January 5, 2016
As we begin 2016, the key question investors should be asking themselves is whether the Fed can pull off the magic trick of the century. Can the Fed convince the markets that the elephant in the room doesn’t exist by pulling a rabbit out of the hat?
It’s a complicated magic trick. The first part of the trick involves pulling a rabbit out of the hat, i.e. raising the Fed Funds rate in an environment where the entire yield curve has been pressed against the floor. Normally, raising the Fed Funds rate, or the short-term interest rate, is a simple matter. However, this previously simple action is now a complex problem that involves new hidden mirrors such as “interest on reserves” and the “reverse repurchasing facility”.
The second part of the trick is even more complicated. In essence, the Fed is attempting to make the elephant in the room disappear, or at least disappear as an issue for investors. The elephant in the room is the bloated balance sheet of the Fed, otherwise known as the monetary base.
Over the past eight years, the Fed has quintupled the size of the monetary base through successive rounds of quantitative easing. Now, it seems that the Fed wants to keep its cake and eat it too: the Fed wants to keep its bloated monetary base, but wants investors to pretend that it doesn’t matter or forget about it entirely.
How do you distract people from the elephant in the room? Well, you make them focus on the rabbit. By being seen to be “doing something” on interest rates, the Fed hopes that markets will be distracted from the fact that they are “doing nothing” about the monetary base.
Why does the size of the monetary base matter? There are two key reasons:
- The size of the monetary base determines the long-term required rate of return on capital. As the Fed increased QE, it brought down the required rate of return on capital, pushing up asset prices across the economy. If the Fed reverses QE, i.e. reduces the size of the monetary base, then this process will go into reverse.
- The expected size of the monetary base determines the value of money and, consequently, plays a critical role in determining the rate of inflation. Fiat money represents a proportional claim against the future output of society. If people suddenly expect the monetary base over the next 20-30 years to be much higher than they previously anticipated then the value of money collapses and prices soar.
This week we will explore these issues by examining a little Fed history (what the Fed did and why) and dispelling a couple of misconceptions regarding the operation of monetary policy.
Monetary Policy Misconceptions
While monetary policy is a poorly understood topic at the best of times, there are two specific misconceptions regarding monetary policy that we need to address in the current environment.
The first misconception is that “the interest rate matters, but the size of the monetary base does not”. More specifically, there is a misguided view held strongly by many in the economics profession that the fed funds rate is somehow far more important to economic outcomes than the size of the monetary base.
The second misconception is one that has popped up more recently regarding the nature of the Fed’s first interest rate rise. More specifically, John Hussman recently argued that by raising interest rates by 25 basis points, the Fed has, in effect, reduced the monetary base by an enormous $1.7bn. It hasn’t. Rather, the recent interest rate decision does very little to unwind a decade of monetary excess and aggressive Fed policy.
However, in order to understand these points, we need to examine a little history and discuss some basic economic theory.
The first point to make, particularly for those not familiar with financial markets, is that while economists like to talk about “the interest rate”, in practice there exists a whole series of different interest rates on US government debt. Typically, the interest rate on a 30-year bond is higher than that on a 5-year bond, and the rate on a 5-year bond is higher than that on a 12-month or 3-month Treasury bill. This series of interest rates on government debt of different maturities is called the yield curve.
Historically, the Federal Reserve has focused its efforts on controlling short-term interest rates, i.e. it has focused on manipulating the short-end of the yield curve. The general principle was that lowering short-term interest rates would encourage banks to lend and drive economic growth, whilst raising short-term interest rates would have the opposite effect.
While this approach to monetary policy seemed to work fine for many years, over the course of 2007/2008 the Fed pushed short-term interest rates down to the lowest point they could… i.e., zero.
The problem was that this extraordinary policy response didn’t resolve the financial crisis that was occurring at that time (Lehman collapse, US housing market debacle, etc.) Therefore, the Fed needed a new way to stabilize markets and boost the economy. The answer: quantitative easing.
What is quantitative easing? Well, “quantitative easing” is a fancy way of saying “creating money and then using this newly created money to buy long-term government securities, thereby pushing down long-term interest rates”.
In essence, the Fed decided that if manipulating short-term interest rates no longer worked, then they would have to start directly manipulating long-term interest rates.
Sounds easy. So why didn’t the Fed always manipulate long-term interest rates? Well, the problem with manipulating the long-end of the government securities market is that it is a really big market. You remember those signs for the national debt clock? $20 trillion and counting? Well, it’s that market. More specifically, three-quarters of that market matures in more than one year. Manipulating a $15 trillion market takes a lot of money. As it turns out, about $4 trillion.
In order to lower long-term interest rates, the Fed had to create $4 trillion in money that never existed before and use this money to buy up some of the $20 trillion of outstanding US government debt. Buy enough long-term government debt and eventually the price of long-term debt rises and the interest rate on long-term debt falls.
If this sounds like a “big deal”, then your right… it is. What is strange is that standing here now in 2016, over seven years after QE began, many economists, including those at the Fed, seem to be preoccupied by short-term interest rates rather than long-term interest rates. Indeed, the message from the Fed seems to be “watch my left hand (the Fed Funds rate and the short end of the yield curve) but not my right hand (the monetary base and the long end of the curve)”.
Is this fair? Does the short end of the curve matter more than the long end of the curve to economic consequences? No. In fact, there is a good case to be made that the long end of the interest rate curve is more important to economic outcomes than the short end of the curve. Why? Well, to answer this question, it helps to remember why the Fed embarked on successive rounds of QE in the first place.
Long-Term Interest Rates and Asset Prices
The first round of QE, “QE1”, was primarily targeted at stabilizing financial markets. By the end of 2008, the entire US mortgage market had stopped working. By creating money and using this money to purchase mortgage-backed securities, the Fed helped this key pillar of the economy to get back on its feet.
Unfortunately, the Fed didn’t stop there. Rather, the Fed launched two more rounds of QE, “QE2” and “QE3”. Those rounds focused almost entirely on purchasing long-term government securities.
Why did the Fed do this? Arguably, the immediate financial crisis was resolved by QE1. So, why spend another $3 trillion in these subsequent rounds? The answer was to boost the economy. But how? What was the transmission mechanism from lowering long-term interest rates to higher economic growth? In a word: speculation.
By lowering the long-term risk-free rate, i.e. the long-term interest rate on US government securities, the Fed effectively lowered the long-term required rate of return across all asset classes, including the riskiest asset classes such as equities and venture capital.
Long-term interest rates matter far more to the price of most of assets than short-term interest rates. Why? Well, most assets are long-duration assets: equities, property and a substantial portion of fixed income securities are long duration assets. The value of these assets depends primarily upon discounted cash flows that will be received in the distant future. What is the rate used to discount these long-term cash flows? The long-term required rate of return on risk capital. What is a key factor in determining the long-term required rate of return on risk capital? The long-term, risk-free rate, i.e. the long-term interest rate on US government debt.
So, what happened when the Fed embarked on QE2 and QE3? Global asset prices soared. Why? Because, in effect, the Fed had artificially lowered the long-term required rate of return on risk assets.
The expansion of the Fed’s balance sheet and the associated manipulation of long-term interest rates has had a very significant impact on asset prices and, consequently, the real economy over the past seven years. By lowering the long-term interest rate and the required return on risk capital, the Fed has encouraged new business formation (shale oil and fintech bubbles) and the creation of jobs.
The problem the Fed faces today is that what works on the way up also works on the way down.
If the Fed begins to reverse QE and reduce the size of the monetary base, then it will have to sell government securities off its balance sheet, thereby forcing down the price of those securities and forcing up the long-term interest rate on government debt and, consequently, the required return on all risk assets. The result: a collapse in asset prices.
All of this raises an obvious question: why reduce the monetary base at all? If expanding the monetary base boosts asset prices and economic activity, then why should the Fed “normalize” the size of the monetary base?
Money isn’t Free… Even for the Fed
The view of The Money Enigma is that the role of the monetary base in the determination of the price level is one of the most poorly understood issues in economics.
At a general level, the relationship between money and prices has been explored in several posts, most notably “Does Too Much Money Create Inflation?” and “A New Perspective on the Quantity Theory of Money”. However, those that are interested in a specific argument for why the Fed must normalize the monetary base should read an article written six months ago, “The Case for Unwinding QE”.
We won’t go into all of the details of the arguments contained in those articles today, but at a simple level, the view of The Money Enigma is that expectations regarding the long-term future path of the monetary base are critical in the determination of (a) the value of money, and (b) prices as expressed in money terms.
More specifically, a permanent expansion of the monetary base carries with it a definitive cost: a devaluation of money and a rise in all prices as expressed in money terms.
Note that I emphasize the word “permanent” in the above sentence. By now, everyone knows that a central bank can dramatically expand the monetary base without causing a sudden increase in prices in the short run. However, this is also balanced by the strongest empirical observation in economics, namely that, in the long run, growth in the monetary base that is in excess of the growth in real output will lead to a commensurate rise in prices.
So, why does monetary base expansion cause inflation on some occasions but not on others? In essence, the issue boils down to one of expectations. If the market expects the monetary base expansion to be temporary, then this should have very little impact on the value of money. Conversely, if the market expects a monetary base expansion to be permanent, then this leads to an immediate fall in the value of money.
Currently, the market expects the recent expansion of the Fed’s balance sheet to be “temporary” in nature. However, if the Fed doesn’t begin to reverse QE in the near future, then expectations could change. More specifically, the market may begin to recognize that the recent expansion of the Fed is more permanent in nature. Such a shift in expectations would lead to a significant fall in the value of money and a rise in prices across the economy.
Why do long-term expectations regarding the monetary base matter to the value of money? Well, in simple terms, fiat money is only as good as the society that issues it. If a society must rely on expansion of the monetary base to support itself, then that society and its currency are in trouble.
In more technical terms, the view of The Money Enigma fiat money is the “equity of society” in that it represents a proportional claim on the future output of society, just as a share of common stock represents a proportional claim on the future cash flows of a company.
Rising expectations regarding long-term real output growth boost the value of each claim (the value of money rises and prices fall). Conversely, rising expectations regarding the number of claims to future output, i.e. the future size of the monetary base, reduces the value of each claim (the value of money falls and price rise).
The other way to think about it is this.
What is the difference between “QE” and “monetizing the deficit”? The short answer is “expectations”. If the Fed’s intention is to buy government debt and keep it, then it is “monetizing the deficit”. In contrast, if the Fed’s intention is to buy some debt and then sell it at a later date, then it is not.
The problem is that it is a fine line. You can’t buy government debt and never sell it and call it a “temporary” market intervention. If the Fed doesn’t unwind QE, then it is has monetized the deficit. There is simply no other way to look at it. Problematically, monetizing the deficit always ends with the same result: a collapse in the value of money and a surge in the rate of inflation.
In summary, while the Fed may be successfully using the interest rate rabbit to distract the markets from the base money elephant for now, this situation won’t last forever. If the markets suddenly realize that the Fed isn’t serious about “normalizing” monetary policy, i.e. reducing the size of the monetary base, then it will take a lot more than a rise in short-term interest rates to prevent a collapse in the dollar and an outbreak of high inflation.
“25 Basis Points” does not equal “$1.7bn Monetary Base Reduction”
There has been a story doing the rounds of social media lately that states that the recent rate rise by the Fed is the equivalent of a massive reduction in the monetary base. This isn’t right and I want to explain why.
I believe that the story originated with John Hussman, economist and fund manager. I have read Hussman’s work for years and I greatly admire his work. In a recent post, “Reversing the Speculative Effect of QE Overnight”, Hussman repeats his view that “the immediate first step of the Federal Reserve in normalizing monetary policy should have been to reduce the size of its balance sheet”. I completely agree with this view.
However, Hussman further argues in regards to the Fed’s recent 25bp interest rate rise that “from the standpoint of investors, the overall effect is just as if the Fed had suddenly removed every dollar of quantitative easing since 2009 ($1.7 trillion).
Hussman bases his view on the principle that supply and demand for money determines “the interest rate” which Hussman defines as the 3-month Treasury bill yield. Therefore, if the Fed raises this rate by 25bp, then, according to his chart, it is the equivalent of the Fed reducing the monetary base by $1.7 trillion.
As regular readers would know, the view of The Money Enigma is that supply and demand for money does not determine the interest rate. Rather, supply and demand for the monetary base determines the market value of money. [See “Supply and Demand for Money: Where Keynes Went Wrong”]
So what determines “the interest rate”? Supply and demand for each government security determines the interest rate on that particular government security. More specifically, supply and demand for 3-month bills determines the rate on 3-month securities and supply and demand for 10-year notes determines the rate of 10-year notes, etc.
The Fed uses the money it creates (the monetary base) to intervene in those markets. As discussed earlier, the Fed intervened in the short end of the market and drove short-term rates to zero. Then, when that wasn’t effective, it intervened in the long-end of the curve, an act that required a massive expansion of its balance sheet.
Hussman’s analysis lumps these two very distinct markets into one (the short-end of the curve and the long-end of the curve). It must be remembered that the Fed didn’t spend $1.7 trillion to push down the 3-month bill rate. It spent that money to push down the interest rate on 5-year, 10-year and 30-year debt.
Today, the Fed wants to raises short-term interest rates. In doing this, it has two choices. Either (a) reduce the size of the monetary base and let the entire yield curve rise, or (b) artificially manipulate short-term rates using interest on reserves and the reverse repurchase facility.
The Fed has chosen option (b). The view of The Money Enigma is that the Fed has chosen option (b) primarily to avoid the risk that Hussman raises: the Fed doesn’t want to raise the long-term cost of capital and thereby reverse the speculative effect of QE.
While I agree with Hussman that global equity markets are overvalued in a historical context, the primary driver of this overvaluation is Fed suppression of the long-term required return on capital. At some point, the Fed will have to blink and allow the long-term required return on capital to rise: that will be a bad day for stocks.
In summary, the Fed finds itself between a rock and a hard place. If the Fed reduces the size of the monetary base, global asset prices will fall markedly. However, if the Fed does not reduce the monetary base, then at some point expectations regarding the “temporary” nature of QE will shift, the value of money will fall and inflation will accelerate.
Using complicated mechanisms such as IOR and RRP to raise short-term interest rates might distract the markets and the mainstream media for a few months, but it won’t solve the big issue: what to do with the elephant in room.
Author: Gervaise Heddle