Tag Archives: QE

The European Union, Nationalism and the Crisis of Europe

By George Friedman

Last week, I wrote about the crisis of Islamic radicalism and the problem of European nationalism. This week’s events give me the opportunity to address the question of European nationalism again, this time from the standpoint of the European Union and the European Central Bank, using a term that only an economist could invent: “quantitative easing.”

European media has been flooded for the past week with leaks about the European Central Bank’s forthcoming plan to stimulate the faltering European economy by implementing quantitative easing. First carried by Der Spiegel and then picked up by other media, the story has not been denied by anyone at the bank nor any senior European official. We can therefore call this an official leak, because it lets everyone know what is coming before an official announcement is made later in the week.

One Bear at a Time

Fresh from finishing Summa: The Great Myth, we came across a Dec. 13 blog entry by Doug Noland, “The Prudent Bear”, titled Q3 2013 Flow of Funds. In reading his blog we came across a section that we reproduce below adding numbering in square brackets and emphasis. We then discuss the errors in his thinking.

Summa: The Great Myth

Listening to an interview of Richard Duncan by David McAlvany we were finally motivated to explore an issue that has nagged at us for quite a while. What disturbs us is that we find ourselves alone in disagreement with the prevalent ‘wisdom’ regarding the Fed’s quantitative easing (QE) policies and their effects on liquidity and markets. This essay will explore our position.

Flash Point: If You’re American, You’re Now Really Screwed – Yellen’ About it Won’t Do No Good

ZeroHedge today reports: Yellen Timestamp: “No Bubble”. We have added emphasis below.

  • YELLEN SAYS FED DOESN’T SEE BUILDUP OF FINANCIAL RISKS
  • YELLEN SEES LIMITED EVIDENCE OF ‘REACH FOR YIELD’
  • YELLEN SAYS FED LOOKS OUT FOR ANY POTENTIAL ASSET PRICE BUBBLES
  • YELLEN DOESN’T SEE `MISALIGNMENTS’ IN ASSET PRICES

Since ZH doesn’t provide a source link we go to Fox Business: Yellen Senate Confirmation Hearings Begin. Quotes from this source areare:

  • Yellen in her opening statement credited the Fed’s interventionist policies with supporting the ongoing recovery and described the economy as “significantly stronger.” [The economy has not recovered to its pre-recession levels and may be rolling over. Contrary to what the Fed might believe, the business cycle remains, even if it is severely distorted by Fed intervention.]
  • Quantitative easing is intended to keep longer-term interest rates on loans such as mortgages low “to spur demand in the economy,” Yellen explained. [after an initial boost there is no ongoing effect. Indeed, the 30 year rate has been rising.]
  • Yellen, addressing questions related to potential asset bubbles, said Thursday she doesn’t currently see any “price misalignments” that “would threaten financial stability.” [compared to normal times, risk in the bond market and the stock market is totally mispriced.]

In short, Yellen will perpetuate the Fed policies that have so damaged markets, partly due to a blindness toward their ineffective and destructive nature.

David Stockman, in a King World News interview reinforced the above analysis:

The greatest danger is the Fed.  It has become a serial bubble machine.  We have seen this move three times already this century … and now they have inflated it even more fantastically for the 4th time.  And yet we now have testimony from Yellen, yesterday, in which she couldn’t even use the word, ‘bubble.’  She kept referring to it (the bubbles) as a ‘misalignment of prices.’

So we have a complete disconnect between the Main Street economy, which is struggling and floundering, and financial bubbles throughout Wall Street and the financial system that are clearly being fueled by the lunatic policies of the Fed.  And now we have a (Fed) chairman who can not see them, or even hear the word.

These comments crystallize the divide between private sector analysts and economists and the Fed. They represent the antithesis of what the private sector sees and in particular with QE, what academic research is beginning to dismiss as having any ongoing effectiveness.

This Is How It’s Done!

The Fed has been desperately trying to goose the US economy for years with various forms of quantitative easing, largely without success. As we have argued, there is no way of separating the effect of QE on recovery from the last recession from normal economic forces that have lead to economic recovery from every recession in history. Now, we have a new and measurable way of creating economic growth independent of QE.

Courtesy of the Commerce Department, we find that simply by revising the way GDP is calculated – cooking the numbers – we can achieve instant economic growth. The following chart from MarketWatch illustrates this achievement:

This result is even more remarkable than at first appears. Looking carefully at the two bars covering the period 1959 to 2007, we find there is essentially no revision to the growth numbers. It all occurs since 2007. Keeping in mind that the last recession started in 2007 and recessions are normally marked by negative GDP numbers, the significant difference in growth between the two methodologies for the recent period shown is actually compressed into the recession recovery since 2009.

As we said, if you can’t create economic growth by dumping tons of liquidity onto the market, simply cook the numbers to get the growth you want.

How Effective Has QE Been?

under construction

We have written a number of essays on quantitative easing (QE) as practiced by the Fed. We also have just finished our series on Understanding Money with the publication of Understanding Money: Part 5 – It’s All Money. As we were finishing we realized that a number of questions in our mind about QE might be tidied up using our ideas on money. This essay examines the monetary mechanics of QE and attempts to quantify its impact on the money supply and hence the economy.

Flash Point: The Fed is Dead!

We have written extensively on the Fed’s broken interest rate policies which along with propaganda (the use of  communications such as FOMC minutes and members’ speeches,  to influence investors and markets), are the main tools the Fed has to affect the economy. In short, lower interest rates encourage borrowing which stimulates the economy through added consumption (spending) and business investment. This traditional tool of using the Federal Funds Rate to control short term borrowing costs, broke in 2009 when effectively the zero rate lower bound was reached (ZIRP).

Unable to stimulate spending by this means, the Fed began a series of quantitative easing (QE) measures to bring down interest rates right across the yield curve to the 30-year long bond. The latest, dubbed QE3, was supposed to increase the downward pressure on long-term rates giving investors money to buy stocks, stimulating company investment.

In an article today titled QE Backfires as Dividend Quest Usurps Growth: Cutting Research, Bloomberg explains how this is not working as planned. Instead of increasing their debt load to invest in high-risk stocks with no return, investors are choosing to invest in the stocks of low-risk blue-chip stocks that pay a dividend and that by buying back their stock, raise the price giving investors a capital gain.

In driving real interest rates negative at the short end of the curve and well below 1-2% at the long end of the curve, the Fed has forced investors into equities to get some minimal positive return. It’s just that the investors didn’t quite go where the Fed wanted them to in terms of equities.

So QE has reached the end of its effectiveness leaving the Fed with what? The only question now is whether any further flatulent announcements and policy proposals are the product of a bad case of monetary overindulgent indigestion or the emissions of a rotting corpse. The Fed is not smart enough to realize that the problem is that of a debt cycle and not a business cycle. The consumer on the other hand, once again demonstrates wisdom as he manages his wealth.

Flash Point: The Fed Prints

(hat tip Metanoodle)

From the latest FOMC statement:

FOMC Redline Sept

Key points and our interpretation:

  • The Fed will continue its zero interest rate policy (ZIRP) through mid-2015 at least.
  • The Fed will continue and extend “Operation Twist” to the end of the year. This recycles funds and creates no new money.
  • The Fed will buy $40 billion of MBSs per month with no set end. This would appear to require new money since no source of funding was announced.
  • Principal and interest from existing GSE debt and MBSs are currently reinvested. This practice will continue, recycling funds while creating no new money.
  • Total investment will be $85 billion a month so we expect the Fed’s balance sheet to increase by $40 billion per month of unsterilized financing. We will watch to see where the liability goes on its balance sheet.

Flash Point: The Limits of QE3

The primary tool of the Fed for affecting the economy has been its ability to manipulate interest rates. Lowering them has traditional stimulated the economy promoting recovery. With the current recession, the Fed first lowered short-term rates to effectively zero. When that didn’t work, it tried Large Scale Asset Purchases (LSAP) or quantitative easing (QE). These programs effectively reduced longer term rates with each successive program working further out the yield curve to the 30-year bond. This has not worked. In the process, the term structure of the Fed’s Treasury portfolio has been altered dramatically as this video from Stone McCarthy shows:

Having lost all leverage at the front of the yield curve (short-term rates) it can only play at the back end, the longest-dated maturities. Moreover, we see that the Fed has very little left of shorter-term Treasuries to sell if it wishes to sterilize the purchase of longer-term Treasuries.

But more importantly, a study by UBS via Zero Hedge (The Scary Math Behind The Mechanics Of QE3, And Why Bernanke’s Hands May Be Tied) indicates the Fed doesn’t have much room there left to work.

the Fed owns all but $650 billion of 10-30 year nominal Treasuries.” Also as pointed out above, Twist 2, aka QE 3.5 is already absorbing all of the long end supply. And herein lies the rub. To quote UBS: “Taking out, say, $300 billion in long-end Treasuries almost certainly would put tremendous pressure on liquidity in that market….Ploughing ahead with a large, fixed size QE program could cause liquidity to tank.

This raises The Dilemma of the Impatient Trader. If it attempts an LSAP of long-dated Treasuries, it first of all may not find enough to create the stimulus effect it would like to, and second of all, would wildly distort markets with an unknown but likely disastrous effect.

UBS then goes on to explain why, if the Fed wanted to but mortgage-backed securities (MBS), it is limited to about $40 billion per month:

The alternative of tilting purchases toward MBS implies that the QE program would need to be quite protracted. Monthly supply of conventional 15yr, 30yr and 30yr GNMA has averaged about $85-90 billion over the past year and the Fed is already buying about $25 billion. The Fed might be able to buy another $40 billion without disrupting the market.

The result is that if the Fed wishes to implement a QE3, it has very real limits on the amount of securities it buys and the rate at which it buys them. And operating in markets where it is the largest player will mean the premium the Fed pays as an impatient trader may be huge.

Flash Point: Where Does It End?

We had just finished our latest essay The Hole in Jackson Hole, when we got this article from Bloomberg: Fed Moves Toward Open-Ended Bond Purchases to Satisfy Bernanke. In our essay we presented our arguments that LSAPs (QE) have been ineffective in stimulating the economy. The Bloomberg article, however, suggests some new LSAP will be coming soon (something we agreed with as a result of our analysis of Bernanke’s speech).

LSAPs were introduced to manipulate interest rates because the traditional tool for doing this, the  Effective Federal Funds Rate (EFFR), became ineffective when it reached the zero lower bound. Since the EFFR was designed to manipulate short-term rates and these were effectively at zero, the Fed used LSAPs to affect longer dated maturities, eventually lowering rates across the entire yield curve to the 30-year bond. All have recently touched historic lows.

As we argued, there has been no observable effect of LSAPs on the employment situation. Bloomberg speculates that the Fed will soon introduce an LSAP policy that is open ended. Its goal will not be to acquire a certain class of assets in a specified quantity in a specified period of time as previous LSAPs have done, but to set an economic target for the program rather than an asset target. Jim Rickards suggested they would do this several months ago, targeting a certain level of GDP. Bloomberg suggests they may target a certain level of unemployment – say 7%.

In an economic environment where GDP and employment are in a cyclical downturn one might assume they will return to historic norms. If however, there are structural changes in the economy, this assumption is invalid. In our essay we showed a thirty year downtrend in GDP and employment growth. We argued that this is structural since it it spans four recessions or business cycles.

Bernanke’s bet is the recovery has a cyclical basis. We argue it has a structural basis*. If Bernanke is wrong and sets a policy objective for levels that are no longer relevant due to structural changes, then he will have created an open-ended ticket to money creation at the Fed bounded by a goal that is unattainable. But what is worse, he cannot realize that the failure of his policy is based on a fundamental misreading of the economy. Rather the danger is he will misread the situation as Paul Krugman has done and feel that the problem simply requires more money to be thrown at  it.

*Update: 20120914

We find today, Ambrose Evans-Pritchard arguing in The Telegraph in his essay Era of ‘jobs-targeting’ begins as Fed launches QE3, that the employment situation is due to a structural change. He quotes Bernanke’s concern as:

a grave concern, not only because of the enormous suffering and waste of human talent it entails, but also because high levels of unemployment will wreak structural damage on our economy that could last for many years

Then he quotes Minneapolis Fed chief Narayana Kocherlakota as saying that the lack of jobs skills imply less slack than assumed – known as an upward shift in the “Beveridge Curve”. The problem is “structural”.

In The Hole in Jackson Hole, Figure 4 shows that for the current ‘recovery’, the year-over-year change in GDP is at trend. This we interpret to mean the full recovery has happened and current employment numbers are the ‘new normal’. To support this notion, we note Ambrose’s statement America’s output is now well above its previous peak in late 2007, unlike Japan and most of Europe. If output has fully recovered, there is no room for any significant expansion in employment. Indeed, the larger levels of unemployed – the actual levels, not the official levels – will prove to be a drag on economic expansion as these people will require social service support while remaining unproductive.

The implication then for a QE program that targets a level of employment is that this level will be reached only when sufficient people drop out of the labour force to reduce the numbers and not by job creation. We have  a nagging feeling, not that QE will not be effective since we believe it won’t be, but that it will actually damage the economy at an accelerating rate. We’re thinking about it.

 

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