Yesterday I reported commentary from two leading economists at Goldman Sachs’ who believe that in order for the Fed to close the Taylor implied interest rate gap they will need to enact a massive $4 trillion QE program, rather than the $500 million whisper number which has been mooted. With the much anticipated November 3rd FOMC meeting expected to bring an announcement on QE2, it got me thinking: what if the Fed is just stringing us along?
For the past several months, the market has been pricing in QE2, and that is exactly how the Fed wants it. In his most recent statement, Chairman Ben Bernanke made some of his most dovish comments to date, reiterating his commitment to maintaining levels of economic growth, unemployment and inflation consistent with the committee’s mandate. As noted on this blog back in March, language has been the Fed’s most powerful tool with interest rates already bound at zero. ‘Extended period’ has been the phrase du jour, and promises of further intervention, if warranted, have been forthcoming.
A floundering consumption-based economy needs consumers to spend, and the Fed has endeavored to boost consumer confidence and get people spending again. The Fed has been propping up the market through POMO via primary dealers for months now for this precise reason, to get people to believe the ‘recovery’ is taking hold (and many believe a little wink-wink has directed money into large index components like AAPL to make sure the Fed gets the most bang for its buck). Consumer confidence is to the recovery like technical analysis is to the stock market; they are largely self-fulfilling prophecies.
The problem is two-fold: a growing public distrust of our leaders and a liquidity trap. The American public has grown cynical in the wake of widespread foreclosure fraud and fraudulent securitization, persistent unemployment, terrorist threats, growing inequality and evidence that the government is the biggest game-rigger of them all. Each astonishing scandal now comes with a shrug of the shoulders, because we have come to expect incompetence and corruption. In psychology it’s called anchoring, a phenomenon where individuals perceive events based on an implicitly biased expectation, or anchor. The government has aimed to restore confidence by imposing regulation and creating ‘too big to fail’, but in the process perpetuated the risk-taking and lack of accountability that is at the root of our society’s problems as a whole. It’s moral hazard, and taxpayers have been the only ones forced to take a penalty stroke. Through its use of supportive, dovish language, the Fed has coddled consumers. It’s like a father in the water standing in the water to catch his child the first time he or she goes off a water slide. “I’m right here, I won’t let anything happen to you.” A good father would let the child paddle for a little while to see if it can stay afloat on its own, and in the process the kid could learn a thing or two that might serve it him or her well in the future.
The second problem, which FOMC committee members have openly noted, is that we are in a liquidity trap. The demand for money has become almost infinitely elastic. Interest rates are already at zero and an expansion of the monetary base has done nothing to stimulate additional demand for capital investment or output.
“After the rate of interest has fallen to a certain level, liquidity preference is virtually absolute in the sense that almost everyone prefers cash to holding a debt at so low a rate of interest. In this event, the monetary authority would have lost effective control.”
-John Maynard Keynes
Monetary velocity is the metric for evaluating a liquidity trap. Velocity is the dollar value of GDP produced per dollar added to the monetary base, basically how much of that money is translating into purchases of good and services. Increasing the monetary base is only effective in stimulating the economy if it increases velocity, something that does not happen when you are already at zero interest rates. That held true in our case, which is the reason the first round of quantitative easing was largely ineffective besides debasing our currency and putting money in the coffers of China, who has not allowed the yuan to appreciate substantially. Individuals and business are sitting on excess cash reserves rather than spending them. In an environment of high interest rates, people are reluctant to hold cash because it is not accruing interest. But with interest rates close to zero (and low yielding debt securities, ex. T-bills) they choose to save the cash reserves because there is no incentive. Banks actually have disincentive to lend because the Fed is paying them interest on cash reserves. The Fed is pushing on a string, as the analogy goes, causing great distortions in the markets while doing little to promote growth or a reduction in unemployment.
Now, we reach the real heart of the issue: is the Fed really serious about QE2? The Fed has made it clear it is not content with merely slow growth, and unemployment, rightfully, remains a huge concern. However, we must examine the current state of the recovery and how it relates to each of the aforementioned problems in regards to whether QE2 is likely. In terms of consumer confidence, we are starting to see a resurgence based on this morning’s reading. The number came in at 50.2 vs. the 49.9 consensus expected (up from 48.6 in September), which may not seem significant, but it shows that optimism is lifting more quickly than expected. While housing remains a drag, last week’s Fed Beige Book showed at least modest pockets of growth, enough, perhaps, for the Fed to just keep leading us on. Also this morning the Richmond Fed Manufacturing index was 5 vs. 1 expected, a strong sign.
That brings me to my second point about the folly of further monetary easing in the presence of a bona fide liquidity trap. Members of the FOMC have acknowledged the presence of a liquidity trap, but have warned about the inherent danger of price deflation and the need to protect against it at all costs. Besides, as economists at Goldman Sachs noted, it would take an obscenely large $4 trillion QE2 to meet the desired level of inflation and close the Taylor gap. The Fed doesn’t want QE2 for the sake of it, and would love to avoid it altogether if possible. The committee and chairman recognize the existence of the liquidity trap and realize the implications of further easing are largely unknown. However, they seek to maintain the ‘Bernanke Put’ on the market in order to maintain confidence and, for example, put Americans in shopping malls ahead of the holiday season.
This brings me to my ultimate point: the Fed is hoping to simply talk its way out of this mess. They don’t want QE2 necessarily, they just want us all to think it is coming. I am not entirely convinced it is coming at all, but the most likely scenario is an incremental approach, supported by language that suggests more could be on the way. It reminds me of the relationship between Andy “Nard Dog” Bernard and Angela in The Office. Angela leads Andy on with promises of ravenous marital sex, but when the wedding day comes Andy is left standing at the altar. After the November 3rd FOMC meeting, I expect the chairman to announce the Fed’s intention to re-enter into large scale asset purchases denominated in, say, $100 billion lots (remember when that was a lot of money?) on the scale of, at the very most, about $500 billion when it’s all said and done, while leaving the door open for future intervention. That will hopefully, from the Fed’s perspective, satiate the market’s voracious appetite for further easing, bouy consumer confidence and buy enough time for the economy to actually recover. At least I hope that is as far as they go. But who knows, sometimes it feels like Michael Scott is running the show.
