What’s Next For the Fed – No Exit
“In the light of these uncertainties the committee decided to await for more evidence that the recovery’s progress will be sustained before adjusting the pace of asset purchases” Ben Shalom Bernanke, Chairman of the Federal Reserve
Thus spake Mr. Bernanke rationalizing why the taper of quantitative easing (QE) was off.
Reasons Given For Not Tapering:
We Need More Data to Confirm the Recovery is Progressing
The Fed is still trying to hold out the pretense that QE has been a success in bringing about a “recovery”. As we have pointed out there really has never been a recovery other than one as measured in rising house prices and a roaring stock market.
The Fed claims it needs to wait to see more evidence of a non existent recovery before scaling back its buying of $85 billion a month of U.S. Treasuries and mortgage backed securities (MBS’s). This is as dramatic of an admission as the one that Mr. Bernanke made back in June when he said the economy “the economy is weak, inflation rates are low, if we were to tighten policy, the economy would tank”.
Here Mr.Bernanke is again, three months later, having spent yet another $255 billion, saying the economy is STILL weak and needs the $85 billion a month support of QE. This should be a slap in the face to all those recovery addicts who have been touting economic recovery for the past few years.
If the economy is in a recovery why does the Fed need to continue to print/spend over a trillion dollars a year to support it?
A recent Bloomberg poll reveals that a vast majority of Americans agree with Mr. Bernanke’s dismal assessment of the economy as 72% believe the economy will stay the same or get worse over the next year.
The day after the Fed announcement to leave QE in place, St. Louis Fed President James Bullard emphasized the point that more data was needed to make a determination as to whether to continue QE. Straining credibility, he concluded that maybe the Fed would taper after all in October if the data cooperated.
I suppose Mr.Bullard thinks, like Groucho Marx that things can change a lot in couple of weeks.
Since Mr.Bullard’s talk we have seen consumer confidence come in far below expectations and pending home sales drop for the third straight month.
Another month of so-so economic data can only lead to one conclusion-more QE.
We Need Low Rates and We Can’t Get Them Without QE
This is a circular riff off the first excuse that the economy is still too weak. Mr. Bernanke noted “the rapid tightening of financial conditions in recent months would have the effect of slowing growth … a concern that would be exacerbated if conditions tightened further.”
What Mr. Bernanke is referring to when he speaks of “tightening financial conditions” are the higher interest rates of recent months that were set into motion when he started talking about tapering. The mere talk of removing ANY part of the $85 billion a month QE program drove yields on the U.S. ten year note straight up for three months from a low around 1.6% in May to nearly 3.00% earlier this month.
Mr. Bernanke soon learned in the aftermath of his comments that interest rates will rise on the credible threat of taking away any QE. Interest rates rose since May not because the pace of the “recovery” was accelerating but rather because the Fed TALKED about reducing the QE program. Since the Fed knows the economy is weak and can’t withstand higher interest rates it knows that rates must be kept low. They won’t stay low just because the Fed keeps the Fed funds rate low – it will require more QE.
The Fed needs to assure investors that they will continue QE and not even THINK, never mind talk, about reducing the size of QE. Hence no taper was announced at the September meeting.
This puts the Fed in a bind and means that if they don’t want interest rates to rise they have to continue QE. If they continue, however with QE, they risk losing confidence in the dollar and creating more inflation than perhaps they are comfortable.
We Could Hurt the Job Recovery
Mr Bernanke noted: “Conditions in the job market today still are far from what all of us would like to see,” and “the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and the labor market.”
This is hard to repeat with a straight face. The only evidence of any improvement in the labor market is a decreasing unemployment rate which is directly correlated to a reduction in the labor participation rate which is at a 32 year low. There are fewer people in the labor force, more people getting food stamps and more people collecting disability than when the recession ended in 2009. In many ways the recovery is worse than the recession. The “improvement” in the labor market has been highlighted by the creation of mostly part time jobs and anemic full time job growth.
Back in June, Mr. Bernanke, who had long targeted a lower unemployment rate tied to a specific percentage as evidence of an improving labor market, admitted that the lower unemployment rate perhaps over stated the strength of the job market and that other factors like wage growth and labor participation should be considered in measuring the strength of the labor market.
In last week’s press conference Mr. Bernanke explicitly disavowed a specific unemployment rate as triggering a change in monetary policy saying: “Last time I gave 7 percent (jobless rate) as an indicative number to give you some sense of, you know, where that might be….There is not any magic number that we are shooting for, we are looking for overall improvement in the labor market”
QE thus far has been ineffective in creating any significant job and wage growth, so increasing it, keeping it the same or tapering would probably be of little effect. No amount of QE can stop the impact that Obama care will have on the the job market.
Looming Government Shut Down
Ben Bernanke also pointed to the pending budget battle as a reason not to taper: “A government shut down….. is one of the risks that we are looking at as we think about policy.”
This is a convenient red herring excuse.
If a government shut down was all the Fed was worried about, they could have chosen to wait to address it when and if it happened. Like everything the Fed does, however, they place markers they can call in later.
If there is a major issue with the debt ceiling at the end of this month, the Fed will announce that they need to keep QE in place and say nothing about the trends in the economy but merely state it wouldn’t be prudent to taper at this time.
We don’t believe worry over a government shut down is a reason for the Fed to forgo tapering. Mr.Bernanke conceded: “That being said, you know, again, our ability to offset these shocks is very limited”.
Then, why mention it as a factor?
The day after the Fed meeting, St. Louis President James Bullard, seemingly oblivious to the threat of a government shut down and Fed credibility, trots out and says if the economic data improves the Fed might taper in October. This statement highlights that worries over a government shut down hardly factored into the Fed’s decision not to taper in September.
We Need More Inflation!
Mr. Bernanke also bemoaned the lack of inflation: “We should be very reluctant to raise rates if inflation remains persistently below target, and that’s one of the reasons that I think we can be very patient in raising the federal funds rate since we have not seen any inflation pressure.”
The Fed is now talking about keeping rates low indefinitely if there is no inflation as measured by the Consumer Price Index.
We Have Lowered Our GDP Forecast
The Fed revised its GDP forecast saying the economy will grow just 2 percent to 2.3 percent this year, down from its previous forecast in June of 2.3 percent to 2.6 percent.
This is a variation of the economy is weak excuse and adds that the Fed expects it to continue to be weak (even with QE).
The Real Reason the Fed Did Not Taper?
The Fed is trapped and can’t taper QE in any significant amount. Just talking taper sent rates higher. The Fed needs interest rates to remain low and only way to keep them low right now is to continue QE.
Back in June we wrote in The King is Surrounded: Bernanke’s no Exit Dilemma: “The Fed knows that if they print too much they risk loss of confidence in the dollar and hyperinflation, and if they print to little, rates will rise and the economy will crash taking down the stock and real estate markets with it.” So they talk taper and print paper.
The song remains the same.
By monetizing debt, the Fed is helping to fund the United States deficit spending because they are buying 60-90% of the newly issued U.S. treasuries and they are willing to print U.S. currency out of thin air to buy them and to receive a ridiculously low interest rate. But don’t feel bad for the Fed; the cost to them to purchase the U.S. Treasuries and MBSs is just the time it takes to make the keystrokes to create the money to buy them. The demand for U.S. treasuries at the current low rates is no longer great enough for the U.S. to fund its deficit spending through normal market demand. The Fed and QE fills that void.
In a counter intuitive way the strength of the dollar is now in the willingness of the Fed to print dollars to meet the United States’ obligations.
What Will The Fed Do With All Those Bonds and Mortgage Backed Securities?
What will the Fed do with the trillions of dollars of U.S. Treasuries and MBSs that it has accumulated and continues to accumulate? Sell them? Rates would soar. Hold them, collect interest and cash them in? The U.S. couldn’t afford to pay.
The Fed will have to roll over the interest and principle on the U.S. Treasuries it holds and buy more. If rates rise they will have to buy more to try to keep interest rates low to prevent the economy from crashing. The more U.S. Treasuries and MBSs the Fed owns the more likely they are to have to continue buy more so they can get paid back on the Treasuries and MBS’s they already own as the U.S. won’t be able to pay them back absent printing the money to pay them, which the Fed will be more than happy to print for them. (U.S. dollars emit from the Federal Reserve not from the U.S. Treasury which issues debt obligation in the form of Treasury bonds and notes.)
This dynamic ensures that QE will continue.
What Happens Next?
QE was designed to bail out the banks, keep borrowing rates low for the U.S. government and to stimulate the economy by creating a wealth effect that would stimulate demand. The Fed has achieved the final objective for a portion of the population as rising stock and home prices have driven up household net worth, at least for now.
The Fed desperately wants to hold on to the gains it has helped achieve in boosting real estate prices. Real estate, no matter what some housing recovery cheerleaders may say or think, is interest rate sensitive. The most recent housing recovery was not sui generis, it was being driven solely by Fed induced low interest rate that were low and getting lower for years before the real estate market reacted to them.
The Fed realizes that by their incessant taper talk they have driven interest rates higher which has threatened the housing recovery. The no taper announcement has brought rates down a bit, but more QE and more pro expansionary monetary policy talk will probably be needed to reverse the inexorable upward trend of interest rates.
The Fed managed to reheat the economic souffle that collapsed in 2008 through low interest rates and the expenditure of $3 trillion worth of QE. It will take a lot more than that to drive rates low enough to reignite home buying interest. BUT, don’t count it out as the Fed seems to only know how to print more money, not less. Click here for a chart showing the relative sizes of QEs 1-3. Keep in mind that even if the Fed tapers QE, it still means they are adding securities to their portfolio.
Real estate is entering a seasonally slow period and we expect prices to level off even if the Fed were able to drive interest rates lower by increasing the size of QE. Any impact the renewed lowered rates night have on home prices would take months meaning there would be an inevitable dip in prices in the interim.
Real estate is already facing supply/demand adjustment headwinds, a catch 22 with respect to underwater/reluctant home sellers and a poor job market that will curb further price appreciation even with out higher interest rates.
The stock market cheered the news when it received word of the surprise no Fed taper announcement. Stocks unlike real estate can respond to rate changes quickly. Fortunes can be made and lost and made again in a single trading session as share prices can swing dramatically.
The stock market can continue to rally with more QE, but concerns over the debt ceiling debate in Congress, Middle East tensions, decelerating earnings growth (during the “recovery” earnings growth has outpaced revenue growth with share buybacks and expense reductions, not increases in revenues providing much of the earnings growth) and high valuations may provide the ingredients for a large correction or crash before the end of the year.
QE actually stunts job growth. Because rates are really low a company can get a better return on its excess cash by buying its own stock back than by hiring new employees.
Gold and Silver
Gold is often viewed as a counter proxy on the health of the dollar. One reason the Fed doesn’t unequivocally align itself to a policy of QE for ever is the concern over the integrity of the dollar. Confidence can be lost in a currency backed by nothing and being managed by overly zealous money printers. Excessive printing of currency leads to a debasement so the Fed needs to communicate constantly that QE is a temporary measure and that it means to end it as soon as it sees the economy has recovered.
Gold and silver sold off on the exchanges earlier this year in part because of an incorrect sentiment that the worst of the financial crisis was over and double digit inflation never materialized and therefore precious metals do not need to be held to protect against tail risk or to serve as inflation hedges. Because the Fed is intent on creating inflation (see above) and we believe they will through their incessant printing of dollars that requires them to print even more, double digit inflation will occur. Just because it hasn’t happened yet doesn’t mean it won’t.
Since the price drops in gold and silver, physical demand for precious metals has exploded without a corresponding increase in price. We expect this imbalance to change in the coming months.
Rates May Still Rise – Liquidity Trap
Is the Fed bluffing about tapering?
Rates may still rise because the Fed may have lost control over interest rates. The markets were expecting a taper but didn’t get one. A day later Fed President James Bullard seemed to be bluffing when he talked about tapering in October. This type of taper on/taper off communication may cause the markets to lose confidence in the Fed. The Fed may regain confidence by leaving the QE in place and/or increasing the size of it. If they do this, however, they may lose credibility and be seen as ace debasers of the dollar.
Keeping QE in place or increasing it may lead to a nightmare liquidity trap scenario whereby the Fed faced with higher rates (in spite of their loose monetary policy) and a crumbling economy decides to print even more dollars and increase QE to combat rising interest rates but rates continue to rise and inflation takes off.
Iacta Alea Est -The Die Is Cast: No Exit
The Fed has crossed the Rubicon to the point of no turning back. The Fed has a no exit dilemma. We have said for months they can’t quit QE. They can try to taper a little but that will quickly require a subsequent increase in QE. The Fed will try and print their way out of financial difficulties only to find that they will have to print more to get out of difficulties they have created.
Since the financial crisis of 2008 the economy has not recovered or restructured. The Fed has not let it. The $3 trillion spent on QE went directly or indirectly to the too big to fail banks that are the Fed’s shareholders either through the purchase of MBSs from the banks or through the purchase of U.S. Treasuries which is done through primary dealers (U.S. Treasuries are not directly purchased from the U.S. Treasury) who are the too big to fail banks.
QE has not created job growth or increased the productive capacity of the economy. It has only temporarily inflated stock and home prices. Perhaps the next Fed President will unwind the QE program and allow market forces to have a greater say in the setting of interest rates. If not QE, will eventually collapse under its own weight with disastrous implications for the economy.
Veni, vidi, Vici – I Came, I saw, I conquered
With Chairman Bernake’s term set to expire at the end of the year, absent any surprises, we will have a new Fed Chairman or woman in 2014. Perhaps Bernanke would like to be remembered as the Fed Chairman who conquered the Financial Crisis of 2008. He may aspire to claim -“I came, I saw, I conquered”
Rather he may be best remembered as the Ben Bernanke King of the Printing Press, or Helicopter Ben whose professional epitaph may read:
“I came, I printed, I left”