Today’s commentary
Summary: At 2PM ET today, the Federal Reserve is releasing the latest FOMC statement. Market players do not expect the Fed to taper its large scale asset purchase program because recent economic data in the US have been weak. Given controversial comments by Eugene Fama about QE yesterday on CNBC, I thought I would lay out some thoughts on QE and the Fed’s predicament on tapering.
I am going to do this post in reference format by running through the arguments we have made in previous posts tagged ‘Federal Reserve’ here at Credit Writedowns.
When the Taper began
Going back to the original taper talk in May, I had signalled in early May ahead of the tapering talk that the Fed’s reaction function and the economy were co-dependent because as the US economy stalls, the Fed’s timetable gets pushed back. And so, it is important to take a view on whether QE and other Fed policy moves will be enough to overcome fiscal tightening. I don’t believe monetary policy at the zero lower bound is sufficiently impactive for the real economy to overcome the negative effects of reduced fiscal stimulus and declining deficits. Therefore, I have always expected the Fed to keep rates at zero percent for much longer than most other market participants, irrespective of what it does regarding quantitative easing.
Soon after that, Bernanke started to act as if the Fed was so uncomfortable with the market’s reaching for yield that the Fed would start to taper its large scale asset purchase (LSAP) program aka quantitative easing. As I wrote yesterday, sometime early in the year the Fed did become uneasy about QE as its main monetary policy tool – to the point where Bernanke felt he had to defend QE. By May then, Bernanke decided he needed to chart an exit path from QE and that’s when the tapering talk began.
At the time Bernanke began the tapering talk, I wrote that “I don’t see QE ending until at the end of the year. From what I have seen, the numbers do not add up to an unambiguously positive economic picture. And that means the reasons for QE remain in place. The problem in my view is asset market froth, particularly in bond markets where private portfolio preferences have moved to higher yielding and riskier asset classes. I believe the Fed is concerned about this and will look to taper asset purchases as soon as they can, depending solely on the pace of economic growth.” I did, however, assume that the Fed would taper – in mid-year already – because of concerns about asset markets. That never came to pass. Not only is QE still happening now, but the pace of the LSAP program continues unabated. So the Fed has actually been more aggressive than I anticipated when Bernanke talked about tapering.
The violent reaction to tapering
Maybe I was actually right about what Bernanke had intended to do. But as soon as Bernanke talked taper, the market sold off violently as punters rushed for the exits. Here’s what I wrote at the time on the Fed’s tapering and the volatility in Japan, which was at the epicentre of the early taper-induced market volatility:
“Yesterday, Ben Bernanke said that the Fed would start to wind down its QE program sometime this summer as I indicated early last week I believed the timetable would be. Market pundits believe these remarks triggered a sell-off in global equities, with Japan being hardest hit as the Nikkei fell 7.3% this morning. I was more concerned about the poor Chinese PMI print. But if the pundits are right, it is an extraordinary move into risk-off thinking given that the Fed had telegraphed its intentions. This incident shows you how the Fed’s exit path is fraught with risk. Japan is another story altogether.
Early this month, I noted that the data started to break a bit to the downside and wrote my daily commentary saying that as the US economy stalls, the Fed’s timetable is getting pushed back. Since that point three weeks ago, various Fed officials have reinforced this idea, stressing that the purchasing of assets could accelerate or decline depending on the state of the economy, particularly jobs.”
The point here was that although the Fed wanted asset markets to cool, the Fed was also jarred by how much the markets had sold off. Fed officials did not expect talk of tapering to have such a pronounced effect on private portfolio preferences. And so you should see this as a major error in Fed communication, one that they tried to undo immediately afterwards – but without success.
How QE works
Now, the interesting bit here is that Eugene Fama is right about how QE works. It is basically an asset swap. No new financial assets flow to the private sector on net. The Fed just swaps whatever asset it buys with reserves that it creates. In this vein, Steve Keen wrote a good post explaining how QE works and what it means for asset prices and credit at the end of May as the market volatility was beginning. He echoed Fama’s characterization and added further that QE has no direct real economy effects. But Steve also pointed to the private portfolio preference channel as a source of volatility that had the potential to produce asset bubbles and malinvestment.
“the ‘printing money’ moniker that critics give to QE is misguided: it actually creates no additional money at all (outside of the gain banks will make on the repo deal). For money to really be created, QE would have to go directly to the Deposits of the public in the private banks, and that’s not what QE does. ‘Printing Money’ is therefore a false model: it implies that Ben Bernanke is printing greenbacks and mailing them in little brown envelopes to everyone on Main Street, and that’s not even close to how QE operates.
[…]
“QE isn’t going to cause The Great Inflation as some of its critics fear, but nor is it going to restore normal economic activity, as Bernanke appears to hope it will. However it’s not “mostly harmless” either: it could well be guilty of another charge critics throw at it, of artificially inflating asset markets in a way that could lead to market crashes when it is unwound.”
Basically, the Fed is a monopolist in that it controls the interest rate for overnight money absolutely through its pegging of the Federal Funds rate for bank reserves and its payment of interest on those reserves. Through interest rate expectations then, the Fed extends its influence beyond the short-end to all interest rates. Bernanke understands this, explaining in March how the Fed exerts a dominant influence across the yield curve, not just on the short end. He said that:
it is useful to decompose longer-term yields into three components: one reflecting expected inflation over the term of the security; another capturing the expected path of short-term real, or inflation-adjusted, interest rates; and a residual component known as the term premium.
And he went on to explain how QE and forward guidance and other Fed policies are designed to alter not just short-term rates but also expected inflation and the expected path of short-term real interest rates. Because we are at the zero lower bound in the US, the Fed cannot use short-term interest rates to influence the economy. Therefore, the Fed is trying to exert more influence over the rest of the curve by altering the expected path of inflation and future real short-term interest rates.
The real problem here is that the Fed’s reaction function and the pace of economic growth are mutually dependent, making the Fed’s reaction function time inconsistent. If the Fed changes the economy in any way, over time its reaction function will change as well. And so as the Fed has become more and more dependent on altering expectations to influence the economy, it has been forced to build up a whole edifice of tools to signal exactly what it intends to do in order to minimize the perceived and actual volatility in its reaction function.
If the Fed presidents all release forecasts for inflation and growth, and the Fed sets quantitative targets based on economic variables on how quickly it will taper, they are essentially tying their hands. They are telling the markets, “we will only deviate from our expressed present reaction function if the data do not pan out the way we are predicting.”
Market over-reaction
The markets didn’t understand this in May and went berserk when the Fed said it expected to taper. In June, after the Fed released the next FOMC statement, I wrote that, based on the Fed statement, the Fed will not raise rates until at least mid-2015. This was nothing new. Fed officials had been saying this for weeks. But, the markets sold off. I wrote: “Now, the problem here is in terms of market expectations. As you know by now, non-interest rate monetary policy like quantitative easing works mostly through an expectations and private portfolio balance channel. This means that QE is mostly about telegraphing the Fed’s stance as either more or less accommodative, allowing investors to shift private portfolio preferences as a reaction. What the market heard yesterday was that the Fed is relatively bullish on the US economy.”
So, it was all about risk off. And yet again, the Fed had made a hash out of its communications strategy.
I wrote that “the Fed is more dovish than the market believes it is. I would call the Fed’s statement neutral to dovish whereas people like Krugman think the Fed is being more hawkish. I was on BNN yesterday before the Fed news and I predicted the Fed would simply reiterate its talking points based on everything I outlined here. And that’s what they have done.”
Here’s the important point though:
“Ben Bernanke’s discussion about Abenomics gave clues to why he is unfazed by this.
“Bernanke was asked by a Japanese reporter whether he still supports Japan’s economic policy in the face of the extreme levels of market volatility in Japan. Bernanke said ”I’m supportive of what Japan is doing,” arguing that aggressive policy is warranted even if it causes the markets to be volatile initially. I thought this was interesting. First, Bernanke’s support of Abenomics implicitly shows him as relatively dovish. He implied he would want the same policies in the US if deflation threatened the US economy. And if Bernanke thinks Abenomics will initially mean volatility that diminishes over time as the markets get used to the new policy, he is implying that the Fed’s telegraphing its tapering timetable is similar; markets will learn over time that the Fed will stick to a timetable based on the guideposts, thresholds and targets it has laid out. Bernanke’s comments on Japan suggest that he believes the short-term volatility in markets due to aggressive monetary policy is worth the benefits of its long-term objectives and that he will continue to telegraph the Fed’s expected tapering timetable with respect to the FOMC’s economic forecast central tendency.
“In sum, the Fed is relatively dovish and it will remain so for the foreseeable future.”
We now see, in fact that this was the right call. The markets have gone completely the other way now, with expectations for rate hikes pushed all the way back to late 2015, even later than the Fed was saying in June. In my view, Bernanke has been vindicated because the initial volatility has subsided and now the Fed has people’s expectations lining up more with reality.
Bubbles
The problem with all of this, of course, is that it is asset-market driven. The Fed, by operating solely through the expectations and private portfolio preference channels is effectively boosting the economy only by boosting asset prices. And that means its QE and permanent zero rate policies create bubbles that are destabilizing. The Fed feels backed into this corner mostly because fiscal policy has become ‘anti-stimulative’. I put it this way in June:
“Yes, fiscal policy has had its day via massive trillion budget dollar deficits. However, after the initial crisis fiscal flurry in 2009 and 2010, the budget deficits were only an artefact of automatic stabilizers and low tax receipts. In fact, the fiscal drag in the Obama Administration has been the greatest since Eisenhower. You wouldn’t know this from listening to what people are saying in the media. But the numbers are telling you that fiscal policy is NOT the principal tool the US government has used to fight this economic crisis. And we are now looking to cut fiscal spending in the US. Fiscal is out.
“What does this mean for the economy? I like to point out that monetary policy does not add net financial assets to the private sector but fiscal policy does. And this is significant in an environment in which policy rates are at zero. What it means is that there can be no credit boom from the Fed’s interest rate lever. But given the primacy of monetary policy, there can be no addition of net financial assets from government largesse to boost the economy either. Instead, the economy is relying on the Fed’s quantitative easing to help boost asset prices and keep long-term interest rates low.
“So the Fed faces a problem. This way of adding stimulus invites speculation as investors leverage up and reach for yield. And the Fed doesn’t like this – hence Bernanke’s comments highlighted at the outset. The increase in yields is therefore positive in Bernanke’s view if it chastens speculators who are leveraging up in a way that could be destabilizing. On the other hand, the Fed wants low rates because it means more credit growth, lower debt burdens, and higher economic growth as a result.
“Bernanke made clear in his testimony before Congress that the Fed is more accommodative as a way of actively counteracting tighter fiscal policy. He began his speech saying, “The economic recovery has continued at a moderate pace in recent quarters despite the strong headwinds created by federal fiscal policy.” Bernanke wants lots of monetary stimulus then as a safeguard against debt deflation. But of course rates are at zero percent i.e. they can’t go any lower. So, how does the Fed finesse this problem? It uses its other unconventional tools – the ones that have caused investors to reach for yield and take on risk. I don’t envy the Fed”
What this effectively means is that asset prices will remain inflated as long as the economy is growing and recession is not on the horizon. Some asset classes will benefit more than others. For example, during the tapering selloff, we saw huge flows out of emerging markets as investors reduced risk and repatriated liquidity. In the US in the MBS market, where the Fed has been making large scale asset purchases, convexity hedging exacerbated the volatility due to expected tapering. Now that tapering is off the table it is risk on again.
But as soon as markets get a whiff of recession, the downdraft in risk assets will be even more violent than during the tapering episode. That’s when we will uncover significant amounts of malinvestment. And the credit writedowns will come back in earnest. Until then, you as an investor or businessperson are forced to be invested in an upturn that you cannot have full confidence in, cognizant that the eventual downturn could be violent and sudden as it was the last two times.
Implications for the future
The first question has to do with tapering. What happens when the Fed does taper? Peter Stella laid out some exit-path scenarios for collateral chains that I recommend. The most important implication of his analysis is that central banks will exit policy accommodation by raising interest rates first, not by shrinking balance sheets. I like the post because Peter goes into the operational challenges posed by the exit path. But I want to concentrate on the corollary of this interest rate first approach. And that corollary is that the Fed needs to prepare for an interest rate hike.
The Fed has already started to set out a whole battery of expected economic scenarios and has also told us what its triggers and thresholds are for future action. Based on all of this, we now have a much clearer picture of the Fed’s reaction function, time inconsistency notwithstanding. This is exactly what forward guidance is all about. To that point, Fed President John Williams even wrote a piece as an explanation of forward policy guidance at the Federal Reserve. So I believe the Fed will more heavily lean on this policy tool going forward in order to pave the way for interest t=rate hikes. It has set up some of the infrastructure for doing so but we should expect more rigour from the Fed in doing so as time goes forward. I think the Fed knows it has not done very well on its communications strategy and so I expect it to work to improve it. With Yellen coming on as Fed Chair, I also expect this improvement to be more geared towards creating rules that lock the Fed into a more limited policy space in order to make forward guidance more credible as a policy tool.
Regarding the asset bubbles the Fed is creating, Fed officials are concerned. I have heard a lot of officials talk about it. I think Jeremy Stein’s speech on central banks leaning against asset bubbles was the most illuminating. He basically says that the Fed is not going to change monetary policy to lean against bubbles. However, he leaves the door open for some regulatory enhancements that are very much in line with the Fed’s warning on credit standards in the leveraged loan arena.
The bottom line here is that the Fed remains dovish, more so now that US economic data is weakening. It is not going to actively lean against bubbles. And so we should expect asset markets to stay in risk-on mode until the data weaken enough that fundamentals begin to undercut the risk-on sentiment. We are not there yet but I believe the move to risk-off will be sudden and violent.