Wednesday, March 30, 2011

The Coming End of Quantitative Easing

For the past few weeks there has been talk in the press that QE II will pause at the end of June, and last week several Federal Reserve Bank Presidents made statements supportive of this view. As we will see below, there is good reason to believe that the government's extraordinary programs of support are coming to an end. We should seriously consider this, because the implications appear to be serious for market liquidity, rate expectations, and the dollar.

Accommodation Is Already Being Removed

Recent Fed pronouncements about ending QE should not be unexpected, because both the Fed and the Treasury have been cutting back for some time on other programs of financial and economic support. In "Crisis Era Props Are Fading Away" the Wall Street Journal last week reported on other support programs that both Treasury and the Federal Reserve have already started to roll back.

The Treasury Department has already announced plans to sell its $142 billion portfolio of federal agency mortgage-backed securities bought at the worst of the crisis. The Federal Reserve moved to the next stage of a plan to drain liquidity from the financial system through reverse repurchase agreements, or "reverse repos." Some of these moves have been going on for months. The Fed started testing reverse repos in the fall of 2009, and it has been some time since the Treasury ended several emergency-lending programs that eased the credit markets through the crisis.

More moves are being contemplated. The Fed is considering an auction for some of the subprime-mortgage securities acquired in the bailout of American International Group Inc.

Reasons for Policy Change at This Time

As pointed out by Glenview Capital in the blog Pragmatic Capitalism, there are some fundamental reasons for QE to pause: (1) the economy has rebounded (at least by some accounts), (2) the risk of immediate deflation has receded, (3) rapidly rising prices of oil, food, and other commodities provide some indication of incipient price inflation, and (4) Fed commentary has grown more cognizant of the risks of inflation.

In addition to the reasons cited in that article, the Fed probably wants to normalize policy so as to leave some "dry powder" ready to counteract the next recession or financial panic. Also, private financial institutions have stabilized to some extent, although much of their problems are being hidden at present by Treasury and Fed programs and by official tolerance of mark-to-fantasy accounting.

Recent Federal Reserve Comments

Based on recent statements, the Fed appears now to be in favor of putting an end of QE, if conditions continue stable or improve. Not long ago, St. Louis Federal Reserve Bank President Bullard said this quite plainly: "If the economy is as strong as I think it is then I think it may be reasonable to send a signal to markets that we're going to start withdrawing our stimulus, and I'd start by pulling up a little bit short on the QE2 program." Then last Friday a parade of Federal Reserve Bank Presidents made well-coordinated statements like these:

Speaking at a conference in Marseilles, Bullard said “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.”

Speaking at the same conference, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said: "If the economy evolves the way I've forecast, I would not foresee us doing further accommodation." He added that the U.S. economy would need to worsen “materially” for the bank to consider further bond-buying.

Atlanta Fed President Dennis Lockhart said in a speech last Friday that "it's a high bar" for the Fed to pursue more QE. He told reporters after his speech that he favors completing the present round of asset purchases as scheduled but opposes additional moves based on his current economic forecast.

At a speech in New York a speech in New York last Friday, Charles Plosser, President of the Philadelphia Fed, said: "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." He suggested selling $125 billion for every 0.25 percentage-point rise in the benchmark rate to almost eliminate $1.5 trillion in bank reserves.

Charles Evans, President of the Federal Reserve Bank of Chicago, said to reporters at a meeting at the bank that the current program of QE was enough: "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."

The rhetoric has continued this week. Richard Fisher, President of the Dallas Fed, said today in an interview on Fox Business that he would vote against any further monetary easing by the central bank after the current program is finished in June. He was definite about this: "I cannot foresee a circumstance where I can support any further liquidity in the economy."

Pressures on the Fed to End QE

A stabilizing economy and a stable financial system have been cited as reasons for taking a pause in QE soon. These are not the only reasons why the Fed might end QE -- or say that it is going to end QE. There are other possible motives that include both real-world finances and Washington politics.

Another reason to consider ending QE in the future, if not right now, is the dollar. The ability of this country to remain solvent depends on maintaining at least some value for the dollar. So far, the dollar has declined only gradually in reaction to the government's extraordinary support for the financial system and the economy, but many of our creditors have complained about the trend. Naturally, dollar weakness is a big issue with the Fed, and they need to do something about it before heretofore modest dollar weakness turns into panic.

Partly, the problem can be seen in the continuing flow of dollars into commodities. When consumers and investors see commodity prices rising suddenly, they try to preserve wealth by exchanging dollars for commodities. This is not what the Fed wants. They want you to hold dollars and other US financial assets, not barrels of oil or gold ingots. A related view is that the Fed needs to forestall the incipient inflation seen in rising commodity prices. In addition, all of this speculation is destabilizing to the markets.

Many observers (such as Bill Gross of PIMCO) worry that the Fed is taking a big risk by tightening policy while it has been buying one-third of all US Treasury issuance. This may be a risk, but others point out that the Fed may already have enough securities on its balance sheet to control rates, and that it doesn't have to depend on incremental purchases.

Maybe the most persuasive explanation for the Fed's recent statements is that it needs to placate the fiscal hawks in Congress. According to this point of view, the Fed is just biding its time until forecasts of robust economic growth are proven wrong. At signs of a faltering economy, the Fed can rein in talk of pursuing QE and start preparing the markets for QE III. Signs of a faltering economy may not be long in coming, considering that the most recent economic data are not uniformly encouraging, and many economic forecasts are being cut back.

Problems with Pausing QE

Unfortunately, a pause in QE would happen at a time when overall economic and financial conditions are hardly conducive to monetary tightening. As Glenview Capital wrote in the blog Pragmatic Capitalism, "a renewed emphasis on deficit reduction in Congress ... will likely slow the growth of both Federal and State/Local spending that has played a key role in reinforcing the economy to prevent a double-dip recession." This austerity-induced fiscal drag seems likely to add its own burden on the weak economy.

If they come to pass, these domestic drags on the economy will happen against a global backdrop of economic negatives. These include high oil prices induced by fears of continuing political unrest in the Middle East, financial instabilities induced by the continuing debt crises on the periphery of the European Union, and the possibility of tightening by China to rein in inflation pressures and rein in an unbalanced and overheated economy.

Pausing QE would tend to raise interest rates, which is a situation that the financial system may not be ready to face. As Bill Gross asked: "Who will buy Treasuries when the Fed doesn't?" This raises the additional question of how high rates might go when the artificial foundation of QE II credit is removed. There is also the question of how well the economy and the financial system can withstand higher rates. The economy hardly seems robust enough to withstand sharply higher borrowing costs. The financial system gives appearances of having stabilized to some extent, but that leaves the question of how dependent is has become on the continuance of rock-bottom interest rates.

There is also a risk that fiscal austerity, induced by fears about government deficits, might actually worsen that situation. This is because the stabilization of the economy has been dependent on stimulus through growth in Federal expenditures. With reductions in Federal, state, and local budgets, there is a higher risk that growth will falter, and that lower economic growth will reduce tax revenues and increase the deficit.

                               Barbara Stevenson, Apple Vendor, 1933-1934.

All of this paints a picture of a financial and economic environment that is hardly appropriate for monetary tightening in the US. As noted above, recent economic news is not encouraging, and continuing signs of weakness could easily raise new fears of another recession.  We have to wonder if QE would not need to be quickly resumed if this uncertain economic climate resumes a downward course.

Tightening to fight inflation runs the risk of undercutting the recovering economy, a situation which would place the Fed and Congress between a rock and a hard place with respect to policy choices. This could lead to a real dilemma for policy, that perhaps deficits cannot be reduced without further weakening the economy.  Perhaps we should not be surprised to see such a dilemma, given that this country has seen decades of Fed policies and national budgets sending false signals to the markets that induced economic participants to misallocate resources into consumption rather than productive investment.

QE and the Markets

One of the best discussions about pausing QE that I have read was John Hussman's March 28 commentary. His argument is based on the fact 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." The implication for the markets is clear. If the Fed does not enter into another round of QE (and certainly if the Fed unwinds past QE), it risks an "an increase in risk aversion" and "a decline in speculative enthusiasm."

Given the momentum-like behavior of the markets, Hussman believes that investors have not priced in "the extent to which this [the market advance] has been reliant on various stimulus measures that are now drawing to a close." In fact, low market returns were almost guaranteed by the nature of QE. This is because by "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." [My emphasis]

There is no way of knowing where the market will go in the short-term, but poor long-term returns are indicated by present market valuations. This is borne out by Hussman's quantitative models, which are definitely long-term and fundamental in their valuation approach. These models assume that "long-term growth in GDP and earnings will persist at the same roughly 6.3% peak-to-peak growth rate across economic cycles," which is the average rate observed over nearly the past century. Based on the level of stock valuations to normalized earnings, "our present 10-year total return estimate for the S&P 500 is only about 3.4% annually," and "the historical skew to these returns easily includes zero in the confidence interval."

Bill Gross's has warned that the end of QE will mean the end of the bull market in bonds and, as we discussed above, there is good reason to worry that the removal of extraordinary monetary accommodation may also drive down the prices riskier asset classes, like stocks and commodities. Whether we agree with all of these arguments or not, it is always a good time to review the asset allocations in our portfolios.