What is QE?

Quantitative Easing (QE) is an unconventional monetary tool used by central banks to revive an economy severely hit by a shock (e.g. financial crisis). The Bank of Japan (BoJ) and the Federal Reserve (Fed) have both used this tool since the early 90’s and 2008 respectively. In USA QE refers to US government debt monetization by the Fed, which implies the conversion of an asset (ie: a bond, or mortgage backed securities) into money. The US Treasury emits bonds while the Fed buys them with cash coming from newly created money, a process called ”printing money”. Remember that money is a liability (debt) on Central Banks’ balance sheets.

Why unconventional and why using it? In case of a severe shock, traditional tools such as reserve requirement ratio and interest rate are no longer effective to cope with the distress created. Because QE is an unconventional tool by nature and quantity, it shall be used only sporadically since it can quickly create deep imbalances. As an illustration, take painkillers: they help reduce pain, but they can also cause severe damage depending on the frenquency and the quantity absorbed. Moreover, they often only hide away symptoms without addressing the underlying causes.

Some key points must be well understood: a QE aiming at monetizing debt, make it affordable to issue debt (low interest rate so low cost to borrow) but doesn’t not necessarily make it sustainable. Despite the prominent scholars Reinhart-Rogoff’s work saying that a debt over GDP ratio of 90% is a threshold for debt sustainability, there is in fact no well defined threshold. Instead, what investors should care about the most is the sustainability of debt, which is the trend (dynamic of debt measured with a variety of tools, including deficit/GDP ratio) and the level of debt (stock measured by debt/GDP ratio).

Now, a government willing to borrow to finance a deficit or to invest in infrastructure projects has to determine whether the debt used to finance its spending is acceptable or not: the benefits of spending must be greater than the costs, government spending must be directed at projects the private sector cannot do on its own and the overall debt level must be sustainable. Things gets ugly when output minus interest expense (from debt) is lower than the primary deficit (tax T minus spending S). In my previous article, we’ve seen how the monetary and fiscal policies are linked and the USA’s 2009 fiscal stimulus has to be considered when talking about QE. However, in this article, we won’t focus much on this aspect. Instead, we will focus and analyze the Federal Reserve’s QE, its impact and potential consequences as it is withdrawn.

Is QE effective?

At his peak, the 3rd round of QE launched in September 2012 had a size of $85bn of assets purchased per month by the Fed. Its composition was as follows: $40bn of Mortgaged Backed Securities (MBS) and $45bn of US bonds with long term maturity (e.g. 10 years). Starting from the end of 2013, the Fed has reduced its operations by $10bn a month of assets purchased, although this move remains conditional on satisfactory economic data (mostly growth, employment and inflation).

The efficiency of QE is a contentious debate. Some observers say that the economic situation would have been even worse without QE, while others claim that QE only inflates bubbles and reinforce inequalities since assets inflation only benefit people holding financial assets. In the US for instance, a minority of people accounting for less than 1% of population holds almost all financial assets. Here we must also acknowledge the fact that US pension funds are heavily invested in stock markets especially in the US stock markets. Therefore, strong performance of US equities might translate to more consumption.

In addition, the targeted wealth effect (the increase of aggregate wealth leading to higher consumption) can only sustain consumption if the amount of asset in the portfolio is significant. Gaining 5% on a $5,000 portfolio won’t increase your consumption by much, whether now or in the future. The wealth effect targeted through Mortgage Backed Securities (MBS) purchases is higher home price. According to the Fed’s point of view, if home price increase, the owners of these homes would perceive an increase in wealth and would be therefore disposed to consume more. The idea is to make a self-sustaining consumption triggered by a wealth effect initiated by the Fed.

However, as home prices fell unexpectedly and the economy slowed down, owners could not afford to pay their mortgages and many were foreclosed by their banks. The latter ended up with a large inventory of unwanted houses. However, because of the Fed policies (MBS purchases and Zero Interest Rate Policy known as ZIRP) a minority of rich people and institutions, such as hedge fund and private equity funds, have been able to acquire these houses at very low prices and in some case rent them at a high price. This deteriorates even more households consumption. Therefore this would act in the opposite direction of the wealth effect advocated by the Fed.

Another theory suggests that setting up low interest rate artificially for a long period of time create imbalances while giving a false perception of stabilization. Moreover ultra low interest rate coupled with large amount of liquidity provided by the Fed made the cost of borrowing for companies, household and government abnormally low.

Yet, while low interest rates usually boost consumption by inciting households and companies to take on loans and/or invest, in post 2008 many of them choose to deleverage instead. As for government borrowing, low interest rate means low financing cost and therefore makes it possible to sustaining growth through expansionary fiscal policies and/or finance current expenditure. The positive effect is that this “strategy” buys time so that governments have latitude to implement structural reforms. The negative effect is that low borrowing cost is exclusively used to finance current expenditure instead of implementing painful but necessary reforms.

This last point highlights another crucial point, which is that a central banker can create a positive environment, but is not responsible for what is done or not within it. In other words, the government is the only entity that has the power of implementing reforms. A central banker power, although significant, is limited when it comes to reforming a country.

Back to the Fed policy, artificially suppressing risks by setting ultra low interest rate does not eliminate risk, it only gives the illusion that risk is reduced, which is very dangerous, especially on the long run. Moreover, it raises the question of what happen when interest rates have to be normalized but the economic situation remains weak? Interest rates cannot be close (or at) zero forever, yet if the economies are dependent from lower interest rates, this situation creates a Catch 22 from which escape is tricky.

Yet the imbalances created by QE include asset bubbles and rapidly expanding central banks balance sheet, which have to be kept under control at some point. The Fed’s balance sheet reached US$ 4 trillion and it now tries to reduce it significantly in order to keep its legitimacy. Other people argue that low interest rate and low growth ultimately lead to deflation, a vicious circle from which it is difficult to extract and it is precisely what the Fed is afraid of.

There are three main reasons why deflation is feared by government and central banks. First, the real value of debt may fluctuate due to inflation or deflation. Given that the nominal value of debt is fixed by contract, in the case of USA, deflation would increase the real value of the debt making it harder for government to pay it back (conversely inflation makes it easier to pay back debt). The second reason is about the health of the banking system: deflation increases money’s real value and therefore increases the real value of lenders’ claims on debtors. This means that, initially, banks can benefit from debtors. However, since the charge of debt is going to overwhelm debtors (household, companies), they might eventually default, resulting in huge losses for banks. The third reason is regarding the impact on tax. It is always possible to increase tax when workers earn higher wages. However, when deflation occurs, wages don’t increase and prices fall. Therefore, consumers benefit from lower prices on goods and services purchases but the government cannot extract money out of it unless increasing the VAT.  In light of these facts, central banks and governments would prefer high inflation rather than deflation. This explains why money printing has been the Fed’s focus point over the last years. Given current economic conditions, it is dubious whether the Fed can now change course.

QE is a very controversial topic. What we can say for sure is that a huge amount of money printed does not circulate in the economy (e.g. Banks excess reserves). This low velocity of money demonstrate why inflation is relatively low compared to what it should be. However, as stated previously, financial assets inflation does exist. Moreover, stock and bond markets are currently completely disconnected from their real intrinsic value, yet withdrawing QE too quickly would crash the worldwide economy, including emerging market which have already been jumpy since the tentative tapering through the summer of 2013. This can be expected since the USD is the world reserve currency. Any severe shock on the US economy and/or US financial market would be a disaster for the rest of the world.

 feddSource: St Louis Fed

Today, the Fed is, willfully or not, manipulating the market by targeting wealth effect. Setting low interest rate greatly reduces the cost of capital for corporation. Yet, instead of expanding, companies are firing workers and restructuring, while corporate tax exemption helps them to increase margins. Moreover, due to Obamacare, employers prefer hire part-time workers instead of full-time workers. As a result, many US citizens have two jobs in order to maintain their standard of living. Since one payroll means one worker is employed, this makes the unemployment rate completely misleading.

If we consider the amount of people on food stamps (over 50 millions US citizens) and US citizen who stopped looking for a job, the unemployment rate would be around 14%, far higher than official figure. Today, around 70% of US’ GDP is based on consumption. As unemployed people draw on savings and decrease consumption, a vicious circle is unfolding. Consumers could get loans in order to sustain their consumption but banks are not much willing to lend and consumers are not willing to borrow as much as before either.

So what happened so far in the US is not exactly a recovery and now that low hanging fruits have been picked, there is not much room for corporations to boost profit by increasing margin. It not possible to fire everybody in the company unless shut it down. The recent dip in US GDP in Q1 2014 (-2.9%) is a reminder of this fact. Lastly, I would point out the fact that what USA is facing today (just like most developed and many emerging nations) is not a cyclical downturn but a structural one. With this diagnostic, it becomes clear that a monetary policy, even the right one, is not enough to overcome the weak and unstable recovery we are facing now. Governments want to avoid to make hard decisions regarding labor cost, labor mobility, taxes, regulatory burden so they simply talk about cyclical problems and put the pressure and responsibility to central bankers to restore growth.

Tapering: the end of QE?

When investors or observers talk about the Fed’s monetary policy, most of their analysis are focused on economic fundamentals. This implies that the Fed has a tendency to adopt a loose monetary policy under economic downturn (conversely tighten its monetary policy under overheating and/or inflation). Generally speaking, under normal circumstances, this conventional monetary approach works.

On the other hand, more and more observers and analyst are highlighting the fact that the Fed policy doesn’t focus on economic fundamentals but mostly on financial markets themselves. As the Fed explained, increasing asset price was necessary to trigger a wealth effect. Yet this approach may be flawed. The following graph show that the “wealth effect” advocated by the Fed is not working, or at least not for the majority of people.

As you can see, the level of wealth for little bit more than 50% of population is lower in 2013 (-20%) compared to (0%) the baseline in 1984. The chart below from the St Louis Fed, tells us that the real median household income in the USA in 2013 is the same level as in 1995! It basically, says that in 18 years time, the real media income in the USA has not improved, a stunning fact when we know that during the same period the US GDP has approximately doubled! Where does the wealth (if really produced) go?

 20140726_lostdecade_0Zerohedge

fredgraph_0

Source: St Louis Fed

inequality

Source

If many observers agree on the correlation between monetary policy and asset inflation, only few talk about very large banks exposure to derivatives (e.g. Deutsche Bank, BNP, JPMorgan…). Indeed, due to large amount of derivatives and swaps on banks’ balance sheets, when the Fed thinks about what is the best monetary policy to implement, it has to consider not only the economic activity on a worldwide basis (starting with the USA) but also all financial markets (stock, bonds, money markets and derivatives…). These two constraints make it very hard for the Fed to act simultaneously for the two side best interest.

At the end of 2013, Ben Bernanke, former Chairman of the Fed, highlighted the need for the Fed to initiate a tapering (i.e.: the gradual withdrawal of QE) in light of the improved economic and employment conditions. Tapering is characterized by a diminishing amount of Treasuries and MBS purchased on a monthly basis as long as economic data are judged satisfactory.

“Tapering” refers to a reduction of assets purchased (MBS and Treasuries) by the Fed. In other words, the Fed tapering means a gradual reduction of stimulus leading to cessation of unconventional monetary tools. However, as the Fed mentioned, tapering will be based on economic data. Good economic and employment data will support tapering, while weak data would suggest keep on stimulus on and postponing the reduction of assets purchased until economic conditions improve.

fed bsSource: Hedge Fund Hayman Capital Management (based on data from Bloomberg)

A continuation of the tapering policy would see additional asset purchases cease by end of 2014. This, all things being equal, would stabilize the size of the Federal Reserve’s balance sheet at around $4 trillion.

Paradigm shift

Before the Tech bubble of the late 90’s, economic fundamentals mostly prevailed on financial markets. With the following burst, Fed’s support and increased financial activity, economic fundamentals now play a smaller role. The current situation implies that the Fed conducts monetary policy to support financial markets over ‘real’ economy because of financial markets’ perceived key role in economic stability. If you have fever, you can use a fake thermometer and claim you don’t have fever. However, if you have fever the way you measure it doesn’t change your true body condition.

The shareholding of the Fed (a private institution) is also a great source of controversies. In order to analyse whether reverse repurchase agreement (RRA) by the Fed offsets, even partially, the tapering, one can consider who the Fed counterparties are. In other words, is the Fed both publicly disengaging from stimulus while feeding the financial market using another monetary tool?

Reverse Repo Counterparties List

To prepare for the potential need to conduct large-scale reverse repurchase agreement transactions, the Federal Reserve Bank of New York is developing arrangements with an expanded set of counterparties with whom it can conduct these transactions. These counterparties are in addition to the existing set of Primary Dealer counterparties with whom the Federal Reserve can already conduct reverse repurchase agreements.

Bank of Montreal (Chicago Branch)
The Bank of New York Mellon
Barclays Bank PLC – New York Branch
Citibank, N.A.
Cooperatieve Centrale Raiffeisen-Boerenleenbank B.A., “Rabobank Nederland”, New York Branch
Credit Agricole Corporate and Investment Bank
Credit Suisse AG, New York Branch
Deutsche Bank AG NY
Discover Bank
HSBC Bank USA, National Association
JPMorgan Chase Bank, N.A.
Mizuho Bank, Ltd.
Morgan Stanley Bank, N.A.
Royal Bank of Canada
Société Générale New York Branch
State Street Bank and Trust Company
Svenska Handelsbanken AB (publ) New York Branch
Wells Fargo Bank, NA

Primary dealers

Bank of Nova Scotia, New York Agency
BMO Capital Markets Corp.
BNP Paribas Securities Corp.
Barclays Capital Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Credit Suisse Securities (USA) LLC
Daiwa Capital Markets America Inc.
Deutsche Bank Securities Inc.
Goldman, Sachs & Co.
HSBC Securities (USA) Inc.
Jefferies LLC
J.P. Morgan Securities LLC
Merrill Lynch, Pierce, Fenner & Smith Incorporated
Mizuho Securities USA Inc.
Morgan Stanley & Co. LLC
Nomura Securities International, Inc.
RBC Capital Markets, LLC
RBS Securities Inc.
SG Americas Securities, LLC
TD Securities (USA) LLC
UBS Securities LLC.

Click on the link above to get access to the list of Government-Sponsored Enterprises (GSE) and Investment Manager. Primary dealers and counterparties seem to be more or less the same who are involved in current Fed’s QE. Notice that dealers earn easy money from the Fed’s operations by receiving fees.

reverse repo rr2

Source: St. Louis Fed

The two charts above show the reverse repurchase agreement engaged by the Fed since 2004. As we can see, during each period of time of heavy stress or big event, we can observe higher activity: the 2008 financial crisis, the summer 2011 debt ceiling in the USA and the 2014 beginning of tapering. Looking at the volume side, the graph shows tremendous use of reverse repo conducted by the Fed. This shows that more and more liquidity are flowing towards the financial markets.

Since the Tapering took place, Reverse Repo volume have greatly increased. From this factual observation some questions might arise regarding what the Fed is doing:

  • Is it trying to publicly claim that the economy is strong enough and thus does not require stimulus anymore (or less) but improvements are not strong enough to give up control on interest rate? This appears to be the official explanation;
  • Is the Fed trying to convince people that it’s tapering because economy is improving and behind the scene still acting a lot to provide liquidity in order to keep financial markets stable and high? It is also important to notice that the Fed cannot simply continue stimulus without explanations: if economy is improving why do we still need stimulus? If economy has not recovered since it began then is QE really effective? These questions are very embarrassing for the Fed.
  • If Reverse Repo are used in order to replace QE, does it mean that the Fed can’t change its monetary stance by rising interest rate?

 Conclusion

Although a large consensus admit that Fed communication has been improved since the Ben Bernanke era, the Fed monetary policy still remains unclear. QE1 (from late 2008 to mid 2010) was necessary in light of the confidence and liquidity crisis. However, many analysts might argue keeping running on QE is not a suitable path either. The question is, is it possible to stop a QE program after having started it, without severe distress? The answer is not straight. Most importantly, even within the Fed, there is no concensus but doubt about the monetary policy to conduct. Fed’s participants are divided in two big groups: dovish (advocate expansionary policy) vs. hawkish (have reserve about QE effectiveness, would like to see more tapering). The annual meeting of the Fed at Jackson Hole scheduled this month might bring light to this concern.

Some 6 years after the Great Financial Crisis, the worldwide economy remains weaker than expected. The IMF recently downgraded worldwide GDP expectations. Geopolitical tensions in the Middle East, Ukraine, and South China Sea are impending growth and threaten to slow it down even more.

China is trying to re-balance and its GDP is under pressure, the USA‘s recovery is still weak, and Europe is still moving slowly, unemployment rate reaching new high in France 9.7% in Q1 2014, while Germany is decelerating. Speaking about Europe, tensions and repression with Russia could lead to a loss up to $1.3 trillion in output, with $250 billion just for Germany, according a Putin’s adviser Mr Sergei Glazyev. Clearly, the macroeconomic picture is not promising, adding pressures on governments (fiscal policy) and central banks (monetary policy).

Given the high government debts and the swimming pool of liquidity around the world, it becomes more and more difficult to sustain growth. In the meantime, each $1 debt yields to lower return as the time goes. Given the large amount of debt, the current regime is completly unsustainable. In this context, it seem that the Fed is stuck and is prisoner of its monetary policies initiated after the 2008 financial crisis. Therefore, tapering seems to be an illusion, the Fed ability to withdraw its stimulus without severely impacting financial markets being at best weak.

Moreover, ultra accommodating monetary policy can lead to liquidity trap and even deflation (e.g. Japan) although a combination of both inflation/deflation is possible. Japan is an infamous poster boy of this situation. Today, the country faces high inflation on energy and food prices while wages remain low.

Since the US and Europe are repeating the errors made by Japan 20 years ago, it is legitimate to have serious doubt about our central bankers ability to effectively cope with a fabulous cocktail of low confidence, lack of risk-takers, worldwide slowdown, high levels of debt, emerging countries slowdown, no bank loans to SMEs, and lack of structural reforms.

Here I want to share some of James Rickards thoughts in his last book “The Death of Money” (2014):

The world is witnessing a climactic battle between deflation and inflation“.

At some point, the U.S. economy will experience “an earthquake in the form of either a deeper depression [from deflation] or higher inflation, as one force rapidly and unexpected overwhelms the other.

Deflation is the Federal Reserve’s worst nightmare. For one, deflation “increases the value of government debt, making it harder to repay.

Because of fear of deflation, the Fed can’t stop its money printing. If it did stop, “deflation would quickly dominate the economy, with disastrous consequences for the national debt, government revenue, and the banking system.

Finally, the Fed policies influence the US Dollar as world currency. What matter the most for the Fed and the US government is debt, deficit, dollar and deflation. At the end of the day, if the confidence is broken in the dollar, then ultimately the US growth would be significantly impacted affecting its status of the richest country in the world, its military power and by extension its geopolitical power.

The recent move and agreement between countries involving China, Russia, Iran and India perfectly illustrate that the confidence in the USD is already shrinking. Now it is just a matter of time before the USD finally lose completely its covet status of worldwide currency. If this happens to be true in the relatively near future, this would also seriously call into question the effectiveness of the Fed policy in place, notably after the 2008-2009.

About Steve Nguyen

Analyst based in China for 4 years, with significant analytical skills in Macroeconomics, Financial Markets and the Chinese economy.