A Reply to Fed (Bernanke) Apologists

Markets worldwide seem intent on ‘not fighting the Fed (all central bank easing)’ to the exclusion of any concern that valuations may be getting out of whack or what the consequences may be of unlimited monetary ease. 

On the first point, in an earlier article “Remember, Buy Low, Sell High”, I presented my arguments for why stocks are in overvalued territory. 

As to the second point, while I am not a trader and, therefore, have a difficult time divorcing fundamentals (overvalued stocks) from current price levels, I do understand the liquidity affects that overly easy central bank monetary policy can have on security prices. 

That said, past periods of excessive Fed supplied liquidity have ended badly; and to date, I haven’t found anyone that has a clear explanation of what will happen when the central banks have to start tightening after this unprecedented expansion in global bank reserves.  Nonetheless, I have a hint.  We know what has happened in the past when the Fed tightened after a period of easy money---100% of the time, it either tightened too quickly and pushed the economy into recession or it waited too long and inflation spiked. 

Unfortunately, this time around the Fed’s balance sheet is exponentially more bloated than it has been in the past.  Hence, it seems like the potential negative consequences in transition to tighter money might also be larger.  I could try to quantify that potential downside by extrapolating into the present the past experiences when monetary policy transitioned from easy to tight.  But I won’t.  I will simply contend that there are risks and that given the extent of money expansion, those risks might be higher than experienced in the past.

What has my dandruff up is the Fed apologists that keep telling me that Bernanke is doing a great job and that there are no monetary related problems about which to be concerned.  I read one such article published on one of my favorite websites yesterday; and after  bouncing off the ceiling a couple of times, I decided to address what the authors entitled ‘Everything You Think You Know About the 'Big Bad Fed' Is Wrong’.  :

                        Here are the ‘misconceptions’ that they attempt to prove wrong. (to be clear, the authors of the aforementioned article are stating that the bold, italicized statements are wrong):  

(1)     ‘printing money increases the money supply’  Well, duh.  Anyone paying attention to the economy and the Fed knows that is not how monetary policy works; and, hence the authors are correct to say that it is wrong.  What is also correct is that the money that the Fed is printing goes into bank reserves; and unfortunately, at the moment those banks are not rushing to lend money (which would create money supply).  So, lots of reserve growth but little money supply growth.  So far, the authors and I are in agreement.

But it stops there.  Because the Fed is increasing reserves with the stated intent of increasing money supply.  That is done by the banks lending its reserves which the Fed believes will speed up economic growth and lower unemployment. The  problem is that to date its policy has been a bust.  However, if we all woke up tomorrow morning and the banks had lent all those reserves overnight, money supply would explode and Bernanke et al would be wee weeing in their whitey tighties and scrambling to withdraw those reserves. 

So it seems to be a bit disingenuous to confuse the result (money printing hasn’t increased money supply---to date) with the intent (printing money increases bank reserves which will hopefully increase money supply).  Yes, there has been no surge in money supply, but not for wont of trying. 

(2)     ‘QE is pumping cash into the stock market’.  OK, not directly.  As you know, most of the QE’s to date have involved the Fed creating money and buying government bonds and mortgages.  The authors argue most of those bonds are bought from banks and a big chunk of that remains as excess reserves.

(a) true technically. But in QEIII, virtually all bonds bought by the Fed come almost dollar for dollar from the Treasury though indirectly (the UST sells the bonds to primary dealers who then sell them to the Fed and make the vig) to finance our on going trillion dollar deficits ($1 trillion, i.e US deficit/12 months = $83,33 billion/month---amazingly close to $85 billion per month wouldn’t you say?).  To be sure, that is not the stock market; but the effect of these purchases are not benign--but that is a whole other issue.  See (3) below.

(b) the authors rightfully point out that much of the positive stock market performance is a derivative of the ‘don’t fight the Fed’ notion; that is, the Fed’s aggressive monetary action theoretically provides a downside to the economy and that is a positive for investor psychology which leads to increased stock investments. 

However, I think psychology is secondary.  The main reason investors are flocking to stocks is that the Fed’s zero interest rate policy isn’t giving them much of a choice. Investors, even conservative fixed income types (seniors), have no other place but the stock market to put their money to earn a return.  So while QE may not be directly pumping money into the stock market, it is forcing money into the stock market via the perversity of zero interest rates.  In the process, it is robbing those conservative investors, enriching the banks and encouraging the misallocation of capital.

(c) if you think the big banks are sitting on all those reserves and not doing anything with them (cough, prop trading, cough), I have a bridge in Brooklyn that I will sell you cheap.

(3)     ‘QE will create runaway inflation’.  I agree with the authors that this is not likely---the runaway part, that is. And they acknowledge that the inflationistas have been lowering their own dire prognostications.  However, that doesn’t mean the economy won’t suffer from another round of Fed induce inflation.  So how about ‘QE may create high inflation’?  I am not arguing Weimar Republic/Zimbabwe level inflation.  But I will argue that based on history, the Fed has never, ever extricated itself from an easy money policy without either (a) starting to tighten too soon which led to an economic slowdown if not recession or (b) waiting too long which led to higher than generally acceptable levels of inflation.  So maybe it should be QE will not create runaway inflation but it will likely lead to either recession or higher inflation’.

The authors pooh pooh the notion that inflation could still occur as a result of current Fed policy.  And you know what?  They could be right.  However, they fail to note that Bernanke has stated that one of the signs that QE is working is.........drum roll---inflation.  Of course, what Bernanke means is just a little bit of inflation.  But what if he is wrong and ‘a little bit’ turns out to be a whole lot.  Assuming the Fed is smart enough to fine tune its results I believe is a dangerous assumption.  As proof I suggest that you check on Bernanke’s statement about the health of the housing market mere months before that bubble blew up.

In other words, what the authors fail to address is that at some point in time, a day, a month, a year, a decade from now, the Fed will have to (a) stop buying $85 billion a month in governments and mortgages, then (b) start removing all those reserves from bank balance sheets.  And what happens then?  To be sure, if the US economy continues to grow at a sub par pace into infinity, the task may be postponed or rendered moot. But that is not the Fed’s stated intent; and assuming that it takes all steps necessary to goose the economy (have banks lend those reserves) and the economy begins to grow, then what happens? 

So, notwithstanding the authors discounting the argument that nothing has happened ‘yet’, in truth ‘yet’ hasn’t happened yet.   But more importantly, they offer no useful explanation of how the reduction of this massive accumulation of reserves is going to be executed without causing problems when, as and if the economy ever picks up steam except to say that investors will ultimately come to understand how the transmission mechanism of monetary policy works.

But I have an add-on question.  How much larger can the Fed balance sheet get before it is forced to do something? After all, if the balance sheet keeps growing, at some point in time even a 5 or 10 basis point move up in rates (down in prices) will destroy the entire Fed highly leveraged equity position.  Now I know that in its infinite wisdom that the Fed has already dealt with the accounting issue, i.e. it excused itself from recognizing capital losses.  But will investors be that forgiving?  I don’t know.  My point is that no one else knows the answers to the above inflation related questions; and that is a problem for which the Fed is directly response.

Furthermore as I noted above, the current QE is basically buying all the new debt issued by the Treasury to finance our deficit.  And that deficit funds what?  Solyndra, Fisker, federal employee salaries and benefits, war, ethanol and other agricultural subsidies.  What do you suppose the inflationary impact is of all that extra inexpensive money courtesy of the Fed being pumped into the economy funding nonessential, inefficient projects, regulations, useless federal employees and defense materiel?

(4)     ‘QE causes high oil prices’.  Hmmm.  I haven’t heard this one; but the authors got me on it anyway.  Technically, they are correct---from the initial date of inception of the QE’s, oil prices may be up a little but not much and nothing about which to complain.  However, check the history of monetary ease, i.e. QE by another name.  Oil and food prices almost always start moving up when the Fed over stimulates or over stays its stimulus policies. 

A big reason this isn’t happening with oil right now is because of the fracking revolution in this country which has added significantly to the supply of oil while the sluggishly growing economy has held back demand.  On  the other hand, have you been to the grocery store lately?

And not to be repetitious, but no one can say definitely what the impact of QE on oil prices will have been until QE is over.

(5)     ‘QE has debased the dollar’.  No, the Fed has debased the dollar and has been doing so since the date of its inception.  Burns, Miller, Greenspan et al, they all did it long before anyone ever heard of QE or Bernanke---he is just the latest.  Sure there have been periods of dollar appreciation, like when Volcker SHRANK money supply (excuse me, bank reserves).  And yes, the dollar is doing fine right now; but more because the rest of the world is such a mess and the US just happens to be the cleanest shirt in the dirty laundry---so funds are flowing into dollar denominated assets. 

In the end, the cold hard facts are that our Fed has a long history of debasing the dollar primary via an overly accommodative monetary policy; and anyone who argues that current Fed policy (QE) is not overly accommodative may need to rethink that position.

The bottom line here is (a) the Fed’s balance sheet is bloated by any measure, (b) that hasn’t had negative effects to date, but not because the Ber-nank isn’t moving heaven and earth in a hopeless attempt to squeeze something positive out a hugely expansionary monetary policy, (c) nobody, including me, knows how this chapter in Fed policy is going to end, because we are in totally uncharted waters, (d) however, a review of monetary history points to numerous examples of easy money leading to economic difficulties (e) nevertheless, I am not arguing that it will end badly, (f) rather I am arguing that current Fed policy has created sufficient potential risks to the economy that it should be held accountable not only for creating those risks but also the consequences of its actions and (g) finally, the history of QE has yet to be written.  I think it unproductive to assume that because nothing untoward has occurred to date as a result of current Fed policy that nothing untoward will ever happen as a result of current Fed policy.