To taper or not to taper, that is the question!

The Federal Reserve surprised almost all of the market participants last week by deciding to maintain its current pace of asset purchases, at $85 billion per month, rather than "taper".  Having guided the market in May to believe, that it will commence its taper by reducing its bond buying program later in the year, its last week’s decision to carry on with its current bond buying program unchanged threw the markets into turmoil.

So what led to this dichotomy in expectations vs. reality?

Earlier in the year, in May 2013, Ben Bernanke guided the market that FED will commence to wind up the QE as and when the unemployment rate falls to 7 percent, with the expectation that that this might happen by mid-2014.  FOMC members repeated those details in speeches, some emphasizing "as early as September."

When the unemployment rate fell in August to 7.3 percent, not far from the threshold and with no caution from the Fed, the die was cast for “Septaper”, as far as markets were concerned.  As a result of the earlier guidance, the market interest rates started to rise in expectation of tighter money conditions with 10 year UST’s yield rising by almost 90bps over this period, in the process impacting economic activity, including home buying.

So when the FED announced on September 19, 2013 to keep its bond buying program unchanged, it caught market participants wrong footed and caused significant volatility in the global financial markets.  Asian equities, Emerging Market currencies and bonds rallied strongly while the UST’s and bonds bled with US equities recording a very modest change.

So, why did the FED decide to delay the taper?

To be fair to Bernanke, he did say that any decision to taper has to be backed by data confirming steady gains in the economy, in particular continued job growth and labour market strength.

Looking a bit deeper in to the data, there are 5 good reasons why the FED decided against the taper:

1.       Unemployment rate is misleading

The unemployment rate continued to fall, aided by reductions in the labour-force participation rate. As Mr Bernanke indicated last week, the Fed sees the unemployment rate as an incomplete measure of labour-market health. Guidance that QE3 would be complete roughly when the unemployment rate touches 7% seems no longer a good idea.

Fed has now declared that rates will stay low until unemployment is down to at least 6.5%, it may in fact leave rates low as unemployment falls well below that figure, so long as inflation remains in check. The current GDP growth rate of 2% is not strong enough for a sustained improvement in the labour market conditions.

2.       Payroll trends weakened during the summer

When Fed began to indicate its taper program the economy, was consistently adding jobs at a rate of about 200,000 per month. But subsequent reports revised down spring job gains and showed much weaker hiring over the summer. It has therefore reacted to the weakening job growth despite its earlier use of unemployment-rate thresholds as guideposts.

This has led many to argue that the Fed is losing its credibility. In my view, it’s far more important to do the right thing for the economy than being popular or pursue populist actions. Fed needs to be comfortable backing off guidance if it isn't likely to achieve its dual mandate. However, it’s communication of forward guidance to the market needs to get better.

3.       Inflation is trending below target

The FED Chairman considered that an inflation floor might be a useful thing to add to forward guidance. Depending on where the floor is set that could be an extraordinarily important development. The big failing of the forward guidance so far has been that it is entirely consistent with continued stagnation: saying rates will stay low until a particular unemployment threshold is met does not rule out stagnation, high unemployment, and low rates forever (e.g. Japan). An inflation floor, if set high enough, changes that by demanding additional action if the economy is not on pace to close the gap. A temporary inflation floor of around 2% would be a consistent with an intended normal growth rate for the economy.

4.       Fiscal cliff and Debt ceiling debates looming in the horizon

The Fed is rightfully worried that the "fiscal cliff" could seriously harm the American economy. Unfortunately politics is influencing monetary policy.  There is a strong possibility of a deadlock in debt ceiling negotiations potentially leading to government shutdown, Sequester causing deeper impact and a prolonged debt-ceiling discussion. The Fed has erred on the side of caution and has taken the approach of better-safe-than-sorry for now. 

5.       The Housing recovery has paused

Figures in 000s

The real estate sector has contributed close to 1/3^rd of the GDP growth rate.  Recent data is indicating slowdown in housing activity as a result of the interest rate increases over the past few months. FED has an eye on the long term interest rates to ensure Mortgage interest rates do not spike up threatening the economic recovery.

The continued strength in the housing sector is critical for both labour market recovery and strong economic growth.

Is QE damaging?

The biggest argument made against QE when it started was that money-printing would necessarily lead to inflation. Surprisingly, that has not happened yet, and in any case, benefits of continuing the QE in for sustaining the economic growth is arguable.  However, the policy has painful side-effects, which is why the Fed wants to exit, albeit gradually with minimal market disruptions. Some of the unintended consequences of QE are:

Poor capital allocation and increased systemic risk

Lower rates, driven by QE, make it easier for inefficient companies to prolong its existence. This means that inefficient enterprises continue to receive credit resulting in poor capital allocation.  As the chase for higher yield spreads, risks to the financial system are increased manifold.

Asset price bubbles

Low interest rates will inevitably lead to asset price bubbles as buyers’ tend to take bigger mortgages driving the demand for housing further leading to the creation of conditions of next cycle of defaults as interest rates rise.

Currency volatility

QE has resulted in large scale capital flows into emerging economies resulting in significant credit expansion in some of these emerging markets.  The announcement of taper demonstrated its impact on some of these emerging economies causing significant currency and capital markets volatility.

Structural reforms take a back seat

QE also helps governments avoid necessary structural adjustments. Taper talk, starting in May, contributed to a sharp run on several emerging market currencies, with those of India, Turkey, Indonesia and Brazil prominent among them.

The market impact was focused on those countries that had fundamental problems, in the form of high current account and fiscal account deficits. This was not solely an issue of an indiscriminate shift in financial flows. The postponement of tapering raises the risk that adjustment will be painful when the end of QE finally comes.

Pensioners and savers suffer

By reducing bond yields, QE impacts the returns for pension funds. Any situation where many pension funds remain far short of meeting their commitments is undesirable. Senior citizens relying on fixed income from investment in bonds continue to suffer.  There has been a massive amount of wealth transfer from savers to borrowers resulting in perverse incentives.  The sooner the QE ends the better it is.

SUMMARY

On balance, the FED’s decision to delay the taper at this point seems well founded.

However, improved forward guidance is desirable in order to avoid the gyrations in markets that resulted from the taper talk. The Fed did reckon that those gyrations and the rise in bond yields in particular, were damaging enough to warrant an action —through the choice not to taper.

The FED is rightfully focussed on achieving sustained labour market improvement as full employment will perk up wage growth, which is the kind of inflation the economy would do well with. A period of strong wage growth and higher labour participation rate will be the reassuring signs the Fed needs before allowing rates to rise.

As Bernanke hands over the mantle to the next FED Chairman in January 2014, it is highly unlikely that FED will make a move until Q1/2014 with its taper.  Even otherwise, the underlying data have to supportive for a move and the following factors will determine the timing the taper:

·         Unemployment rate to fall below 7%;

·         A rise in labour participation rate;

·         Inflation expectations above 2.5% p.a. driven by wage pressures;

·         GDP growth rate > 2.5% p.a.

So, in the final analysis, to taper or not to taper will depend on a combination of factors listed above and data is not likely to improve over the next few months on all fronts. 

The precise timing of the taper is a $42 question.  As 42 is the answer to the Ultimate Question of 'Life, the Universe, and Everything'!!!  [If you believe The Hitchhiker’s Guide to the Galaxy J].

The brave new world of QE Infinity….

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“If the only tool you have is a hammer, every problem looks like a nail”! Abraham Maslow. 

That may well sum up the current predicament of Bernanke and many of his counterparts in Europe with interest rates at record low for about four years now.

After launching Quantitative Easing 1 (known as QE1) of US$1.65trillion and QE2 of US$600bn, to stave off deflation, Fed has now launched QE Infinity to boost employment. It has committed to buy $40bn of agency mortgage-backed securities every month until the labour market improves. An open ended commitment (as he has not been specific on unemployment targets) besides promising to hold the ultra-low rates until mid-2015.

It signals that he is prepared to hold an accommodative policy stance even if economy gains strength and has moved away from the deflation argument. But before we get to analyse the merits and effectiveness of QE Infinity, let’s understand the theory of behind benefits of QE and why some economists seem to worship it.

How does QE work?

QE is an unconventional emergency tool of monetary policy that the Central Banks can use to boost the economy by pumping liquidity into the system. The Central Bank generates fresh amounts of electronic money to encourage lending to businesses. Specifically, the Bank buys assets like Government and corporate bonds with its new cash. The companies selling those assets - usually commercial banks or other financial businesses such as insurance companies - will then have new money in their accounts, which in turn should feed into the wider economy. 

Central banks create money to buy government, and sometimes corporate, bonds, for three main reasons:

• To reduce the cost of borrowing - buying government bonds increases their price and lowers their yield, which in turn puts downward pressure on interest rates across the spectrum;
• To inflate asset prices - with bonds paying out lower interest rates, investors look to buy other asset classes, such as equities, real estate thereby pushing prices up;
• To increase lending - by paying money to banks to buy bonds, the banks then have more money to lend to businesses and individuals.

In theory if QE works, credit growth should pick up and businesses should find it easier to get credit.

How is this different from actions of the 1920s Germany and Mugabe’s Zimbabwe?

Weimar Republic (German Reich) resorted to printing money to finance government debt and war reparation damages. The value of the Papiermark declined from 4.2 per U.S. dollar at the outbreak of World War I to 1 million per dollar by August 1923 and a further slid to 238 million to dollar by November 1923. Following this, new terms were negotiated, a new currency was introduced, at a rate of 1 trillion Papiermark for one Rentenmark, bringing back the US Dollar to 4.2 to a Rentenmark!

More recent actions of printing money were undertaken in Mugabe’s Zimbabwe. In 1980, Zim dollar was worth US$ 1.54. In March 2007, the Z$ 500,000-note was issued, signalling the official arrival of hyperinflation (more than 50% inflation per month). In January, 2009, Zimbabwe issued the one-hundred-trillion Zim dollar note, the largest denomination banknote ever!! It marked the end of the currency. In February 2009, the Reserve Bank of Zimbabwe introduced the fourth Zim dollar, which chopped off 12 zeros. Finally in 2009 the currency was abandoned, a humiliating end.

In contrast the US and the UK are buying asset backed securities and government bonds.  To the extent banks are required to hold government bonds as regulatory liquidity requirements, Central Banks buying of bonds indirectly feeds the government deficit financing, very similar to printing money!

Has it ever worked ?

No. Let's look at Japan’s lost decade(s) - After keeping rates near zero for an extended period, the Bank of Japan finally launched QE in March 2001 and dropped in March 2006. Over the five years, the Bank of Japan increased its outright purchases of longer-dated Japanese government securities driving the call-money rates to zero. The policy helped to stabilise the weak banks but failed to spur growth.

At first, it appeared the program had succeeded in stabilizing the economy and halting the slide in prices. But deflation returned with a vengeance, putting the Bank of Japan back on the spot. Critics say the Japanese central bank wasn't aggressive enough in launching and expanding its bond-buying program—then dropped it too soon. Others say Japan simply waited too long to resort to the policy.

BOJ officials have said quantitative easing wasn't the right tool to fight Japan's deflation, which was rooted in structural problems such as a rigid employment system that failed to eliminate redundant jobs to stay competitive.

Some economists support QE as the right medicine, then why doesn’t it work?

The arguments for QE are based on money multiplier effect. As the available reserves increases, banks ability to lend increases, creating the money multiplier effect leading to economic recovery.  But for this to work economic conditions needs to be different!

Factors that are NOT aiding monetary transmission or lending growth:

1. Banks are over leveraged and capital deficient; additional cheap source of liquidity is helping it to refinance expensive funding and improve profitability; but very little flow through to the real economy;
2. Interest rates have remained low for 4 years and yet demand has been muted, further QE is not going to spur demand;
3. Over leveraged consumer, weak labour market combined with declining home prices have failed to create any new housing demand;
4. Small business are not looking to borrow due to the uncertain economic outlook;
5. Large corporations will borrow more at even lower rates — even though they’re already sitting on mountains of cash.

But such large corporation borrowing won’t create new jobs and may even lead to job losses as they invest their cheaper cash to achieve further economies through mergers and acquisitions. QE1 reduced corporate-borrowing rates by nearly a percentage point; while QE2 succeeded in bringing down corporate rates by only 13 basis points. The law of diminishing returns come into play.

Banks have increased their reserves with the Central Bank rather than use the proceeds of QE for further lending. The average level of excess reserves for banks was roughly $19 billion from 1984 to 2008.  

Since 2008 excess reserves held at banks has swelled to more than $1.5 trillion currently!! As explained earlier, this is due to the combination of lack of demand for credit and overstretched balance sheet of banks.

While the pending inventory has dropped to pre-crisis levels of 6 months, this conceals the housing market weakness as the effects of foreclosure moratorium and pending foreclosures on home owners (estimated at 700,000) is not reflected in this. The average time take to foreclose has also increased from 4 months in to over 12 months. 

Once banks recommence their foreclosure process, the supply overhang will continue. This combined with lack of credit growth will push the housing market recovery further out. 

Quantitative easing didn’t help the Japanese economy, instead it only big Japanese companies and the current experience will be no different.

Do QE programmes have any effect on employment…

The chart shows net gains in employment since beginning of 2009 as compared to the number of individuals that have moved into the "Not In Labor Force" category where they are no longer counted. While there was an increase of 3.4 million jobs since the financial crisis, that is far lower for a sustainable economic recovery.  At the same time, more that 8.4 million have either "given up" or "retired" during that period. The decline in unemployment rate to 8.3% is partly as a result of a fall in workforce participation.

There is NO evidence that bond buying programs have any effect on fostering employment. However, at the current rate of individuals leaving the work force, Bernanke is likely to achieve low unemployment rate in the next few of years!  Of course, economic prosperity will have deteriorated much further as the rise of the "welfare state" persists.

The charts below show the number of individuals, since 2009, who are now claiming disability and food stamps and the increase in welfare costs.

If core inflation is benign, what is the harm in pursuing QE?

The Federal Reserve claims QE is not a problem because "core inflation" has been relatively contained. But core inflation excludes food and energy prices, which are two of the biggest components of consumer budgets and have been rising. On top of that, the average US household income has declined by over 9% since the onset of recession. As a result, food and energy consume more of wages and salaries it leaves less available for consumption within other areas of the economy. The chart below shows the consumer conundrum where declining wages meet up with rising costs of food and energy. With recent severe drought in the US food prices will only rise further. Of course, the USD benefits from its status as a reserve currency that offsets potentially severe outcomes.

 

The important point is that for businesses to hire require an increase in aggregate end demand. Rising inflationary pressures in food and energy prices only act as depressants to discretionary consumption thereby reducing the need for employers to expand capacity.  It is unlikely that the Fed's purchases of mortgage back securities will spur businesses to expand.  The inflation expectation has also risen above 2 per cent and there is little justification for additional QE at this point.

Conclusion

While QE will push liquidity into the equity markets thereby inducing higher asset prices - it will do little to help the economy, employment or housing.  Money will chase anything that is perceived as a “hard asset.” Industrial metals have already risen by 16.6 per cent since early August. The S&P is near all time highs, but if viewed in terms of gold it is 61 per cent below its 2007 high. Fed is engaged in debasing the dollar and this leading to competitive devaluation from other Central Banks (Japan has reacted). 

Monetary policy has a very limited reach economically and cannot be a substitute for fiscal policy measures that are required to promote economic growth.  

With the consumer sentiment weak, unemployment high, foreclosures and delinquencies still burdensome, and businesses constrained by lack of demand - there is little desire or need and even if there was, the banks are too constrained to lend.  This is unlikely to change anytime soon even as businesses are forced to pullback as demand is further reduced by rising inflationary pressures.

The lack of employment, lower incomes, excess debt and poor credit history will keep a large chunk of the population from qualifying to avail a mortgage for quite some time.  If the lowest mortgage rates in history could not lead a housing market recovery, there is little likelihood that a few more basis points will do the trick.

With QE Infinity, Bernanke is determined to pump up the US economy, full throttle. Be prepared for the next asset bubble burst, only this time it’s going to be a lot bigger and a lot more painful!