The Fed Is Likely Stuck With QE
June 27, 2013
(This item originally appeared at Forbes.com on June 27, 2013.)
Usually, when a government starts financing itself with the printing press, it finds it mightily difficult to stop, even if there is some will to do so.
The notion that the Fed will continue with QE forever is not tenable, on an intellectual basis; thus, it must stop. With asset markets getting rather bubbly from a valuation perspective (particularly credit markets), Ben Bernanke suggested that the Fed would indeed reduce its bond-buying, and perhaps cease it altogether sometime in mid-2014.
This caused a pullback in equities. But, much more importantly, it caused a mini-crash in U.S. Treasury bond prices, which rose about 100bps from bottom to top in May and June. This alone, due to the leveraged nature of bank balance sheets, the mountains of derivatives (especially interest rate swaps) based on Treasury yields, and the use of Treasury bonds as collateral for all sorts of lending, may have led to substantial destabilization of several major banks in June.
At the same time, mortgage rates made an even larger jump higher, brushing the 5.0% level for 30-year fixed mortgages. This shuts down any advantage from refinancing, makes home purchases substantially more difficult, and also makes present valuations in many markets once again rather suspect.
Simply suggesting the possible end of QE – an idea rather tame in itself – caused the conditions that justified further continuation of QE.
For now, Wall Street is probably pretty happy with that. The first reaction toward the suggestion of a “taper delay,” in other words, more QE for longer, will probably be some recovery in both stock and bond prices.
The U.S. economy has been on a gentle slope of deterioration, which may accelerate if asset markets stumble and mortgage rates remain at relatively elevated levels.
Elsewhere, both Europe and Japan are becoming increasingly troublesome. Sovereign bond yields in Europe, which cooled off last autumn, have been rising back toward crisis levels – no surprise, since the last nine months have proven that nothing in Spain, Italy, and elsewhere is getting any better. China, for a while a bulwark of stability, may have begun a hot crisis in the financial sphere. Places like Brazil and Turkey are seething with civil unrest.
In Britain, a new Bank of England governor promises more “easy money” – yes, a reignition of QE there too – to solve difficult problems. Japan’s latest QE is turbo-printing mania, at a pace (relative to GDP) three times as large as the Fed’s present program. With the JGB market persistently unsettled, the prospects of Japan backing off its QE agenda are also less likely, as that might precipitate a bond crash there that would make the recent rise in Treasury yields look like a speedbump. The ECB might be pressed into making good on its promise to buy up troubled sovereign debt if necessary. It’s looking more necessary.
“Austerity” in Europe has been largely abandoned, and the United States will not likely trouble itself much more with such things either. Politically, the drift is back towards “stimulus,” though leaning more toward the monetary sort as governments’ borrowing capacities have been depleted worldwide.
In other words, the rest of the world is not only drifting toward more (not less) QE itself, but the implications of all of this for the U.S. is also – more problems, and thus more QE for longer.
One of the problems with Keynesianism in general is “the ratchet.” The government spends a lot of money to supposedly get the economy going. This is inevitably disappointing, but enough effects are felt – and enough money was spread among the political cronies – that the program seems justified. Now, the government must not only maintain its pace of spending, but increase it, lest it supposedly suffer a “fiscal contraction.”
We are beginning to see the QE ratchet. The U.S. economy is disappointing, but enough benefits have seemed apparent from very low interest rates that allowing rates to rise back to what are actually still very low levels seems unacceptable.
Remember the “exit strategy”? It was a topic of discussion in 2010. The idea that the Fed could continue what it had been doing for a long period of time seemed intellectually untenable then too. Three years later, not only has there been no exit, but the Fed is in deeper than ever.
We will have continuous talk of the “taper,” “exit,” or whatever new buzzword is brought out when the old ones become noticeably worn. The notion that the Fed could just keep going will continue to seem implausible, even as that is what actually happens. A hot crisis in banks, perhaps later this year, might even turn the “taper” into the “ramp” as the QE spigots open wider.
The first reaction would probably be giddy enthusiasm, just as it was earlier this year in Japan when their QE afterburners kicked in and slammed everyone back into their seats with smiles on their faces.
Perhaps it will not work out that way. I could be wrong. But, that is what has happened to many governments in the past, and today seems to me no exception.