The first Quantitative Easing program was pretty much universally applauded. At the time the global financial system was descending into a dangerous self reinforcing deflationary spiral. Something needed to be done and Bernanke’s bold plan was just the ticket. It worked wonders. Markets stopped going down. The economy stabilized. The crisis seemed to have been arrested. Then the QE program ended. Before too long, everything started sagging again. The Fed had hoped that the economy was strong enough to stand on its own, but they quickly came to the conclusion that more QE was needed. This time the consensus amongst market participants was not as unanimous. There was a growing group that worried the Fed had embarked on a dangerous path from which it would be difficult to deviate. They even wrote an open letter to the Fed outlining their concerns:
We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.
We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.” In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.
We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.
The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.
The Federal Reserve respectfully disagreed and pushed through with the second round of QE. This again resulted in the hoped for effect of pushing inflation expectations higher and stopping the deflationary dip. Yet once again at the end of the second QE program, the anticipated point where the economy could stand on its own proved elusive. As soon as the Fed stopped its purchases, everything once again sagged. Before too long, the Fed decided that they needed to provide some other form of stimulus, so they engaged in Operation Twist. This program extended their balance sheet out the yield curve. This was surprisingly effective, but as soon as it ended, the deflationary tendency reasserted itself. Then in his final big decision as Federal Reserve Chairman, Bernanke made the daring bold gamble of the third QE program. This time instead of stating the amount of Quantitative Easing ahead of time, the Fed said they were going to keep expanding their balance sheet until their objectives were met. It was a risky move and if there was public outcry with the previous two QE programs, that was nothing compared to the criticism of this program dubbed QE infinity (due to the fact that it had no end date).
I was skeptical that the Fed would be able to control what parts of the economy would be inflated, and worried that it would result in inflation in areas that they weren’t expecting. Well, it looks like I was wrong. Along with all their other cynics who felt that Bernanke’s balance sheet expansion was going to end in tears, we stand here today with the US economy in the best shape of the previous five years.
But we aren’t weaned off the QE quite yet. At the end of the previous three programs, the deflationary impulse resumed. The Fed judged that the economy could not stand on its own and quickly panicked. Was that panic justified? Did they really need QE2, Operation Twist and QE3? We will never know.
The market has learned to be scared of the ending of the Quantitative Easing programs.
Have a look at this chart of one of the Fed’s favourite indicators of inflation expectations – the 5 year 5 year forward breakeven rate (I know that seems overly complicated, but think about it as a long run inflation barometer):
I believe the market is in the process of discounting the end of the third Quantitative Easing program. They are testing the Fed. I am not yet sure how it is going to resolve itself.
My best guess is that much of the Fed’s largesse found its way into financial markets. As the Fed winds down their expansion, this will pressure financial asset prices. But I am still not sure whether this will translate into an actual real economic slowdown.
Could it be that the Fed panicked too early on their previous attempts at stopping QE? Were the horrors of 2008 still too fresh in their minds? Did the markets scare the Fed into more QE programs? And if so, did that push up financial asset prices to levels that make the eventual removal even more difficult?
This time I don’t think the Fed is going to respond to the market’s wailing. The Fed has seen how the previous QE programs have helped exacerbate the growing inequality problem. Yellen has even been warning how markets are getting frothy.
The best the market can hope for is a Fed that is slow to raise rates.
This time, even if the deflationary spiral sets in, I suspect they are going to let it play out. Rightly or wrongly, we are going to plough through the removal of QE. We are going to answer the question as to whether the economy can stand on its own two feet without a Fed that is expanding its balance sheet.
The markets are scared of this fact. They should be. Too much cheap money has sloshed its way into markets pushing them to levels that make expected future long term returns skinny. But markets aren’t the same as the economy.
My guess is that the economy would have healed on their own without the third Quantitative Easing program. I am confident that the first QE was the right thing to do. I am unsure about the next two programs. But I feel strongly that the third program was a mistake. We will never know whether it was needed or not, but there can be no denying that it has pushed financial markets to levels whose unwind might actually cause a disruption that once again affects the real economy.
In the coming months be careful in assuming that;
- a growing economy means higher financial asset prices
- declining financial asset prices means a deteriorating economy
If I had to guess, we are going to have both a growing economy and declining financial asset prices. The days of all the benefits going to Wall Street while Main Street is left out in the cold are probably behind us.
On Friday the unemployment report indicated that the economy continues to improve. Yesterday the JOLTS data confirmed that trend. The total Job Openings exploded to a level that is higher than the peak of the 2007 expansion.
The ZeroHedge types will highlight how the job openings are indicative of the problem of an insufficiently trained workforce. They might be correct that this is contributing to the JOLTS data being a little higher than it should be. But don’t overthink this – the employment picture continues to improve. It is good news and shows no signs of slowing down.
And don’t forget that the Fed puts a lot of stock in the JOLTS data. The Atlanta Fed’s graph of the condition of the labour market shows that JOLTS data accounts for three of the inputs.
I know the markets are wobbling because of the removal of QE, but the Fed is not going to set monetary policy based on financial markets. Although many other parts of the global economy seem to be descending into a deflationary funk, the US economy is perched to take off.
Maybe the rest of the world is going to drag down the budding US economic recovery. That certainly wouldn’t be out of the question.
But when I look at the declining energy prices, the stronger US dollar and the lower long term interest rates, I see some very big tailwinds at the back of the US consumer. There used to be a saying that you should never underestimate the average American’s ability to spend. That went away with the 2008 credit crisis. However I suspect that in the coming year, many of the pessimists will be surprised at the strength of the American economy.
Don’t forget that today we get the release of the Fed minutes. There is going to be growing debate amongst the Fed governors on the appropriateness of the emergency low Fed funds level. The market will most likely be surprised by the apparent hawkishness of the minutes. Don’t forget – the Fed follows their models and many are pointing to the fact that rates are too low. This worry will come through in the minutes.