Summary: We have begun a critical phase in the great monetary experiment. We know that we should stop, but our leaders fear the resulting economic shock. They fear to stop, fear to continue. There is a clear model describing this process, but one too disturbing for most people to accept: addiction. The decisions made during coming months might teach us much about America, and perhaps have historic effects.
All the perplexities, confusions, and distresses in America arise, not from defects in their constitution or confederation, nor from want of honor or virtue, as much from downright ignorance of the nature of coin, credit, and circulation.
— John Adams, letter to Thomas Jefferson, 25 August 1787
- What kind of drug is monetary policy?
- What model best describes it?
- Look at our history
- What comes next?
- Other guesses
- It’s not just the US
- For More Information
- The big picture
(1) What kind of drug is monetary policy?
Ed Dolan (economist, bio here) made a typically brilliant insight in the comments to this post. I referred to monetary policy as a “drug”; he replied that it was not a drug — in the sense of illegal drugs (stimulants, intoxicants, hallucinogenics). This forced me to rethink this idea. What kind of drug is monetary stimulus?
There are drugs which are both legal and illegal — medicines with risks. Like heroin. As described in previous posts, heroin was the battlefield medic’s most powerful drug — but dangerous if used too long.
(2) What model best describes monetary policy?
We usually understand the working of complex systems in terms of models. Since the US joined the great monetary stimulus experiments in 2008, some have warned that it was a process of addiction — like that of heroin (see details in this post). Most users of heroin stop before serious effects hit; the sad cases are addicts who ride their addiction to the bottom, following this path:
- This is great!
- Increasing tolerance, responded by increasing dosage.
- Awareness of the need to change, and resolution to end via slow “tapering” of the dosage
- Discovery that tapering is difficult, even painful. Decision to defer the start until a better time in the near future.
- Repeat #4.
- Recognition of ill effects from the drug. Renewed resolution to start tapering.
- The downward spiral begins.
- Recognition of addiction. Start of a new life, down one path or another.
In November 2008 the US began intense monetary stimulus, starting quantitative easing. The first wave took Fed assets from $800 billion to $2.1 trillion in March 2009. By June 2011 Fed assets were $2.8T. Their assets are now $3.8T. (source here)
Consider one effect of this, noted by Paul Jackson of Société Générale. The Fed doubled the monetary base (cash plus bank reserves) in six years during the 1930s; the Fed did that in 2008. During the 15 years 1930-1945 the Fed increased the base by a factor of six. During the past five years the Fed has already increased the base by a factor of 4 – it’s growing at aprox 3%/month (40% annualized).
This has worked well for us, helping grow US real GDP at 2.2%/year since the start of 2010. With few side-effects, other than contributing to a boom in asset prices (a feature, not a bug, as it enriches the 1%).
But if we are in the addiction model these happy days will end. We cannot predict when. The line in the sand marking “addiction” is visible only in hindsight.
(3) Look at our history: so far we’re tracking the usual course of an addiction
Bernanke announced the coming of the taper at the 9 June 2013 press conference following the meeting of the Fed’s Open Market Committee:
If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year. And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear.
Investors’ reaction was swift and strong: the ten year Treasury yield rose by half from 2.1% to almost 3%. Worried that a sharp rise would prove too much for an economy limping along at stall speed, Bernanke announced that the Fed decided to delay the taper. He did so at the 18 September 2013 press conference:
… the sense of the Committee was that the broad contours of the medium-term economic outlook — including economic growth sufficient to support ongoing gains in the labor market, and inflation moving towards its objective — were close to the views it held in June. But in evaluating whether a modest reduction in the pace of asset purchases would be appropriate at this meeting, however, the Committee concluded that the economic data do not yet provide sufficient confirmation of its baseline outlook to warrant such a reduction.
Moreover, the Committee has some concern that the rapid tightening of financial conditions in recent months could have the effect of slowing growth, as I noted earlier, a concern that would be exacerbated if conditions tightened further. Finally, the extent of the effects of restrictive fiscal policies remain unclear, and upcoming fiscal debates may involve additional risks to financial markets and to the broader economy. In light of these uncertainties, the Committee decided to await more evidence that the recovery’s progress will be sustained before adjusting the pace of asset purchases.
… In the coming meetings, we’ll be looking to see if the data confirm that basic outlook. If it does, we’ll take a first step at some point — possibly later this year — and then continue so long as the data are consistent with that continued progress.
The remaining meetings this year are on October 29-30 and December 17-18. While nobody can reliably predict such things, especially as it depends on unknowable economic data released during the next 7 weeks, most Fed watchers believe the Fed will deferring tapering until the new year. The hoped-for strong growth will cushion the shock (I say “hoped for” since accelerated growth was expected in 2010, then 2011, then 2012, then 2013. It’s now faith, not an analytical forecast).
If the growth does not arrive, they will have only delayed the eventual confrontation to a time when we’re many months deeper into the addiction process.
The big question: does massive sustained monetary stimulus have ill-effects not yet seen?
(4) Other guesses
These illustrate the range of consensus opinion about monetary stimulus. It’s fun, should not stop unnecessary, and more is better.
(a) Don’t worry, be happy: “The downsides of quantitative easing” Cardiff Garcia (FT Journalist), FT blog, 23 October 2013
He cannot find any likely possible bad effects from QE, except from some vague (“increased inequality”) and technical (“trading disruptions” ones. He does not even mention any possible side-effects from boosting asset prices (other than “inequality”).
Inflation as a possible side-effect is described as “lazy” and “unpersuasive”. So why stop the fun?
(b) Why stop the party? From the “Macro Strategy Report” by Jim Reid (Fixed Income Strategist), Deutsche Bank, 23 October 2013 — Red emphasis added.
After yesterday’s payroll number the opening paragraph writes itself this morning with the softness clearly further reducing the probability of tapering over the next 3-6 months. I suppose the only concern is that this is becoming consensus and perhaps too obvious. However if the employment data isn’t improving its hard to imagine a Yellen-led Fed risking upsetting the recovery whatever their fears about the risks of ongoing QE. What else is there?
Potentially cleansing defaults have been a policy no-no for years now and expansive fiscal policy which might be useful for jobs and growth is not going to happen with politics so divided. So QE remains the highly imperfect main policy tool.
If you’re looking for a less consensus view, I was chatting with DB’s US rate strategist Dominic Konstam yesterday and he is continuing to run with his recent theme that the labour market is exhibiting “late cycle” tendencies which lead him to believe that this cycle only has a 50/50 chance of extending much beyond 2015. Therefore he is considering the prospect that the Fed possibly only has a narrow window to taper before it’s faced with economic headwinds again and if this is the case then why bother taper at all? If employment is indeed late cycle maybe the conditions don’t quite get strong enough in 2014 to persuade the Fed to be too aggressive in pulling back liquidity.
… An interesting chat and his thoughts are always worth listening to.
(c) More is better: “A Case for the FOMC Increasing Asset Purchase”, Mary Beth Fisher (head of Interest Rate Strategy), Société Générale, 24 October 2013 — Summary, red emphasis added:
Federal Reserve Chairman Ben Bernanke described the FOMC’s decision not to begin tapering asset purchases at the 18 September meeting as “a close call”. At the time it took most of the market by surprise. In retrospect, it appears a very prescient decision. The fiscal uncertainties escalated into a near fiscal disaster; and what appeared to be “mixed” economic data over the late summer is now emerging as a true -– though perhaps temporary — economic weakening in light of the downtrend in payrolls and home sales.
The FOMC has been reiterating, since the talk of tapering first began in the spring, that asset purchases could increase or decrease based on the economic data. Which brings us to ponder:
- Is it possible that the FOMC will decide to increase asset purchases this year; or
- Reinsert language in the FOMC statement that was dropped in September, that “the Committee is prepared to increase or decrease the pace of its purchases … as the outlook for the labor market and inflation changes.”
We parse the FOMC minutes from the 18 September meeting for what the Fed was focusing on in the data, and how that has changed in the interim period. Although we assign a very low probability to a decision by the FOMC to increase asset purchases at its October meeting, it is not a possibility we can ignore. …
The potential downsides to increasing asset purchases would be that
- the market would assume the FOMC was focusing on a very grim economic picture;
- the perceived risk of inflating asset bubbles in various market segments would rise; and
- the FOMC may run into a credibility problem (again) by whipsawing the market.
(5) It’s not just the US
Britain, Japan, the EU, and China are all — in different ways — using unconventional monetary policy on a scale never attempted in peacetime. They all face the same dilemma as the US: “Central Banks Drop Tightening Talk as Easy Money Goes On“, Bloomberg, 24 October 2013 — Opening:
The era of easy money is shaping up to keep going into 2014. The Bank of Canada’s dropping of language about the need for future interest-rate increases and today’s decisions by central banks in Norway, Sweden and the Philippines to leave their rates on hold unite them with counterparts in reinforcing rather than retracting loose monetary policy. The Federal Reserve delayed a pullback in asset purchases, while emerging markets from Hungary to Chile cut borrowing costs in the past two months.
“We are at the cusp of another round of global monetary easing,” said Joachim Fels, co-chief global economist at Morgan Stanley in London.
Policy makers are reacting to another cooling of global growth, led this time by weakening in developing nations while inflation and job growth remain stagnant in much of the industrial world. The risk is that continued stimulus will inflate asset bubbles central bankers will have to deal with later. Already, talk of unsustainable home-price increases is spreading from Germany to New Zealand, while the MSCI World Index of developed-world stock markets is near its highest level since 2007.
“We are undoubtedly seeing these central bankers go wild,” said Richard Gilhooly, an interest-rate strategist at TD Securities Inc. in New York. They “are just pumping liquidity hand over fist and promising to keep rates down. It’s not normal.”
Normal or not, that’s been the environment now for five years after monetary authorities fought to protect the world economy from deflation and to hasten its recovery. In the advanced world, central banks drove interest rates close to zero and ballooned their balance sheets beyond $20 trillion through repeated rounds of bond purchases, a policy known as quantitative easing.
The economic payoff has been limited. …
(6) For More Information
The other post about monetary policy: Government economic stimulus is powerful medicine. Just as heroin was once used as a powerful medicine., 19 September 2013
Other posts about monetary policy:
- 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
- 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
- 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
- Two warnings about quantitative easing, the taper, and what comes next, 27 September 2013
- Dr Hunt explains the great monetary experiment. It will be historic, no matter what the result., 20 October 2013
(6) The big picture
Growing debt is a defining characteristic of this economic cycle for the developed nations as a group. Too see this for other nations go to The Economist’s interactive graphic of total debt/gdp by nation. The US is 7th highest among the world’s major nations.