The Federal Reserve has just announced that it will continue its policy of purchasing $85 billion worth of mortgage backed securities and Treasury securities each month. Perhaps I was too optimistic but I was expecting the Fed to announce the ‘tapering’ that Bernanke had mentioned last June to begin by the end of this year.
I am still shocked and unable to understand how the Fed can believe that maintaining rates so low will help the current economic climate. The experiment that is Quantitative Easing is very much that – an experiment, that as Bernanke states, is “a different kind of thing”, an “unconventional policy” that comes “with certain risks and certain uncertainties”.
In my effort to better understand how Bernanke & Co. feels that QE makes sense, I want to ponder some of the effects of such on the economy and the markets. But before doing that I just want make sure that QE is broken down into it’s most simplest explanation – a program by the Federal Reserve to print money and to use that money to purchase debt securities in order to keep interest rates at near zero.
Saving & Investment
In a normal economy, there are folks who save and invest and there are folks who borrow and spend. A normal economy needs a healthy balance of both savers and borrowers. An economy with too many savers would push interest rates down as savers compete to lend their cash to the few who want to borrow. An economy with too many borrowers would push interest rates up because the smaller pool of savers with capital to lend would have more folks competing to borrow.
The stock of money in the market is not fixed and thus a change in the stock of money has a subsequent effect on the value of each dollar – hence the mechanics of how the Fed affects interest rates. So when the Fed increases the stock of money by printing more dollars they are essentially making the dollar cheaper.
As you can see from the chart above, the M2 Money Supply has been increasing at a rapid pace and has reached just under $11 trillion. Compare the M2 Money Supply with what has happened to the 1 Year Treasure rate, which was around 2.5% in 2008 and now hovers below 1% or near zero.
In a QE Economy savers are punished. The 1 Year Treasury Bill is considered the least riskiest asset that one can own. In fact, modern portfolio theory relies on the 1 Year Treasury, as does the Capital Asset Pricing Model (CAPM), for its ‘risk free rate’. What this means is that whereas savers once had the ability to put their cash into a very safe investment that would at least cover the cost of inflation now they must venture into riskier assets to make up for the fact that investing in 1 Year T-Bills will essentially provide a negative return after factoring in inflation. Since 2008 QE has presumably forced a massive shift in asset allocations as investors and savers search for yield.
Consumption & Debt
We all know that the U.S. economy is driven mostly by consumer spending – about 70% of GDP. My question is how much of that spending is done with extra cash in the average American’s pocket and how much is with that marvelous invention – the credit card?
The chart above shows something interesting, but still it is not something many of us did not already know – that since 2000 (the tech bubble) U.S. consumers have increasingly relied on debt to maintain their spending habits. It seems that not until 2008 (the depth of the last recession) did consumers finally begin to reduce their debts. The medium term trend for household debt looks promising – as it is finally converging with consumer spending where it seems to have historically been.
So what does this have to do with the Fed printing money and keeping interest rates low? Well, one has to ponder what might happen to consumer spending and household debt if easy money policies persist. We have seen this show before, do we really want a repeat?
It is interesting to note that while household debt is beginning to trend down, consumer spending growth is still relatively unchanged. How so? What is fueling this continued spending?
Well look at that! I thought household debt was trending down??? If you strip out the credit card debt from household debt what you have left is mostly mortgage debt. Looking only at credit card debt one can see that Americans have nearly doubled their credit card balances since 2000! I am not arguing that QE created this but I am confident that QE will only exacerbate it. QE is not only making it difficult to save but it is also creating a strong incentive for consumption based on debt. This sounds like a deck of cards that is waiting for its impending fall.
In short, I think QE is an experiment that could be one of the most massive Fed failures of all time. I think QE is distorting the global markets by artificially keeping the dollar cheap relative to foreign currencies, forcing large amounts of cash into emerging markets that may otherwise have stayed in the U.S., and driving values of alternative investments to levels that deserve ‘bubble’ discussions.
In short, I think that when the American consumer runs out of credit (I will let you ponder the ‘how’ on that) and all else has remained the same – flat wages and unemployment around 7% – U.S. GDP could take a major hit. That means that stocks (on the prospect of declining earnings) could take a major hit. That means that prices, which have been risen mercilessly for the average American consumer, could see a decline (read deflation). That means that the global economy, to the extent that it relies on the American consumer, could take a significant hit – something the E.U. really does not need right now.
So if you are one of those folks who has been ‘chasing returns’ for the last few years then I might reconsider if gold has much more value at its current price, or if the record prices many collector cars are bringing at recent auctions are warranted or if your emerging market holdings make sense when U.S. rates come back to normal territory.
If you don’t believe me, just take a look at what happened when Bernanke merely whispered the idea of an eventual slowdown (not termination) of QE last June. Emerging markets went into a frenzy.