantitative easing) was so interesting:

“One of the main concerns that firms have is there’s not enough demand. There are not enough people coming and demanding their products. And, if people feel that their financial situation is better because their 401(k) looks better or for whatever reason—their house is worth more—they’re more willing to go out and spend, and that’s going to provide the demand that firms need in order to be willing to hire and invest.”

In other words, the Fed is relying on the wealth effect. It can’t directly bring down unemployment (i.e., part of the “real” economy), so it is focusing on the areas that it can affect, the financial economy and asset prices. Since both PCE and Core CPI inflation measures have been fairly low and are unlikely to become uncomfortably high in the near term due to the slack labor market, low capacity utilization and stagnant incomes, the Fed is again taking aim at asset prices.

The central bank cannot enact infrastructure or research programs, it can’t reform the tax or regulatory codes, and it can’t institute trade reform or any other reform that might give those who hire (i.e., businesses) any clarity about the future upon which they might make long-term decisions. That is the job of Congress, and Congress—arguably by choice—has avoided doing much of anything about any of these issues. After all, they have more important things to worry about, like their jobs and those of their colleagues. This has left the Fed as the de facto last man standing for economic stimulus.

The obvious question to ask is, “Has QE worked?” This is a very tough one to answer because there are a lot of moving parts in the employment market. In my mind, the evidence is mixed at best. Let’s oversimplify the analysis for a moment. The chart below plots the Federal Reserve balance sheet against the 4-week average of initial unemployment insurance claims. The chart shows that initial claims began to decline shortly after the Fed embarked on QE1, and the trend in claims has been lower ever since. At the same time, the same kind of drop in initial claims has happened—in many cases much more quickly—in every past recovery coming out of recession, and those past recoveries had no QE.

The Fed will correctly point out that it could have been much worse. They would likely suggest that there was a risk of a negative feedback loop like the one that took over during the Great Depression. Their actions, they have argued, helped to avoid that. Okay, but rates are already at generational lows, so it doesn’t seem to me that there is any rate impediment that is keeping people or businesses from borrowing or banks from lending. In light of this, I have to wonder aloud, “Is the Fed really trying to keep interest rates down to spur lending, or are they just trying to push capital into risky assets by crowding it out of Treasuries and agencies?”

Let’s not forget the actual mechanics of how Quantitative Easing works:

  1. The Central Bank credits its own account with money
  2. The Central Bank buys longer-maturity Treasuries and Agencies with the new money.
  3. Theoretically, those bond prices go up and yields go down (In reality, the market anticipates and pre-adjusts rates down, so usually rates rise when the program starts). This puts cash in the hands of the banks.
  4. Banks should lend some of that money, and it should be at lower interest rates since the banks own borrowing costs should be lower.
  5. That increased bank lending, if it manifests, should spur economic activity in the real economy.

Steps 1 – 3 are the mechanical steps. Steps 4 – 5 are what the Fed aims to accomplish as the “trickle down” to the real economy. Through the first two rounds of QE, the evidence is mixed on points 4 and 5. Lending has picked up some, but much of the cash has remained on bank balance sheets as the chart below of U.S. banking system equity/assets shows. At the consumer and corporate levels, there has been a lot of refinancing to lower rates for existing loans, but new loan growth has been tepid at best over the last few years.

A week or so has now passed since what has been dubbed QE-infinity was announced. After a brief and violent move up, the price action has now settled down for many risk assets. Many asset classes like gold (GLD) and the S&P 500 (SPY), as one might expect, moved higher. The big surprise was crude oil which moved lower.

The experiment of QE lives on. We in the U.S. are part of the experiment. The Europeans are in, and Japan, the kings of QE, have been in the lab for decades. The experiment can probably go on for longer than many of us expect, but it can’t go on forever. We will know that the experiment has “worked” if the employment situation gets back to normal before inflation starts to move above central bank targets. That would be the positive outcome. A very difficult central bank decision will arise should uncomfortable inflation show up before we reach full employment. If that day comes, it will most likely be the day that we know the Fed is out of proverbial bullets and we will need to rely on our legislators to legislate. Either way, at some point in the future, we will get to take part in a new experiment—the unwinding of QE. That could be just as “exciting” as the initial implementation.


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