Last thing I remember, I was
Running for the door
I had to find the passage back
To the place I was before
“Relax, ” said the night man,
“We are programmed to receive.
You can check-out any time you like,
But you can never leave! ”
Hotel California, The Eagles
The Fed surprised the markets last week when it decided to maintain the current pace of Large Scale Asset Purchases, the program commonly known as quantitative easing. The Fed will continue to purchase $85 billion of Treasuries and MBS on a monthly basis in the apparent belief that – contrary to all evidence – QE is having a positive effect on the economy just not enough yet to scale back. Or maybe they decided to maintain the current pace of QE because Congress and the President are about to come to blows on the budget and the debt ceiling. Or maybe it was because of the turmoil the tapering talk caused in emerging markets. Or maybe it was because the mere talk of ending QE had the same effect of actually doing it (or at least Bernanke believes that) and Bernanke decided the economy just couldn’t handle higher interest rates yet. Or maybe it was because Larry Summers dropped out of the running for Bernanke’s job, clearing the way for Janet Yellen, and Ben decided to let her take the FOMC for test drive. I don’t have any idea why the Fed did what it did and neither does anyone else except for maybe Ben Bernanke. And I’m not even sure about him.
The market’s reaction to the decision, first soaring and then giving back all the gains in subsequent sessions, is probably what one should expect. The Fed had laid out some pretty explicit markers for when QE would end and now we – the markets – don’t know whether to believe him or not. If he postponed curtailing QE because of the political impasse of the budget, does that mean he won’t change policy until it is resolved? Or are the previously stated unemployment and inflation thresholds still operative? If unemployment drops to 7% but Congress is still passing meaningless legislation to defund Obamacare and the President is still saying he won’t negotiate, will the Fed postpone tapering again? And what about that unemployment target? Is it really 7% or is it dependent on the participation rate too? If the FOMC postponed what everyone expected because Yellen is the new dominant voice, does that mean she’s more dovish than Bernanke? Does it mean she is looking at different criteria to adjust QE? If they decided to postpone because of the effect on emerging markets, does that mean that the level of the Brazilian Real or the Indian Rupee are now metrics we should keep an eye on?
The effect of the decision is a rise in uncertainty and increased volatility in both directions should be expected. Every utterance from a Fed governor will now have an even bigger impact than previously. Every twist and turn of the budget battle will have an outsized impact on markets. Every rumor about Bernanke’s replacement will be reason to buy or sell. Every little hiccup in some far away emerging market will be scrutinized for its effect on future US monetary policy. Every economic release will have more market moving potential. Bernanke has spent his entire term as Chairman trying to make the Fed more transparent in the belief that monetary policy should not surprise the markets – a dubious proposition in my opinion – and then he surprised the market by disavowing his previous forward guidance. If forewarning the markets about future policy changes is so important, why did Bernanke just make it harder to divine future policy?
Of most concern to me is that Bernanke has essentially introduced a political element to monetary policy. I believe that last December’s change in policy was driven by the fiscal cliff but Bernanke never mentioned it as a factor. This time he specifically cited the budget negotiations as a factor in the decision, making politics an explicit part of monetary policy. Of course, monetary policy has always responded to fiscal policy in that the Fed’s dual mandate requires them to pursue policy that keeps inflation low and employment high. If Congress enacts some policy that actually affects economic growth, monetary policy would be required to respond. But the response was always after new policy had an actual effect on the economy. Now, the Bernanke Fed is trying to judge the effects of fiscal policy in advance and respond accordingly. Given their lousy track record in economic forecasting, one can’t help but worry that they will over react to a change in fiscal policy. Furthermore, Congress can now enact bad policies with the assurance that the Fed will paper over their mistakes. That assumes of course that monetary policy is as powerful as the powers that be imagine.
And that is where the rubber meets the road with QE. While the effect on markets appears clear cut, any effects on the real economy are much harder to discern. Is current growth higher, lower or the same as it would have been in the absence of QE? No one, least of all the Fed, knows the answer to that question. I would argue as well that even the effect on the markets is not as clear as everyone seems to believe. Where would stocks be today without QE 2, 3 or 4? That depends at least to some degree on its actual effect on growth which as I said is unknown. What if the effect of QE is actually to suppress economic growth? If that is true then in the absence of QE stocks might actually be higher today.
QE also has a psychological effect on the market. If people believe that ending QE will make interest rates rise, then any hint that the end of QE is coming will cause interest rates to rise. What if QE actually has no effect – or a negligible one – on interest rates? If the Fed had tapered at this meeting what would have happened to interest rates? It is entirely possible – I think likely – that tapering would have caused rates to fall due to the belief that QE is good for the economy and therefore its end would mean lower growth and lower inflation.
Bernanke’s problem now is that he’s stuck with this policy. It was started as an emergency procedure to relieve the effects of the financial crisis. Now it is justified merely because the President and Congress can’t agree on a budget. Milton Friedman once said there was nothing so permanent as a temporary government program and it appears that QE will not be the one that disproves that adage. If QE is judged to be effective at raising growth then any mention of ending it will cause a drop in the stock market as the extra growth from QE is removed. If QE is believed to reduce interest rates, any mention of ending it will cause interest rates to rise, negatively affecting the bond market. There is no way to end QE without negatively affecting the markets. If market reaction is how the Fed judges the effectiveness of QE – and that is how it appears – they will never be able to end it. Like the denizens of Hotel California, the Fed wants to check out but it can never leave.
Thanks to my friend Eric Hull for the title of this week’s commentary.
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