Doug Noland: The Short but Momentous History of Fed QE

Central banking traditionally operated as a judicious and conservative institution, with an overarching mandate focused on promoting monetary and financial stability. Historically, recognition that missteps can impart such profound societal hardship necessitated an incremental and risk-averse approach. Stability and doing no harm took precedence. At least that’s the manner in which central banking has been approached for generations.

The world is now in the throes of history’s greatest experiment in central bank doctrine and operations. It’s easy to forget that the Federal Reserve is only about 13 years into experimental QE activism. Indeed, central bankers have minimal history for a well-founded assessment of how QE operates, its various impacts and consequences, both intended and unintended. The lack of clarity beckons for circumspection.

It’s also clear that observation and evaluation of QE is left to us. Wall Street, of course, is bewitched by the Fed’s powerful tool. Meanwhile, the Federal Reserve is these days uninterested in assessing either QE’s effects or risks, while the economic community remains reticent. After doubling its balance sheet to $7.4 TN over the past 74 weeks, the Fed is now locked into a policy course that will see an additional $120 billion of liquidity injected into the markets on a monthly basis well into the future.

With 13 years of observation, we know for sure that all QE is not created equal. It is important to recall that the initial $1.0 TN of QE back in 2008 was employed to accommodate post-Bubble deleveraging. The Fed essentially transferred onto its balance sheet a Trillion of Treasuries and MBS (and some other instruments) accumulated by highly levered institutions during the Bubble period. The crisis-response expansion of Federal Reserve Credit was offset by a corresponding contraction of speculative leverage, leaving overall system liquidity only marginally impacted.

The “QE2” doubling of Fed Credit (to $4.5 TN) between 2011 and 2014 had a much more significant market impact. The S&P500 essentially doubled from 1,000 to 2,000, with the Nasdaq100 doubling to surpass 4,000. And while y-o-y nominal GDP growth did reach 5% in 2014, for the most part the economy was not overly responsive to QE stimulus. Ditto for consumer prices. Year-over-year CPI, which rose above 3.5% in 2011, was back below 2% in 2014. Clearly, QE2 monetary inflation had a much more pronounced impact on equities prices than on both the consumer price level and economic activity.

The general economy was in an impaired post-mortgage finance Bubble state, suffering the consequences of years of deep structural maladjustment. The housing sector was burdened by post-Bubble Credit impairment and associated deflationary forces, a powerful dynamic fueling disinflation in key segments of the economy. Even by 2014, annual growth in total Non-Financial Debt (NFD) of $1.5 TN was the lowest since 2011 and still only two-thirds the level from 2007.

The Fed’s reemployment of QE in September 2019 (with stocks at record highs and unemployment at multi-decade lows) was perilous policy activism. Rather than accommodating deleveraging (QE1) or countering disinflationary forces (QE2), the Fed resorted to aggressive QE measures to bolster a faltering Bubble. In particular, equities and corporate Credit markets had turned highly speculative. At $2.7 TN, NFD in 2018 had expanded the most since 2004 – and this strong Credit expansion continued into 2019. M2 grew a record $968 billion in 2019, or 6.7%. Home price inflation had gained momentum, with increasingly powerful inflationary biases having taken hold throughout securities and asset markets.

Unprecedented QE injections were then commenced last March to forcefully reverse de-risking/deleveraging dynamics – and they were then sustained even as “risk on” speculative leveraging and manic market speculation gathered powerful momentum.

The current QE backdrop is unprecedented. The Fed is creating $120 billion of additional market liquidity on a monthly basis in the face of extreme market developments: unprecedented debt and “money” supply expansion; record stock prices and valuations; the most speculative equities market in generations; booming leveraged speculation; record equities and corporate bond inflows; record corporate debt issuance; unprecedented public market participation; booming equities and options trading volumes; record low junk bond yields; along with overheated markets for IPOs and SPACs.

Evidenced by the GameStop and cryptocurrency spectacles, the Fed is today throwing additional fuel on historic speculative manias. Moreover, our central bank is sticking with its massive “money printing” operation despite previously unfathomable fiscal stimulus – with a two-year federal deficit poised to exceed $6.0 TN – or approaching 30% of GDP. NFD likely exceeded $7.0 TN last year, while M2 “money supply” inflated an incredible $3.724 TN, or 24%.

Harvard Professor Gregory Mankiw (Economic Club of New York Q&A 2/10/21): “After the great recession and the pandemic recession that we’re just getting out of now, the Fed’s balance sheet is vastly different – much larger – than it was, say, 15 years ago. Now I know this is not the time to shrink it – you’re not. But look past this current crisis, look ahead where we might be 15 years from now, do you envision the Fed going back to a smaller balance sheet – having a more modest role in the financial markets as it did in the past – or do you think we’re in a new world where this expanded balance sheet is a permanent fixture of the financial system?”

Federal Reserve Chair Jay Powell: “I do want to begin by agreeing with your first point, which is the economy is far away from maximum employment and stable prices – and the balance sheet will be the size that it needs be to provide support to the economy. As you know, we’re currently buying assets. It’s a key part of what we’re doing in providing overall accommodation to the economy. That is our focus. We’re not thinking about shrinking the balance sheet, just to be clear…

To get to your real question, in the long-run our balance sheet will be no larger than it needs to be to meet the demand for our liabilities and allow us to implement monetary policy effectively and efficiently. So, it really is, in the long-run, it’s demand for our liabilities – the two biggest which are currency and reserves… When the pool of assets declines over many years, as it did after the global financial crisis, it really is the public’s demand for our liabilities. We will return to a place – gradually with tons of transparency and not beginning anytime soon – to a place where really the size of our balance sheet is set by the public’s demand for our liabilities. It won’t be the $20 billion balance sheet that we had in 2005 – and that partly is just that demand for currency has been surprisingly high at a time when in many parts of the world people are declining to use currency. Demand for reserves – reserves are the most liquid asset, and they’re in high demand for banks to meet their liquidity requirements and payment utilities and all that. The longer-run – we will get back to that. We did ultimately do that after the global financial crisis. We froze the size of the balance sheet in 2014 – and then as the economy grows the balance sheet shrinks as a percent of GDP. In addition, reserves decline as currency and other liabilities sort of organically grow. So, the answer to your question is ‘yes’ with a long explanation.”

Noland: It’s not demand for reserves and currency that will dictate the future size of the Fed’s balance sheet. Unparalleled Federal Reserve monetary inflation has accommodated a historic financial Bubble. Going forward, the Fed’s role as market liquidity backstop (“lender of last resort”) will ensure ongoing massive asset purchases – with incessant risk of marketplace deleveraging and illiquidity governing an increasingly unwieldy Federal Reserve monetary inflation.

The system is beyond the point where “normalization” is possible. I titled a February 2011 CBB “No Exit” following the Fed’s release of its QE exit strategy. Sure, the Fed later in 2014 “froze” balance sheet growth, but only after doubling the balance sheet from 2011 levels and, in less than six years, inflating its holdings by $3.548 TN, or 390%.

The Fed did then shrink assets by $740 billion between December 2014 and August 2019, presenting a deceptively sanguine appraisal with respect to the ease of balance sheet contraction. Yet this was a near-zero interest-rate “risk on” backdrop, where the expansion of speculative leverage throughout the marketplace easily absorbed the Fed’s Treasury and MBS sales. It proved a fleeting phenomenon. The Fed’s 2014-2019 balance sheet contraction was fully reversed in only six months – with assets set to surpass $8.0 TN later this year.

At this point, it is difficult to envisage a scenario where the Federal Reserve’s balance sheet doesn’t continue to significantly inflate. The Fed is currently locked into a flawed strategy of ongoing market liquidity injections with a stated focus on full employment and above target consumer price inflation. This liquidity onslaught continues to fuel historic asset inflation and Bubble Dynamics – stocks, bonds, homes, derivatives, private business, cryptocurrencies, collectables, luxury properties, and so on. And the greater these Bubbles inflate, the more destabilizing even the contemplation of a Fed “taper” becomes.

The 10-year Treasury inflation “breakeven rate” added another two bps this week to 2.22%, the high since July 2014. Friday’s University of Michigan reading on consumer price inflation saw one-year inflation expectations in February surge to 3.3% (up from December’s 2.5%), also the high since July 2014. The Bloomberg Commodities Index closed out the week at the highest level since November 2018 – already up 7.7% y-t-d. Energy prices are surging. Ten- and 20-year Treasury yields ended the week at the highs since February.

February 11 – Bloomberg (Amanda Albright): “U.S. home prices, fueled by the lowest mortgage rates in history, rose at the fastest pace on record, surpassing the peak from the last property boom in 2005. The median price of a single-family home climbed 14.9% to $315,000 in the fourth quarter. That was the biggest surge in data going back to 1990… The Northeast led the way with a 21% gain…”

Mankiw: “Let’s imagine that your next job is not Fed Chair but a member of Congress. Would there be a particular issue you would want to champion – big problems out there we aren’t addressing as a nation that you think are high priorities…?”

Powell: “One I will mention that connects a lot with our work here…, it would be great if we had a national strategy to make the U.S. economy as big – the prosperity that the United States economy has as broadly shared as possible – and to have that economy be as big as it could possibly be. In other words, the productive capacity of the economy. Part of that is investing in the labor force. Part of it is having a tax code and regulatory policy that promotes growth. Growth is what enables incomes to rise generation upon generation. So, we want growth to be high, we also want it to be very widely spread. People come to Washington, they work on all these hot political issues, but we don’t take a step back and say, ‘Okay, what is the supply side strategy that we need as a country to maximize the potential growth of the United States economy, and also the distribution of that – more broadly inclusive prosperity.’ So those are the things I would really want to work on if I were an elected representative.”

John Maynard Keynes, 1920: “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

I found myself this week also recalling Dallas Fed President Robert McTeer’s comment from early-February 2001: “If we all join hands together and buy a new SUV, everything will be OK.” At the time, I was stunned by McTeer. The “tech” Bubble had been pierced and the scope of Bubble malinvestment was being revealed. Yet there was no recognition of the Fed’s role in promoting the Bubble or how distorted markets and Bubble excess had negatively impacted investment decisions and the economic structure. It was a harbinger of the subsequent 20 years.

It is impossible to maximize sustainable long-term growth and “broadly inclusive prosperity” during a period of massive monetary inflation, acute market speculative excess and flourishing Bubble Dynamics. “What is the supply-side strategy” when the marketplace is so indiscriminate in financing uneconomic businesses and enterprises? “If we all just hold hands (and plug noses) and continue to participate in the securities market mania, everything will be okay.”

The problem is contemporary central bank doctrine has morphed to the point that the prevailing objective is simply to sustain asset inflation. And at this point, it’s clear that QE has unleashed a dangerous mania while prolonging “Terminal Phase” excess. The current period of free “money” is financing all kinds of crazy crap, and the longer this period of egregious excess continues, the greater the impairment to the underlying economic structure. The longer this dynamic unfolds, the greater the scope of inequality, animosity and social strife.

And this gets us back to the critical issue of sound money. As a society, it is completely unrealistic to hope sustainable prosperity will somehow emerge from an extended period of Monetary Disorder. The underlying insecurity afflicting society will only continue to fester. Most will lose faith in an unfair and unjust system, with today’s Bubble excess creating enormous systemic risk. A bursting Bubble will inevitably inflict terrible hardship throughout the economy. In the meantime, runaway Monetary Inflation creates myriad risks to the fabric of society.

So, “What is the supply side strategy that we need as a country to maximize the potential growth of the United States?” Chair Powell poses the critical question, though it is hopelessly divorced from the reality of a historic monetary inflation, out of control Bubbles, market manias and resulting financial and economic dysfunction.

The policy focus at this point is little more than a desperate monetary inflation to incite higher markets and more borrowing and spending. There is no long-term strategy – how could there be? It’s ruinous inflationism. Capitalism has been crippled; the pricing mechanism sabotaged by central bankers hijacking the “cost of money.” Markets are broken, with the entire financial apparatus – from the Fed, to Wall Street, to Washington – geared toward imprudent spending and the reckless expansion of non-productive debt.

Without some semblance of sound money, the notion of sound investment, robust economic structure, real generational income growth, and broadly inclusive prosperity is, most regrettably, nothing more than a pipedream. Current policy and market structures ensure instability and persistent hardship.

Of the Trillions of fiscal spending, only a trickle finds its way toward investment in our future. Instead, most will be directed at redistribution measures – a policy approach viewed as necessary to counter systemic inequality. How crazy has this all become: Trillions of monetary stimulus stoke Bubble Dynamics and resulting inequality, while Trillions of fiscal stimulus are employed to counteract the inequities promoted by central bank activism.

Meanwhile, China has its own serious issues with monetary inflation and deep structural impairment. Aggregate Financing, China’s broad measure of system Credit, expanded $803 billion (second only to March 2020’s $805bn) during January, about 2% ahead of the previous record from January 2020. One-year growth of $5.432 TN was 35% ahead of the previous year’s growth and 46% above one-year growth from two years ago. Aggregate Financing expanded 13.0% over the past year to $45 TN. Aggregate Financing has expanded 57% since the PBOC began reporting this iteration of Credit data four years ago.

China’s financial system traditionally experiences huge lending growth to begin the year. Total Bank Loans expanded a record $555 billion during the first month of 2021, up 7% from January 2020 growth. Bank Loans were $3.085 TN higher y-o-y, an increase of 17.4% from comparable one-year growth from a year ago.

Corporate Bank Loans increased $396 billion in January, down 11% from January 2020’s $443 billion. One-year growth of $1.842 TN was up 22% from comparable 2020 growth, 31% from comparable 2019, and 71% from comparable 2018. Corporate Bond issuance added another $58 billion in January, the strongest expansion since April’s $143 billion.

Consumer Loan growth surged to a record $197 billion in January, up from December’s $86 billion and compared to January 2020’s $99 billion. Twelve-month growth of $1.320 TN was 20% ahead of one-year growth from the previous year. Consumer Loans were up 15.2% in one year, 32% in two years, 56% in three and 133% in five years.

Government Bonds increased $36 billion in January, the smallest gain since last February. However, 12-month growth of $1.211 TN was 47% ahead of comparable growth from a year ago. Government Bonds expanded 20% over the past year, 40% over two and 64% in three years.

Curiously, M2 expanded “only” $407 billion in January, down significantly from January 2020 growth ($568bn). One-year expansion slowed to 9.4%, the weakest reading since February 2020. Over the past three months, M2 growth of $982 billion was down 18.3% from comparable three-month growth from last year.

Original Post 13 February 2021

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