Tag Archives: QE4

Why “Not-QE” is QE: Deciphering Gibberish

I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.”  – Alan Greenspan

Imagine if Federal Reserve (Fed) Chairman Jerome Powell told the American people they must pay more for the goods and services they consume.

How long would it take for mobs with pitchforks to surround the Mariner Eccles building?  However, Jerome Powell and every other member of the Fed routinely and consistently convey pro-inflationary ideals, and there is nary a protest, which seems odd. The reason for the American public’s complacency is that the Fed is not that direct and relies on carefully crafted language and euphemisms to describe the desire for higher inflation.

To wit, the following statements from past and present Fed officials make it all but clear they want more inflation:  

  • That is why it is essential that we at the Fed use our tools to make sure that we do not permit an unhealthy downward drift in inflation expectations and inflation,” – Jerome Powell November 2019
  • In order to move rates up, I would want to see inflation that’s persistent and that’s significant,” -Jerome Powell December 2019
  • Been very challenging to get inflation back to 2% target” -Jerome Powell December 2019
  • Ms. Yellen also said that continuing low inflation, regarded as a boon by many, could be “dangerous” – FT – November 2017
  • One way to increase the scope for monetary policy is to retain the Fed’s current focus on hitting a targeted value of inflation, but to raise the target to, say, 3 or 4 percent.” –Ben Bernanke October 2017
  • Further weakness in inflation could prompt the U.S. Federal Reserve to cut interest rates, even if economic growth maintains its momentum”  -James Bullard, President of the Federal Reserve Bank of St. Louis  May 2019
  • Fed Evans Says Low Inflation Readings Elevating His Concerns” -Bloomberg May 2019
  • “I believe an aggressive policy action such as this is required to re-anchor inflation expectations at our target.”  Neel Kashkari, President Minneapolis Fed June 2019

As an aside, it cannot be overemphasized the policies touted in the quotes above actually result in deflation, an outcome the Fed desperately fears.

The Fed, and all central banks for that matter, have a long history of using confusing economic terminology. Economics is not as complicated as the Fed makes it seem. What does make economics hard to grasp is the technical language and numerous contradictions the Fed uses to explain economics and justify unorthodox monetary policy. It is made even more difficult when the Fed’s supporting cast – the media, Wall Street and other Fed apologists – regurgitate the Fed’s gibberish.   

The Fed’s fourth installment of quantitative easing (“QE4”, also known as “Not-QE QE”) is vehemently denied as QE by the Fed and Fed apologists. These denials, specifically a recent article in the Financial Times (FT), provide us yet another opportunity to show how the Fed and its minions so blatantly deceive the public.

What is QE?

QE is a transaction in which the Fed purchases assets, mainly U.S. Treasury securities and mortgage-backed-securities, via their network of primary dealers. In exchange for the assets, the Fed credits the participating dealers’ reserve account at the Fed, which is a fancy word for a place for dormant money. In this transaction, each dealer receives payment for the assets sold to the Fed in an account that is essentially the equivalent of a depository account with the Fed. Via QE, the Fed has created reserves that sit in accounts maintained by it.

Reserves are the amount of funds required by the Fed to be held by banks (which we are using interchangeably with “primary dealer” for the remainder of this discussion) in their Fed account or in vault cash to back up a percentage of specified deposit liabilities. While QE is not directly money printing, it enables banks to create loans at a multiple of approximately ten times the reserves available, if they so choose.

Notice that “Quantitative Easing” is the preferred terminology for the operations that create additional reserves, not something easier to understand and more direct like money/reserve printing, Fed bond buying program, or liquidity injections. Consider the two words used to describe this policy – Quantitative and Easing. Easing is an accurate descriptor of the Fed’s actions as it refers to an action that makes financial conditions easier, e.g., lower interest rates and more money/liquidity. However, what does quantitative mean? From the Oxford Dictionary, “quantitative” is “relating to, measuring, or measured by the quantity of something rather than its quality.”   

So, QE is a measure of the amount of easing in the economy. Does that make sense to you? Would the public be so complacent if QE were called BBMPO (bond buying and money printing operations)? Of course not. The public’s acceptance of QE without much thought is a victory for the Fed marketing and public relations departments.

Is “Not-QE” QE?

The Fed and media are vehemently defending the latest round of repurchase market (“repo”) operations and T-bill purchases as “not QE.” Before the Fed even implemented these new measures, Jerome Powell was quick to qualify their actions accordingly: “My colleagues and I will soon announce measures to add to the supply of reserves over time,” “This is not QE.”

This new round of easing is QE, QE4, to be specific. We dissect a recent article from the FT to debunk the nonsense commonly used to differentiate these recent actions from QE.  

On February 5th, 2020, Dominic White, an economist with a research firm in London, wrote an article published by the FT entitled The Fed is not doing QE. Here’s why that matters.

The article presents three factors that must be present for an action to qualify as QE, and then it rationalizes why recent Fed operations are something else. Here are the requirements, per the article:

  1. “increasing the volume of reserves in the banking system”
  2. “altering the mix of assets held by investors”
  3. “influence investors’ expectations about monetary policy”

Simply:

  1.  providing banks the ability to make more money
  2.  forcing investors to take more risk and thereby push asset prices higher
  3.  steer expectations about future Fed policy. 

Point 1

In the article, White argues “that the US banking system has not multiplied up the Fed’s injection of reserves.”

That is an objectively false statement. Since September 2019, when repo and Treasury bill purchase operations started, the assets on the Fed’s balance sheet have increased by approximately $397 billion. Since they didn’t pay for those assets with cash, wampum, bitcoin, or physical currency, we know that $397 billion in additional reserves have been created. We also know that excess reserves, those reserves held above the minimum and therefore not required to backstop specified deposit liabilities, have increased by only $124 billion since September 2019. That means $273 billion (397-124) in reserves were employed (“multiplied up”) by banks to support loan growth.

Regardless of whether these reserves were used to back loans to individuals, corporations, hedge funds, or the U.S. government, banks increased the amount of debt outstanding and therefore the supply of money. In the first half of 2019, the M2 money supply rose at a 4.0% to 4.5% annualized rate. Since September, M2 has grown at a 7% annualized rate.  

Point 2

White’s second argument against the recent Fed action’s qualifying as QE is that, because the Fed is buying Treasury Bills and offering short term repo for this round of operations, they are not removing riskier assets like longer term Treasury notes and mortgage-backed securities from the market. As such, they are not causing investors to replace safe investments with riskier ones.  Ergo, not QE.

This too is false. Although by purchasing T-bills and offering repo the Fed has focused on the part of the bond market with little to no price risk, the Fed has removed a vast amount of assets in a short period. Out of necessity, investors need to replace those assets with other assets. There are now fewer non-risky assets available due to the Fed’s actions, thus replacement assets in aggregate must be riskier than those they replace.

Additionally, the Fed is offering repo funding to the market.  Repo is largely used by banks, hedge funds, and other investors to deploy leverage when buying financial assets. By cheapening the cost of this funding source and making it more readily available, institutional investors are incented to expand their use of leverage. As we know, this alters the pricing of all assets, be they stocks, bonds, or commodities.

By way of example, we know that two large mortgage REITs, AGNC and NLY, have dramatically increased the leverage they utilize to acquire mortgage related assets over the last few months. They fund and lever their portfolios in part with repo.

Point 3

White’s third point states, “the Fed is not using its balance sheet to guide expectations for interest rates.”

Again, patently false. One would have to be dangerously naïve to subscribe to White’s logic. As described below, recent measures by the Fed are gargantuan relative to steps they had taken over the prior 50 years. Are we to believe that more money, more leverage, and fewer assets in the fixed income universe is anything other than a signal that the Fed wants lower interest rates? Is the Fed taking these steps for more altruistic reasons?

Bad Advice

After pulling the wool over his reader’s eyes, the author of the FT article ends with a little advice to investors: Rather than obsessing about fluctuations in the size of the Fed’s balance sheet, then, investors might be better off focusing on those things that have changed more fundamentally in recent months.”

After a riddled and generally incoherent explanation about why QE is not QE, White has the chutzpah to follow up with advice to disregard the actions of the world’s largest central bank and the crisis-type operations they are conducting. QE 4 and repo operations were a sudden and major reversal of policy. On a relative basis using a 6-month rate of change, it was the third largest liquidity injection to the U.S. financial system, exceeded only by actions taken following the 9/11 terror attacks and the 2008 financial crisis. As shown below, using a 12-month rate of change, recent Fed actions constitute the single biggest liquidity injection in 50 years of data.

Are we to believe that the latest round of Fed policy is not worth following? In what is the biggest “tell” that White is not qualified on this topic, every investment manager knows that money moves the markets and changes in liquidity, especially those driven by the central banks, are critically important to follow.

The graph below compares prior balance sheet actions to the latest round.

Data Courtesy St. Louis Federal Reserve

This next graph is a not so subtle reminder that the current use of repo is simply unprecedented.

Data Courtesy St. Louis Federal Reserve

Summary

This is a rebuttal to the FT article and comments from the Fed, others on Wall Street and those employed by the financial media. The wrong-headed views in the FT article largely parrot those of Ben Bernanke. This past January he stated the following:

“Quantitative easing works through two principal channels: by reducing the net supply of longer-term assets, which increases their prices and lower their yields; and by signaling policymakers’ intention to keep short rates low for an extended period. Both channels helped ease financial conditions in the post-crisis era.”   -LINK

Bourbon, tequila, and beer offer drinkers’ very different flavors of alcohol, but they all have the same effect. This round of QE may be a slightly different cocktail of policy action, but it is just as potent as QE 1, 2, and 3 and will equally intoxicate the market as much, if not more.

Keep in mind that QE 1, 2, and 3 were described as emergency policy actions designed to foster recovery from an economic crisis. Might that fact be the rationale for claiming this round of liquidity is far different from prior ones? Altering words to describe clear emergency policy actions is a calculated effort to normalize those actions. Normalizing them gives the Fed greater latitude to use them at will, which appears to be the true objective. Pathetic though it may be, it is the only rationale that helps us understand their obfuscation.

Warning! No Lifeguards On Duty

In a poll administered by the CFA Institute of America {Link}, readers, many of whom are professional investors, were asked which behavioral biases most affect investment decisions. The results are shown in the chart below.

We are not surprised by the results, but we believe a rational investor would put these in reverse order.

Compounding wealth, which should be the primary objective of every investor, depends first and foremost on avoiding large losses. Based on the poll, loss aversion was the lowest ranked bias. Warren Buffett has commented frequently on the importance of limiting losses. His two most important rules are: “Rule #1 of investing is don’t lose money. Rule #2 is never forget rule #1.”

At Real Investment Advice, we have covered a lot of ground on investor behavioral biases. In 5 Mental Traps Investors are Falling In To Right Now, Lance Roberts lucidly points out, “Cognitive biases are a curse to portfolio management as they impair our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the “opposite” of what they should when it comes to investing their own money.”

Lance’s quote nicely sums up the chart above. These same biases driving markets higher today also drove irrational conduct in the late 1920s and the late 1990s. Currently, valuations are at or near levels reached during those two historical market peaks. Current valuations have long since surpassed all other prior valuation peaks.

One major difference between the late 1920s, the late 1990s, and today is the extent to which the Federal Reserve (Fed) is fostering current market conditions and imprudent investor behavior. To what extent have investors fallen into the overconfidence trap as the herd marches onward?

This “ignorance is bliss” type of behavior raises some serious questions, especially in light of the recent changes in Fed policy.

Not QE

As predicted in QE By Any Other Name, the Fed recently surprised investors with a resumption of quantitative easing (QE). The announcement of $60 billion in monthly Treasury bill purchases to replenish depleted excess reserves and another $20 billion to sustain existing balances was made late in the afternoon on Friday October 11. With a formal FOMC meeting scheduled in less than three weeks, the timing and substance of this announcement occurred under unusual circumstances.

The stated purpose of this new round of QE is to address recent liquidity issues in the short-term funding markets. Up to this point, the Fed added additional liquidity through its repo facility. These are actions not taken since the financial crisis a decade ago. The liquidity problems, though not resolved, certainly have largely subsided.

So why the strange off-cycle announcement? In other words, why did the Fed seemingly scramble over the prior few days to announce a resumption of QE now? Why not wait to make this announcement through the normal FOMC meeting statement and press conference process? The answer to those questions tells us more about current circumstances than the actual policy change itself.

The Drowning Man

As is always the case with human beings, actions speak louder than words. If you observe the physical behavior of someone in distress and know what to look for, you learn far more about their circumstance than you would by listening to their words. As an example, the signs of drowning are typically not what we would expect.  A person who is drowning can often appear to be playing in the water. When a person in the water is in distress, their body understands the threat and directs all energy toward staying alive.

People who drown seldom flail and scream for help as is often portrayed on television. If you ask a drowning person if they are okay, you might not receive a response. They are often incapable of producing the energy to speak or scream as all bodily functions are focused on staying afloat.

Since the Financial Crisis, investors, market analysts, and observers are helplessly watching the Fed, a guardian that does not realize the market is drowning. The Fed, the lifeguard of the market, is unaware of the signs of distress and unable to diagnose the problem (see also The Voice of the Market – The Millennial Perspective).

In this case, it is the global banking system that has become so dependent on excess reserves and dollar liquidity that any shortfall, however temporary, causes acute problems. Investor confidence and Fed hubris are blinding many to the source of the turbulence.

Lifeguards

Fortunately, there are a few other “lifeguards” who have not fallen into the behavioral traps that prevent so many investors from properly assessing the situation and potential consequences.

One of the most articulate “lifeguards” on this matter is Jeff Snyder of Alhambra Investments. For years, he has flatly stated that the Fed and their army of PhDs do not understand the global money marketplace. They set domestic policy and expect global participants to adjust to their actions. What is becoming clear is that central bankers, who more than anyone else should understand the nature of money, do not. Therefore, they repeatedly make critical policy errors as a result of hubris and ignorance.

Snyder claims that without an in-depth understanding of the dollar-based global lending market, one cannot grasp the extent to which problems exist and monetary policy is doomed to fail. Like the issues that surfaced around the sub-prime mortgage market in 2007, the funding turmoil that emerged in September was a symptom of that fact. Every “solution” the Fed implements creates another larger problem.

Another “lifeguard” is Daniel Oliver of Myrmikan Capital. In a recently published article entitled QE for the People, Oliver eloquently sums up the Fed’s policy situation this way:

The new QE will take place near the end of a credit cycle, as overcapacity starts to bite and in a relatively steady interest rate environment. Corporate America is already choked with too much debt. As the economy sours, so too will the appetite for more debt. This coming QE, therefore, will go mostly toward government transfer payments to be used for consumption. This is the “QE for the people” for which leftwing economists and politicians have been clamoring. It is “Milton Friedman’s famous ‘helicopter drop’ of money.” The Fed wants inflation and now it’s going to get it, good and hard.”

We added the emphasis in the quote because we believe that to be a critically important point of consideration. Inflation is the one thing no one is looking for or even considering a possibility.

Summary

Today, similar to the months leading up to the Financial Crisis, irrational behavioral biases are the mindset of the market. As such, there are very few “lifeguards” that know what to look for in terms of distress. Those who do however, are sounding the alarm. Thus far warnings go largely unheeded because blind confidence in the Fed and profits from yesteryear are blinding investors. Similar to the analogy James Grant uses, where he refers to the Fed as an arsonist not a firefighter, here the Fed is not the lifeguard on duty but the invisible undertow.

Investors should frequently evaluate a list of cognitive biases and be aware of their weaknesses. Humility will be an enormous asset as this economic and market expansion ends and the inevitable correction takes shape.  We have attached links to our other behavioral investing articles as they may be helpful in that difficult task of self-evaluation.

Finally, we must ask what asset can be a life preserver that is neither being chased higher by the herd nor providing any confirmation bias.

Gold is currently one of the most hated investments by the media and social media influencers. The only herd following gold are thought to be relics of ancient history and doomsday preppers. Maybe, as we saw in the aftermath of the prior valuation peaks, those who were ridiculed for their rigor and discipline will once again come out on top.

Gold provides ballast to a portfolio during troubling times and should definitely be considered today as the distress becomes more pronounced and obvious.

Please find below links to some of our favorite behavioral investing articles:  

Dalbar 2017: Investors Suck at Investing and Tips for Advisors

8 Reasons to Hold Some Extra Cash

The 5-Laws Of Human Stupidity & How To Be A “Non-Stupid” Investor

The Money Game & the Human Brain

The Definitive Guide to Investing for the Long Run

Navigating With The R Star

“It’s difficult to make predictions, especially about the future.” – Niels Bohr

On November 28, 2018, Federal Reserve (Fed) Chairman Jerome Powell gave a speech at the Economics Club of New York that sent the stock market soaring by over 2%. The reason cited by market pundits was the reversal of language he used a few weeks earlier suggesting that the Fed still had several more rate hikes ahead. In other words, he softened that tone and seemed to imply that the Fed was close to pausing.

By most accounts, Fed policy remains very accommodative but the “Powell Pivot”, which began in late November and continues to this day, hinges on an obscure metric called R-Star (r*).  Even though interest rates have been held low and vast amounts of liquidity force fed into markets through quantitative easing, the idea that interest rates should not rise much further presents a unique dilemma for the Fed. Rationalizations for their guidance hinges on r*. Before going in to details about this important measure, let us reflect on history.

Doomed To Repeat It

“Well, we currently see the economy as continuing to grow, but growing at a relatively slow pace, particularly in the first half of this year. As the housing contraction begins to wane, as it should sometime during this fiscal year, the economy should pick up a bit later in the year. –Federal Reserve Chairman Ben Bernanke on January 17, 2008 in response to Congressman John Spratt ranking member of the House Budget Committee

The table below was a document used on an unscheduled Fed conference call on January 9, 2008 to discuss deteriorating credit conditions in the U.S. economy. At that time and unbeknownst to the Fed, the economy slipped into recession the prior month, yet the Fed’s commentary and one- and two-year outlook for growth remained positive. The point is not to deride Bernanke and the Fed, but show that even the most well-informed PhD economists struggle to forecast economic activity or assess current economic conditions properly.

The challenge in assessing the outlook for a highly complex system like the U.S. economy cannot be overstated. Yet, what we saw in the past and still see currently, is a small group of people with enormous influence over the economy failing to grasp the natural mechanisms of a market economy. To put it another way, the Fed continues to believe that they know things they simply cannot know, and most concerningly, they set monetary policy on the basis of that fallacy.

An Abstract Barometer

Over the past several years, Fed economists invented a concept that purportedly identifies the point at which monetary policy is “neutral” or in equilibrium with economic activity. This number, called r* (r-star), is abstract and imprecise as it requires a variety of assumptions about the level of interest rates and economic activity. R* is formally defined as the “inflation-adjusted, short-term interest rate that is consistent with the full use of economic resources and steady inflation at or near the Fed’s target level.

As discussed in Clues from the Fed II – A Review of Jerome Powell’s Speech 11/27/18, his exact language was the following:

“Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy – that is, neither speeding up nor slowing down growth.”

The current “target level” for the Fed Funds rate, the primary interest rate lever used to impact the economy by altering interest rates, is currently in a range of 2.25-2.50%. What Powell seems to have implied, or what the market gleaned from the comment above, is that the Fed may only increase the target rate by another 0.25-0.50% as opposed to the 1.00-1.50% forecast by the very same Fed just two months prior. The extent to which the Fed is willing to tighten monetary policy by raising interest rates has a dramatic impact on the amount of risk investors are willing to take. Thus, with the dovish change in Powell’s language, the stock market took off.

Just The Facts

The data on the economy remains robust. Annualized GDP growth through the 3rd quarter of 2018 was 3.3% and the unemployment rate sat near a historic low at 3.9%. The regional surveys from the Fed consistently reflect that companies are having difficulty finding qualified workers, which implies that demand is good and wage growth, a key determinant of inflation, is likely to move higher. The index of Leading Economic Indicators remains solidly positive and consumer and business sentiment surveys nationally, while weakening, continue to point towards expansion.  

Data Courtesy: St. Louis Federal Reserve

Examining charts of various measures of inflation also offers insight into current circumstances. The traditional measures of inflation, Consumer Price Inflation (CPI) and Core (ex-food & Energy) CPI seem benign with core levels at roughly 2.2% although those indicators have declined modestly in recent months.

Data Courtesy: St. Louis Federal Reserve

Alternative inflation indicators like the Employment Cost Index (ECI) wages and average hourly earnings reflect a steady trend of rising wage pressures as shown in the chart below.

Data Courtesy: St. Louis Federal Reserve

The chart below uses the ECI Wages and Salaries data from above and compares it with two components of compensation from the NFIB small business survey. As shown, both metrics demonstrate mounting wage pressures. The NFIB survey shows that companies planning to raise worker compensation is trending higher. Additionally, the survey shows that the single biggest problem for small business is availability of quality labor (correlation using 9-month lead is over 76%) and that measure is also trending higher.

Data Courtesy: St. Louis Federal Reserve

Manufacturing activity captured via the Purchasing Managers Index (PMI) appears to lead CPI with some durability. The correlation is 52% since 2000 and 76% since 2006. Given the current level of manufacturing activity, it suggests that Core CPI should remain above 2.0% over the next several months.

Data Courtesy: St. Louis Federal Reserve

Economies Are Hard To Forecast

Economic systems are complex with many hidden, unobservable and non-linear relationships making economic activity very difficult to forecast. However, by applying simple logic about possible outcomes, we can better frame the risks of higher inflation due to wage pressures. If, as is currently forecast, GDP growth begins to gradually decline as the effects of tax reform and fiscal stimulus diminish, then we should expect gains in employment to moderate. That scenario does not necessarily argue for unemployment to rise which leaves the current labor market situation tight. The effects described above would remain well in place and higher labor costs could reasonably push inflation higher. Higher inflation would put upward pressure on long-term interest rates while creating a headwind for corporate profits, margins and stock prices. That would not be good for most investors.

Another scenario, again given the difficulties associated with forecasting GDP, is that economic growth does not moderate as much as expected and remains somewhat above the post-crisis trend. Labor costs, in that case, would accelerate and could cause wage inflation to move meaningfully higher. Clearly, the risks emanating from that scenario would be very bad for both stocks and bonds and thus a world enamored with passive investing and awash in 60/40 portfolios.

Other Info

A cursory review of other economic data provides even more evidence that the level of interest rates is well below what it should be. Household net worth, industrial production and retail sales are all more than fully recovered from the crisis and have been for some time. Furthermore, the U.S. never experienced deflation, and thus the common point of comparison and rationalization for gradual policy adjustments – that the U.S. could end up in a situation akin to what Japan has been experiencing and combatting for decades – rings hollow. The counter-factual argument is that Fed actions prevented a “Japan-like” outcome, but there is no evidence to support that claim. All this strongly argues that the Fed Funds target rate remains not just slightly accommodative as Powell acknowledges but extremely accommodative.

The following graph, from our article Why Fed’s Monetary Policy Is Still Very Accommodative, shows that the current level of monetary policy is accommodative and unprecedented over the last four decades.

Fortunetellers

Since the financial crisis, the Fed has exerted ever more influence over the economy through extraordinary policy measures. Importantly, their financial crisis and post-crisis involvement came partially as a result of their prior involvement in stoking a housing and stock market bubble that in part led to the crisis.

Now, as they seek to reverse out of those policies, their job is proving more difficult than anticipated and contrary to what Bernanke, Yellen and Dudley told us as they were enacting said policy. That circumstance does not appear to have imposed much humility on the Fed. Despite all their innovations, such as r*, complex labor market indicators, data dependency and forward guidance, Jerome Powell is flying just as blind as Bernanke was in the early innings of the financial crisis. He confirmed this by reasserting and then reversing prior language around his assessment of the economy four times since October 3, 2018. This is not the most confidence-inspiring tactic for a Fed Chairman.

A more reliable approach to monetary policy would be to allow markets to dictate prices. Billions of buyers and sellers, borrowers and lenders, who transact every day are collectively better informed than the small group of unelected and unaccountable figureheads at the Fed. Should the Fed find the urge to become engaged, and it would be a rare occasion indeed, they should respond to market forces and stay out of the way of the robust pricing mechanisms of markets.

Summary

The analogy for the Fed and its approach to monetary policy is one of a driver on a curvy country road. A licensed driver obeying the law who pays attention to the speed limit and other important road signs indicating warnings should be able to successfully navigate to a destination. If, however, the driver decides to navigate by anticipating the contours of the road and confidently driving above the speed limit, he will eventually end up off the road, through a fence or over a cliff. Unfortunately, we are all passengers along for the Fed’s ride currently.

Most of us are willing passengers, having been convinced that the Fed knows what they are doing. That is understandable given the influence on markets from the trillions in liquidity they supplied, but it is not true. The consequences of years of excessive policy will eventually begin to reveal themselves, and we posit they already are. The intersection of manipulated economic forces and societal outrage are exhibit A. What is so confounding, is the misplaced trust in the entities and leaders that are causing the problems described.

R* and all the other economic terms that supposedly guide policy-makers are conjured from the realm of scientific economic analysis but human beings and their behavior cannot be modeled in a spreadsheet. The problem is the failure to apply proper humility or even common sense when crafting the formulas on which policies rest and livelihoods depend.

Normal Is In The Eye Of The Beholder – RIA PRO

A scorpion asks a frog to ferry it across a river. The frog tells the scorpion he fears being stung. The scorpion promises not to sting the frog saying if I did so we would both drown. Considering this, the frog agrees, but midway across the river the scorpion stings the frog, dooming them both. When the frog asks why the scorpion replies that it was in its nature to do so.

On February 20, 2019, the Federal Reserve released the minutes from their January policy (FOMC) meeting. As leaked last week by Fed Governor Loretta Mester, and discussed HERE, it turns out that in January the committee did indeed discuss a process to end the systematic reduction of the Fed’s balance sheet, better known as Quantitative Tightening (QT).

Within the minutes was the following sentence:

Such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve balance sheet.”

The message implies that when the process of reducing the balance sheet ends the Fed’s balance sheet will be normalized. Is that really the case?

This article was made exclusive to RIA Pro subscribers on February 25th. We share it with you to demonstrate one of the many benefits of subscribing to RIA Pro. If you would like to take us for a test ride, use the coupon code PRO30 for a 30-day free trial. To learn more please click here.

The New Normal

Before discussing the implications regarding the present size of the Fed’s balance sheet, we help you decide if the balance sheet will truly be normal come later 2019. The graph below plots the Federal Reserve’s Adjusted Monetary Base, a well-correlated proxy for the Fed’s balance sheet, as a percentage of GDP. The black part of the line projects the current pace of reduction ($50 billion/month) through December.

Data Courtesy: St Louis Federal Reserve

As shown, even if the Fed reduces their holdings through the remainder of the year, the balance sheet will still be nearly three times larger as compared to the economy than in the 25 years before the financial crisis. Would you characterize the current level of the balance sheet as normal?  

Implications

If you answered no to the question, then you should carefully consider the implications associated with a permanently inflated Fed balance sheet. In this article, we discuss three such issues; inflation, safety/soundness, and future policy firepower.

Potential Inflation

When the Fed conducted Quantitative Easing (QE) with the primary purpose of injecting fresh liquidity into the capital markets, the size of their balance sheet rose as they purchased Treasury and mortgage-backed securities from their network of banks and brokers. To pay for the securities the Fed digitally credited the accounts of those firms for the dollar amount owed. A large portion of the money used to buy the securities ultimately ended up in the excess reserve accounts of the largest banks.  Before explaining why this matters we step back for a brief banking lesson.

Under the fractional reserve banking system, banks can lend a multiple of their reserves (deposits and capital). The multiple, governed by the Fed, is known as the reserve ratio. Banks maximize profits by leveraging reserves as much as the reserve ratio allows. Before 2008 the amount of excess reserves was minimal, meaning banks maximized the amount of loans they created based on reserves.

Currently, banks are sitting on about $1.5 trillion of excess reserves that are unconstrained. To put that in context, the average from 1985 to 2007 was only $1.3 billion. This large sum of untapped reserves means that banks can lend, and create money far easier than at any time in the past. If they were to do this the growth in the amount of credit in the system could surge well beyond the rate of economic growth and generate inflation. This potential did not exist before 2008.

Safety and Soundness

Banks and brokers in 2008 were leveraged as much as 40:1. Lehman Brothers, for example, was levered 44:1 at the time they filed for bankruptcy. Many banks failed, and a good majority required unprecedented action by the Fed and U.S. government to bail them out. Clearly the combination of declining asset values and too much leverage broke the financial system.  

The Fed currently has $39 billion of capital supporting $3.9 Trillion of assets. They are leveraged 100:1, meaning a 1% percent loss on their assets would wipe out their capital. This amount of leverage is approximately three times that which was normal prior to the crisis.

Fortunately, the Fed does not re-value their assets so the daily volatility of the fixed income markets cannot bankrupt them. Regardless, one would think the Fed would apply similar safety and soundness measures that they require of their member banks.

Ultimately, this inordinate amount of leverage raises questions about Federal Reserve integrity and the value of the dollar which is issued and supported by the Fed. Fiat currency regimes perch delicately on trust. Should we trust the entity that controls the money supply when they employ such unsound banking practices? More importantly, if I am a foreigner using U.S. dollars, the world’s reserve currency, should I be concerned and possibly question my trust in the Fed?  What is the risk that a problem emerges and to recapitalize the Fed simply prints dollars causing a significant devaluation of U.S. dollars? At what point does the risk-free status of U.S. Treasuries become challenged due to unsound Fed practices?

Next Recession

The Fed’s balance sheet is about four times larger today than it was at the start of the last recession. With the Fed Funds rate only at 2.25%, the Fed has little room to stimulate the economy and support the financial markets using traditional measures. During the next recession the onus will assuredly be put on QE. The questions raised above and many others are of much greater concern if the Fed were to boost their balance sheet to $6, $8 or even $10 trillion. Such growth would further increase the already high level of leverage and potentially introduce fresh concerns about the real value of the U.S. dollar. This raises the specter of a negatively self-reinforcing feedback loop. 

Summary

Over the last year, the market has struggled as the Fed steadily reduced the size of their balance sheet. The S&P 500 is unchanged over the past 13 months. The liquidity pumped into the markets during QE 1, 2, and 3 is being removed, and asset prices which rose on that liquidity are now falling as it is removed. The Fed is clearly taking notice. In December Jerome Powell said the QT process was on “autopilot” with no changes in sight. A week later, with the market swooning, he discussed the need to “manage” QT. “Autopilot” became “manage” which has now turned to “end” in only two months.

If the Fed’s mandate is to support asset prices, this behavior makes sense.

To the contrary, the congressionally chartered mandate is clear; they are supposed to promote stable prices and full employment. Our concern is that capital markets, which are heavily dependent on the Fed and seemingly insensitive to price and valuation, are promoting instability and gross misallocation of capital. One cannot fault markets; they are responding as one should expect on the basis of Fed posture and the prior reaction function. Markets are properly agnostic under such circumstances. It is the Fed that has created an environment that leads markets to react in the ways that it does.

Like the fable of the scorpion and frog, the Fed is trusting markets to not destabilize as long as the Fed gives it a ride. While the relationship may seem cooperative today, it is not in the nature of markets to comply with foolish policy-making. Just like it is natural for scorpions to sting, it is natural for markets to find and expose weakness.

Regardless of the Fed’s characterization of a normal balance sheet, the normalization process is far from normal. What the Fed is doing is redefining “normal” to support inflated and over-valued asset prices and accommodate an unruly market. This will only aggravate any deeper problems lurking.

At the end of the day, are we ever going to have price discovery in the natural way or is the Fed going to step in every single time the markets try to normalize?” –Danielle DiMartino Booth

Normal is in the Eye of the Beholder

A scorpion asks a frog to ferry it across a river. The frog tells the scorpion he fears being stung. The scorpion promises not to sting the frog saying if I did so we would both drown. Considering this, the frog agrees, but midway across the river the scorpion stings the frog, dooming them both. When the frog asks why the scorpion replies that it was in its nature to do so.

On February 20, 2019, the Federal Reserve released the minutes from their January policy (FOMC) meeting. As leaked last week by Fed Governor Loretta Mester and discussed HERE, it turs out that in January the committee did indeed discuss a process to end the systematic reduction of the Fed’s balance sheet, better known as Quantitative Tightening (QT).

Within the minutes was the following sentence: “Such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve balance sheet.” The message implies that when the process of reducing the balance sheet ends the Fed’s balance sheet will be normalized. Is that really the case?

The New Normal

Before discussing the implications regarding the present size of the Fed’s balance sheet, we help you decide if the balance sheet will truly be normal come later 2019. The graph below plots the Federal Reserve’s Adjusted Monetary Base, a well-correlated proxy for the Fed’s balance sheet, as a percentage of GDP. The black part of the line projects the current pace of reduction ($50 billion/month) through December.

Data Courtesy: St Louis Federal Reserve

As shown, even if the Fed reduces their holdings through the remainder of the year, the balance sheet will still be nearly three times larger as compared to the economy than in the 25 years before the financial crisis. Would you characterize the current level of the balance sheet as normal?  

Implications

If you answered no to the question, then you should carefully consider the implications associated with a permanently inflated Fed balance sheet. In this article, we discuss three such issues; inflation, safety/soundness, and future policy firepower.

Potential Inflation

When the Fed conducted Quantitative Easing (QE) with the primary purpose of injecting fresh liquidity into the capital markets, the size of their balance sheet rose as they purchased Treasury and mortgage-backed securities from their network of banks and brokers. To pay for the securities the Fed digitally credited the accounts of those firms for the dollar amount owed. A large portion of the money used to buy the securities ultimately ended up in the excess reserve accounts of the largest banks.  Before explaining why this matters we step back for a brief banking lesson.

Under the fractional reserve banking system, banks can lend a multiple of their reserves (deposits and capital). The multiple, governed by the Fed, is known as the reserve ratio. Banks maximize profits by leveraging reserves as much as the reserve ratio allows. Before 2008 the amount of excess reserves was minimal, meaning banks maximized the amount of loans they created based on reserves.

Currently, banks are sitting on about $1.5 trillion of excess reserves that are unconstrained. To put that in context, the average from 1985 to 2007 was only $1.3 billion. This large sum of untapped reserves means that banks can lend, and create money far easier than at any time in the past. If they were to do this the growth in the amount of credit in the system could surge well beyond the rate of economic growth and generate inflation. This potential did not exist before 2008.

Safety and Soundness

Banks and brokers in 2008 were leveraged as much as 40:1. Lehman Brothers, for example, was levered 44:1 at the time they filed for bankruptcy. Many banks failed, and a good majority required unprecedented action by the Fed and U.S. government to bail them out. Clearly the combination of declining asset values and too much leverage broke the financial system.  

The Fed currently has $39 billion of capital supporting $3.9 Trillion of assets. They are leveraged 100:1, meaning a 1% percent loss on their assets would wipe out their capital. This amount of leverage is approximately three times that which was normal prior to the crisis.

Fortunately, the Fed does not re-value their assets so the daily volatility of the fixed income markets cannot bankrupt them. Regardless, one would think the Fed would apply similar safety and soundness measures that they require of their member banks.

Ultimately, this inordinate amount of leverage raises questions about Federal Reserve integrity and the value of the dollar which is issued and supported by the Fed. Fiat currency regimes perch delicately on trust. Should we trust the entity that controls the money supply when they employ such unsound banking practices? More importantly, if I am a foreigner using U.S. dollars, the world’s reserve currency, should I be concerned and possibly question my trust in the Fed?  What is the risk that a problem emerges and to recapitalize the Fed simply prints dollars causing a significant devaluation of U.S. dollars? At what point does the risk-free status of U.S. Treasuries become challenged due to unsound Fed practices?

Next Recession

The Fed’s balance sheet is about four times larger today than it was at the start of the last recession. With the Fed Funds rate only at 2.25%, the Fed has little room to stimulate the economy and support the financial markets using traditional measures. During the next recession the onus will assuredly be put on QE. The questions raised above and many others are of much greater concern if the Fed were to boost their balance sheet to $6, $8 or even $10 trillion. Such growth would further increase the already high level of leverage and potentially introduce fresh concerns about the real value of the U.S. dollar. This raises the specter of a negatively self-reinforcing feedback loop. 

Summary

Over the last year, the market has struggled as the Fed steadily reduced the size of their balance sheet. The S&P 500 is unchanged over the past 13 months. The liquidity pumped into the markets during QE 1, 2, and 3 is being removed, and asset prices which rose on that liquidity are now falling as it is removed. The Fed is clearly taking notice. In December Jerome Powell said the QT process was on “autopilot” with no changes in sight. A week later, with the market swooning, he discussed the need to “manage” QT. “Autopilot” became “manage” which has now turned to “end” in only two months.

If the Fed’s mandate is to support asset prices, this behavior makes sense.

To the contrary, the congressionally chartered mandate is clear; they are supposed to promote stable prices and full employment. Our concern is that capital markets, which are heavily dependent on the Fed and seemingly insensitive to price and valuation, are promoting instability and gross misallocation of capital. One cannot fault markets; they are responding as one should expect on the basis of Fed posture and the prior reaction function. Markets are properly agnostic under such circumstances. It is the Fed that has created an environment that leads markets to react in the ways that it does.

Like the fable of the scorpion and frog, the Fed is trusting markets to not destabilize as long as the Fed gives it a ride. While the relationship may seem cooperative today, it is not in the nature of markets to comply with foolish policy-making. Just like it is natural for scorpions to sting, it is natural for markets to find and expose weakness.

Regardless of the Fed’s characterization of a normal balance sheet, the normalization process is far from normal. What the Fed is doing is redefining “normal” to support inflated and over-valued asset prices and accommodate an unruly market. This will only aggravate any deeper problems lurking.

At the end of the day, are we ever going to have price discovery in the natural way or is the Fed going to step in every single time the markets try to normalize?” –Danielle DiMartino Booth