"Last week, a number of Fed officials came out in tandem with essentially the same message - the Fed's policy of quantitative easing is likely to end with QE2. It's important to think carefully about the implications of this for the markets. My impression is that investors are still in something of a "momentum" mentality both with respect to the market and the overall economy, and it's not clear that they've pieced out the extent to which this has been reliant on various stimulus measures that are now drawing to a close.
It is clear that the effect of QE2 has not been to lower interest rates, or to materially expand credit. Rather, QE2 has been built on two blunt forces. The first is that increasing the stock of non-interest bearing money in the economy toward $2.4 trillion, all of which has to be held by somebody, the Fed has created a market environment that has raised the prices and lowered the returns on all competing assets in order to accommodate that equilibrium. As asset prices are bid up, their expected future returns fall, and the process stops at the point where on a risk-adjusted basis, no asset is expected to achieve returns that compete meaningfully with cash (at least over some horizon of say, a year or two). The second force has been purely rhetorical. The opening salvo in QE2 was Bernanke's public endorsement of risk-taking in the Washington Post. Strikingly, he has seemed to eagerly take credit for the speculation in the stock market, particularly in small cap stocks, while denying any culpability for the commodity hoarding and dollar weakness that predictably results from driving real short-term interest rates to negative levels.
In our view, quantitative easing has been a reckless policy, not only because it has fueled what Dallas Fed president Richard Fisher calls "extraordinary speculative activity," but because aside from a burst of short-term optimism, the historical evidence is clear that fluctuations in stock prices have very little impact on real spending (the so-called wealth effect is on the order of 0.03-0.05% for every 1% change in stock prices). People consume off of perceived permanent income, not off of fluctuations in the prices of volatile assets. Now, it's true that QE2 has probably been good for a fraction of 1% in additional GDP, which should be sustained over a period of a year or two, and though we haven't observed real activity or actual industrial production that matches the optimism of survey-based measures such as the ISM indices, it's clear that some pent-up demand was released. Still, the links between monetary base expansion, stock values, and GDP growth are tenuous at best. The most predictable outcome was commodity hoarding, where our expectations have been fully realized, with awful consequences for the world's poor, not to mention for geopolitical stability.
So for our part, we'd be happy to see the termination of QE simply because it is misguided, reckless policy. In contrast, most of the Fed officials pulling back on their enthusiasm for QE argue along the lines that "the economy is strong enough now to do without it," which is unfortunate because it leaves the door open to continue this sort of lunacy should the economy weaken again. A few quotations from various Fed officials last week:
Charles Evans (Chicago Fed) "Following through on that to the tune of $600 billion, like we've said, I think is appropriate. I personally don't see as many needs for a further amount, as I probably thought last fall."
James Bullard (St. Louis Fed): "The economy is looking pretty good. It is still reasonable to review QE2 in the coming meetings, especially this April meeting, and see if we want to decide to finish the program or to stop a little bit short."
Charles Plosser (Philadelphia Fed): " If this forecast is broadly accurate, then monetary policy will have to reverse course in the not-too-distant future and begin to remove the massive amount of accommodation it has supplied to the economy. Failure to do so in a timely manner could have serious consequences for inflation and economic stability in the future. I don't think that is necessarily imminent, but we have to be very careful we don't get behind the curve. I worry about us getting behind the curve. "
Richard Fisher (Dallas Fed): "In essence what we have done as a central bank is to monetize the entire US debt through the end of June. Had I been a voter last year, which I am this year, I would have joined Hoenig and would have voted against what is known as QE2. In my opinion, no further accommodation is needed after June -- either by tapering off the bottom of the purchases of Treasuries, or by adding another tranche of purchases outright. In my view it is unlikely that we will have or need more accommodation by the central bank. I think we've done our job."
While the possibility of ending QE2 early may come up in the FOMC's April meeting, I doubt that the Fed will stop short. Regardless of the lack of meaningful "wealth effect" from stocks to GDP in the historical data, it's clear that Bernanke views a speculative stock market as a good thing, and my impression is that he would consider the risk of disappointing the markets as too great. Instead, the Fed will have enough on its hands simply removing the expectation of the market for QE3, not to mention telegraphing the potential for the Fed to eventually reverse course.
Still, barring a surprise early-conclusion to QE2, there are two important issues for the market as we look ahead to gradual changes in Fed policy.
First, what happens when QE2 is complete? From our standpoint, it is incontrovertible that the primary factor behind the market's recent advance has been speculation based on the belief, explicitly encouraged by Bernanke, that the Fed would provide a backstop for risk-taking. Investors clearly took Bernanke at his word. But without yet another round of QE, not to mention the potential for an unwinding of existing QE, a decline in speculative enthusiasm will likely have the identical effect as an increase in risk aversion.
Second, how likely is it that economic growth will be successfully "handed off" to the private sector as fiscal policy tightens and monetary policy becomes less aggressive? It is clear that the economy is enjoying some surface economic progress - the most notable being a gradual drop in new claims for unemployment. But the real fiscal "cliff" for states and municipalities doesn't hit until about mid-year, which is the same time that QE2 comes off. What we're observing at present is decidedly still fiscal- and monetary-induced growth. It is not enough that the data have improved gradually. The real question is whether it would have, or will, improve without that stimulus.
My intent is not to argue strongly that the economy cannot continue to expand as fiscal and monetary stimulus comes off, but instead to at least ask why this should be expected as a foregone conclusion. On the basis of leading indices of economic activity, we observe more indications of economic slowing worldwide than we observe growth. Moreover, strong periods of employment growth have historically been preceded by high, not low, real interest rates. This is far from a perfect relationship, but it is clear that historically, high real interest rates are far more indicative of strong demand for credit, new investment, and new employment than low real interest rates are."
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