What The Fed Does Next

Via Scotiabank's Guy Haselmann,

In 2008, various liquidity facilities, designed by the Fed, unclogged broken capital markets.  Shortly thereafter in early 2009, QE1 was implemented to improve market liquidity and transform investors’ general revulsion to financial assets.  The combination helped avert economic and financial disaster. The Fed responded well at that time; however, the cost-benefit equations for QE2 and QE3 are much less clear.

The Fed’s (subsequent) QE and ZIRP policies have enabled fiscal stalemate, turbo-charged wealth inequality, and arguably led to financial asset bubbles.  For these reasons, I believe they have become counter-productive.   New tactics, should they be needed, would therefore be welcomed.

  • It is counterfactual to know, but it could be argued that current market turmoil is partially the result of the Fed purposefully encouraging asset price inflation, and staying in crisis mode long after the economy began to heal, and after the financial markets were operating smoothly on their own.  Over the past few years, too many investors, piggy-backing off of Fed policy, have diverged valuations away from economic fundamentals.  Recent down -grades to forecasts of global growth and inflation by the IMF and World Bank further expose this fact.  In turn, wrong-footed investors are now belatedly trying to recalibrate.

The Fed’s feeling as if it is ‘the only game in town’ has been a factor leading to its unusual measures. Polarized politicians should take some blame. They are too frequently reactive (as opposed to proactive), so it could take a financial crisis to get them to act.

Another intention of the QE programs was to sufficiently boost GDP enough to deal with, and reduce, the problem of excessive debt.   Since sovereign and non-financial corporate debt-to-GDP levels have risen significantly during the programs, QE, under this metric, has been a failure.

Financial repression unintentionally created growth in debt, but not in money or inflation as intended (thus resulting in higher debt-to-GDP).   Furthermore, punishing savers at the expense of helping risk-takers and speculators is bad long-run policy for any country.  Therefore, using zero interest rates and QE, as tools to ‘inflate away’ debt, will have to be replaced at some point with new tactics and remedies (below).

  • Attempts to reflate will not be abandoned altogether, because rising debt levels and falling velocity of money means the US is now even more vulnerable to a deflation shock, but other tactics will have to be found.
  • I believe that SF Fed’s Williams comment today about potentially revisiting QE if necessary is a complete non-starter.

Should the negative aspects of QE policies continue to materialize, the Fed’s efforts to ‘normalize’ rates (i.e., hike rates) may certainly be deferred.  The real question is what remedies will, or can, the Fed turn to should market turmoil become unhinged, or should the US recovery falter?  The answer, of course, is that the Fed will turn to “macro-prudential” polices.  If you are wondering what this means, Kevin Warsh said it well at the IMF meeting this past weekend: “macro-prudential policies are vital, but we have no idea what they are”.   

I have a theory.  New onerous banking regulations have restricted the ability and willingness of banks to lend, shrinking bank credit growth and the velocity of money.  The Fed’s enlargement of its balance sheet by more than $3 trillion via QE has been unable to offset these regulatory factors, because most money creation occurs as a function of lending in the fractional-reserve banking system. Therefore, I suspect that part of the “macro-prudential” remedy will include the Fed (or some other type of government agency) playing a role in targeted credit allocation.

Such a tactical shift will mean that the holders of capital who were so amply rewarded under QE will be badly hurt.  The Fed (or other activist gov’t agencies) will decide the winners and losers.

This plan likely has many political obstacles, but it should not be considered a far-fetched idea.  State-directed (subsidized) credit is not unprecedented and not dissimilar to the BoE’s ‘Funds for Lending’ scheme, or the ECB’s TLTRO program.  Certainly, the Fed needs to find a way to better way to control credit growth with tools other than interest rates or security purchases.

The Fed has provided years of uber-accommodation.  Its stimulus efforts were assisted by entities abroad. Today, global quasi-coordination has fractured with other countries now focusing on domestic issues.   Markets are already showing signs of worry.  Since the Fed’s balance sheet is still growing, withdrawing accommodation (the second half of the game) has yet to even start.

After years of one-way accommodation, markets are likely in for a messy unwind process; particularly as (and when) Fed tactics change. The US Treasury 30-year dropped below 3% well-prior to my “before Thanksgiving” prediction, and now sets its sight on my prediction “of a move toward 2.5% in 2015”.  As I outlined in last week’s note, the global factors are aligning in the perfect storm.  It is always easier to provide accommodation than to remove it.

“I took a course in speed waiting.  Now I can wait an hour in only ten minutes.” – Steven Wright