Will U.S. Quantitative Easing End Badly?

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1 Will U.S. Quantitative Easing End Badly? Does the U.S. Federal Reserve expect too much from monetary policy? Through the Federal Reserve Chairman Alan Greenspan era an increasingly optimistic view developed that monetary policy could have important long-term positive effects on the economy. Markets came to believe that carefully chosen quarter-point moves in the Fed Funds rate target could dampen economic volatility and keep the U.S. economy growing at a historically high trend rate. All the while, it was largely ignored that monetary policy makers were keeping U.S. GDP growth strong by supporting an unprecedented expansion of household debt. From the standpoint of economic fundamentals, it is hard to see how monetary policy can provide sustained long-run benefits to a well-functioning economy. Long-term benefits would have to rely on increasing labor force participation or gains in productivity. Good monetary policy might affect the latter through various mechanisms (e.g., lowering the market price of risk), but the long-run benefits are probably quite small. By its nature, labor-force participation has a limit and so cannot lead to unending increases in productive capacity. In contrast, monetary policy has the ability to mitigate some short-run risks by smoothing out the business cycle. However, the associated benefits are also likely to be more limited than people believe because long-run growth is largely unaffected. Certainly central banks can provide important crisis management benefits through emergency liquidity provision, but this (hopefully) happens fairly rarely. Considering our recent history, we should be very mindful of unintended consequences of recent unconventional monetary policy. In this paper we discuss recent policy actions and explore risks associated with quantitative easing. By our estimates, it is increasingly likely that unconventional monetary policy will end badly for parts of the economy and certain market sectors (e.g., U.S. Treasuries). Recent Monetary Trends To gain perspective on the risks of quantitative easing, it is useful to understand some basic facts on U.S. monetary policy over recent years. Since July 2007, broad money supply (M2) has grown at a 6.7% annual rate. A broader measure of money that includes institutional money funds has grown at 5.9% rate. 1 Yet, nominal gross domestic product (GDP) growth has averaged only 2.4%, much slower than the average 5.5% nominal GDP growth over the last 30 years. This implies that broad money velocity (GDP/M2) has declined from a peak of 2.1 in the mid-1990s to only about 1.5 today (see Figure 1). This is the lowest level over the period for which good data are available (1959-present). 1 Through December 2012.

2 Figure 1: M2 Velocity (Unadjusted and adjusted by subtracting excess reserves from M2) The drop in velocity coincides with the onset of the financial crisis and the Federal Reserve pumping liquidity into the financial system. Of course, this is a response to the crisis and not a cause of it. However, as the financial crisis waned, the supply of money did not. Instead the Fed has continued to grow the money supply and its balance sheet. Interestingly, almost all of the growth in M2 is the result of savings deposit growth at commercial banks. In contrast, time deposits, retail money funds, and institutional money funds have all shrunk over the last five years. Coinciding with the surge in M2 is a large decline in the money multiplier to below 1.0. A multiplier less than one is a perverse situation implying that the fractional reserve banking system is, in some sense, working in reverse. These realities are all facets of the same phenomenon of unconventional monetary policy. What are some possible interpretations and implications of these facts? First, the Federal Reserve is likely trying to achieve growth in broad monetary aggregates consistent with potential GDP growth, and they have been successful at this. Furthermore, the Federal Reserve is still adding excess liquidity to the financial system to cushion the economy from the massive contraction in the shadow banking system and prevent a credit crunch where qualified borrowers are not able to access credit. Savings deposits are low-powered money, and the accumulation of these funds means that we should continue to see a structural shift in money velocity data as long as other components of monetary aggregates expand more slowly than nominal GDP. The Fed, however, may be playing a dangerous game. While it is an admittedly ad hoc adjustment to the data, let us consider a simple cleaning of monetary statistics by subtracting 2

3 a measure of extra money equivalent to the amount of excess reserves in the banking system. 2 Once the level of excess reserves is subtracted from M2, there is no trend in money velocity. If the level of excess reserves is subtracted from the monetary base, there is a small but consistent upward trend in the money multiplier. If the increase in the money multiplier adjusted for excess reserves starts to accelerate, money supply growth could rapidly outpace potential GDP growth. The increase in savings deposits coincides with increased risk-aversion by households, an increase in the savings rate (i.e., desire to delever), and the closing of the gap between money market mutual fund yields and savings deposit rates. This raises the question of what might happen when these forces abate. Sins of Our Fathers If easy monetary policy helped create the problem, should we expect it to solve the problem? Or, will an expansion of easy money just be further punishment for the sins of our fathers (e.g., baby boomers with underwater McMansions and depreciating Porsches)? In its 2012 Annual Report, the Bank for International Settlements (BIS) included a chapter discussing the limits of monetary policy. 3 The authors discuss in detail how prolonged easy monetary conditions conducted with unconventional policy tools can produce a range of negative consequences. First, most households that took on excessive debt prior to the financial crisis may be unlikely to borrow more to support discretionary consumption, thus the lever is pushed harder to induce consumption. As we discuss below, more consumption necessitates a slowing of savings and the process of balance sheet repair that is ultimately required for the economy to regain healthy sustainable growth. Second, financial institutions bear less than the free market cost of carrying bad loans and thus less pressure to clean up balance sheets. This misallocation distorts and delays an efficient allocation of capital by banks. At the same time low rates and a flattening yield curve are likely to reduce profits of banks. Low rates put pressure on other parts of the financial system such as insurance companies and pension funds. Third, the deliberate attempt to push investors out the risk spectrum necessarily means that some investors may be taking more risks than they would otherwise desire. This might include institutional investors tilting towards equities and commodities. Fourth, easy conditions in the U.S. are likely to have negative spillovers to the global economy. Easy money in the U.S. has helped fuel global credit and asset booms that now may be jeopardizing growth that is important to a sustained U.S. recovery. The BIS is not alone. Some of the world s most respected economists are now warning of further unintended consequences of QE. Stanford economist John Taylor warned last year how low U.S. interest rates also encourage non-u.s. firms to borrow in dollars. 4 This puts pressure on global central banks which in turn can result in instability in the global real economy. According to Taylor, The current sharp slowdown in most emerging markets coincides with an 2 Excess reserves are included as part of the monetary base but not the primary measures of money supply such as M1 and M2. Thus, this is just a loose way of capturing the degree of money that the financial system does not have a good use for WSJ Op-ed Taylor: Monetary Policy and the Next Crisis. 7/5/12 3

4 inevitable bust of this easy-money induced boom, and the decline of foreign demand for American goods is now feeding back to the U.S. economy. While it is difficult to quantify the overall economic impact of these results, we estimate that they are an important part of the slow recovery. We estimate that undesirable side effects of past and current QE programs amount to 2-3% of GDP. Perhaps a better way to interpret the effect is on the speed of the recovery. A drag of this magnitude will result in a 1-2 year delay in the economy returning to potential output levels. For the Fed this could represent an acceptable trade-off: the recovery is slower, but with less risk of Japan-style deflationary doldrums. Other Downsides to QE Unfortunately, these are not the only potential downsides to QE. We see other mechanisms by which QE might distort the economy in undesirable ways. 1. QE masks the real cost of federal budget deficits. The Federal government budget deficits over the last four years have been massive, but the cost of all the new debt has not been transparent. Low interest rates orchestrated through QE, combined with a decline in average maturity of debt, means that the cost of servicing the debt has remained low. When interest rates increase, the debt burden will rapidly increase. This will fuel the issuance of more government debt to cover the increased interest expense which will push rates up further in a vicious circle. This rise in real rates could coincide with an increase in inflation expectations (as we discuss below). The resulting shock to the fiscal situation could result in an even worse fiscal tragedy where the government would be forced to make very undesirable adjustments to spending and tax policy. 2. Slowing household balance sheet repair through financial repression may be discouraging the savings needed to lay the foundation for robust domestic growth. By design, QE has forced real interest rates in the U.S. to negative levels at almost all maturities. This means that savers in high quality investments expect to lose purchasing power which provides an incentive to consume instead of save. We estimate that if real interest rates were at the long-run average, the U.S. saving rate would be 2-3% higher. This would have the benefit of helping households repair their balance sheets more rapidly. Furthermore, it would provide a long-run benefit of shifting output away from a still too-high level of consumption toward real investment which would support the long-run growth potential of the economy. In this way QE provides a force that prolongs the transition to self-sustaining growth and encourages excess consumption. 3. QE may slow the return to equilibrium in the housing market. Many families are still in houses they would prefer not to own. QE helps people stay in these houses by letting them refinance at below-market rates. While this helps stabilize the housing market in the short-run (by reducing supply and supporting prices), it may not be doing these households a favor. The potential problem stems from people occupying homes with consumption values that are too high for their income and wealth levels. Since the value of structures depreciates, these households will either be incurring losses on the structure value or have to invest in upkeep at a rate that exceeds what they would be doing absent QE. This implies less real savings and balance sheet repair by these households. Without QE, more of the large empty-nester houses would be sold to younger families better suited to these homes. So while QE supports the market, there is a hidden cost for many households in the form of a housing capital stock misallocation. 4

5 4. Financially unsophisticated households that have piled into high quality bonds lately may have been set up for significant losses. In 2012, net inflows to bond funds reached $328 billion (+11.9% versus 2011) while equity funds experienced small outflows. 5 Longer-term data provided by the Federal Reserve s flow of funds accounts show that households direct equity holdings in 2012:Q3 remain about 16% below the 2007 peak whereas holdings of U.S. Treasury securities by households has increased dramatically over the same period. 6 Currently, real interest rates on U.S. Treasury securities are negative at most maturities less than 20 years. Consequently, households as a group are very likely to lose purchasing power on these investments almost regardless of their holding period. Since individual investors often use historical returns as a basis for expected future returns, many households will be surprised by the low returns. For those familiar with this line of reasoning, it is basically a restatement of the financial repression argument described by economists Reinhart and Sbrancia. 7 So How Exactly Might QE End Badly? The most likely scenario is that QE continues as expected for the next 1-2 years and the negative effects grind away at a slowly recovering economy. Beyond low interest rates, neither the costs nor the benefits of QE will be readily obvious to the typical household. However, there is a real possibility that QE could unwind more quickly than anticipated. The catalyst for this scenario is most likely an upside surprise to economic conditions in 2013 that sparks an inflation scare. It is not even necessary that actual inflation tick up much, only that inflation expectations increase and markets start to fear a sooner-than-expected end to accommodative Fed policy. So, could it be that the major risk to the bond markets (and unsuspecting households) is upside economic growth? To us, the Fed s actions seem analogous to someone trying to start an old car. The Fed has been trying to prime the economy by pouring gas in the carburetor. On the first few attempts this led the economy to sputter and stall. Now out of frustration, the Fed is dumping in all of the gas it has. This might get the economy started, but it might also lead to a car fire! But, what starts the fire? There are several possibilities that could work independently or in tandem. 1. Housing takes off Currently, uncertainty abounds about what constitutes the true supply of housing available to buyers. Measures of combined supply that include bank-owned properties suggest that there is still 1-2 years of excess supply. However, supply could be much tighter than widely assumed, if these houses are not in the locations needed to meet new demand, there is a quality mismatch, or banks continue to hold a lot of properties off the market. We have already seen positive surprises in home prices and current valuations are low relative to measures of fair value implied by rents. Record low mortgage rates could further juice demand. Pent-up household 5 Based on EPFR year-to-date data for week ending December 26, Source: Table L.100. Note that the Fed s definition of households includes nonprofit organizations, hedge funds, private equity funds, and personal trusts. 7 See 5

6 formation has started to propel housing as deleveraging slows. So, it is certainly possible that recent price increases will bring people off the sidelines as they sense that the market has bottomed. A price jump could be self-reinforcing if this causes others to worry about missing the bottom. 2. Resolution of uncertainty Recent academic research suggests that the economic recovery has been hindered by high levels of uncertainty. 8 That uncertainty is rapidly resolving: The Fed has removed most nearterm monetary policy uncertainty for U.S. The ECB has signaled it will do whatever it can to preserve the Euro. The global economy is stabilizing after a second-half slump. The U.S. presidential election is over. Most near-term fiscal uncertainty should get resolved sometime in the second quarter. Equity market volatility has been trending down since mid Consumers come back strong The long slog by U.S. households through excessive debt levels continues, but there is an increasingly bright light at the end of the tunnel. Household debt as a percent of disposable income has declined from a peak of 129.4% in 2007 to 107.9% in the third quarter. 9 There is good reason to believe it will start to level off around 100% sometime in the next year or two since the debt service burden (i.e., debt service payments as a percent of disposable income) is approaching a 30-year low. 10 Continued stock market gains could lead to a positive wealth effect and further stimulate spending. All of this combined with historically loose financial conditions and an improving housing market means that consumers could come back with a vengeance. 11 If the economy shows unexpected strength and at the same time we observe some surprises in monthly inflation reports, the bond market could get spooked. Investors could grow concerned that the Fed is behind the curve and will end QE sooner than expected. This in turn could result in a rapid climb in U.S. Treasury yields much like the sell-off in 1994 when bond traders were caught off-guard by Fed rate hikes. Recall that while the Fed has promised to be exceptionally accommodative until the labor markets improve significantly, there is an important caveat. The Fed has conditioned its policy on intermediate-term inflation expectations staying below 2.5% and longer-term expectation remaining well anchored. With inflation currently running at about 2%, this does not leave much headroom. Given the Benefits and Risks of QE What Do the Markets Think? QE1 may have prevented another Great Depression, so the Fed deserves a pat on the back for that. QE2 looked to be heading off a scary decline in core inflation in 2010 that could have resulted in a Japanese-style liquidity trap. For the sake of argument, let us assume QE2 was the preferred policy. However, QE3 comes during a time of stable inflation near the Fed s implicit target, an expanding economy, and employment growth. No one will argue that economic 8 See Stanford economist Nick Bloom s website (http://www.stanford.edu/~nbloom/) for current research and data for his Economic Policy Uncertainty Index. Also, Nicholas Bloom, "The Impact of Uncertainty Shocks," Econometrica, Econometric Society, vol. 77(3), pages See, for example, The Federal Reserve Bank of Chicago National Financial Conditions Index (NFCI) and adjusted NFCI (ANFCI). 6

7 growth has been sufficient, but for all of the reasons above, we might think QE3 is the wrong prescription for what ails us. One way to judge the potential effects of QE3 is to look at how some important markets reacted since just before the Fed s announcement on September 13 th, Below we table levels of 10-year U.S. Treasury Yields, 5-year forward expected inflation 5 years forward implied from TIPS, the spot price of gold, the U.S. dollar index, and the level of the S&P 500 index through the end of October. Indicator Pre-Announcement (September 10, 2012) Post-Announcement (October 29, 2012) Change 10-year Treasury Constant Maturity Yield 1.66% 1.72% +0.06% 5-year Breakeven Inflation 5- years Forward 2.80% 3.02% +0.22% Spot Price of Gold ($/oz.) $1,726 $1,709 -$17 U.S. Dollar Index (DXY) S&P 500 Index 1,429 1, Source: Bloomberg Interestingly, all of these variables are very close to where they were just before QE3 was announced. So despite some ups and downs, the emerging consensus across multiple markets appears to be that QE3 will have little net effect. The only variable that may have experienced a meaningful change is expected inflation between 5-10 years from now that has moved even further outside of the Fed s comfort zone. Could this be an omen of further changes in expectations down the road? Investment Implications In a world where not much is certain, it is important to evaluate and balance risks. The Fed has clearly adopted the view that downside economic risks outweigh upside inflation risks. But this is not an easy call. With both short-term and long-term rates near historic lows, the Fed is relying on unconventional and untested methods for stimulating economic activity. Pushing investors into riskier assets through massive price pressure on safe assets has its own risks. Given the range of possible adverse side-effects and the magnitude of built-up pressures in the markets, we see the possibility of a disorderly unwinding of QE effects as a significant risk in the fixed income markets. Our analysis suggests the risks are primarily associated with better than expected economic news that results in inflation concerns. The crux of the problem is understanding how much expected inflation would be good for the economy and markets (maybe as much as 3% on a forward-looking basis). However, the combination of surprising growth and current Fed policies makes for a highly flammable combination which may lead to inflation expectations beyond those levels. So, our underlying theme is that ending badly likely pertains most to assets exposed to inflation risks such as conventional U.S. Treasuries. In contrast, Treasury Inflation-Protected Securities (TIPS) could be largely insulated from a sell-off if increases in real yields are offset by increases in expected inflation. The situation is more complicated for mortgage-backed 7

8 securities (MBS). MBS would be hurt by both higher volatility and a lack of Fed buying. Higher nominal rates will extend the duration of pass-through securities, but a strong economy will allow many currently constrained households to qualify for refinancing (via higher incomes and home prices). This means that unique characteristics of mortgage pools would become increasingly important for determining returns. The countervailing forces would be strong for private-label RMBS and CMBS. A strong economy is likely to be more of a positive than a negative for these securities because of the expected boost to the underlying collateral value of assets. The lower liquidity of these assets is a relatively minor concern unless markets experience a massive deleveraging episode which we do not expect given current levels of leverage. Corporate bonds would be adversely affected by the increase in U.S. Treasury rates, but improving credit quality would partly mitigate price changes through tighter spreads. In particular, shorter duration, lower quality bonds would outperform longer duration high quality bonds. In conclusion, Smith Breeden s base-case is not for a sudden and disruptive end to QE and we are not betting on a huge rate increase. Instead, we remain very mindful of the possible unintended consequences of unconventional monetary policy and that we must guard against them. Gregory W. Brown, Ph.D. is a Principal and Director of Research at Smith Breeden Associates, Inc. and the Sarah Graham Kenan Distinguished Scholar at the Kenan-Flagler Business School of the University of North Carolina at Chapel Hill. Prof. Brown currently serves as the Director of the Center for Excellence in Investment Management. Since becoming a consultant to Smith Breeden in 2010, he has served as a member of the Investment Committee and has contributed to the firm s macroeconomic analysis. His research centers on risk measurement and the use of financial derivative contracts as financial risk management tools. Prof. Brown has published in leading academic and practitioner finance journals such as The Journal of Finance, The Journal of Financial Economics, The Journal of Derivatives, Financial Analyst Journal, and RISK. He is also the co-editor of Corporate Risk: Strategies and Management (Risk Publications) and associate editor for Derivatives and Risk Management of FMA Online. Prior to joining Kenan-Flagler, Prof. Brown worked at the Board of Governors of the Federal Reserve System in the Division of Research and Statistics. He has also consulted for money management firms, software developers, and Fortune 500 companies on various aspects of financial risk management. He holds a Bachelor of Science with honors in Physics and Economics from Duke University and a Ph.D. in Finance from The University of Texas. All information in this paper is provided for informational purposes only and should not be deemed as a recommendation to buy or sell specific securities. It is not intended to be a forecast or a guarantee of future results. Smith Breeden cannot guarantee the success of any investment strategy. Past results are not necessarily indicative of future performance. No assurance can be made that profits will be achieved or that substantial losses will not be incurred. All investments involve risk including the loss of principal. Information in this paper is taken, in part, from external sources. We deem these external sources to be reliable but no warranty is made as to accuracy. 8

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