"A Classic Minsky Trap Appears To Have Developed"

From Guy Haselmann of ScotiaBank

Data show quantitative easing (QE) is having ever-diminishing economic benefits while the risks to financial stability accumulate the longer the program endures. Inevitably, there is a point in time when the costs outweigh the benefits. Determining that point is critical, and some believe it may have already passed.

When the Federal Reserve’s current asset purchase program was initiated, both the necessity and scope of it were questionable. Inflation was stable and near the Fed’s target. The unemployment rate had already fallen steadily to 8.1 percent in the second half of 2012 from a high of more than 10 percent in 2009.

The program’s $1 trillion per year in asset purchases equates to the annual GDP of Belgium and Norway combined. The FOMC justified the  open-ended program by pointing to the unacceptably slow pace of the recovery, thereby tying its lifespan and magnitude to making “sufficient progress” toward economic targets.

Focus was purposely directed toward economic benefits, rather than risks, because benefits are easier to explain and ‘guesstimate’ using econometric models. However, large errors can occur in those models, due to the vast complexities of interconnected markets and economies.

Unfortunately, unquantifiable and unintended consequences from the enormous ballooning of the Fed balance sheet may be on the horizon. Recent market volatility might be a warning sign to the FOMC about the extent of risk-taking (which QE policies encourage), and how the market will react when its exit strategy finally materializes. Even with the present sub-optimal economic growth, the Federal Reserve may decide to announce tapering of asset purchases as soon as today. After all, the FOMC can claim success at having ‘made progress’ toward their stated goals. At last
September’s FOMC meeting, their central forecast for the unemployment rate for the end of 2013 was 7.75 percent. The May rate has already fallen to 7.6 percent.

For the past several years, a firmly entrenched psyche of ‘win-win’ for risk-taking behavior has dominated. The thinking has been that the Fed would either help achieve a sustained recovery (allowing distorted prices to be validated by economic fundamentals), or the FOMC would provide more price-boosting liquidity. Now, faith in this proposition is slowly being eroded.

Global central banks have collectively provided $11 trillion in liquidity over the past several years. The initial moves were taken to spark domestic demand, but some recent external actions have been retaliatory in nature, implemented as a means to influence currency levels. These new forms of hostilities are indications that the external ramifications of QE policies may no longer be passively tolerated.

While offsetting actions by non-U.S. entities may not influence the FOMC, they are aware that currency disputes lead to trade disputes, and that protectionist pressures are a great risk to a highly globalized economy.

Invoking the motto, “Don’t fight the Fed,” has rewarded investors. They have ‘reached for yield’ and ‘chased risk’ to take full advantage of the implicit ‘Fed put’. FOMC speeches have hinted at speculative excesses. It has not gone unnoticed that NYSE Margin Debt has risen to all-time high levels. The problem is that as asset prices have veered far from economic fundamentals investors, enjoying ‘right-tail’ benefits, have been lulled into complacency. A classic Minsky Trap appears to have developed.

When market participants sense the Fed’s unwind is beginning, they (and the central bank) may be surprised by the extent of the reversal.

Regulatory constraints may compromise market liquidity during ‘fed-piggybacking trade’ unwinds, leading to a harsh ‘left-tail’ overshoot.

‘Tapering’ earlier might be better for markets in the long run. An early ‘taper’ would allow officials to regain a unified voice and control the market message. They could then emphasize the extraordinary amount of accommodation that they are still providing in an effort to calm markets.

Moreover, a slower pace of asset purchases of, say, $60 billion would allow the FOMC to increase it back to $85 billion should the economy slow over the next few months. Without a slower pace now, the FOMC may run into credibility issues about the program’s efficacy at the same time an increase in purchases might be expected. This would further exacerbate funding stresses and fears of financial instability.

The longer QE persists, the greater the magnitude of the ‘left-tail’ event that is growing in probability. Continuing to provide massive stimulus for a growing economy will turbo-charge the ‘reach for yield’ and ‘chasing of risk’, leading to financial instability.