Wednesday, August 1, 2012

The Federal Reserve's "Bridge to Nowhere"

In recent weeks and months, we've been reading many headlines in the mainstream media along the lines of "Markets react positively to central bank actions" or "Markets suffer double digit losses based on central bank inaction".  

Earlier this year, Dr. Mohamed A. El-Erian, an economist and CEO and co-CIO of Pimco, one of the world’s largest bond investors, gave a speech entitled "s " at the Federal Reserve Bank of St. Louis.  In this speech, he outlines the role of the ECB and the Federal Reserve in today's highly complex environment.  Central bankers tend to like certainty and, in the current post - Great Recession economic environment, uncertainty is a greater part of our world than it has been for decades.  Dr. El-Erian suggests that, in some cases, central bankers "...have even had to make things up as they go along...", a phrase that pretty much says it all.  As well, he states that "...the outlook remains unusually uncertain..." and that changes are necessary to prevent "...bad surprises down the road...".

Dr. El-Erian feels that central banks have been carrying the bulk of the policy burden and that both the public and private sector have not stepped up to the plate.  The declining effectiveness of the tools used by the world's central banks (i.e. near-zero interest rates and quantitative easing) has left the world's economy with a growing risk of collateral damage and unintended consequences from central bank actions.  Governments have done very, very little to improve the situation by meaningfully controlling debt level by reigning in spending.  Since governments appear to be sitting on the side-lines while central banks act in ways that they would not have previously, this has led to increasing demands that some of the world's central banks be more carefully policed by those that we elect.

As I have posted before, actions taken by four of the world's most influential central banks have led to ballooning balance sheets as shown here:

The Fed's balance sheet is now 20 percent of America's GDP and the ECB's is 30 percent of Europe's GDP.  

Let's focus on the effectiveness of the Fed's policies.  Unlike the recent past where interest rates were the tool of choice, the Fed is using measures including QE, the Twist and aggressive use of communication (i.e. signalling low interest rates for a prolonged period) as shown on this chart:

Unfortunately, the Fed's policies have been stubbornly ineffective on certain aspects of the economy, particularly employment, one of the Fed's mandates.  While the Fed's efforts have been somewhat effective at keeping the American stock market from tanking and have pushed Treasury interest rates to unthought-of lows, its efforts have not been transmitted to the "real economy" where you and I live.  What has gone wrong?

1.)  Funds in the banking sector are ending up as excess reserves at the Fed since it is viewed as a non-risky counterpart.  

2.) Borrowers that previously relied on money market investors for funding can no longer do so since the long period of near-zero interest rates has decimated and distorted the money market industry, formerly an important source of commercial funding.  

3.) The Fed's easing policies have badly wounded the pension industry, resulting in underfunding that is pandemic.  

4.) The bond purchasing actions by the Fed (as well as the central banks of the world's advanced economies, the Bank of England and the Bank of Japan), have led to changes in the balance between what is perceived of as a "safe" investment and what is not.  This has led to distortions in the world's bond market.

5.) The willingness of the Fed to inject liquidity has contributed to higher commodity prices, particularly oil, precious metals and other “real assets”.

6.) The increase in liquidity has led to a perception that there could be a rise in liquidity-induced inflation, affecting the value of TIPS (inflation protected Treasuries)

7.) Increased volumes of "cash" sloshing around in the system has impacted economies outside of the United States.  Recently, Brazilian officials have suggested that low interest rates in Europe and the United States have led to investors speculating on their currency in a search for reasonable yields, thereby negatively impacting their economy by overvaluing their currency.

Basically, the results of the Fed's policies are a prime example of the law of unintended consequences in action.

Looking forward, Dr. El-Erian suggests that there are reasons to believe that we are nearly at the limit of net effectiveness when it comes to central bank policies.  He notes that yields on government securities are now basically zero right up to five years, the segment of the bond market that has the most impact on economic activity.  He also notes that it is becoming increasingly uncertain whether central banks can rely on quantitative easing as a means of enticing investors into doing things that they would not normally do based on economic fundamentals.  Basically, central banks have backed themselves into a fiscal corner from which there may only be a very painful escape.  Here is a quote:

"To put it bluntly, there are now multiple reasons to worry about central banks' expensive (and expansive!) policy bridges risking to end up as bridges to nowhere. In other words, there is a growing possibility that, absent mid course corrections, unsustainability may be the common characteristic of the central banks’ unusual policy activism." 

Basically, the Federal Reserve and other central banks are now at the end of their tether.  What is even more disturbing about Dr. El-Erian's commentary is that he observes that central banks are far more "agile" than elected bodies.  For example, Fed policies can be enacted much more quickly than policies from Congress, America's bickering political black hole.  Basically, this leaves the American economy at the mercy of Mr. Bernanke et al since the government still seems unable to cope with the severity of the issues that are under their jurisdiction.

More's the shame.


  1. I question how strong the demand for money actually is. If I understand correctly, the only place where the demand for loans is higher is in government spending. Most everyone else is deleveraging. Business expansion is down as people take a cautious approach.

    I can understand that if governments had to go to investors rather than the central banks, 1) they would have to pay higher rates, and 2)investors would therefore get better that rock-bottom returns. But I don't see how that would revive demand in these economies.

    Frankly, I don't see how the central banks can make these economies perk up, and I'm tired of people blaming them for something that is outside their power to fix.

  2. That said, it's unclear why the Fed should consider another round of QE. What are the dangers? What are the indications it might help (very little, I suspect).