This piece was originally written for Encima Global.
As expected, the Fed announced today that QE4 bond buying will start in January. We think Fed policy is contractionary. The announcement of more bond buying doesn’t improve the outlook. Equities and gold rose following the announcement but then closed flat on the day. Even though we disagree with the Fed’s decision to buy more bonds, we welcome the openness of the Fed’s discussion about its monetary policy vision. In today’s press conference, Fed Chairman Ben Bernanke answered many detailed questions from financial reporters on Fed policy and on the fiscal cliff, creating a sharp contrast with the lack of openness and vision for U.S. fiscal policy.
- Under QE4, the Fed’s liabilities will quickly expand beyond $3 trillion and, given today’s announcement of an aspiration for 6.5% unemployment, probably above $4 trillion. We expect the growth impact of QE4 to follow the pattern of QE3, QE2 and Operation Twist, which saw steady declines in the Fed’s own growth expectations as the QE policies were implemented (see graph in the attachment.)
During the press conference, Chairman Bernanke was asked how QE works. He drew on the portfolio rebalancing theory that he had laid out in his 2010 Jackson Hole speech. Today he said: “What matters primarily is the mix of assets on the Fed’s balance sheet. The Fed is acquiring Treasuries and MBS, forcing investors into other closely-related assets.” In his August 27, 2010 Jackson Hole speech, Bernanke said: “Our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration.”
We don’t think Bernanke’s transmission theory works when private sector credit is constrained by regulatory policy. The Fed is causing a rationing process which channels capital to the government and to assets with similar characteristics at the expense of small businesses (see WSJ Near-Zero Rates Are Hurting the Economy on December 4, 2009 and WSJ How the Fed is Holding Back the Recovery on October 19, 2010.) Our view:
- Fed policy distorts markets, hurts savers, and favors the government at the expense of the private sector. There’s been no change in credit or regulatory policy, so there’s no increase anticipated in the M2 money supply or private sector credit. There’s been no loosening of bank regulatory policy, no increase in expectations for bank leverage and no un-freezing of the money multiplier that connects excess reserves to private sector loan growth, which remains stagnant.
- From a money supply standpoint, QE4, unlike Operation Twist, will accelerate the growth in the monetary base (by adding to excess reserves which are counted in the monetary base.) It will not have any discernible impact on the growth in the M2 money supply, which is linked to GDP growth. The money multiplier assumed in monetarist theory has simply stopped functioning under current regulatory policy, blocking any connection between the expansion of the Fed’s balance sheet and actual monetary stimulus.
In its statement today, the Fed said will begin buying $45 billion per month in Treasuries to replace Operation Twist, with no limit in terms of time or amount of these purchases. It added the concept that it anticipates that the “exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”
- Fed policy is making the Fed accountable for unemployment and turning it into an interest rate predictor. This conflicts with its primary role in setting interest rates and assuring price stability and, through it, maximum unemployment. The Fed’s policy approach puts heavy emphasis on the public’s inflation expectations, which we think are a lagging indicator of monetary policy. The policy asserts the Fed’s legal authority to make unlimited “large-scale asset purchases” on its sole discretion even when there’s no crisis, a harmful precedent for future economic growth. By promising low rates for a long period, the Fed undercuts the normal attraction of borrowing to lock in low rates before they go up.
- In today’s announcement, the Fed again declined to “sterilize” its bond purchases using reverse repos or a term deposit facility (as the ECB does.) We don’t think that makes the bond purchases stimulative. With bank lending constrained by regulatory policy rather than the availability of reserves, sterilization of the monetary base doesn’t make a difference. In the press conference, Bernanke made clear that today’s policy announcement is a continuation of previous policy rather than an effort to add stimulus.
- Chairman Bernanke attributed the recent drop in consumer confidence to the fiscal cliff. We agree that is part of the problem, but think the weakness is also the result of contractionary Fed policy. Small business confidence fell to 87.5 in November, the sharpest one-month drop on record and well below previous recession readings. Most of the decline was due to a plunge in expectations about future business conditions.