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Two warnings about quantitative easing, the taper, and what comes next

27 September 2013

Summary: Quantitative easing is the easy cheap stimulus (unlike the politically difficult but effective fiscal action. Like heroin, it provides a lift with no ill effects. Slowly economists begin to realize that the cost of QE is not paid up front, but during withdrawal. Faced with the necessity and cost of tapering, last week the Fed wiffed. They’re at bat again in October and December, hoping for strong growth to mask the pain of tapering. Here we have analysis from two experts who warned about the risks and weak benefits of QE, explaining what comes next.

Withdrawal

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Contents

  1. The state of play today
  2. Russell Napier
  3. Richard Koo
  4. For More Information

(1)  State of play

Fed faces trap as it frets over withdrawal from QE” in the Financial Times — “The exit from QE is always going to be messy … {as} rising rates threaen growth .” It reads as though written today. But it was written on 9 January 21, during QE1. But even then the addictive nature of QE was obvious, as was the eventual problem of withdrawal.

Look at the history.

  • QE1: Q4 2008 to Q2 2010 — $1.3T, large impact, easy to end
  • QE2: Q4 2010 to Q2 2011 — $600B, much less impact, easy to end.
  • QE3:  Q4 2012 to ?? — initially $40B/mth, in December increased to $85B/mth, little or no broad impact, first attempt to stop aborted.

Monetary easing might share the key characteristics of heroin  (see here for details).

  • Feels great (i.e., market love it).
  • Rapid increase in tolerance, so that increased dose needed for same effect.
  • Continued use leads to addiction, and withdrawal pains.

Now the people who warned of this danger when we started QE repeat their warnings as we attempt to end it.  They have been ignored so far. The Fed’s actions at their October and December meetings will show if the Fed Governors share their fears. Only time will tell if they are correct.

(2)  “Beyond easing: QE has failed to lift inflation or boost credit demand”

Russell Napier, CLSA, 25 September 2013 — Excerpt:

A major change is coming, where bad news will be seen as such. The fact that the economic recovery remains anaemic will not be a reason to cheer as it will prompt more QE: it will be a cause for gloom, because it will show that QE is not producing growth and inflation.

… Boomers heading for retirement. US bank property lending and total bank credit have been contracting since April. Total household borrowing is just off its 3Q12 low — and this is only because of the relentless growth of student debt. As baby boomers prepare for retirement — degearing, saving more and spending less — banks are struggling to create credit or money growth. Younger Americans, crushed under student loans and with balance sheets badly hit by lower property prices, cannot gear up to offset this. Meanwhile, real personal disposable-income growth is at levels associated with recessions, bond yields are rising and inflation falling.

Ben Bernanke warned in his November 2002 “helicopter” speech that he would never allow the USA to have inflation below 1% and nominal interest rates near zero. We are almost there now and any shock to aggregate demand could quickly move us to that nightmare scenario.

(2)  “US faces QE ‘trap’”

Excerpts from report by Richard Koo (Chief Economist), Nomura Research Institute, 25 September 2013:

(a)  Koo shows that the Fed’s communication policy is to say what will work today, relying on our amnesia about what was said yesterday.

Your brain on QE

Your brain on QE

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While the Chairman is obviously concerned about tightening of financial condition, he has also argued — quite optimistically, in my view — that the recent surge in interest rates was a one-off event triggered by leveraged bond speculators rushing for the exits. He claims that the steep rise in rates was due to the existence of “excessively risky and leveraged positions” and that renewed talk of tapering would not lead to a similar rise in rates now that those positions are off the table. In other words, the Chairman is saying the 10-year Treasury yield’s previous slide into sub-2% territory represented a speculative bubble.

However, this explanation contradicts what he said at the 2012 Jackson Hole conference, where he attempted to justify QE3 by claiming the QEs lifted US GDP some 3% by lowering long-term interest rates. Asking us to believe now that that was merely a bubble is a little too much, in my view. …

(a)  About QE

Vicious cycle of rising rates and economic weakness has already emerged

Instead of falling back to 2.0% or lower following the Fed’s decision to delay tapering, the 10-year Treasury yield has settled at around 2.5%, which means the next rise in rates could easily take the 10-year yield into 3.0%-plus territory.

I worry that this kind of intermittent increase in rates threatens the recoveries in interest rate-sensitive sectors such as housing and automobiles. That could lead to renewed hesitance at the Fed and prompt it to temporarily shelve or postpone tapering. While rates might then decline, reassuring the markets for a few months, talk of tapering would probably re-emerge as soon as the data showed some improvements, pushing rates higher and serving as a brake on the recovery. Then the Fed would again be forced to delay or cancel tapering.

In my view, recent events have greatly increased the likelihood of this kind of “on again, off again” scenario, something I warned about in my last report. To be honest, I did not expect it to occur so soon.

US now facing real cost of quantitative easing

Given that this would never have been a problem if the central bank had not engaged in quantitative easing, I think the US is now facing the real cost of its policy decision. Had the Fed not implemented QE, long-term rates would not have risen so early in the rebound, and the economic recovery would have proceeded smoothly. Now, any talk of ending QE pushes long-term rates higher and throws cold water on the economy, making it more difficult to discontinue the policy.

That raises the possibility that by buying longer-term securities the central banks of the US, the UK and Japan have placed themselves in a QE “trap” of their own making and will be unable to escape for many years to come. I have previously described QE as a policy that is easy to begin and hard — even scary — to end. The recent drama over tapering signals the start of the less-pleasant second part.

No country has injected so much liquidity and lived to tell about it

If the Fed’s purchases were small enough that the funds supplied to the market thus far could be mopped up in one or two painful operations, “shock treatment” would be one option. But the excess reserves supplied by the Fed now amount to 19 times statutory reserves, and putting them back in the bottle, so to speak, will be a difficult undertaking to say the least.

When a balance sheet recession is addressed with the monetary policy tool of QE, repeated applications are almost assured because monetary policy is largely impotent during such downturns, forcing the central bank to inject ever-larger amounts of liquidity in a hope of seeing some improvement down the road. That is why excess reserves in the US financial system are now equal to 19 times statutory reserves.

If the balance sheet recession is addressed using fiscal policy, on the other hand, it will lead to a significant increase in the national debt no matter how skilfully done. But at least there is historical precedent for a nation surviving a 250% debt-to-GDP ratio — that of the UK following the Second World War. In no case has a central bank injected as much liquidity as the Fed and lived to tell about it. All nations that did something similar experienced hyperinflation and a serious currency re-denomination, with tragic results for workers and savers.

Continued QE “trap” more likely than hyperinflation

Amid all the talk of ending QE, I think hyperinflation is a less likely outcome than a QE “trap.” As soon as the economy picks up a bit, the authorities begin to talk about tapering, which sends long-term rates sharply higher and nips the recovery and inflation in the bud, effectively preventing them from winding down the policy. In this kind of world the economy never fully recovers because businesses and households live in constant fear of a sharp rise in long-term rates.

The problems involved in leaving all the funds supplied under QE in the market will probably be felt most acutely when the economy recovers and the monetary authorities feel the need to raise interest rates.

What comes next in saga of quantitative easing?

We can see that the story of quantitative easing is in fact a saga — its adoption during the balance sheet recession was merely the first chapter.

The second chapter began in May when the Fed started talking about winding down the program. That has not led to serious strains in the market yet because private demand for loans in the US remains relatively weak. However, Chapter 2 is where the Fed falls into the QE “trap” of being unable to wind down quantitative easing because attempts to do so send long-term interest rates sharply higher and arrest the economic recovery.

The situation worsens as the private sector completes its balance sheet repairs and businesses and households start to borrow money again, which leads us to Chapter 3: “Monetary tightening.” Here the Fed is forced to pay a high rate of interest on the excess reserves it has created and also faces huge capital losses on the long-term bonds it has purchased. If the Fed fails to tighten policy, the risk that excess reserves equal to 19 times statutory reserves could inflate the money supply sparks fears of hyperinflation and sends long term rates even higher. Meanwhile, raising rates leads to heavy capital losses on the bonds purchased under QE, possibly rendering the Fed technically insolvent.

Speculation that the Fed would never undertake tightening resulting in a $500bn loss could then fuel talk of a dollar collapse and hyperinflation. Something must be done in response.

Then Koo describes Chapter 4, and what comes after that…

(4)  For More Information

(a) About the great experiment:

  1. Bernanke leads us down the hole to wonderland! (more about QE2), 5 November 2010
  2. The World of Wonders: Monetary Magic applied to cure America’s economic ills, 20 February 2013
  3. The World of Wonders: Everybody Goes Nuts Together, 21 February 2013
  4. The greatest monetary experiment, ever, 20 June 2013
  5. Government economic stimulus is powerful medicine. Just as heroin was once used as a powerful medicine., 19 September 2013
  6. Different answers to your questions about the momentous Fed decision to delay tapering, 20 September 2013
  7. Do you look at our economy and see a world of wonders? If not, look here for a clearer picture…, 21 September 2013

(b) Other posts about monetary stimulus:

  1. A solution to our financial crisis, 25 September 2008 — Among other things, large monetary action
  2. Important things to know about QE2 (forewarned is forearmed), 21 October 2010

(c)  State of the US economy:

  1. A look at the state of the US economy. Join me in confusion!, 13 July 2013
  2. The US economy is slowing. Things might get exciting if this continues., 17 July 2013
  3. About today’s jobs report: mixed news. No prize in this box., 6 September 2013
  4. Look at the economy to see why today’s jobs report is so important!, 6 September 2013
  5. Warnings about the economy from people you should listen to, 13 September 2013
  6. Let’s reflect on the course of the course of the US economy. Not a pretty picture., 8 September 2013

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19 Comments leave one →
  1. Jordan permalink
    27 September 2013 5:17 pm

    I hope that you have learned that QEs do not put money into the economy. Money stays in reserves since there is no credit expansion.
    Exiting QE in the case of the RECOVERY, not recovery as it is claimed now where unemployment is kinda fixed at the same level. And any recovery should mean only recovery of employment, there is no other kind of recovery that matters to people. You can rise GDP without rising employment, that is no recovery.
    Exiting QE is easy without any negative consequences to the country. It will rise interest rates to public debt, so what? USA can not run out of money to pay for higher interest rates unless Congress decides not to pay it. It has only political constraint on paying higher interest rates, not operational constraint.
    Why did mortgage rates go up? It has diferent reasons then higher interest rates, it is because of demand for housing.

    Problem of 19 times statutory reserves is easily solved with selling MBS and Tsy’s back to the banks or raising requierd reserve ratio from 10% to 20% or more. Croatia’s Central Bank recently lowered its reserve ratio. It is FED’s decision to make and it is only a political problem to decide that.

    Once you get FED and Congress to act properly and stop ideologising, all those problems you mention is easily solvable when you have fiat money. But you can not solve such problems if you behave as if you are on the Gold standard when acctualy you have fiat money.
    politicians are acting as if they are on the Gold Standard but FED knows they are not.
    Ben Bernanke said it, and Greenspan also said it that there is no limit on money quantity for FED or for Treasury. Saying that FED can become insolvent is just plain ridiculous. Only politicians can make them insolvent.

    Like

    • 27 September 2013 5:30 pm

      Jordan,

      I suggest that you rely on citing actual economists rather than making stuff up about these complex matters — and worse, asserting you know more than the actual experts cited.

      You will learn something, and by you posting them we can learn as well.

      These things are, like most of the matters discussed on the FM website, on the edge of the known. So there is a wide range of interesting opinions among experts. Only time will tell who is correct.

      Like

    • Jordan permalink
      27 September 2013 6:43 pm

      Here is Greenspan saying; “There is 0 probability of US default on debt.” So it can be only as political choice to default on US debt, not operational constraint.

      I am searching for BB saying about the same.

      Like

    • 27 September 2013 8:23 pm

      Quite right. I have discussed this many times in posts.

      Under stress governments have a range of what are called “soft defaults”. Monetize the debt (usually meaning inflating away its real value), extend maturities of existing bonds, force purchase of govt bonds (e.g., by banks, pension funds, insurance companies), sell assets (including the right to tax or have have monopolies), and financial repression (e.g., force down interest rates, force up savings rates).

      Actual default (hard defaults) are relatively rare.

      The solution chosen depends on political and operational considerations.

      People often assume that inflation is the only or always-chosen solution. This is false.

      Like

  2. Jordan permalink
    27 September 2013 5:19 pm

    Russel Napier: “banks are struggling to create credit or money growth.”
    FM, what is this about?

    Like

  3. lhw0 permalink
    27 September 2013 7:14 pm

    In 2011, Bernanke testified that when he started making trillions in free money available to the too-big-to-fail, he had anticipated that the too-big-to-fail would use it to lend to main street … but was surprised when they didn’t … and he had no way of forcing them to lend to main street. They were using the money for speculation and gambling … and some to buy treasuries (making significant profit off the spread). Note however, the federal reserve also spent a year in court attempting to prevent making public what they were doing behind the scenes.

    One of the alternatives would be for Bernanke to buy treasuries at zero percent … instead of massive subsidy for the too-big-to-fail, a massive subsidy for the federal government (and making the federal debt effectively free).

    Like

    • 27 September 2013 8:17 pm

      Ihwo,

      The Fed is buying Treasuries. The Fed’s profits are given to the Treasury. The Fed, the national agency (part of the government, unlike the regional Fed banks), can be thought of as part of the government — so Treasuries bought by the Fed are de facto monetized, no longer part of the national public debt.

      But normalizing interest rates will require selling off those holdings, hence the useful practice of thinking of the Fed as a stand-alone entity with a government guarantee.

      Like

  4. 27 September 2013 9:04 pm

    Paraphrasing Bones on Star Trek when Kirk would ask him a question he couldn’t answer, “Damn it, FM, I’m just a simple art historian, not some financial genius.”

    But it’s not that complicated.

    So, Napier writes:

    “As baby boomers prepare for retirement — degearing, saving more and spending less — banks are struggling to create credit or money growth. Younger Americans, crushed under student loans and with balance sheets badly hit by lower property prices, cannot gear up to offset this. Meanwhile, real personal disposable-income growth is at levels associated with recessions, bond yields are rising and inflation falling.”

    Sound like post-1929, when the average Joe and Josephine didn’t have any extra cash to spend, which ain’t good for businesses and employment. But you guys have been saying that for years as the disparity in income grows between the 1% and the rest of us.

    Like

    • 27 September 2013 9:12 pm

      I should have added. Maybe Barry should have proposed a JOBS BILL that would have strongly modified his BAILOUT. Maybe things would have been different if he hadn’t solely protected the big financial institutions and really have given us “change we can believe in.”

      Like

    • 27 September 2013 10:34 pm

      Marc,

      I agree on all points.

      The question is what happens next. On both Right and a Left there are murmurings about the coming Revolt — when the u washed moochers — oppressed workers arise and commit acts of senseless vandalism — righteous violence.

      These fears-dreams are a commonplace among the aristos and dreamers. We heard the amidst the race riots of the1960s, the left wing violence of the 1970s, about the right wing militia of the 1990s…

      In fact concentration of income means concentration of political power. The gilded age cycle ended only with the Depression, which combined with the threat of communism sparked large scale social reforms.

      In other words, there must be a catalyst. None visible today.

      Like

  5. 28 September 2013 12:06 am

    I agree: none visible today. Great topic, though. Please keep it up!

    Like

    • 28 September 2013 12:12 am

      The next post, going up soon, looks at another — and shocking — aspect of our evolving society.

      Like

  6. merocaine permalink
    28 September 2013 12:48 am

    It is interesting that we would never tolerate any kind of inherited political power, but in the society we live in we have developed a system that will allow large amounts of economic power to become consecrated within a certain class. That economic power is important, and over time concentrates and becomes political power. A plutocracy rule by the wealthy. Not that this has to be inherently bad, but it is certainly not democracy in the sense the Greeks meant it, or we believe it.
    I myself believe that political power and economic power are often tied up together in enlightenment societies like the US (the best society to use as an example as it is closest to john locks ideal).
    The importance attached to private property in the locken system of government is so strong (and over time in america has become so emotionally important) as to present an almost insuperable obstruction to creating a more equal society. People complain about being in the grip of long dead economists, they tend to ignore the philosophers.

    Like

  7. merocaine permalink
    28 September 2013 12:57 am

    If you look at Russia, independent economic power is seen by the government as a threat to be neutralized, the Russian government saw quite clearly that economic power will transform into political power and acted accordingly to prevent this development. This couldn’t happen in a country that used Locks philosophy as its governmental template.
    I certainly don’t agree with the Russian method, which is mired in Les majesty of a bygone age. But I can’t help but feel that locks philosophy has lead us in to an end he never foresaw. An age where increasing concentration of wealth is protected by a deification of material wealth.

    Like

  8. 28 September 2013 1:43 am

    How about some numbers.

    http://www.newyorkfed.org/markets/tot_operation_schedule.html

    I found this. The Fed is buying about $45B in treasuries every month. Figure 45*12=540B in treasuries per year (I’m just estimating, if you want you can go in and add up all the numbers yourself.) (This is NY Fed, I don’t think the other branches do QE, do they?)

    http://en.wikipedia.org/wiki/2013_United_States_federal_budget

    Here’s the 2013 deficit. Expected to be $901B. So, I guess bond markets fund about 901-540= about $360B of the deficit?. QE is a pretty substantial relative to the deficit. I think US government needs the FED.

    If the FED buys fewer treasuries then what has to happen is investors need to buy more bonds instead. In order to buy more bonds, they’re going to have to raise rates relative to what people earn other places, like in stocks or municipals or state bonds and sell those assets and buy US treasuries instead.

    What happened though, is just by announcing the taper, investors started bailing out of bond funds. Rates went up without even starting on any actual reduction of QE.

    Like Ku says it in your article, raising rates would hurt auto/housing and make the budget deficit even worse. Moving money from stocks and other markets to treasuries sucks the oxygen out of the other markets and will depress values.

    I don’t see how there can be an escape.

    Like

    • 28 September 2013 2:40 am

      QE3 is not a secret. They are buying $85billion of $40B of government-guaranteed mortage-backed securities and $45B of Treasuries (long-term) per month. It’s a policy.

      The point of QE is, among other things, to lower rates. And so vice versa. Furthermore, ending QE is just the first step on the road to normalizing rates — at a level far above today’s.

      But no matter what the beneficial effects, QE is distorting the economy. Perhaps in ways we do not know, or perhaps even understand. Economic theory is immature, and this has been done very few times on this scale (never successfully in peacetime). It might get more difficult with time, if the adiction metaphor is accurate. Perhaps much more difficult.

      Like

    • 28 September 2013 4:06 am

      I’m just in awe of the scale of this. That $85B/month, that’s about $1T. All the personal income tax comes in around $1.2T/year.

      [quote] Here the Fed is forced to pay a high rate of interest on the excess reserves it has created and also faces huge capital losses on the long-term bonds it has purchased. If the Fed fails to tighten policy, the risk that excess reserves equal to 19 times statutory reserves could inflate the money supply sparks fears of hyperinflation and sends long term rates even higher. Meanwhile, raising rates leads to heavy capital losses on the bonds purchased under QE, possibly rendering the Fed technically insolvent.[/quote]

      I’m trying to parse what he’s saying here. The Fed balance sheet is such an mind-blowingly odd thing. My understanding of this is that as the economy starts to heat up, what the Fed would normally do is take some of their bonds they have purchased and sell them back to the market. This is the reverse of QE, and it drains the excess money out of the system. The ‘huge capital losses’ is pretty obvious to anyone who has ever owned a bond — as rates go up the value of the bonds goes down. So I think what he’s saying is that as rates go up, the value of Treasuries they purchased collapses and the Fed has no ammunition reduce inflation once it starts.

      Err, and Kuu actually mentions ‘fears of hyperinflation’ — That’s gotta make one pause for a moment. This guy isn’t one of the gold bug conspiracy theorists.

      I looked up this term here.

      http://en.wikipedia.org/wiki/Statutory_reserve

      Like

    • 28 September 2013 4:15 am

      Cathryn,

      Exactly so. We are in a world of wonder, in which this is the great experiment.

      The capital loss issue is a technicality, since the Fed is by law and in effect a Federal agency — and can create money.

      The risk of continued QE is inflation as the economy accelerates. Japan avoided this fate, since their economy never got out of slow growth. That is possible for us.

      Since the Fed expects fast growth (in Jan 2011 they expected 2013 GDP to be the fastest since 2000; not going to happen) they worry about inflation if they do not normalize fast enough.

      Scylla and Charybdis. QE was easy to start, fun to run. We will learn how easy it is to stop.

      Like

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