The story behind why the Fed created the risks that are now haunting them is a revealing one, and it has perverse implications for the future.
QE3 is a monetary extremum. It arose out of frustration from years of unsuccessfully stimulating the economy the old-fashioned way — by purchasing securities that resulted in mountains of cash being deposited at banks at record low rates with the unfulfilled expectation that the cash would be loaned and spent.
Lead by Bernanke, a still-determined Fed embarked on a policy tweak that they hoped would cause banks to lend, encourage businesses to borrow and invest in plant and equipment, and drive consumers to spend on durables. The scheme also encouraged investors to drive up financial prices, hence creating a wealth effect that would provide the resources for more spending.
The idea was to tweak expectations that arose out of the simple notion that people invest in physical plant or financial shares based on their probabilistic expectations of the cash flows from future economic growth. Key to that projection is what they believe policymakers will do to maintain growth. Inside of academia, this notion became known as rational expectations, a theory that has been glorified with the award of at least two Nobel prizes.
So as it stood last fall, expectations were “rationally” priced into economic activity and market securities, but the rational level of activity was not very satisfying to the body politic or to the Fed. Given the impasse and the mounting fears of a further setback from the looming fiscal cliff, the Fed decided on a Hail Mary policy play. Fortified by the academic acclaim of rational expectations, they thought it clever to manipulate existing expectations to cause agents to do what they wanted them to do, which was to generate more real investment spending.
In rational expectation logic, in order for the policy change to have an effect on the outcome, it needed to be a policy surprise, otherwise the outcome was already reflected in existing activity and prices. Hence, it can be said that the Fed sought to create irrational expectations of growth. What especially makes it irrational is earlier QEs have already revealed that growth doesn’t necessarily follow more money. But if the market believes and acts on it, expectations can become self-fulfilling.
In the good old days of pre-government debt distress and Great Recessions in which commercial banks would take excess cash and actually lend it, the policy options were spoken of as either Open Market or Open Mouth. Open Market means the Fed shapes market prices by actually going to the open market and buying, whereas with Open Mouth, they merely imply they will be buyers, which causes front-running investors to change the prices for them without the need to load up their own balance sheet.
In today’s world of the Great Quagmire — after more than five years and counting in which at least two other predecessor QEs did not do the trick of extracting the economy — the Fed believed the only way to generate some traction would require both Open Mouth and Open Market with breathtaking amounts of monetary increase never previously witnessed, anticipated or priced in.
To do so they needed to oil up the printing press and but also ramp up Bernanke’s Open Mouth skills to exude some confidence in order to move the expectations needle — not an easy task for a rather dry academician. To do this, it is reported that Bernanke hired a media coach and scheduled unprecedented press conferences never before conducted by a central bank Chairman in the manner of King George VI of Great Britain, who needed to announce his country’s entry and progress through WWII.
What was most important in the Fed’s announcement of QE3 was the notion that they would not take their foot off the monetary accelerator until we were out of the Quagmire, however long that would take, in an open-ended commitment. This is something akin to the wartime philosophy, “We do not stop until unconditional surrender.”
And while its way too early to determine the extent of the success of the gambit as it relates to jobs, economic growth, and a little bit of inflation, these effects only occur after a bit of time, which even in less challenging times would require 18 months to be noticeable.
But rather than waiting that long to judge the leading edge of the results, after only about 8 or 9 months or so of QE3, the Fed hinted that it would throw in the towel on Quantitative Easing. To lay the groundwork for exiting, it backed off the timeless open-ended commitment by defining targets of unemployment and inflation that would allow them to exit, and more recently it forecasted time limits for reaching those targets which now is but a fuzzy time limit for QE3. Gone is the open-ended commitment, replaced by a strong hint that they wish to back out.
So now we have it as to why the Fed started QE3 — but why are they now backing off the strategy known in Bernanke (and speech coach) gibberish as “tapering,” which was met with a disconcerting thud in the financial markets.
Basically to date, while there is no clear evidence that real investment is taking place as a result of the policy, but it is clear that financial market participants took the Fed’s promise of growth along with cheap money and ran with it. Given their “do not fight the Fed” culture, they responded to the Fed’s unanticipated announcement in minutes, not the months or years the real economy requires to assess the response.
Basically the financial investors salivated at the ultra-low rates offered to borrow and purchase financial assets — a process known as leveraging — which drives a wedge between financial pricing and the underlying economic income streams they were purchasing. It is also known as an asset bubble, which tends to collapse.
Well, the asset bubble pricing started to collapse on its own weight, prior to the Fed hinting that it will be exiting earlier than planned. That occurred because of a new monetary phenomenon that is important to understand. It involves new realities of global financial intermediation.
QE3, with its eager financial market participants, enabled a great deal of low-quality debt to be not just sold but scooped up by financial leveragers with borrowed funding. Leveragers do, after all, live off the difference in the yields of the assets they purchase less what they pay for the borrowed funds required to purchase the assets. This is known as spread.
So while low-quality debt assets were flying off the shelf into the hands of the leveragers, generally known as the shadow banking system, outstanding amounts of high-quality debt securities in the form of U.S. Treasuries were being scarped up by the Fed in its QE3 operation.
Ironically, this ended up limiting the amount of low-quality assets the shadow banks could purchase, because they are required by their funding sources to collateralize their borrowings with high-quality debt.
The critical nature of the availability of high-quality debt is amplified when they don’t simply borrow once against the high-quality debt, but they instead use their high-quality collateral repeatedly to borrow yet more funds and purchase yet more assets making available Treasuries in the secondary markets the defining limit of their balance sheet size.
It would be like you or I pledging our same house over and over again as collateral to succeeding lenders to borrow yet more funds for unrestricted uses. Yes, borrowing over and over again against the same collateral might not be legal for you or I, but it is legal up to a point in the shadow banking system. The extent to which this can happen is called the re-hypothecation multiplier.
In this way, by removing Treasury collateral from the available asset pool, the Fed’s QEs caused the shadow banking system to contract. Because the shadow banks are at least twice the size of commercial banks and the only eager lenders at this time, this greatly squeezed credit.
The contraction of the shadow banks showed up in the markets a number of ways: The prices of risky debt fell as shadow bank portfolios shrunk; the prices of the funding currency (cheapest source of funds) such as the Yen and the Dollar rose as leveragers were repaying their funders as they unwound their portfolios; and the leveragers closed shop on expansion by only accepting funds if the funder was willing to pay them for the transaction.
That is, negative funding rates occurred when the funders needed to pay shadow banks to accept their funds, rather than having the shadow banks pay for them. This is the equivalent of walking into your friendly bank, asking the rate they offer on CDs and being notified that your money will only be accepted for a CD if you agree to pay the bank to take your money! Such is the surrealism in today’s markets.
That surrealism includes the commercial banking system with free cash to lend some great multiple of the available cash — yet they do not lend it, and the larger shadow banking system runs out of Treasuries to expand off. All in all, it is de facto restrictive credit conditions, despite the QEs.
So where are we now? For one, the above has revealed that maximum money is not optimal money. QE, at some point, makes credit conditions worse off. In fact, credit is restrictive. Another way to put it is that we have backward-bending reaction functions that are definitely not part of the Keynesian or monetarist textbook of how more money produces higher prices and improved economic conditions.
The Fed’s ability to move the dial on real investment and financial prices has been shown to have reached an upside limit, and their announcement effects in financial markets are now met with cynicism instead of awe as they vacillate back and forth on QE3.
The recent crumbling of debt and equity prices embarrassed the monetary authority and revealed that Open Market operations do not have the desired effect. This negates their power to move the markets with Open Mouth policy, as there are precious few left who believe the Fed will stick to an announced expansion.
Of course, not wanting to admit to impotence, the Fed claims mysterious “headwinds” prevent the effects they are seeking as a face-saver for those who question monetary policy. They clearly would like to put QE3 in the rear-view mirror and have vacillated between statements of tapering and then damage control to their reputation (and financial market wealth) by dispatching various Fed bank presidents to claim they are still in it until victory. They have the QE3 Tiger by the Tail, and they are afraid to let loose as they know their reputation will plunge on a scale equal to the market plunge that would follow.
Bernanke is lucky as his term as chairman (but not as a member of the board) is over in January. He might even leave earlier, as the president already publicly closed the door on a re-nomination when he said: “He’s already stayed a lot longer than he wanted, or he was supposed to.”
The irony is that he is being chastised for backing off of QE3 by the administration despite it being a doomed and embarrassing policy. One sort of graceful way out is to declare victory and leave, a strategy not without precedent in both war and peace.
The far larger issues ahead are not the future of QE3, or of Bernanke or the stock market, but rather the Fed. The salad days of hard-earned market confidence that allowed Open Mouth Policy to have an effect have been built on 70 years of performance since the Great Depression. That confidence has been sacrificed, and it will not just return with the appearance of a new Fed Chairman in January.
Divining the short list of candidates to replace Bernanke has been tasked to Treasury Secretary Lew, so whoever it is will very likely be a Democrat, not just because of who is nominating but also because the appointment requires an advice and consent majority from a Democratic Senate. So whoever replaces Bernanke is likely to try it all over again in the faint hope that mega QEs both dazzle the financial markets and still provide economic uplift. Good luck to whoever that might be!
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