QE, UNCERTAINTY AND CPI / PRUDENTBEAR.COM

QE, Uncertainty and CPI

by Doug Noland

March 28, 2014 


Equity market internals have turned increasingly unsettled.

In last Wednesday’s press conference, Janet Yellen upset the markets with her comment suggesting that the Fed might commence rate adjustments as early as six months after it concludes its latest QE program. Several officials have since tried to reassure market participants that the Fed has not moved forward its plans to raise rates. Even hawkish Fed officials went to pains to communicate that rate moves were not in the immediate offing.

Clearly, the Fed’s strategy is to do its utmost to reduce market uncertainty. The FOMC is moving forward methodically to wind down its balance sheet operations, while telegraphing an ultra-cautious rate policy (future, future little “baby steps”).

The Fed has good reason to worry about the markets and fret the issue of “uncertainty.” And it’s difficult to envisage a more transparent – and market-friendly - interest rate policy. When markets are in a good mood, it’s virtual nirvana. Financial markets – in particular stocks and corporate Credit – can enjoy splendid market excess without concern that the Fed might choose to “lean against the wind” of destabilizing speculation. And for the Fed to actually get rates to what would be considered “slamming on the brakes” – harsh enough to puncture powerful market Bubbles – well, that would be years away (most likely never).

Yet I would argue the notion that the Fed is capable of bridling market uncertainty is a Bubble mirage. Thus far, our central bank has been successful in keeping the markets focused on rate policy. Meanwhile, a great uncertainty furtively lurks: What will the end of Fed “money” printing mean for U.S. and global markets, the emerging economies and the U.S. and global economies more generally?

The entire QE (quantitative easing) issue/analysis is incredibly fascinating. Since September 2008, the Fed’s balance sheet has ballooned from about $900bn to $4.227 TN. If tapering runs its expected course, QE will end late this year with the Fed’s balance sheet near $4.5 TN. This would leave the latest round of QE totaling almost $1.7 TN, with the Fed’s balance sheet having expanded (a parabolic) 60% in two years. This would also place total Fed asset growth at $3.6 TN, or 400%, in six years.

And why do I posit that the notion of the Fed harnessing uncertainty is a mirage? Because the Fed doesn’t have a clue as to the consequences of the $3.6 TN of liquidity it has pumped into the markets since 2008. And I don’t say this flippantly. Best I can tell, the Federal Reserve has not even attempted a comprehensive study of how this massive liquidity injection has flowed through the Treasury and MBS markets, U.S. financial markets more generally, global markets and financial systems, and economies at home and abroad. They have just been determined to keep pumping it out there, supposedly to fight heightened deflationary forces. The Bernanke Fed had a theory.

In admittedly superficial analysis (from my perspective), I’ve in past analyses tried to differentiate the widely-divergent effects of QE1, QE2 and (“open-ended”) QE3. Past analysis tried to explain how QE1 was largely a shift of positions from leveraged players onto the Fed’s balance sheet. While this had a profound impact on sentiment, it didn’t really function as a direct injection of liquidity into the markets. QE2, on the other hand, was injected directly into a marketplace with a powerful propensity (“inflationary bias”) for purchasing/speculating in U.S. fixed income and the emerging markets. QE2 fueled “blow off” excesses, proving most destabilizing for EM markets and economies. QE3 has been an altogether different creature. With bond and EM Bubbles having already begun to falter, the Fed’s (along with the BOJ’s) liquidity onslaught predominantly spurred speculative “blow off” dynamics in U.S. equities and corporate debt.

When addressing QE effects, Fed speakers (and papers) focus on basis point declines in Treasury and MBS yields, along with adjustments in the structure of term premiums (the yield curve). Dr. Bernanke’s theories held that Fed “money” printing could ensure a rising rate of inflation (i.e. central banks could inflate away problematic debt loads). Now, as the biggest QE yet begins to wind down, most notions of how Fed “money” printing operations actually function are (over)due for a thorough reexamination. After all, in the face of what will be $1.6 TN of new liquidity, bond yields rose and CPI declined. Stocks, on the other hand, went on a historic moonshot. In corporate Credit, it became 2007 reincarnate.

When the Fed was discussing its so-called “exit strategy” back in 2011, I was writing there would be “No Exit.” Well, the Fed has since doubled the size of its balance sheet. And I just don’t see how the Fed can inflate liquidity from $900bn to $4.5 TN and then just shut down the “printing presses” – that is, without some major consequences for the general liquidity backdrop. The history of monetary inflations provides unequivocal support for this view.

Conventional thinking, well, it simply could not see things more differently. Most believe that QE has had minimal effect, so ending the program will be inconsequential. The bulls (these days that means just about everybody) believe stock prices have been driven higher by robust earnings. The economic recovery has seen a superior economic structure generate outsized corporate profits. The economy drives the markets – and not vice versa. From this viewpoint, QE is for the most part insignificant.

The commonly held view of limited QE impact is driven by another momentous “flow of funds” misperception. Even top Federal Reserve officials these days believe that QE has thus far exerted minimal impact because Fed “liquidity” has been sitting inertly as “reserves” on the banking system balance sheet. I say “another” misperception, because I am constantly reminded of how the profound market impacts of Fannie, Freddie and the FHLB went unrecognized for years (especially 1994-2004) during a protracted Bubble period. The view then was that “only banks create money and Credit.” Somehow, a historic inflation in GSE Credit unfolded with barely a notice from Wall Street analysts or the Fed. The view today is that there is little impact from the Fed’s balance sheet so long as QE is held as “reserves” by the banks.

There is definitely confusion on the issue of “flow” versus “level” analysis. In QE operations, the Fed “Credits” accounts with new purchasing power as it consummates purchases of Treasury and MBS securities in the marketplace. Essentially, the Fed creates new electronic liabilities (“IOUs”) that provide immediate liquidity/purchasing power (“money”) to the seller of securities. Importantly, these liabilities will exist until the Fed liquidates securities and uses the proceeds to pay down its IOUs. To be sure, Fed operations dictate the “level” of its liabilities. Moreover, these liabilities by design are held by financial institutions that have a clearing relationship with the Fed, largely U.S.-operated financial institutions.

At a point in time, the “level” of “reserves” liabilities created by the Fed will be held as banking system assets (it’s just “accounting”). But this basically tells us nothing in regard to the transactions that took place between the Fed’s purchase and the eventual deposit of this liquidity into the banking system. Moreover, the “level” of “reserves” informs us nothing about the “flows” – flows that could be in the hundreds of billions or more on an intra-day basis (who knows?). And it is these transactional “flows” that have profound impacts on market dynamics and pricing.

From my perspective, it’s all rather obvious that the greatest QE3 impact has been the stoking of Bubbles in U.S. equities and corporate Credit. I’ve used the example of the Fed purchasing Treasuries and MBS from a rather large “bond” fund suffering redemptions. In this case, Fed liquidity would then be used to fund bond investor outflows that find their way to, say, a major U.S. equities ETF. The ETF then uses this liquidity to buys stocks, providing the sellers the liquidity to buy other securities (or things). Another example would have Fed liquidity accommodating a rotation of hedge fund positions from bonds to equities. In this example, a hedge fund might sell a (underperforming) 10-year Treasury note to purchase an outperforming Facebook stock. And if the seller is Mark Zuckerberg, a chunk of his sales proceeds will boost California and federal income tax receipts (quickly spent by both governments). Zuckerberg’s employees can use stock sale proceeds to buy homes and luxury automobiles (and planes!). And Zuckerberg can use booming Facebook stock as currency to buy companies in a hotly contested industry acquisition boom.

And with 2013/early-2014 too reminiscent of Nasdaq 1999, one should not understate the role QE3 has played in stoking another historic Bubble and “arms race” throughout the broadly-defined “technology” sector. The mad dash for hits, clicks, likes, advertising dollars and revenues throughout “social media,” the “cloud,” 3D printing, solar, etc. even surpasses 1999 – whether the bulls are willing to admit as much or not. At this point, it’s a full-fledged mania (again).

It’s ironic – and I believe really important. The Bernanke Doctrine holds that the Fed’s printing press can basically guarantee a rising general price level. Meanwhile, QE1-3 liquidity has ensured that only more and bigger companies from Silicon Valley to China to “Hollywood” provide a virtually limitless supply of smartphones, computers, tablets and electronic gadgets, along with a plethora of downloadable content and services. Throughout the markets and the real economy, it’s all leading to unusual price instabilities (which the Fed is expected to counter – of course, with only more QE).

As much as it is reminiscent of the late-nineties, the more apt comparison is to the Roaring Twenties. Major technological innovation throughout the 1920’s had unappreciated consequences on the economic structure and price dynamics more generally. Misunderstanding the forces behind the downward pressure on many prices, the Federal Reserve remained too highly accommodative for too long. In the process, the Fed harbored a prolonged period of deep economic maladjustment, while fostering a historic speculative financial Bubble.

From my reading of history, central banks must be especially diligent with respect to monetary stability (“money” and Credit) during periods of profound technological and financial innovation. Repeating mistakes from the Twenties, the Fed and global central bankers have again done the exact opposite (for a long time now).

From my perspective, the downward pressure on the general consumer price level has been exacerbated by QE3. But this is foremost a “supply” issue as opposed to “deflation.” And as much as the Fed speaks of its 2% inflation “mandate” – and as much as the markets assume this mandate will eventually justify QE4 – low inflation should be recognized at this point as predominantly a global issue. The Fed and its now grossly bloated balance sheet do not - and will not - control CPI.

Surprisingly, there is little insightful discussion on an issue of such critical importance. As such, I found interesting comments this week from Mario Draghi worthy of highlighting below.

Question: “To what extent do you (the ECB) have a symmetric (inflation) target and, if so, why not act now to achieve the inflation target of 2.0%?”

ECB President Mario Draghi (speaking Wednesday in Paris): “I actually claim that our targets remain symmetric. The question we should ask is not (about) immediate inflation or immediate low inflation, but a medium-term assessment of inflation. And we should ask which factors are causing inflation to be low. And if we do this exercise we will discover that a great percentage of the factors that keep inflation low don’t have to do with our own euro-area economy. Consider for example, the inflation rate in July 2012 – that was 1.9% and now its 0.7% in the latest data. Two-thirds of that decline is due to the price of energy. Another way to look at this is the appreciation of the exchange rate. That by itself impinges on inflation by between 0.4% and 0.5%. Also, when you look at exactly why is inflation low in the euro-area you see that a good deal – if you exclude energy, taxes and food prices - you see that a good deal of the decline in core inflation has taken place in the so-called stressed countries. Which makes you think that it’s actually a relative price adjustment. Because in these countries’ prices were out of balance – out of equilibrium and clearly these countries had huge imbalances. And we can see the results of this because the so-called stressed countries now are actually showing current account surpluses, trade surpluses and much better economies. So some of this rebalance is taking place. Also let me add, that if you put this in perspective, you see that inflation is actually low globally. In the United States, in spite of the fact they are well more advanced than we are in their recovery, inflation… was not different from what it was in the euro-area three or four months ago. And not to mention Japan of course – or other parts (of the world), even the UK now is low. So, like one of my colleagues said, if you see that demand goes up and price goes down, that is not demand but it’s supply (dictating price). And so the concern for this assessment in the medium-term is different from what it would be if it were an inflation generated by demand factors… But again, you ask us the question “do we have any evidence that people are actually postponing their spending plans with a view to buy the same commodities at lower prices later on” – which is the definition of deflation. We don’t see any evidence of that. When we look at the percentage of commodities that (have seen prices) grow at or less than 1% or even decline… we see that the percentages, even in some stressed countries, are way lower than what they were in Japan, for example the late nineties and into 2000. So right now, we think the risks of having deflation are limited. That we have a medium-term assessment. In both cases, both if inflation were too high or were too low, we’d have to charge it through our medium-term. It would not be an instant decision.”