Bubble trouble

Is there an end to endless quantitative easing?

by DETLEV SCHLICHTER

The publication, earlier this week, of the Federal Reserve’s Federal Open Market Committee minutes of January 29-30 seemed to have a similar effect on equity markets as a call from room service to a Las Vegas hotel suite, informing the partying high-rollers that the hotel might be running out of Cristal Champagne.  Around the world, stocks sold off, and so did gold.

Here is the sentence that caused such consternation:

“However, many participants also expressed some concerns about potential costs and risks arising from further asset purchases (the Fed’s open-ended, $85 billion-a-month debt monetization program called ‘quantitative easing’, DS). Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behaviour that could undermine financial stability.”

Here is how one may freely translate it: “Guys, let’s face it: All this money printing is not without costs and risks. Three problems present themselves: 1) The bigger our balance sheet gets (currently, $3 trillion and counting), the more difficult it will be to ever load off some of these assets in the future. When we start liquidating, markets will panic. We might end up having absolutely no maneuvering space whatsoever. 2) All this money printing will one day feed into higher headline inflation that no statistical gimmickry will manage to hide. Then some folks may expect us to tighten policy, which we won’t be able to do because of 1). 3) We are persistently manipulating quite a few major asset markets here. Against this backdrop, market participants are not able to price risk properly. We are encouraging financial risk taking and the type of behaviour that has led to the financial crisis in the first place.”

All these points are, of course, valid and excellent reasons for stopping ‘quantitative easing’ right away. Readers of this site will not be surprised that I would advocate the immediate end to ‘quantitative easing’ and any other central bank measures to artificially ‘stimulate’ the economy. In fact, the whole idea that a bunch of bureaucrats in Washington scans lots of data plus some anecdotal ‘evidence’ every month (with the help of 200 or so economists) and then ‘sets’ interest rates, astutely manipulates bank refunding rates and cleverly guides various market prices so that the overall economy comes out creating more new jobs while the debasement of money unfolds at the officially sanctioned because allegedly harmless pace of 2 percent, must appear entirely preposterous to any student of capitalism. There should be no monetary policy in a free market just as there should be no policy of setting food prices, or wage rates, or of centrally adjusting the number of hours in a day.

But the question here is not what I would like to happen but what is most likely to happen. There is no doubt that we should see an end to ‘quantitative easing’ but will we see it anytime soon? Has the Fed finally – after creating $1.9 trillion in new ‘reserves’ since Lehman went bust – seen the light? Do they finally get some sense?

Maybe, but I still doubt it. Of course, we cannot know but my present guess is that they won’t stop quantitative easing any time soon; they may pause or slow things down for a while but a meaningful change in monetary policy looks unlikely to me.

The boxed-in central banker

I think that in financial markets and in the press the degrees of freedom that central bank officials enjoy are vastly overestimated. I consider central bankers to be captives of three overwhelming forces:

1) Their own belief system which still holds that they are the last line of defence between dark and inexplicable economic forces and the helpless public, and that therefore, whenever the data or the markets go down, it is their duty to ride to the rescue. Thus, when the withdrawal of the Cristal, whether actual or only prospective, dampens the party mood, the Fed will soon feel obliged, by its own inner logic and without any motivation from outside influences, to open another bottle. Just wait until the present debate about an end to QE leads to weaker markets and until, in the absence of the diversion from rallying equity markets, the almost consistently uninspiring ‘fundamental data’ becomes the focus of attention again, and we will witness another shift in Fed language, again back to ‘stimulus’. We had these little twists and turns a couple of times without any major change in trend. Anybody remember the talk of ‘exit strategies’ in the spring of 2011?

Of course, like most state officials, central bank bureaucrats are largely preoccupied with the problems of their own making. It is precisely the Fed’s frequent rescue operations that have created the dislocations (excessive leverage, asset bubbles) which cause instability and repeated crises in the first place. However, there are no signs anywhere that, intellectually, the Fed is willing and able to break out of this policy loop.

2) The size of the dislocations, which are – as I just explained – largely central-bank-made and now, after years and years of Greenspan puts and Bernanke bailouts and zero-interest rates, still sizable in my view, maybe as large as ever. The Wall Street Journal reported that total borrowing by financial institutions is down by about $3 trillion from its all-time high in 2008. That’s the widely heralded ‘deleveraging’. But does that mean that the current level of about $13.8 trillion is a new equilibrium? The Fed’s balance sheet expanded by almost $2 trillion over the same period, and super-easy monetary policy has provided a powerful disincentive for banks to shrink meaningfully. What is truly sustainable or not, will only be discernible once the Fed stops its manipulations altogether and lets the market price things freely. My guess is that we would still have to go through a period of deleveraging and probably of headline deflation. This would be a necessary correction for a still unbalanced economy addicted to cheap credit but nobody is willing to take this medicine.

3) Politics. Falling stocks, shrinking 401K-plans, and shaky banks don’t make for a happy electorate. Additionally, the state is increasingly dependent on low borrowing costs and central bank purchases of its debt. The chances of the US government repairing its own balance sheet look slim to non-existent so dependence on ultra-low funding rates and the Fed as lender of last resort (and every resort) will likely continue.

Look at Japan

When it comes to any of the major trends in global central banking of the past 25 years, Japan has consistently been leading the pack. It had 1 percent policy rates for years in the mid 1990s when such rates were still deemed exceedingly low in countries like the US, and when the global community still looked upon them in disbelief – and growing annoyance at the small pay-off in terms of real growth. Japan was the first to have zero policy rates and the first to conduct ‘quantitative easing’, albeit on an altogether smaller scale – thus far at least – than some of the Western central banks managed since 2008. Now the country seems to point the way towards the next phase in the evolution of modern central banking: the open and unapologetic politicization of the central bank and the demotion of the head central banker to PR man.

Any pretence of the ‘independence’ of central bankers has been unceremoniously dumped in Japan. Ministers take part in central bank meetings and give joint statements with central bank governors afterwards. New Prime Minister Shinzo Abe has made it very clear what he wants the central bank to do (print more money faster, devalue the Yen, create inflation) and to that end he is looking for a new central bank governor. Of course, only accredited ‘doves’ need apply. A few days ago, Mr. Abe also spelled out what skill-set he is really looking for: good marketing skills. Salesmanship.

“Since we all have our national interests, sometimes, there will be criticism about the monetary policy we are pursuing. The person needs to be able to counter such criticism using logic.”

The course of monetary policy is pretty much fixed. Now it is all about marketing.

In the meantime, the debasement of paper money continues.