Fed Policy and QE
Pundits continue to speculate wildly on possible future actions the Federal Reserve could take to stimulate the economy. Here is an excerpt from one of my recent posts in which I outline what to expect from the Fed.
“The Fed is responding to economic needs. The tools all have marginal economic impact. They often use the market response like a poll, to gauge the instant sentiment. Who wouldn’t? But that is not the major purpose. The “wealth effect” on the economy is modest, but the occasional Fed comments on this topic have created a sense that the Fed objective is to drive up stock prices.
Anyone maintaining this position should be able to find evidence in the detailed transcripts of past meetings. Put up or shut up!”
Now, a select list of my best posts on Quantitative Easing and other Fed Policies. Additonal analysis provided below.
Three Fearless Forecasts (Nov 16, 2010)
Importance of Economic Perceptions (Mar 30, 2011)
Can Investors Survive the End of QE II? (April 12, 2011)
The Political Sideshow Continues (April 17, 2011)
Debunking the Myth of a QE II Rally (May 17, 2011)
Breaking News: QE II is not Ending (June 1, 2011)
Bernanke Meets the Press, Round 2 (June 19, 2011)
The Super Powers of Ben Bernanke (June 20, 2011)
Will the Fed Disappoint the Markets? (April 21, 2012)
Bernanke’s Next Move (June 3, 2012)
Can the Fed Meet Expectations? (June 16, 2012)
Hopes Too High for Jackson Hole? (August 25, 2012)
Will the Fed Disappoint the Markets (September 8, 2012)
My first post about the hype and rumors surrounding Fed policy was back in November of 2010. By this point, rumors were already starting to abound about QE II as investors were swamped with sensationalist headline after sensationalist headline. While QE II is long over, this post is still relevant as a framework for analyzing how the Fed will operate in the future. My advice was (and still is) to focus on the market fundamentals. Investors must consider what the most likely future outcome will be, rather than what you think it should be.
“I do not know whether QE II will ‘work.’ I am much more confident about what the Fed will do. Here are three fearless forecasts:
- The Fed will be completely unmoved by foreign criticism. This should be obvious.
- The Fed will not react to partisan criticism. This is also obvious. I suppose there will be some great theater in the next two years. Those who do not think we should have a central bank will make a big fuss in Congressional hearings.
- Those choosing to ‘fight the Fed’ with their investments will be big losers.”
I addressed the issue again as it began to pop up in headlines at the end of March. I continued to emphasize a data-oriented approach to investing. My attitude towards these rumors and speculation can be summed up very simply:
“For most investors, the biggest cost of 2008 will not be their losses from that year, but from missing a lifetime of opportunity.”
By mid-April these fears of the end of QE II had already caused many investors to miss out on a significant stock market rally. Bearing this in mind, I set out to disarm those who claimed stocks were only rallying because of the QE II by pointing out three simple facts:
- Expected corporate earnings have improved dramatically during the QE II period;
- Risk, as reflected in objective measures, has declined;
- Economic expectations, measured by objective third parties, have improved.
Despite these objective pieces of data and their obvious ramifications, these irrational rumors continue to persist. At this point it was clear to me that the end of QE II was in many ways similar to Y2K, or any apocalyptic prediction for that matter.
“Much ado about nothing. For those experienced enough to remember, the Y2K worries just did not happen, although many wise people laid out plenty of fears. As I analyze the QE II data, I think there was a modest direct impact and also a secondary impact on confidence. The end of QE II will be similarly modest, except for the anticipatory trading. “
A month later, I systematically laid out the hard data in an attempt to debunk the myth of the QE II rally once and for all. I contrasted my viewpoint, that improved fundamentals were responsible for recent gains, with the mainstream view that the market is only being propped up by Fed policy. Looking at objective indicators for valuation, risk, and potential, it is obvious that there is something going on in the market fundamentals that has nothing to do with the Fed. The full post is well worth reading, but in summary:
“For those of us looking at data, it is so easy to understand the stock market rally. The big question is why the market has not moved even higher. I see many specific stocks that are more attractive than ever on a P/E basis, even if the prices are higher. (JPM, AAPL, and CAT are among current choices)…In an era where many data series have moved higher, it is easy to find strong correlations. While most people pretend to know about the difference between correlation and causation, very few market studies demonstrate the ability to distinguish.”
At the beginning of June 2011 I wrote about the continuing stimulating effect of QE II. It was an important opportunity to clarify an important concept:
“The Fed purchase of Treasuries from dealers increases the monetary base. The money creation effect — and this is the “printing money” you hear so much about — is the reciprocal of the reserve requirement, currently ten percent in the US. This means that $600 billion in QE II buying has created the potential for $6 trillion in new money. This potential has not been realized.”
In order to work to debunk more myths about Fed policy, I wrote a post about a “super power” Bernanke possesses that nobody knows about – the ability to block out the sun. It was an offbeat sort of way to get across exactly how journalists and pundits skew their economic data – especially with regards to Fed policy and Quantitative Easing.
“At this point there will be some who are (correctly) objecting that correlation does not prove causation. They will (correctly) point out that there is no logical relationship between Fed Treasury purchases and night time hours in NYC. These are merely two events that happened to take place in the same time frame.
I did this to illustrate how this cheating is commonplace in widely-publicized Wall Street research, the stuff you read about and see on TV every day.”
More recently, continued rumors of a double dip recession have led to a lot of buzz about the possibility for additional stimulus. Since Congress is assumed to be deadlocked until after the 2012 elections, many are looking to the Fed to possibly engage in a third round of quantitative easing.
“Most of the hot money remains in complete disagreement with Bernanke and the bulk of the economic establishment. The trader viewpoint is that the economy is near collapse, if not already in a recession, and that the Fed just can’t see it. Many also believe that the Fed has no ammunition left because interest rates are already so low. Nonetheless, there is continuing attention to the prospect for more quantitative easing since that was associated with higher commodity and stock prices in the past.”
In April of 2012 I wrote about the potential for the Fed to disappoint markets without even changing their policies.
“Traders — and therefore the “market” in the short term — want to see the Fed doing more. At the most fundamental level there is no need for a deep explanation. The last two years show a pattern which (to a very forgiving eye) seems to show a market that rises when the Fed is active and declines when it is not.
While I disagree with this interpretation, success in trading means understanding the perspective of everyone else. The Fed policy has had much less impact than traders believe.”
Amidst much market speculation over potential action from the Federal Reserve, I predicted that the Fed would eventually act, but that they would do something other than another round of Quantitative Easing.
“Here is my rationale:
- Jackson Hole is typically not the forum for policy announcements. It is an occasion for mixing and exchanging ideas. Most speeches by the Fed Chair are of the cerebral and background variety.
- The 2010 Bernanke speech is a piece of Wall Street truthiness. In fact, there was little immediate market reaction. Stocks were lower a few days later. It was only after a big rally that those seeking a bogus correlation reached back to the “hints” from the Jackson Hole speech. In fact, there was nothing new in these hints, and the official policy did not start until November. When someone is on a mission to prove something, and has a choice of starting dates, it makes it easier to create bogus correlations.
- The jury is still out. There is no reason for Bernanke to tip his hand before getting the employment report for August.
I have a dozen links (not included) to stories speculating about this and forcefully explaining what the Fed should do. Most of them confuse personal opinion and politics with forecasting.
For those seeking investment success, the key question is what the Fed will do, not what you think it should do.”
After the announcement of the new Fed policy, I analyzed the market reaction in the following way:
“The Fed Skeptic has the following collection of beliefs:
- QE has no positive economic effect. It has not helped employment and has boosted stocks only because the Fed bond buys act like direct purchases of stocks and commodities — in addition to pushing conservative savers into tech stocks and soybeans. Fed action has artificially kept stock prices and the economy higher, but is ineffective. You can see this because things are worse than they were a few years ago. It is all a sugar high, and it will end badly either through deflation, or hyperinflation, or both. These forecasts are certified by an array of “chief investment strategists” whose credentials do not include economic education but do include frequent media appearances. The most popular are “self-taught in Austrian economics.”
The FOMC has the opposite viewpoint:
- QE has lowered interest rates by a few bps and generated a gain of about 2 million jobs over what otherwise would have happened. There was no direct effect on commodity prices. Misguided speculators drove these prices higher. Stock price increases reflected the improved economic prospects from the program, and also created a virtuous cycle of confidence and wealth effects. The proponents are all credentialed mainstream economists of both political parties.”
As financial media still buzz about unfounded rumors surrounding Fed policy, I laid out four very clear points to use as a frame of reference for anticipating Fed action.
- “The basic objective is to change behavior on the part of borrowers and lenders. The stock market is only one method for evaluating the impact and the “wealth” effect is only a minor transmission mechanism.
- The key to understanding QE3 is to think about marginal effects, not the all-or-nothing, “light-switch” thinking of those without economic education. If you lower the price of something, it has a marginal effect. Lower interest rates encourage more borrowers, qualify more borrowers, and increase the size of qualified loans. The price changes affect (marginally) the interest rates on all related bonds. The increased Fed balance sheet creates more excess reserves for banks and nudges them toward more lending. Lower rates make business investments slightly more attractive. This all takes place at the margin. This is the incentive for risk that Bernanke talks about. None of it has anything to do with pushing the average investor into risk assets, the popular pundit theme.
- The Fed is not monetizing debt if the purchases of securities are temporary. The concept of “printing money” should relate to an increase in the money supply — M2 or MZM. These increases have been modest — too low in fact. The hyper-inflationistas have been wrong for a decade or so, but that does not stop their chorus.
- Reversing course depends upon the demand for US debt, both Treasuries and Agency securities. Readers should note that those who have questioned this theme in the past, asking who will buy our debt at the end of prior QE’s have been completely wrong. I do not understand why Bill Gross could be so mistaken, but he was. He does not seem to distinguish between the total volume of US Treasury trading and the net issuance. Or maybe he has his own agenda. Meanwhile, the average investor does not understand the total volume of Treasury trading. (See this piece for an illustration).”