- The view of The Money Enigma is that the “risk/reward” of QE4 doesn’t stack up. QE4 doesn’t make sense from an economic perspective, nor does it make sense for the Fed politically.
- From an economic perspective, the benefits of more QE in the current climate are likely to be very limited. The $4 trillion expansion in the Fed’s balance sheet has already had the “desired effect” of reducing the required return on risk capital down to exceptionally low level. The marginal benefit for markets and the economy of further compressing the required return on risk assets is likely to be limited.
- On the cost side, an additional round of QE creates the risk of tipping long-term expectations in such a way that the value of money declines precipitously and prices rise sharply.
- The view of The Money Enigma is that the inflationary response to QE1-3 was subdued primarily because the market perceived the QE experiment to be “temporary” in nature. If the market suddenly decides that QE is a more “permanent” part of the landscape, then this could have a very damaging impact on long-term economic confidence and inflation expectations.
- The only circumstance in which the risk/reward of more QE may be justified is if there is a dramatic deterioration in financial market conditions (i.e. a 25%+ decline in equity markets). Nevertheless, it is not clear that, given current circumstances, the Fed could catch a falling knife even if it wanted to. Moreover, the long-term risks associated with attempting to stage-manage the market with QE4 probably outweigh any short-term benefits.
- From a political perspective, the case is arguably much clearer. A decision to undertake QE4 at this point in the cycle would indicate that the Fed’s bold experiment with quantitative easing has failed. If the Fed finds itself forced into further easing before the tightening cycle has even begun, then serious questions will be asked about whether the theoretical models that justified QE1-3 were sound. Politically, this would put the Federal Reserve in a very bad position, one that the Fed will attempt to avoid at all costs.
QE4: The Problem of Diminishing Marginal Returns to Policy
The view of The Money Enigma is that the marginal economic benefit associated with another round of quantitative easing at this time is likely to be minimal. “QE4”, the term most often used for the possible next round of monetary easing by the Fed, is unlikely to have anywhere near the positive impact on markets and the economy that QE1-3 had.
In order to understand why this is the case, it is worth examining a little of the history associated with quantitative easing and thinking about the primary transmission mechanism from “more money” to “good economic times”.
The first point that we need to remember about the grand monetary experiment that is quantitative easing is that the experiment only started because the Federal Reserve had backed itself into a policy corner.
In each of the major economic cycles in the 1990s and 2000s, the Fed was very quick to cut interest rates but very slow to raise them: interest rates went down by the elevator and up by the stairs. Some people will argue that the Fed was “late” to cut interest rates on some occasions, and this may be true, but the Fed has always tended to be more aggressive when in the midst of an easing cycle than it has when in the midst of a tightening cycle.
By late 2008, this repeated pattern of placating financial markets had created an awkward situation for the Fed. In simple terms, the Fed never raised interest rates aggressively enough in the 2004-2007 period, thereby fueling the US housing bubble. As liquidity disappeared from credit markets throughout 2007 and 2008, the Fed found that it didn’t have enough traditional policy tools to deal with the situation and was forced to consider unorthodox methods of dealing with the crisis.
In November 2008, the Fed started buying $600 billion in mortgage-backed securities, an act that nearly doubled the monetary base in a very short period of time. This first round of unorthodox monetary policy, “QE1”, met with almost instant success: liquidity returned to most credit markets, equity markets rallied and the decline in economic confidence was arrested.
In this sense, QE1 was the appropriate response by the Fed, even if it was the Fed that was responsible for putting itself in this awkward position in the first place. More specifically, the risk/reward tradeoff for QE1 made sense, both economically and politically. Politically, the Fed had to do something to arrest the worst financial market conditions since the 1930s. From an economic perspective, QE1 stabilized global financial markets and helped restore order.
When the history books are written, QE1 will represent a good example of the circumstances under which monetary base expansion should be considered. “Printing money” is a dangerous tool, but it is also a powerful tool. Every now and then, complex economic systems founded upon fractional reserve banking get themselves into trouble. In times of genuine economic crisis, monetary base expansion represents an important and effective last-resort policy option.
The problem for the Fed is that it didn’t reserve quantitative easing solely for times of genuine economic crisis. Rather, in November 2010, two years after the depths of the crisis, the Fed decided to launch another round of quantitative easing, buying a further $600 billion of Treasury securities. Less than two years after this, a third round of quantitative easing commenced, but this time on a much larger scale than anything seen before, with purchases of Treasury securities rising to $85 billion per month.
By the time the Fed finished QE3, the monetary base of the United States had quintupled in seven years, a simply extraordinary and historically unprecedented rate of monetary base expansion.
So, why did the Fed become so aggressive in subsequent rounds of QE? The view of The Money Enigma is that the Fed had to up the ante because of diminishing marginal returns to monetary base expansion.
In simple terms, the primary transmission mechanism from “more money” to “good economic times” is the impact that a massive and sudden expansion of the monetary base has on the required rate of return across all risk assets. As the Fed buys government securities, the required rate of return across all risk assets falls and, all else remaining equal, the price of risk assets rise. The problem is that there is a limit to how far the Fed can depress the required return on risk assets.
For those not familiar with how financial markets operate it may seem surprising that buying government bonds will force up the price of equities. After all, what does the price of government bonds have to do with the price of stocks? The answer is “everything”.
There are two ways to think about this: we can think about it in theoretical terms or in more practical terms.
In theoretical terms, the market value of a business is determined by the net present value of future cash flows that investors expect to receive from that business. If the Fed creates money and use this money to buy government bonds, then this forces down not only the interest rate on government bonds, but forces down the risk free rate which is used as the baseline for all risk asset valuations.
We can also think about this issue from a more practical perspective.
Government bonds, corporate bonds and equities are, at least to some degree, substitutes for each other. They are not perfect substitutes, but they are substitutes. As the Federal Reserve begins to buy government bonds and forces down the interest rate on government bonds, then induces investors who invest in both government and corporate bonds to seek higher yields in corporate bonds. In turn, those investors who invest across the corporate spectrum (corporate bonds and equities) will now, at the margin, chase the higher expected return in equities, forcing up the price of equities.
In this way, the Fed’s actions create a domino effect across all asset classes: investors shift from government bonds to corporate bonds, corporate bonds to low-risk equities, low-risk equities to high-risk equities, high-risk equities to venture capital.
This whole process has a positive impact across all areas of the real economy. By lowering the required cost of capital for all investments, more investment activity is stimulated and more jobs are created.
The problem is that there are diminishing marginal returns to this approach.
QE1 worked because it stabilized the required return on risk assets. In essence, risk assets were in free fall and the Fed’s actions put a floor under prices. In late 2008, early 2009, it didn’t take much (“only” $600bn) to support the global credit and equity markets.
QE2 had a positive effect because it drove down the required return on risk assets from what many would consider to be a normal level to a low level. But the $600bn committed in QE2 didn’t really get the scale of result the Fed wanted.
Enter, QE3. In essence, QE3 represented an attempt by the Fed to drive down the required return on risk assets from a level that was already low by historical standards to a level that was exceptionally low. This third round of stimulus required a much larger commitment because, at some point, you begin to approach the limit of how far you can artificially manipulate the required return on risk capital.
So, what is the expected return to QE4?
If this view of the transmission mechanism from “more money” to “more economic activity” is correct, then the economic reward to QE4 is likely to be negligible.
The required return on risk assets is already at or near historical lows (see John Hussman’s work for a description of this). Any further expansion of the monetary base is unlikely to have a major impact on the required return on risk assets and, therefore, is unlikely to have any sustained impact on the price of risk assets.
The only scenario that may offer a higher near-term reward to further monetary base expansion would be one in which the markets fall precipitously over the next few months. In this scenario, it may be the case that QE can once again be used to “put a floor” under the market and arrest a decline in economic confidence. However, even in this scenario, it is not clear that further rounds of monetary stimulus would work.
As discussed in a recent post titled “Can the Fed Catch a Falling Knife?” the Fed can control the risk-free rate, at least under normal market circumstances. However, it is much more difficult for the Fed to control the risk premium, the premium required over and above the risk-free rate. There is a high likelihood that any attempt to manipulate the risk premium and stage-manage global equity markets will backfire, an event that could lead to a loss in market faith in the omnipotence of central banks.
QE4: Up the Ante, Raise the Risk
While the problem of diminishing marginal returns to policy is well appreciated by many in financial markets, the risks associated with additional monetary stimulus are very poorly understood.
The reason the risks of further monetary stimulus are poorly understood is because most economists and market commentators subscribe to what one might call an “expectations-adjusted Phillips Curve” or “New Keynesian” view of the world.
In essence, the New Keynesian model is one that recognises the benefits of intervention, but not the costs.
The New Keynesian view of the world is that inflation is a function of two factors: (1) aggregate demand, and (2) inflation expectations.
This view of the world implies that in a weak economy, an economy operating below full capacity, monetary stimulus is unlikely to have any impact on inflation. In this scenario, the only circumstance under which monetary policy could lead to inflation is if somehow damages “Fed credibility” (Fed credibility is the key in the determination of inflation expectations).
In other words, as long as everyone believes that the Fed will do the right thing eventually, then they can keep doing the wrong thing for as long as they like.
Ironically, there is an element of truth to this. The problem is that most economists don’t appreciate what constitutes the “tipping point”: the point at which the Fed goes from being “credible” to something “not credible”.
The view of The Money Enigma is that the tipping point is the point at which monetary base expansion goes from being something that is perceived as a “temporary” phenomenon by the markets to something that is perceived as a more “permanent” phenomenon.
QE4 could represent that magical tipping point: the point at which the market decides that QE is not some temporary experiment, but rather a permanent feature of the new world order.
Why does market perception regarding the “temporary vs permanent” nature of QE matter? It matters because expectations regarding the long-term path of the monetary base are one of the critical determinants of the value of the money that we use every day. In turn, the value of money is the “denominator” of every money price in the economy: as the value of money falls, the price level rises.
Let’s take this last point first: “the value of money matters to the determination of prices as expressed in money terms”.
While this may seem like an obvious statement, it isn’t something that you will read in standard economics textbooks. Why? Well, for a start, economics doesn’t recognize the “market value of money” as an independent variable. (See “The Value of Money: Is Economics Missing a Variable?”) At a more fundamental level, economics doesn’t recognize an explicit role for the value of money in the price determination process because most economists ignore one of the most basic tenets of economics: “price is a relative measure of market value”.
In order for a commercial exchange to occur, both parties must offer for trade something that possesses the property of “market value”. Whether it is apples for oranges, or apples for money, both items being exchanged must be perceived to possess value.
The ratio of exchange, one good for another, is determined by the relative value of the two goods. For example, if one apple is twice as valuable as one dollar, then the ratio of exchange is two dollars for one apple. This ratio of exchange is also known as the “price” of the trade. The price of apples, in dollar terms, reflects the relative market value of both apples and dollars. Importantly, the price of apples can rise either because (1) the market value of apples rises, or (2) the market value of dollars falls.
If every price is a relative measure of market value, then the price level is also a relative measure of market value. More specifically, the price level measures the market value of the basket of goods in terms of the market value of money. If we measure both the market value of the basket of goods and the market value of money in terms of a “standard unit” used for the measurement of market value, then we can express the price level as a ratio of these two values.
In essence, Ratio Theory states something that is obvious to everyone except professional economists: the value of money matters to the determination of the price level. As the value of money falls, the price level rises.
This brings us back to our key point. What determines the value of money? More specifically, what is the risk that QE4 triggers a shift in long-term expectations and could that shift lead to a sudden decline in the value of money?
The view of The Money Enigma is that fiat money is a financial instrument. In other words, it derives its value from its implied contractual properties. More specifically, fiat money is a long-duration, special-form equity instrument and represents a proportional claim on the future output of society.
What does that mean in practical terms? In simple terms, this theory of money implies that the value of the fiat money we use every day depends primarily upon two key factors.
First, the value of money is positively correlated to expectations regarding the long-term future growth of real output. If money is a claim on future output, then higher expected future output growth will make each claim (each dollar) more valuable.
Second, the value of money is negatively correlated to expectations regarding the future path of the monetary base. Importantly, the current level of the monetary base isn’t as important as expectations regarding the long-term future path of the monetary base.
This is a slightly more complicated concept, but you can think of it this way. If we expect that a company will have to issue lots of shares in the future in order to survive, then the value of those shares will decline. Similarly, if the market decides that a society will have to print lots of money (claims on future output) in order to sustain itself, then the value of the fiat money issued by that society will decline.
This comparison between money and shares is explored in several recent posts, most notably “Money as the Equity of Society”. The important point is that the value of fiat money is highly dependent upon the expected long-term path of the “output/money” ratio.
In even simpler terms, we can say that the value of fiat money is a barometer for confidence in the long-term economic prospects of society. If people become more pessimistic about the long-term (20-30 year) outlook for society, then the value of money will fall.
So, why might QE4 represent a tipping point?
The view of The Money Enigma is that QE4 could negatively impact expectations in two ways.
First, it could erode market confidence in the long-term growth of real output. After all, if the Fed just quintupled the monetary base and that wasn’t enough for the US economy to reach “lift-off”, then maybe there is a bigger problem. The initiation of QE4 might just be the factor that forces people to focus on this issue and adjust down their expectations for long-term real output growth.
More importantly, the instigation of QE4 could force a dramatic rethink on the part of market participants regarding the long-term path of the monetary base.
Up until recently, the view of the market seems to have been that QE is a temporary phenomenon, something that would be wound down in due course. But if the Fed is forced to enter into a new round of monetary expansion before any contraction in the previous expansion has even begun, then surely this will force the market to consider whether the Fed will ever be able to reduce the monetary base from its current bloated level.
The view of The Money Enigma is that the Fed must reverse the existing programs of quantitative easing, as discussed in a recent post titled “The Case for Unwinding QE”. Failure to unwind previous programs puts the US economy at risk of a significant acceleration in the rate of inflation. If the Fed follows the alternative route and decides to further expand the monetary base, then the risk of a dramatic acceleration in the rate of inflation becomes very real.