Tag: QE

The Stock Market’s Embarrassing Fall after the Fed Reneged on the Taper

Unlike nearly everyone else, I have argued that the Fed’s latest round of “quantitative easing” is not why stock prices went up until recently, and that “tapering” Fed bond purchases would have had only a negligible effect on long-term interest rates.   

This was a testable hypothesis. If I was wrong, the Fed’s unexpected decision to back away from its previously-expected tapering of bond purchases would have been greeted by a significant, sustained rally in stock and bond prices. That didn’t happen. Instead, stocks fell for at least five days in a row and bond yields barely budged until stocks swooned (triggering a modest flight toward safe havens).

Before the Federal Reserve’s “surprise” at 2 p.m. on Wednesday September 18, nearly every financial reporter was confident the yield on 10-year Treasuries had increased to 2.86 percent from 1.66 percent in early May, simply because Fed officials hinted in May that they might begin to slow the pace of bond-buying by September. If that story had been true, we should have expected bond yields to retrace most of their rise as soon as the Fed removed that fear of the taper. Instead, the 10-year bond yield ended the week of the Fed announcement at 2.75 percent – no lower than the average yield in August (2.74) and merely a trivial 11 basis points lower  than the day before the Fed’s surprise.

Financial analysts and reporters were likewise certain the stock market had been terrified about the possible taper before September 18. If that was true, stocks should have soared for days or weeks on the supposedly terrific news that a taper was off the table. On the contrary, U.S. stocks were rising briskly for many days before the Fed meeting, but have since fallen persistently. A few hours of speculative stock gains on Wednesday the 18th were more than erased by Friday the 20th and stocks kept falling the following Monday, Tuesday and Wednesday.

Reporters and analysts who claimed stocks had been shored up by quantitative easing were logically obligated to expect a stock boom from the Fed’s message of no change. When stocks instead moved in the wrong direction, baffled reporters tried to blame their bad forecasts on mysterious “uncertainties” about the taper although there is obviously less uncertainty now than before.

Anyone who bases investment decisions on trendy theories that fail to predict what actually happens is either a poor journalist or a poor investor who pays undue attention to poor journalists. The market’s thumbs down vote on the Fed’s gutless decision to stick with quantitative easing provides added evidence that QE never helped stocks or the economy, and that ending such an obviously unsustainable policy will one day be welcomed as the good news that it really will be.

The Federal Reserve vs. Small Business

Given all the attention that the Federal Reserve has garnered for its monetary “stimulus” programs, it’s perplexing to many that the U.S. has been mired in a credit crunch. After all, conventional wisdom tells us that the Fed’s policies, which have lowered interest rates to almost zero, should have stimulated the creation of credit. This has not been the case, and I’m not surprised.

As it turns out, the Fed’s “stimulus” policies are actually exacerbating the credit crunch. Since credit is a source of working capital for businesses, a credit crunch acts like a supply constraint on the economy. This has been the case particularly for smaller firms in the U.S. economy, known as small and medium enterprises (“SMEs”).

To understand the problem, we must delve into the plumbing of the financial system, specifically the loan markets. Retail bank lending involves making risky forward commitments, such as extending a line of credit to a corporate client, for example. The willingness of a bank to make such forward commitments depends, to a large extent, on a well-functioning interbank market – a market operating with positive interest rates and without counterparty risks.

With the availability of such a market, banks can lend to their clients with confidence because they can cover their commitments by bidding for funds in the wholesale interbank market.

At present, however, the interbank lending market is not functioning as it should. Indeed, one of the major problems facing the interbank market is the so-called zero-interest-rate trap. In a world in which the risk-free Fed funds rate is close to zero, there is virtually no yield be found on the interbank market.

In consequence, banks with excess reserves are reluctant to part with them for virtually no yield in the interbank market. As a result, thanks to the Fed’s zero-interest-rate policies, the interbank market has dried up (see the accompanying chart).

 

Without the security provided by a reliable interbank lending market, banks have been unwilling to scale up or even retain their forward loan commitments. This was verified in a recent article in Central Banking Journal by Stanford Economist Prof. Ronald McKinnon – appropriately titled “Fed ‘stimulus’ chokes indirect finance to SMEs.” The result, as Prof. McKinnon puts it, has been “constipation in domestic financial intermediation” – in other words, a credit crunch.

When banks put the brakes on lending, it is small and medium enterprises that are the hardest hit. Whereas large corporate firms can raise funds directly from the market, SMEs are often primarily reliant on bank lending for working capital. The current drought in the interbank market, and associated credit crunch, has thus left many SMEs without a consistent source of funding.

As it turns out, these “small” businesses make up a big chunk of the U.S. economy – 49.2% of private sector employment and 46% of private-sector GDP. Indeed, the untold story is that the zero-interest-rate trap has left SMEs in a financial straightjacket.

In short, the Fed’s zero interest-rate policy has exacerbated a credit crunch that has been holding back the economy. The only way out of this trap is for the Fed to abandon the conventional wisdom that zero-interest-rates stimulate the creation of credit. Suppose the Fed were to raise the Fed funds rate to, say, two percent. This would loosen the screws on interbank lending, and credit would begin to flow more readily to small and medium enterprises.

How to Increase the Money Supply, Without Increasing the Government’s Debt

In my August 2012 Globe Asia column, “Money, Where’s the Money?”, I explained why the global economy is still sputtering, and proposed a partial solution. In short, I called for governments (not central banks) to engage in debt market operations – a way to increase the money supply directly, without increasing the overall level of government debt. A number of readers have since contacted me with questions about the specific example I discussed in my column. The most frequent question was:

“Isn’t your proposal just the same as the Fed’s Operation Twist, where the Fed purchases long-term government securities from the public and increases high-powered money?”

The answer is, in short, no – and here’s why:

The first thing that should be noted is that both a central bank and a government can conduct debt market operations. Debt market operations constitute either central bank, or government, transactions with non-banks, which change the bank deposits held by those non-banks. There are many combinations of such operations that can be employed, but with all debt market operations of the type I am envisioning, long-dated debt is replaced with short-dated debt (and so, in one sense, there would be some similarity with Operation Twist).

In my Globe Asia example, however, the government would conduct the debt market operations with no involvement by the central bank. The government would borrow from private banks and purchase outstanding long-dated government debt from the public, and then cancel the debt that had been purchased. The result would be an increase in the money supply, with no change in the monetary base. If the government were instead to borrow from the central bank, both base money and broad money would increase – a fundamental difference.

The central bank could engage directly in debt market operations (and several have done so in recent QE operations). But, in this case, the long-dated bonds purchased by the central bank would end up on the central bank’s balance sheet. The debt would not be canceled out, as it would be if the government was to conduct debt market operations. It is this fact that defines one of the fundamental differences between debt market operations conducted by a central bank and those conducted by a government. A central bank engaged in debt market operations would be left with holdings of long-dated government debt and be exposed to interest rate risk on those securities. It could incur large accounting losses if interest rates were to rise. This would not be the case if the government conducted debt market operations.