Wednesday, June 18, 2014

The Problems with Quantitative Easing

Since the Federal Reserve first announced that it was going to experiment with monetary policy in December 2008, the brain trust at the Fed has "stimulated" like never before, pushing interest rates down to what would have been unthinkable lows just a decade ago for an extended period of time.  Obviously, their interference in what passes for a free market economy has some key negative impacts that I will outline here.

1.) The prolonged period of near-zero interest rates has pushed investors into riskier investments in a search for yield.  This can quite easily be seen in ICI's monthly net new cash flow into equity mutual funds as shown on this graph:

Given that the market saw a major correction as the Great Recession took hold, you would think that investors that can ill-afford capital losses would have learned a lesson but apparently such is not the case.  If/when the market does retrace its QE-fed gains, it could look like 2007 - 2008 all over again.  There goes that elusive "wealth effect"!

2.) All sectors of the economy have been living in a debt fantasy world as shown on this graph:

With ultra-low interest rates on outstanding debt, as a whole, all sectors of the economy have been accruing unsustainable levels of debt.  Total debt liabilities have grown from $51.971 trillion at the beginning of 2008 to $59.398 trillion in the first quarter of 2014, an increase of $7.427 trillion.

3.) The Federal Reserve now holds a significant and unprecedented portion of the Federal debt as shown on this graph:

Here is a chart showing the current composition of the Fed's balance sheet:

At the end of April 2014, the Fed held $2.35 trillion in U.S. Treasuries, up $415 million from the year before.  At the end of the first quarter of 2014, there were $12.591 trillion of outstanding Treasuries.  This means that the Federal Reserve holds 18.7 percent of all outstanding federal government market debt.

Some economists feel that the Fed will have no problem managing an orderly reduction of its balance sheet if it holds all of the debt to maturity.  The fly in the ointment is that when interest rates begin to rise, the value of the Treasuries held by the Fed will drop.  This would likely eliminate the ability of the Federal Reserve to remit its annual profits to the Treasury.  This is not an inconsequential amount as shown on this graph:

In 2013 alone, the Fed made $90.4 billion in interest income and remitted $77.7 billion to the Treasury Department.  To put this number into perspective, this is roughly the amount that was budgeted for Transportation in fiscal 2014.  While not terribly significant, if the $78 billion was not remitted to the federal government, Washington would have to add the amount to its annual deficit.

As well, some economists feel that the Fed's dramatic expansion of its balance sheet through the purchasing of Treasuries has allowed the government to finance its deficit by adding to the money supply since the money used to purchase the Treasuries is created out of thin air.  With interest rates so low, there is no motive to reduce deficit spending.  

3.) Speculation surrounding QE has had an upward impact on commodity prices.  This can be seen on this graph of the producer price index for all commodities which is now above pre-Great Recession levels:

As a result of QE, the financial industry was forced to find a new asset class that rewarded investors with a better than zero percent yield.  This asset class was commodities.  Through the promotion of alternative investments like commodities, hedge funds were able to earn fees based on their services  as they invested clients funds in various commodities at the same time as commodity prices rose.  A study by Gueorgul Kolev concluded that a permanent one percent increase in the United States monetary base resulted in a one percent increase in the price of commodities.  As we all know, commodity price inflation can be counterproductive to long-term economic growth.

4.) As investors perceive the impact of the Federal Reserve withdrawal from the bond market, they will begin to sell bonds, pushing the price of bonds down and yields up.  In this scenario, there is a risk that interest rates will rise more quickly than inflation, making it increasingly painful for both the private sector and the government to refinance existing debt or finance new debt.   

No one, including the learned minds at the Federal Reserve, know when or if it is safe to remove the economic "training wheels" of unconventional monetary policy.  At some point, the risks involved in either continuing or discontinuing monetary support will have to be faced.  Most unfortunately, all the Federal Reserve has done since December 2008  is to buy more time rather than fixing the underlying economic problems that caused the near meltdown in the world's economy.


  1. right on ... mis-allocation of capital can be seen everywhere ... the most elusive and highly relevant question is when ??? it is always when :-)

  2. Why the hell are we helping investors as a national policy? That money never makes it down to where real people live. If the Fed/President/Congress had really wanted to help the economy, they should've made that low-cost money available to community banks for local investment in small business, community development, and infrastructure (i.e., JOBS). Instead, all of that QE has gone to investors looking for "ROI" (for what investment exactly?), keeping the stock market at stratospheric heights and inflating the value of commodities. We need an accounting of where this $2.8 trillion (?) QE has gone, what the results have been, and whether it has increased the federal debt (the media certainly has not reported on this). We need a bottoms up economy, not a trickle down economy.

    1. Carole, QE money printing is not exactly what it seems at first sight. Have a look here:

      Also, QE allowed cheap funding for companies which issued bonds at very low yields. US corporation now hold record piles of cash and have refinanced at ultra low interest rates. They are ready to increase capex, which unfortunately is not yet happening, but with unemployment going down and possibly soon rising wages, discretionary income is likely to rise and with it consumer spending. Which will cause firms to invest and their cash piles will come in very handy.

      Asset are somewhat overvalued but hardly in stratospheric height. S&P forward p/e ratio is 16. That's not cheap and we may be in for a small correction. But that's all.

      Outlook is very positive for the US. See here what the IMF just announced:

  3. America imports around five hundred billion dollars more from other countries every year than they export. This means we have a giant trade deficit, when we add this to our massive government deficit it is easy to see that we are living far beyond our means. The Fed has been superbly entrepreneurial when it comes to Ponzi schemes or pseudo-economics hocus-pocus that has allowed the current situation to develop. The Fed must at some point begin to ponder a real exit strategy and end the massive and corrosive stimulus that the economy has come to expect. To make matters worse little has been done to address our structural problems and make America more competitive, this will thwart growth going forward. More on this subject in the article below.