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.
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Contents
- The state of play today
- Russell Napier
- Richard Koo
- 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.
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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:
- Bernanke leads us down the hole to wonderland! (more about QE2), 5 November 2010
- The World of Wonders: Monetary Magic applied to cure America’s economic ills, 20 February 2013
- The World of Wonders: Everybody Goes Nuts Together, 21 February 2013
- The greatest monetary experiment, ever, 20 June 2013
- Government economic stimulus is powerful medicine. Just as heroin was once used as a powerful medicine., 19 September 2013
- Different answers to your questions about the momentous Fed decision to delay tapering, 20 September 2013
- 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:
- A solution to our financial crisis, 25 September 2008 — Among other things, large monetary action
- Important things to know about QE2 (forewarned is forearmed), 21 October 2010
(c) State of the US economy:
- A look at the state of the US economy. Join me in confusion!, 13 July 2013
- The US economy is slowing. Things might get exciting if this continues., 17 July 2013
- About today’s jobs report: mixed news. No prize in this box., 6 September 2013
- Look at the economy to see why today’s jobs report is so important!, 6 September 2013
- Warnings about the economy from people you should listen to, 13 September 2013
- Let’s reflect on the course of the course of the US economy. Not a pretty picture., 8 September 2013
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