“Of these effects, the first only is immediate; it manifests itself simultaneously with its cause — it is seen. The others unfold in succession — they are not seen…”
--- Frédéric Bastiat
Today, we are launching our global macroeconomics blog at Two Centuries Investments. Our focus will be events and developments with longer term implications, which are less visible, or that are not widely discussed by the financial media. We will also address questions which we receive from clients. Generally, our postings will be brief.
We will begin with a discussion of the recent actions by the Federal Reserve and the U.S. Treasury, in particular the expansion of Quantitative Easing (QE), the many programs authorized by the CARES Act and expansion of U.S. dollar swap lines. The Federal Reserve was responding to a trifecta of body blows to the global economy, namely
a demand shock,
a supply chain shock, and
a global shortage of U.S. dollars, which was exacerbated by a collapse of petrodollar recycling.
The immediate impact of the Fed’s actions is straightforward, namely a short-term boost to economic activity, a shot of liquidity to U.S. fixed income markets, and near-term price support for some fixed income assets. However, these near-term benefits are likely to have hidden costs, in other words, intermediate and long-term impacts that we cannot currently see.
This week, let’s begin with QE that started in 2008
What does QE mean for the Federal Reserve’s balance sheet?
It represents an expansion of the balance sheet beyond what is needed to keep up with growth of the economy.
LIABILITY: The Fed creates non-interest bearing cash and bank reserves.
ASSET: The Fed buys US Treasury securities (bills, notes and bonds) and mortgage backed securities (MBS) that has guarantees from GNMA, FNMA and FHLMC.
What is a simple way to think about QE? If it walks like a duck, and quacks like a duck…
It is an asset swap. The public was holding savings in one form (Treasuries, MBS), and now holds it in another form (cash).
with a caveat…
U.S. Government Spending
= Taxes + ΔTreasuries held by public + Δ Treasuries held by the Fed
Since the government is running a fiscal deficit, the effect of QE is to reduce the amount of debt that the public (includes non-US entities) would have to buy, so the Fed is effectively creating money and bank reserves to indirectly finance government spending.
Is QE unusual or unprecedented?
The Bank of Japan was the first major central bank to engage in QE. For one year, starting in October 1997, it bought commercial paper. In 2001, it started large scale QE. But the Fed’s actions are unprecedented in that Japan was supposed to be an outlier, because it had close to zero population growth at the time (now slightly negative), a strong anti-immigration mentality, a bias against women in the workforce, and a lower overall level of productivity due to massive underinvestment in the domestic non-manufacturing sector.
What is the Fed’s plan?
The Fed’s plan from the outset was to allow the Treasury securities and MBS to mature. The Fed reinvested the principal it received at maturity back into Treasury securities and MBS. The Fed recognized that once it slowed down its reinvestment program, it would pull currency out of the system and effectively begin the process of tightening monetary policy. The initial shrinking of its balance sheet would not be much of a tightening since the supply of currency was sufficient for the economy’s needs. Market forces of supply and demand would determine how much the Fed needed to shrink its balance sheet before short-term interest rates started to rise.
However, in December 2015, the Fed decided not to shrink its balance sheet. Instead it chose to raise the Fed Funds to 0.50% and the amount of interest it pays to banks on excess reserves, raising that rate to 0.50% too. The Fed also expanded its “reverse repurchase” facility to pay 0.25% to other institutions which also held cash and were not eligible to receive interest on reserves (i.e., GSEs, foreign banks, and money market funds). Over the next 4 years, the Fed raised the Fed Funds rate to 2.5%, halting increases in September 2019.
In 2018, the Fed decided to shrink its balance sheet, then at $4.5 trillion, by not reinvesting the proceeds of Treasury securities and MBS. In September 2019, it halted the balance sheet shrinkage at $3.8 billion.
Will QE continue forever? Can the Fed really do infinite financing? Where is the catch?
In theory, infinite financing is possible, as long a sufficient highly rated securities are available for purchase by the Fed. The Fed can keep buying Treasury debt until there is no more to buy, i.e., no more issuance and no more willing sellers among public holders. That is the constraint. The first risk to manifest itself, even before long term inflation risk, is likely to be secured financing problems, as the Fed will have removed the highest quality collateral for secured lending in financial and non-financial markets. Treasuries are not just used by hedge funds for leverage in financial markets, they also are used in the real economy to back derivative contracts and support trade finance.
What are the economic benefits of QE?
First and foremost, QE provided financial market liquidity during the 2008 financial crisis and allowed banks time to recapitalize, so that the risk of contagion further compounding in the real economy was mitigated. However, the data is more mixed with regard to the acceleration of economic growth and restoration of the labor market to its prior healthy state.
In the decade ending 2019, the U.S. economy experienced an average of 2.4% real GDP growth and 4% nominal GDP growth. Decent performance but not a big success in light of history, and certainly not at the level predicted by the Fed.
At first glance the unemployment decline to 3.5% (pre-COVID-19), the lowest level since 1968, points to success. However, labor market strength is more than low unemployment. The employment to population ratio is another measure of labor market strength. It peaked near 62.5% under President George W. Bush and 65% under President Bill Clinton. Recently, it topped out just above 61%. Yes, it started from a low base of around 58.5% in 2009. But the measure also declined to 57% in 1983 under President Ronald Reagan and rose almost 6% in the subsequent decade. In the recent decade the measure only rose less than 3%. In conclusion, the labor market improved, but it does not qualify as complete healing.
What were the initial impacts of QE on financial markets? What are the emerging impacts?
Someone has to hold the non-interest bearing cash and bank reserves that were created out of thin air. The first and most direct effect of QE was to drive the interest rate on cash substitutes towards zero. Think one month and three-month T-bills. Their price will rise, their yield will move towards zero.
QE has likely driven up the prices for longer term and riskier assets, like credit-oriented debt securities. equities and real estate. In other words, QE distorts market equilibrium and reduce the prospective returns on nearly every asset class, without changing the risk profile of the asset class.
Never ending QE provides incentive for economic entities and non-bank financial entities to increase financial leverage. Unless that leverage is used productively to sustainably increase return on invested capital (ROIC), it makes both the economic system and the financial system more fragile. The repo crisis in the Fall 2019 is an example of the fragility.
Commodity markets may also experience a boost over time. Inflation expectations are generally positive, as inflation has been positive for the last several decades, though this situation could conceivably change. If low risk fixed income securities are yielding near zero, interest earnings will not make up for higher prices of goods and services. In other words, purchasing power declines. People cannot easily pre-buy most goods and services, but they can buy many commodities, driving up their prices.
Counterintuitively, market liquidity may be reduced. The Fed views itself as providing liquidity. However, from another lens, market liquidity is enhanced when there are many buyers and many sellers, all with different viewpoints.
Next week, we will discuss the CARES Act, which raised the stakes and hints at the potential endgame for the economy and financial markets.