Friday, September 23, 2011

The Law of Unintended Consequences Part 2 - The Downside of Quantitative Easing and the "Twist"

You know how we never hear about the downside of the Federal Reserves quantitative easing programs from their architects?  We all know that QE1and QE2 really didn't work out that forcing the Fed to flash back to the 1960s to pull their next stunt out of their bag'o'tricks.  Not only did QE not have much of a positive impact on the American economy, it seems that its impact may well have been created at least part of the problem with the economy that it was intended to fix , contrary to what Mr. Bernanke and his Band of Merry Bankers would have us believe.  Remember how we were told initially that QE had resulted in lower unemployment, rising house prices, lower interest rates, a stock market that was on a seemingly never-ending tear upwards and that a cure for cancer had been found all because of the Fed's policies? (well, maybe not the last one)  Apparently, the suspicions that those of us who live on Main Street have had about QE have not been in error.  All is not well in America and we need look no further than Fed policies to see where things went off the track.

I found this interesting analysis of the impact of quantitative easing on America's economy at the website for the American Institute for Economic Research (AIER).  The paper, entitled "The Downside of Monetary Easing" by William F. Ford and Polina Vlasenko published by the American Institute for Economic Research dated July 4th, 2011, outlines the unintended consequences of the Fed's policy of "pumping and dumping" "money" (also known as a binary code that only computers can understand) into the system.

The Federal Reserve's quantitative easing programs QE1 and QE2 dumped about $2 trillion into the financial system after the near meltdown of 2008.  To keep interest rates from rising and further smothering the economy, the Fed flooded the financial markets with “paper” by purchasing larger than normal quantities of United States Treasuries and mortgage-backed securities in an attempt to get credit flowing.  In the minds of central bankers, there are three benefits to the economy that result from lower interest rates which I will outline in the following three paragraphs.

First, the low interest rates that result from QE are supposed to entice consumers to borrow and spend and to prod businesses into investing in plants, equipment and inventory.  These temptingly lower interest rates will lower the total cost of expenditure for both consumers and businesses and the resulting increase in economic activity will result in lower unemployment.  Whoppee!  We all win!  We get to buy all kinds of stuff on cheap credit and keep our jobs too!  Apparently, the bankers at the Fed seem to have forgotten that it was their policy of easy and cheap credit from the early part of the decade that helped consumers buy too much house and use their meagre home equity to borrow even more of a bad thing.

Secondly, another benefit of ultra low interest rates is related to the value of the American dollar.  When American interest rates are low compared to our trading partners, the value of the United States dollar is driven down since it is a less attractive currency.  This leads to an increase in exports of U.S.-made products since, when all else is equal, consumers et al outside the United States get more bang for their buck by purchasing American goodies.  As well, the low greenback makes imported products relatively more expensive, meaning that Americans are more likely to consume domestically produced goods.  Both increased exports and decreased imports should result in more jobs for Americans.  Once again, we all win!

Third, when the Fed buys up long bonds, their prices are pushed up, driving yield down.  As a consequence, yield-hungry investors that are looking for a reasonable return on their money are essentially forced to look to investments other than bonds.  In many cases, investors will turn to the stock market; their increased investment in stocks pushes prices up and creates a feeling of increased wealth.  This wealth factor results in investors/consumers prying open their wallets and spending more, further stimulating the domestic economy and creating employment.  Yet again, we all win!

Now for the downside.  The authors of the paper note that the prolonged period of ultra-low interest rates put in place by our friends at the Fed have had a very marked impact on the lives of both savers and particularly retirees who rely on interest-bearing investments as a key part of their portfolio.  This period of generationally low interest rates has made it almost impossible for most retirees to live off the returns from their interest-bearing savings, particularly if these investments took the form of bank issued CDs or GICs which generally mature in five years or less.  Right now, 5 year CD/GIC rates in the United States range from 1.5 percent to just over 2.0 percent annually.  Short-term rates are even worse as shown in this graph of 6 month CD rates for the past 10 years:

When you're getting a fraction of a percent on your investments, one wonders if money wouldn't be just as well off stuck between the mattress and box spring where it is out of the reach of the unstable banking industry.  In the low interest environment, investing strictly becomes capital preservation, less the impact of inflation.  Interestingly enough, if you look at all yields, they are extremely low right across the maturity curve with 30 year yields falling south of 3.4 percent, very close to an all time low as shown on this graph:

With an estimated $9.9 trillion in interest-sensitive assets held by United States households at the end of the second quarter of 2010, plus the investments made by life insurance companies and private pension plans, low Treasury yields are impacting the income levels from up to an estimated $18.8 trillion in assets.  Since pension plans and life insurers don't invest all of their funds in interest-bearing investments, the authors of this study assume a mid-point estimate of $14.35 trillion for the total American assets affected by the generationally low interest rate environment created by Ben Bernanke and his pals.

If you don't believe the observation that current interest rates are stunningly and comparatively low following the Great Contraction of 2008 - 2009, here's a table showing the average United States Treasury yields one year after the start of the last 9 recoveries compared to the current recovery and the difference between the two:

Current interest rates are dwelling in the basement by comparison to the average of the last 9 recoveries and are showing no signs of improvement any time soon.

Now, let's take the difference between the average post-contraction interest rate and the current post-contraction interest rate and utilize the mid-point $14.35 trillion in interest-sensitive investments as noted above.  Over the spectrum of maturities from 6 months to 30 years, the interest rate difference from the above chart is negative 4.93 percentage points (i.e. the interest rate after the Great Contraction was 4.93 percentage points lower than what it would normally be one year after the start of a recovery).  For the mid-point $14.35 trillion in interest-yielding investments, the authors estimate that the total loss in consumption as a result of our current abnormally low interest rates environment is $371 billion which equates to 2.53 percentage points of GDP or 3.5 million jobs.  This increase in the number of jobs could have lowered the unemployment rate from its current 9 percent to roughly 6.8 percent.  As well, the authors calculate that the additional GDP growth from additional spending by those who hold interest-sensitive investments would have brought GDP growth to 4.86 percent, close to the average for most recoveries in their second year.  Further to their analysis, the authors note that for every 1 percentage point decrease in yields, $75 billion of consumption or 0.51 percent of GDP or 715,000 jobs are lost using the midpoint $14.35 trillion asset figure.  We must also keep in mind that additional spending by those who receive interest income has a multiplier effect as it works its way through the American economy, multiplying the positive effects on economic growth that is not explained by simple one-time spending by consumers alone.

Once again, perhaps the Federal Reserve has fallen into the "law of unintended consequences" trap.  While low interest rates seem to be a partial panacea for the ills that affect the world's economy, they are a trap for more than one reason.  Lower interest rates do not necessarily cause savers to spend, rather, savers may take additional and ill-advised investment risks to boost their investment income, exposing themselves to a potentially calamitous loss of capital.  In addition, consumers that have not over-leveraged themselves may be tempted to take on additional consumer debt because, at current interest rates, the additional debt appears to be quite serviceable.  This is an issue that concerns at least one of the world's central bankers, the Bank of Canada's Mark Carney.  Even more importantly though, is the risk posed by governments that are being duped into thinking that they can continue to borrow and spend endlessly because interest on the accrued debt seems reasonably manageable at the current generational lows in interest rates.  Such will definitely not be the case when interest rates rise to their historic norms and we can all imagine who will suffer the greatest pain from their impact on sovereign debt interest costs.

If you recall my posting of September 29th, 2010 entitled "Quit griping and spend your!", you'll recall that a central banker, the rather aptly named Mr. Bean from the Bank of England, stated the following:

"Savers shouldn't necessarily expect to be able to live just off their income in times when interest rates are low. It may make sense for them to eat into their capital a bit."

"Very often older households have actually benefited from the fact that they've seen capital gains on their houses."

Mr. Bean's comments are most interesting in light of the findings of the AIER study.  Central bankers are interested in one thing only - economic growth at any cost and they want us to pay by increasing our consumption of consumer goods.  From what we have seen from the results of this study, it appears that the issues related to artificially low interest rates will only get worse as the Fed does the “Twist”.  Stand by for more bad economic news.


  1. This is a very good writeup. The central bankers need to think long and hard about trying to entice the same overburdened consumers with more credit. This is akin to trying to start a car with a carb that is already flooded by to keep pumping the gas. Sooner or later it's so flooded it won't start for a long time.

    What the Fed needs to do, and do now, is the following:
    1. The FFR will rise from .25 to 1.5% immediately.
    2. Announce that effective 2/1/2012, the rate will rise to 2.5%, with an increase of 1% every three months until the rate is at 5%. The benefits of this are multiple:
    a. We don't screw our seniors, savers, and otherwise responsible people.
    b. We have provided notice to companies that now is a good time to invest, and the window for cheaper rates is closing, so do it now or expect to pay more later.
    c. For those on the verge of financial disaster, they have a few months to either shore up their balance sheets or file banktuptcy.
    3. Announce that the Fed reserve policy of easy money is over for good. There will be NO bailouts of anyone for any reason. This will lead to the market pricing risk appropriately. Some sectors will hurt but more will benefit.
    4. Work with Congress to eliminate the dual-mandate, instead with a goal of price stability. If prices and interest rates are stable and rational, the remainder will fix itself.
    5. Elect Thomas Hoenig (KC Federal Bank) to become the next Chairman. We could use some good common sense from middle America at the top.

  2. My late wife was a firm believer in take no risk. I used to tease her that gold coins in the bath tub were her idea of retirement savings. Turns out she was right. Even my medium and low risk investments lost money and the high risk lost all. Gold on the other hand has appreciated considerable. There is something to be said for cash in a coffee can in the garden under the third post or as you put it under the mattress. The markets are designed to take money from the poor and give it to the rich.

  3. TBF you need to be pro active...PJ told us back in July that a twist could happen,so I looked up histroy of the 60's...saved my bacon,but i didn't have the nad's to go short.

  4. Hi. Sorry if this seams like an obvious observation. I find the thinking that keeping rates low helps the main street consumer ridiculous. It is all well and good that banks can lend at <.25% ; however, I have yet to be offered a loan at that rate...

  5. Mortgage holders benefit from low interest rates, savers are hit.
    Raise interest rates and you do the opposite. Will savers then spend more - probably not - most are older and conservative and need to eek out an income for another 20 years. My parents just got a tax refund, they have just put it into their savings account !

  6. Many people miss the point which is that all of this QE nonsense is not about helping Main Street - small business, the citizen, promoting economic growth, etc.

    It is all about propping up the banking system at all costs and I mean all costs as it will collapse the real economy that we are all dependent upon. Unfortunately the banking system is a zombie system and will at some point in time collapse in on itself the issues are systemic. We had an opportunity to deal with the problem in 2008 but did not. It just goes to show how much the banks are 'skimming' from us all and are now threatening our very existence.

    This is simply a kick the can down the road exercise and each time it adds fuel to the debt crisis. Paradoxically it starves the economy of liquidity as all the banks to is increase 'carry trade' operations and increase their funds. It will never work as the create debt, lend to consumers, consumers spend, we import, borrow from overseas model is dead.

  7. I am happy with the low interest rate as I have a variable rate mortgage to pay off. I have a good job at the moment and will pay off the mortgage in 3 years oif rate stays low.

    I don't know what the bank does with the money I pay back. They keep increasing my line of credit with the hope that I will use it. But it just sits there. I am deleveraging like crazy.

    1. I suspect that a big part of this quantitative easing is to keep interest rates low for all those interest-paying entities who may be hard-pressed to pay higher rates. That includes leveraged businesses, governments, and consumers. It also lets people and businesses deleverage and make themselves less vulnerable to a banking crisis.

      I also wonder whether it is supposed to help large banks rebuild their balance sheets, like an extended bailout but with less political fallout.

      What the long-term goal is, I wish I knew. If the Fed gradually backs away from cheap money, maybe the large banks can adapt instead of failing catastrophically.

      To sum up, I hope this is step one in a process of weaning the economy from running on so much debt.

  8. Governments in the USA and Europe will continue printing money as long as bankers control the political system. The root of the problem is voter ignorance. The average voter in a political election knows much less about the budget and the organization of the polity than the average voter in a corporate election. Anyone can vote in a political election while voters in corporate elections must earn the privilege by buying shares.

    To be realistic, individuals should boycott political elections and vote with their feet. Alternatively, imagine living with a responsible government like Hong Kong, in a Mediterranean climate like California. Chile offers a combination of pleasant climate and fewer government burdens than many others. If you’re ready to shed the debt your government has imposed upon you, it is a good destination to consider.

  9. I hate to think that that baby will always be Brooks & Dunn associated! If it was so country associated, I might like it. My favorite last name for a first is "Smith" my friend has a little boy named Smith and I think it's a great way to have something that is familiar, but not common.
    Atlanta Roofers