Different answers to your questions about the momentous Fed decision to delay tapering

Summary: We have now had a 24 hour avalanche of analysis about the Fed’s decision not to taper. Most technically accurate, as economic news often is. But myopic, as news coverage usually is. Today’s post gives a wider perspective on this decision, putting it in the content of the Great Recession and the following slow recovery. This gives a different set of answers.

This is a follow-up to yesterday’s post, Government economic stimulus is powerful medicine. Just as heroin was once used as a powerful medicine.

“I have absolutely no doubt that when the time comes for us to reduce the size of the balance sheet that we will find that a whole lot easier than we did when expanding it.”
— Meryvn King (Governor of the Bank of England), press conference on 15 February 2012

Never underestimate the Fed’s dovishness“, Gavyn Davies , Financial Times, 18 September 2013

Fed Taper sign

Contents

  1. Why did they not taper?
  2. When did monetary stimulus become super?
  3. When will they start the taper?
  4. For More Information

(1)  Why did they not taper?

  • Minor Answer #1: Because they feared that today the economy was too weak, and believe that the strength in Q3 and Q4 will allow a slow start to tapering.
  • Minor Answer #2: Because they were afraid that the coming DC budget follies would slow the economy, and wanted to delay the taper’s impact until that act was concluded.

Real Answer #1:  Because America is dysfunctional

Because the GOP opposed using fiscal policy, borrowing at generational-low rates to put unemployed people to work rebuilding America’s decaying infrastructure.Because Obama was too weak and short-sighted to fight for large-scale use of fiscal policy. His acquiescence to the GOP on this destroyed the great potential of his Administration, elected (like FDR) at a potentially pivotal moment in history.

Real answer #2: Because economists (like climate scientists) have become political activists

Since monetary policy was the only game available, they talked it up as the next best thing to Jesus return.  In fact it probably has had little effect on the real world, but appears to have set off an asset price bubble (our third in the past 15 years, a record of incompetence).

Real answer #3:  Because their policies assumed we would have a strong recovery by 2013, not the below-stall speed growth we got

The Fed staff publishes their forecasts, the basis on which the Open Market Committee takes action. The recovery has proven far less vibrant then they planned. By 2013 the economy they expected a boom, with GDP growth the fastest since 2000. Now they expect a strong second half to bring GDP up to 2.0% – 2.3% (slightly above the 2% stall speed). Does this graph build your confidence?

Fed forecasts
From article by Scott Minerd of Guggenheim Partners, 19 September 2013

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About central bankers’ hubris, and their blindness to bubbles — CNBC interview with Ben Bernanke, 1 July 2005:

Q:   What is the worst-case scenario if in fact we were to see {home} prices come down substantially across the country?

Bernanke: Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though.

(2)  When did monetary stimulus become super?

From “Print baby, print – emerging value and the quest to buy inflation” by Dylan Grice, (strategist, Societe Generale), 27 May 2010.

{T}he crash of 2008 and its sovereign debt aftermath have changed everything. It’s difficult to exaggerate just how dirty the phrase deficit monetisation was when I studied economics at university: loaded with evil images of political irresponsibility and short-sightedness, it evoked the haunting spectre of catastrophic and ruinous hyperinflation. It’s what they did in Weimar Germany; it helped cause WW2; to say it had an image problem would be a grotesque understatement. No wonder it’s been rebranded as quantitative easing.

… Enter central banks. In 2009, the BoE printed £200bn, thus completely financing the UK government deficit. It can’t have felt good about doing it but since the alternative scenario was so scary – financial meltdown and possibly IMF support – it held its nose and did it anyway. It said it was going to sterilise the intervention, but on discovering that such was the financial system distress it was unable to, it just carried on regardless. In the US, the Fed printed $1.25 trillion to monetise the problematic mortgage market. It also said it was going to sterilise the intervention, but like the BoE it soon found it couldn’t, and like the BoE continued anyway because the alternative financial meltdown scenario was too scary to contemplate.

… the need for a central bank response to the threat of financial collapse is clear:

  1. Print money
  2. Keep printing until the financial system stabilises
  3. Worry about removing liquidity later (and if removing liquidity stresses the financial system, go back to step 1)

What’s interesting is that central banks feel they have no choice. It’s not that they’re unaware of the risks (although there are profound behavioural biases working against them in their assessment of those risks). They’re printing money because they’re scared of what might happen if they don’t. This very real political dilemma is what is missing from the simplistic understanding of inflation as “always and everywhere a monetary phenomenon.” It’s like they’re on a train which they know to be heading for a crash, but it is accelerating so rapidly they’re scared to jump off.

The political failure to use large fiscal stimulus — as we did during the Great Depression and (in effect) WW2, put a central banker in the pilot’s seat — a role for which Bernanke was unsuited on many levels. Not least because him, and his cast of supporting mainstream economists, in the role of confidence builders. Their only tool was monetary policy, so monetary policy was sold as monetary magic. Since there was little evidence of any such ability (especially after short-term treasury rates reached zero), they invoked the miraculous power of “expectations” and “confidence”. Printing money boosted asset prices, which would boost confidence and so spur household spending and business investment.

They got the asset price bubble, but not the boom. They still expect it (ie, the continued acceleration of growth from Q4’s near-zero). If they get it, they’ll taper. Michael Hartnett (Strategist, BofA-Merrill Lynch, 18 September 2013) believes the Fed will watch for a specific signal:

They won’t taper until a rise in bond yields coincides with a rise in mortgage applications, in our view. The summer reversal in housing activity was a likely signal to the Fed that the macro is still too fragile to withstand even a small tapering. We believe tightening is unlikely to happen until higher bond yields, bank stocks, housing activity and corporate “animal spirits” all signal in unison that policy has traction.

(3) Compare QE3 ex post with what economists expected from it

Learning from experience, or not:

Paul Krugman explains QE3, at the New York Times:

Other economists look at QE3:

  • Quantitative Easing: A Tutorial Slideshow, Ed Dolan (economist, bio here), 13 September 2012
  • Effects of QE3“, James Hamelton (Prof Economics, UC San Diego), 16 September 2012
  • QED: QE3“, Marco Annunziata (Chief Economist, GE), 17 September 2012 — “As the Fed announces a third round of quantitative easing, this column argues that it is unlikely to work. Investment and hiring are held back by huge uncertainty over the long-term outlook and the stimulus provides a monetary bridge over the election gap but little more.”
  • Tim Duy explains how QE3 represents two change of Bernanke’s policies.

(4)  For More Information

(a)   Reference page about the Financial crisis – what’s happening? how will this end? – esp section 8, about solutions

(b) About today’s meeting of the Open Market Committee

(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

(d) 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
  3. Bernanke leads us down the hole to wonderland! (more about QE2), 5 November 2010
  4. The World of Wonders: Monetary Magic applied to cure America’s economic ills, 20 February 2013
  5. The World of Wonders: Everybody Goes Nuts Together, 21 February 2013
  6. The greatest monetary experiment, ever, 20 June 2013

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13 thoughts on “Different answers to your questions about the momentous Fed decision to delay tapering

  1. “The political failure to use large fiscal stimulus — as we did during the Great Depression and (in effect) WW2, put a central banker in the pilot’s seat — a role for which Bernanke was unsuited on many levels.”

    Given the other potential pilots (Congress, the White House, the Bankers), I’m in favor of giving Ben the seat. I’m not arguing against your statement but am expressing extreme discomfort with the slate of candidates for the position.

    1. At ZIRP there is no pilot seat for monetary policy, only co-pilot- Monetary policy can only ensure that fiscal policy is not too expensive-keep interest rates down, or do not counter attempt of fiscal policy to fix economy.

      There is no efficasy for monetary policy at ZIRP. That is why ZIRP is important as paradigm change.

    2. Jordan,

      Please some expert basis for your assertions. These are things debated among the world’ stop economists. Your comments read like you are just making stuff up.

    3. I believe this is not controversial. In the econ 101 textbooks, monetary policy lowers interest rates and stimulates growth. But at 0% interest, there’s nowhere lower for rates to go, so nothing happens with monetary policy.

      This is why, if rates are stuck at zero the FED either has QE or it has nothing. Conventional monetary policy hits a wall at ZIR.

      This is something I just made up, but I think it’s right. QE is the difference between the USA and Greece. That Greece has debt in a currency they don’t control, so they only way to dig out is to cut everything, to sell everything. The USA has run massive deficits, but the FED just buys the bonds, which bids down the interest rates.

    4. No.

      You appear to be confusing “setting interest rates” with “monetary policy, or “conventional monetary policy” with “monetary policy”. In both cases the former is only a subset of the latter.

    5. Cathryn and Jordan,

      At the end of this post are — as usual — links to a wide range of analysis by many experts about QE and, more broadly, monetary policy. They explain these things clearly for a general audience.

    6. When you asked about referencing an economist about ZIRP ineficiency of monetary policy, conventional and unconventional, i find that your next post about Wonders of economics did mephasize exactly that point. Unconventional monetary policy is pushing on a string when economy is concerned, you proved that it only raised asset prices and with that doing a great harm to the economy. I totaly agree. You can raise GDP by inflating asset prices without ever improving anyone’s life or without employing a single person more.

    7. Jordan,

      (1) “ZIRP ineficiency of monetary policy, conventional and unconventional”

      Too broad a statement. QE is only one form of unconventional monetary policy. Even if QE were shown to have little effect — as some economists believe (me, too) — that does not mean that all forms of unconventional monetary policy are ineffective.

      (2) “i find that your next post about Wonders of economics did mephasize exactly that point. Unconventional monetary policy is pushing on a string when economy is concerned, you proved that it only raised asset prices and with that doing a great harm to the economy.”

      In the “Wonders” post I discussed economic stimulus programs broadly (not specifically QE), and made the opposite point:

      Do not interpret this poor result to mean that US economic stimulus was in vain, as conservatives often do. Imagine if your daughter lies in a hospital bed with a serious illness, and the doctor reports that the treatment resulted in a slow improvement. Do you fly into a rage and demand that the treatment end — since there should be no treatment unless its provides a fast cure? Of course not.

      But this modest result despite intense medicine shows the seriousness of the “illness” that infects our economy.

  2. Where is the evidence for Fed actions having created new asset bubbles? Because since March of 2009 stock prices and housing prices are up and credit spreads are down? Pretty weak stuff.

    1. The usual candidate mentioned for a bubble is housing prices, where there have been massive government efforts to boost lending — and prices have increased disproportionately to reductions in the vacancy rates (per Census Quarterly Vacancy report).

      That is important, since home values are for most Americans by far the largest part of their marketable HH wealth (most people’s consumer goods have little market value, although large if valued at cost).

      Also, home vacancy rates and home prices are major factors driving new home construction – a major factor in economic growth — and mortgage lending, a roughly $10 billion part of the nation’s balance sheet (hence of great importance to both banks and investors).

      Equity prices are by comparison a dot in terms of their macroeconomic effects. However, they are a big part of the news media’s narrative about the economy, which contains large dosages of noise and nonsense.

      Regarding “credit spreads … Pretty weak stuff”

      There have been numerous warnings about misallocation of credit in the USA since the crash.

      *. The largest increase in consumer lending has been Federal education loans. Several studies have warned of theY possibility of massive defaults (cannot get water from stones).
      * I do not have the reference (perhaps Fed consumer loan survey) but there has been a massive increase in automobile to individuals with low credit scores — probably a factor in the recovery of auto sales. That is potentially ugly when combined with the long life of these loans so that there is little or no equity in them for the last year or so (hence, as with housing, a high risk of default).
      * Many experts have warned about the rapid growth of corporate borrowing to non-investment grade corps. Most recently the alarming BIS report — noteworthy since they were one of the few such organizations to warn before the big crash.

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