Summary: Prosperity, perhaps even survival, in the 21st century might require learning which experts we should listen to. In economics its a short list, if we limit it to people who have understood large aspects of the great recession and the aftermath. Richard Koo certainly deserves to make that short list. Here he tells us what to expect next.
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“Post-QE forecast for leading economies:
sunny,cloudy, or stormy?”
Richard Koo, Chief Economist
Nomura Research Institute
25 March 2014
Excerpt
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{People} were roiled by Fed Chair Janet Yellen’s first press conference last Wednesday, where she suggested a rate hike could come as soon as next spring. The fact that {people} reacted so much led some in the media to question her communication skills, given her predecessor’s skill in this area.
{People} also appear to have been surprised and disappointed that the supposedly dovish Ms. Yellen indicated the possibility of a tightening of policy. “This wasn’t supposed to happen” seemed to be the general reaction.
Marketsand media unaware that US is in QE trap
Nevertheless, it was easy enough to predict that the Fed would have to move in this direction when it began normalizing policy after years of quantitative easing. The media’s criticism of her dialog and {people’s} complaints about the lack of further accommodation tells us that most of them have yet to realize the US economy has fallen into the QE trap. Their ignorance is of far greater concern, in my view.
{People} and members of the media simply do not understand that an economic recovery in a country that has undertaken QE is going to be very different from a recovery in a country that has not.
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First rate hikes could come next Spring
Most of the current brouhaha can be traced to Ms. Yellen’s post-FOMC press conference, where when asked to elaborate on the phrase “considerable time” (“it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends”) she responded “it probably means something on the order of around six months.”
The Fed’s tapering exercise, taking a page from the book of former Chairman Alan Greenspan, who raised rates by 25bp at each FOMC meeting over an extended period from 2004 to 2006, calls for reducing asset pur chases by $10bn at each meeting of the policy-setting committee. If it continues along this path, purchases of new securities would end this autumn.
Six months from then would be next spring, which came as a shock to many market participants who did not expect rates to be raised until the second half of next year at the earliest.
Some also felt the indication of a potentially earlier rate hike was inconsistent with recent economic data, which show an inflation rate (core PCE deflator) of just 1.09% and an economy that is not particularly strong.
Central banks much less tolerant of inflation after QE
What they need to understand is that a central bank that has engaged in QE is far less tolerant of inflation expectations than a bank that has not. The central bank that has conducted only orthodox monetary accommodation can sit back and watch as private loan demand pick s up, driving an economic rebound. Rate hikes need to be considered and implemented — gradually — only after the economy approaches full employment and prices and wages have started to rise.
In this case there is no reason for the central bank or the market s to fear an economic recovery — it can be welcomed with open arms. …
Fed faces arduous journey in normalizing monetary policy
… as I explained in my previous report, it will take an extended period of time for the central banks of the US, Japan, and the UK to wind down their current QE programs because they chose instead to supply funds via the long-term government bond market.
Like the BOJ in 2006, Fed Chair Yellen is trying to keep a step ahead of the market in winding down QE. However, she is likely to face quite an ordeal — not only has the Fed created excess reserves equal to 19 times statutory reserves, versus a maximum multiple of six for the BOJ in 2001–2006, but most of those funds were supplied in the long-term government bond market.
Better dialogue will not help drain excess reserves
Any Fed chair would have to deal with the unpleasant fact that the institution has supplied funds equal to 19 times statutory reserves by purchasing long-term Treasury securities. This is not a problem that can be resolved by better dialog with the market.
In fact, I suspect a key reason why Ms. Yellen’s predecessor was seen as being such a good communicator is that throughout his tenure — at least until May 22, 2013 — he was generally bearing good tidings in the form of more quantitative easing, which of course the market welcomed.
QE at a time of weak private loan demand and a sluggish economy is harmless and will always be welcomed by the market. But when it came time to start winding down this policy, on 22 May last year, Mr. Bernanke’s heralded communication skills failed to prevent a sudden surge in long-term interest rates or corresponding damage to emerging markets and the US housing market. Ms. Yellen acknowledged at her press conference last week that the housing market has yet to regain its earlier momentum since it slowed in response to last summer’s rise in rates.
In other words, this is not an issue that can be dealt with via better communications with the market. Far from it. …
Forecast for post-QE world: day after day of dark, low-lying clouds
The Fed’s decision to emphasize its willingness to stay ahead of the curve on inflation and keep long-term rates from climbing out of control signifies a reduced likelihood of a sharp acceleration of US inflation. In effect, the central bank has demonstrated its intention to nip any inflation in the bud.
With the Fed acting in this way, the most likely scenario for the US economy going forward is one in which the economy ekes out a hesitant recovery against the backdrop of constant concerns at the Fed and in the markets about a surge in long-term interest rates. Such an outcome is unlikely to lead to significant inflation.
This is the world of the QE trap. It is the price that must be paid when a nation conducts quantitative easing }by buying} long-term bonds.
The “new normal” awaiting an economy where the central bank has implemented QE is day after day of dark, low-hanging clouds with no sunny skies. While this is clearly preferable to the storms that followed Lehman’s failure, we face the prospect of a world weighed down by worry instead of sunny skies and a quickly rebounding economy (which would be the case by now without the QE).
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About Koo’s pasts forecasts
Most Americans knew 4 big things at the start of this recession, things confidently explained by our experts. Richard Koo, economist for Nomura, told us that time would prove all of 4 wrong.
- Our banks were the strongest they had ever been on the eve of a recession. Unlike Japan’s before their 1989 crash.
- We were free-market capitalists. Any banks that proved weak would be closed (as we did during the S&L crisis). Unlike Japan, that propped up their banks (becoming zombie banks).
- We were smart. If the recession was deep, we would stabilize the economy with wise public spending, repairing and building our infrastructure (as FDR did during the depression). Unlike Japan, who channeled stimulus funds to politically powerful interests, wasting vast fortunes on large train stations in villages and bridges to nowhere.
- Our economy was resilient and adaptable, so any recession would be brief and followed by a strong recovery (the “V”). Unlike Japan, where the crash ushered in a 20 year (and counting) period of economic stagnation. The economy slumped every time the fiscal stimulus was slowed (either through higher taxes or spending cuts).
So far Koo is 4 for 4.
- Much of our financial system collapsed. Large banks, investment banks, AIG (a weird hybrid), and the government-sponsored enterprises (Fannie Mae and Freddie Mac), and many smaller banks.
- We boldly closed small S&L’s during the 1990s. But when politically powerful banks tottered, our government politely asked how many billions would they like — on the easiest possible terms, at low rates, combined with a wide range of additional subsidies from the Fed.
- We’ve spent — and continue to spend — tens of billions on fiscal stimulus. Some provides valuable support for the unemployed. Some has gone to the States, so that they can continue their feckless spending. Some has gone into visible infrastructure work (e.g., roads). Most of the rest has left behind little but public debt.
- Since 2010 real US GDP has grown at an average of 2.2% per year. The first quarter is estimated to have grown more slowly than that, perhaps more slowly than the ~1.9% of 2013. That’s better than stagnation, aided by massive fiscal and monetary stimulus (zero rates and QE).
I suggest we listen to him.
About the author
Richard C. Koo is Chief Economist of the Nomura Research Institute, providing economic analysis to Nomura Securities, the leading securities house in Japan, and its clients. Consistently voted as one of the most reliable economists by Japanese capital and financial market participants for nearly a decade, he has also advised prime ministers on how to deal with Japan’s economic and banking problems. He is also the only non-Japanese member of the Defense Strategy Study Conference of the Japan Ministry of Defense.
Prior to joining Nomura, he was an economist with the Federal Reserve Bank of New York, and was a Doctoral Fellow of the Board of Governors of the Federal Reserve System. {source}
Some works by Richard Koo:
- “‘Plan B’ for the Global Financial Crisis“, presentation at the Center for Strategic and International Studies, 22 October 2008 — Here is a PDF of his slides.
- Interview of Koo by Kate Welling, Welling @ Weeden, 11 September 2009
- “Financial markets rocked by ‘Obama shock’”, Richard Koo (Chief Economist), Nomura Research Institute, 26 January 2010 (on Scribd)
- “The Age of Balance Sheet Recessions: What Post-2008 U.S., Europe and China Can Learn from Japan 1990-2005″, April 2010 (on Scribd)
- “Whither the patchy US recovery”, 20 April 2010 (on Scribd)
- The Holy Grail of Macroeconomics, Revised Edition: Lessons from Japans Great Recession (2009)
Posts by Richard Koo:
- A certain casualty of the recession: the US Government’s solvency, 25 November 2008
- The greatest monetary experiment, ever, 20 June 2013
- Two warnings about quantitative easing, the taper, and what comes next, 27 September 2013
For More Information
(a) Posts about monetary stimulus:
- The lost history of money, an antidote to the myths
- A solution to our financial crisis — Among other things, large monetary action
- The lost history of money, an antidote to the myths
- Recommended: Government economic stimulus is powerful medicine. Just as heroin was once used as a powerful medicine.
- The easy way to understand unconventional monetary policy
(b) Posts about our great monetary experiment:
- 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
- A Fed Governor speaks honestly to us about the costs and risks of our monetary policy, 18 January 2014
- Wagering America on an untested monetary theory, 22 January 2014
- What happens if the economy hits some rocks? Will the Fed stop the taper?, 9 February 2014
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I am going to make a couple of bold (reckless?) predictions:
1. QE will either go away completely on schedule or be reduced to a token amount 10-20 billion per month (hardly worth noticing, he says with considerable irony)
2. Rates will either not go up at all or will go up marginally and then come back down again quickly
3. Anything that resembles a fiscal downturn will be treated in radical and poorly thought out ways
4. Financial journalism will continue to consist of nothing more than reporting the current trends and explaining why explosive growth is just over the horizon
We seem to be stuck in the same trap as Japan and I cannot see a way out. To make matters worse, it’s not just us. Europe is in a similar position and nobody yet understands what is happening in China (especially the Chinese Communist Party) but it is beginning to look a bit ominous.
Prediction #5 is a bit further out:
5. Because we have hit an interlocking grid of problems and solutions that cause problems, small changes will have no effect because they will be damped out by the grid of problems. Change can only occur when something overwhelmingly powerful happens and then nothing will be unaffected (again because of the interlocking nature of our problems and solutions) and the changes will mostly be in unpredictable ways
“Prediction” #5 is the least doubtful of all. It is a description of any mature bureaucracy, be it a nation, an army, a corporation, or the local school district.
“Europe is in a similar position”
Europe is in a different position: its institutions do not yet have (EU Commission, ECB) or no longer have (all € countries and their central banks) the tools to try the kind of approaches that Japan and the USA have pursued (QE and the like); the EU has imposed upon itself a multilayered economic straightjacket (Maastricht treaty, Lisbon treaty, Sixpack, Europlus, etc) which prevents it from undertaking decisive action.
“Change can only occur when something overwhelmingly powerful happens”
I agree about the interlocking nature of things. However, you are assuming that we are in a stable equilibrium — where an overwhelming powerful force is needed to change state — instead of an unstable one — where a small deviation pushes the entire state out of whack. Why this assumption? It was enough for two financial institutions to go broke (Bear Stearns and Lehman Brothers) to push the entire worldwide economic system into depression. Seems like an unstable equilibrium to me.
“[Y]ou are assuming that we are in a stable equilibrium — where an overwhelming powerful force is needed to change state — instead of an unstable one — where a small deviation pushes the entire state out of whack. Why this assumption?”
A few years after the crash, the market is happy, the wealthy are doing as well as or better than ever, the struggling are struggling somewhat more… nothing much has been done to counter excess and fraud in the financial sector… workers’ rights and security are still neglected and declining… we continue to fight foolish wars that enrich oligarchs while refusing to finance public projects, such as infrastructure, that at least might provide both useful Keynesian stimulus and lasting public benefits…
Oh, and we have a health care “reform” that took as its overarching design principle the requirement that no industry with a significant vested interest in the existing system would be unhappy with the changes.
Sounds pretty stable to me.
Guest: “Europe is in a different position:”
Technically you are correct but the end result is the same. It shouldn’t be, but it is.
Coises is right, our situation is stable.
“The QE “trap” happens when the central bank has purchased long-term government bonds as part of quantitative easing. Initially, long-term interest rates fall much more than they would in a country without such a policy, which means the subsequent economic recovery comes sooner (t1). But as the economy picks up, long-term rates rise sharply as local bond market participants fear the central bank will have to mop up all the excess reserves by unloading its holdings of long-term bonds.
Demand then falls in interest rate sensitive sectors such as automobiles and housing, causing the economy to slow and forcing the central bank to relax its policy stance. The economy heads towards recovery again, but as market participants refocus on the possibility of the central bank absorbing excess reserves, long-term rates surge in a repetitive cycle I have dubbed the QE “trap.”
Read more: http://www.businessinsider.com/koo-says-no-one-can-refute-the-qe-trap-2013-10#ixzz2xGwRpWvT”
Hmm, yeah, interesting. I think this is the ‘secret sauce’ behind his prediction. Any hint of recovery, also brings in the fear of tightening, then rates rise and kills the recovery. So that keeps us in eternal ‘muddling around’ mode.
I’m not sure if the black hole of dollars is the right metaphor, really. It’s more a hoard of bonds at the Fed, and a hoard of reserves at the banks — and these are large relative to the size of the ‘actual economy that matters.’
QE does absolutely nothing to stimulating the economy. It does not increase the supply of money in our vast economy. Essentially all it does is transfers funds from a savings account at the Fed to checking account at the Fed. Think about it. When you transfer money from your saving account to your checking account have you increased the money supply? Of course not. QE is just a big transfer of money from one account to another. Money that already exists in our economy.
Kip,
The effect of QE varies upon the circumstances. By all accounts, QE1 had a large and beneficial. The research on QE3 (ongoing) paints a mixed picture as to the results, in kind and magnitude.
How so? It does nothing to increase the money supply. It’s just moving money around. In fact it ends up reducing the money supply because the interest paid to the T-bond buyers is eliminated.
Kip,
There is no single definition of the money supply. However, all of the conventional measures have risen under QE3. See the latest US Financial Data report from the St Louis Fed:
http://research.stlouisfed.org/publications/usfd/
I would agree that there isn’t one definition of “money” hence the difficulty in quantifying. I’ll go with the Fed data though. QE was not the culprit behind the increase. How could it be? It is was deficit spending that added the additional dollars to the supply.
Kip,
Can you cite an authoritative support for your theories? That QE does not increase the money supply, and deficit spending (without central bank action) does?
Do the math. QE by The Fed has totaled over $4 trillion. Has the money supply increase by $4 trillion? QE does not add dollars to the economy, for the simple reason that those dollars already are in the economy. I used the checking account/savings account example above to explain how it works. The so called deficit is the difference between what the Federal Government removes from the economy via taxes and what it put backs into the economy by paying its bills (taxes are not used to pay bills. They are permanently removed from the economy when they are collected by the IRS). The difference between the two (bill paying minus taxes) is the additional dollars that are placed into the economy. That’s just how it works based on the authority of the Federal Gov’t.
Kip,
OK, so you are just making stuff up. That’s what I thought.
M2 was aprox $7.2 trillion in Jan 2008; Fed assets were aprox $0.8 trillion. M2 now ~$11T; Fed assets ~ $4.2 T.
Money is not like apples. But the growth in the two numbers is quite similar.
You’re right I didn’t word my last reply well. My bad. I’ll put it a different way. You are ascribing the entire growth in M2 to QE. Which is impossible. At one point in time QE was at $100 billion/month yet the M2 during that time period was much less than the $100 billion. Even when there was a pause in QE during 2010 the M2 still grew. Just look at the recent numbers. There isn’t an increase of $85 billion (the amount QE is supposedly buying now/month) in the M2. Again, QE is just The Fed buying back t-bonds/securities/etc. from the banks. The money the Fed is using to buy back the T-bonds is the money the Banks used to purchase the t-bonds/etc. in the first place (money that was placed in a “saving’s” account at the Fed, as I described above, that was earning interest). The bank purchased t-bond/etc. represented money that was already in circulation, not money The Fed created.
http://research.stlouisfed.org/publications/usfd/
Kip,
You are just making stuff up, showing no actual knowledge of these matters. If you have actual expert references, please post them. Otherwise I’m done.
“You are ascribing the entire growth in M2 to QE.”
No I didn’t. I expressly said that these things are complex, not like counting apples.
Ok, here is an expert demystifying QE:
http://financialservices.about.com/od/StrategiesandResearch/fl/3-Quantitative-Easing-Myths-for-Financial-Services.htm
And I stand by my previous statements.
Kip,
(1) Francesca McLin is a “financial writer”, not an economist. Google will surface a wide range of links, but most are chaff.
(2) Please read my first comment to you. There is a large literature by economists on this subject. The consensus is that the effect of QE varies depending on the circumstances: QE1 was very effective, but QE3 less so — perhaps ineffective. The big experiment is Abenomics, but too soon to draw conclusions.
You’re completely over your head on this.
You asked for an expert. I gave you one. The woman has her degree in economics and a ton of financial/economic experience.
Japan has been using QE for decades which become known as the “lost decades” for good reason. As for Abenomics, tax increases and stimulus programs will neutralize each other and massive QE is going to do nothing for them. They may in fact go into a recession like they did when they raised taxes (took money out of the economy) in late ’90’s.
Kip,
She has an undergraduate degree in economics. That she worked as a stock analayst is irrelevant. This is dumb.
You’re just making stuff up. I’m done.
Oy. You need to open your mind. How about this quote from the one and only Ben Bernanke (from a 2010 60 Minutes Interview):
Pelley: Some people think the $600 billion is a terrible idea.
Bernanke: Well, I know some people think that but what they are doing is they’re looking at some of the risks and uncertainties with doing this policy action but what I think they’re not doing is looking at the risk of not acting.
Pelley: Many people believe that could be highly inflationary. That it’s a dangerous thing to try.
Bernanke: Well, this fear of inflation, I think is way overstated. We’ve looked at it very, very carefully. We’ve analyzed it every which way. One myth that’s out there is that what we’re doing is printing money. We’re not printing money. The amount of currency in circulation is not changing. The money supply is not changing in any significant way. What we’re doing is lowing interest rates by buying Treasury securities. And by lowering interest rates, we hope to stimulate the economy to grow faster. So, the trick is to find the appropriate moment when to begin to unwind this policy. And that’s what we’re gonna do.
Is he making this stuff up?
Watch it here: http://www.cbsnews.com/news/fed-chairman-ben-bernankes-take-on-the-economy/