The Federal Reserve: Dismal Failure or Shrewd Complicity?
Following the June Federal Open Market Committee (FOMC) meeting, Janet Yellen spelled out in greater detail the central bank’s plans to start slowly shrinking its $4.5 trillion portfolio of bonds and other assets this year. Recall that the U.S. Federal Reserve System held roughly $700 billion of Treasury notes on its balance sheet prior to the Financial Crisis. The Fed’s plan would start reducing the holdings by allowing a small amount of net maturities per month — $6 billion in Treasury securities and $4 billion in mortgage bonds — and to allow that amount to rise each quarter. Those limits would ultimately rise to a maximum of $30 billion a month for Treasurys and $20 billion a month for mortgage securities. According to the FOMC minutes “the committee currently expects to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated.”
To get readers up to speed, we’ll start with a quick history lesson. The Fed carried out several rounds of “quantitative easing” (QE) since the Financial Crisis. In November 2008, the Fed began buying $600 billion in mortgage-backed securities (QE 1). In November 2010, the Fed announced a second round of quantitative easing (QE 2), buying $600 billion in U.S. Treasurys through the second quarter of 2011. Finally, a third round of quantitative easing was announced in September 2012 during which the Fed committed to buy $40 billion (and later up to $85 billion) of bonds per month on an open-ended basis (“QE forever”). Purchases were finally halted in October 2014 after the central bank had accumulated $4.5 trillion in assets.
As QE in the U.S. is supposedly on the point of winding down (supposedly because we don’t believe the Fed projections have any credibility), we wanted to take a moment to see what the “Great Monetary Policy Experiment” has done for the U.S. economy. First, real GDP has grown at an annualized rate of +1.9% for the 2009-2017 expansion. This compares with a +3.1% GDP growth rate for the 2002-2007 expansion and a +3.9% growth rate for the 1992-2000 expansion. In terms of employment, one of the Fed’s economic targets, the U.S. unemployment rate retreated at a slower pace from the recession trough in 2009 compared to prior jobs recoveries…despite the Fed’s monetary policy stimulus. Finally, the Fed has failed to get the annual inflation rate up to its 2% target, even as the money supply has swelled to never-before-seen levels. Not many economists would disagree with the assessment that the quantitative easing experiment did not produce benefits to the economy proportional to the amount of stimulus employed.
But Why?
Looking back, we are left with one big question. The Fed chose to inject money into the economy via bond purchases (literally buying bonds from Goldman Sachs). We see how providing “the economy” liquidity via the purchase of financial assets has had a limited impact on the economy and a huge impact on financial markets. There is no mystery why inflation remains stubbornly below the central bank’s target — inflation has mostly incurred in financial asset prices due to the Fed’s choice to inject liquidity via the banks. So why did the Fed, eager to jumpstart the economy and generate inflation, not inject newly printed money directly into the hands of Americans? We calculated that each tax-paying America household could have received $5,000 from the Fed if QE1 had been allocated directly to the economy. Another $5,000 per household for QE 2. And for the third round of QE, a whopping $11,500 would have been given to each American household.
There is little doubt that a $21,500 gift to American households from the Fed would have juiced retail sales, investment projects, and stoked inflation many times greater than giving this money to the banks. Moreover, the QE money provided to the banks from the Fed found its way mostly into financial instruments, and not into consumer and business loans as the Fed had been anticipating.
It’s All About The Balance Sheets, Stupid
As we stand in 2017, the world’s three most important central banks are holding balance sheets inflated well beyond any historical precedent. It remains a serious rhetorical question to ponder – why did central banksters increase money supply uniquely via asset purchases on financial markets instead of directly giving money to the consumer. Although central banks act as “stewards” of the economy, overseeing its well-being, the primary clients of central banks are commercial banks. And within the central bank systems, private bankers have great influence. Within the Federal Reserve System, for example, each regional bank president (who votes on monetary policy) is nominated by the bank’s board of directors, consisting of the top brass of commercial and investment banks. To put it mildly, there is a strong complicity between the central banks and private banking interests. Most market observers don’t realize that the Fed’s Treasury Bond purchases were not made from the Treasury itself at par value, but rather bought from banks like Goldman Sachs at a premium. One day this will be recognized as a scandal.
Given that rising asset prices are good for the banks’ business, it’s not surprising that central banks have pulled out every excuse not to shrink their balance sheets over the past several years. Even as the economic benefits of excess liquidity have been shown to be negligible.
We see the only meaningful threat to equity markets today being a significant shrinking of central bank balance sheets across the world. For the moment, we are only getting talk of a symbolic move from the Fed, with no signs of slowing from the Bank of Japan (BoJ) and the European Central Bank (ECB).
The first chart below shows that the Fed’s bond holdings have held at $4.3 trillion since 2014, supporting U.S. equity indexes. Even if the Fed stopped adding to its holdings more than three years ago, the central bank has been reinvesting the proceeds of maturing assets to keep those holdings steady. We don’t expect the blue line will fall very much before equities fall out of bed and the Fed stops shrinking its balance sheet.
The European Central Bank (ECB) got in on the “QE show” after the Fed opened the flood gates in 2009. The ECB balance sheet doubled from 2015 to 2017 and now stands at €4.2 trillion. If you wonder what stopped the mini bear market in European equities in 2015, just take a look at the chart below.
The third major QE-actor, the Bank of Japan (BoJ), put the yen printing press into overdrive starting in 2013. Unsurprisingly the Nikkei broke out in 2013 and ran up over +150% in a two year period.
Conclusion
It’s nice to hear Bull’s talk about their great long equity positions being backed by strong company earnings and good economic fundamentals. However if the above three central banks were to reduce their asset holdings by, say 10%-15%, we’ll see just how strong company earnings and the economy really are as share prices tumble.
It is manifestly obvious that equities can not suffer a deep or lasting bear market as long as the majority of world central banks maintain balance sheets at current levels. A safety net is in place below equity markets and professional investors know this. Any pull-back, whatever the reason (Brexit, Trump, geopolitical) is reason to buy – as long as central banks maintain balance sheets at the levels above. Unfortunately for free-market patriots, there is no incentive for central banks to reduce their balance sheets today. Economic growth across the planet will never be strong enough (in the foreseeable future) to take the economy off life-support and inflation – the only constraint that could force central banks to shrink their balance sheets – remains contained within financial assets prices. We are living in a surrealistic world where the “authorities” are overseeing the creation of potentially the greatest asset bubble of all time. Unless confronted by accelerating real-world inflation or political pressure, central banks have no incentive to significantly reduce their balance sheets. The madness continues….