Dear Chairman Bernanke,
I applauded your leadership in the spring of 2009 when you employed an unconventional monetary policy tool to reverse the fear-induced deflationary spiral in stock and bond prices during the financial crisis. It was this initial bond-purchase program, known as quantitative easing (QE1), which emboldened many of us to maintain an aggressively bullish outlook at the early stages of the recovery. Yet over the past four years, the quantitative easing that began as an economic resuscitation program has transformed itself into a life-support system for our financial markets, and alongside the rapidly diminishing returns this has meant for the real economy, escalating levels of risk continue to build. While you were successful in restoring some semblance of rationality in market valuations by purchasing Treasury bonds during the financial crisis in order to mitigate fear and restore confidence, I think it is reckless to manipulate valuations beyond what fundamentals would otherwise dictate today in an attempt to entice irrational exuberance, thus engineering a desired economic outcome.
You said late last year that your economic models indicate that continued bond buying will result in an increase in economic growth, creating jobs and lowering the unemployment rate. Are these the same models that guided monetary policy just prior to the financial crisis? As economic growth was slowing in July 2007, just five months before the onset of the Great Recession, you told us that "overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy's underlying trend." That forecast did not pan out.
Today, we see an economic slowdown very similar to what we saw in 2007. The rate of growth has slowed from what was 4% more than a year ago to what looks to be less than 1% in the most recently reported quarter, despite more than $2 trillion of bond purchases to date. Instead of inflated home prices in the early stages of decline, it is corporate profits and revenues that have been inflated by fiscal and monetary policy stimulus. Corporate profits for S&P 500 companies are on track to decline for a second quarter in a row. That is not a good sign for growth, considering that previous consecutive quarterly declines were followed by recession. At the same time, you are encouraging investors to take more risk.
I hope that you have a better understanding of financial market fundamentals today than you did of real estate fundamentals in 2007, considering that you have openly targeted the stock market as your primary transmission mechanism for monetary policy. I fear that you do not. Your expertise seems limited to the recognition that each time you launched another quantitative easing program the stock market would rally until the program ended. Since the growth and job creation you expected did not follow, you launched one program after another until your most recent announcement to purchase Treasury debt and mortgage-backed securities indefinitely (QEternity). Have you considered the consequences of what might happen if your models that are forecasting the growth necessary to substantiate the stock market gains we have realized to date are wrong again? I don't think you have. Furthermore, your blitzkrieg of liquidity has muffled the market's ability to flash warning signs to investors. I recognize that most investors are not concerned with the means, when the end is higher stock and bond prices, just as most Americans were not concerned with the means by which home prices were artificially inflated and rising, that is until they began to fall.
By manipulating the prices and yields of the safest securities, you have forced investors to redirect money into increasingly higher-risk investments in an attempt to simply maintain purchasing power after taxes and inflation. This has become exceedingly difficult to accomplish for those of us that do not wish to speculate or assume substantial principal risk. I understand this to be your master plan -- inflate financial asset values to create a perception of wealth that will then encourage investors to spend money on goods and services. Yet this manipulation has a domino effect across a broad spectrum of fixed-income and equity assets, and centrally planning supply and demand in what used to be a free market has consequences.
Investors look at changes in the prices and yields of different types of fixed-income securities from a historical perspective in order to receive signals about developing economic risks. The recent decline in junk bond yields to all-time historic lows of 5.9% does not seem justified at this stage of the business cycle. Given the declining rates of growth in corporate revenues and the economy, junk bond yields should be rising, not falling.
The stock market used to be viewed as a similar discounting mechanism, or leading indicator, meaning that changes in trends were a window into the economic developments that lie ahead. However, you have deafened this indicator's forecasting ability as well with your Pavlovian monetary response to every market correction. Your counterpart at the European Central Bank, Mario Draghi, has taken note. His primary focus is on keeping the sovereign yields of bankrupt countries like Spain below a certain threshold (6%) in order to give the perception that all is well. He has gone as far as to lend money, with your assistance, to insolvent banks, in order to create the artificial demand necessary to prop up prices of sovereign debt.
From my perspective, at a time when there is tremendous risk in the global economy and financial markets, we have an unprecedented suppression of the market's ability to measure or reflect that risk, because you have thwarted the pricing mechanism that rules free markets-supply and demand. You are attempting to engineer an economic outcome by manipulating the value of financial assets that should be reflections of that outcome, and not the catalysts to achieving it. The illusion of prosperity that you are helping to create is just that -- an illusion. Should real-world fundamentals continue to deteriorate, the illusion will lose its luster, volatility will soar, and financial markets will return to fair value. It is completely nonsensical to think that the solution to our economic plight is the same combination of low interest rates and abundant liquidity that led to the last crisis, especially when the primary benefactors are the same too-big-to-fail banks that built the last house of cards. It is naive to believe that they will be responsible the second time around. In fact, after the scandals at MF Global and JP Morgan, we know that they continue to be irresponsible.
The Fed is governed by a dual mandate to maintain stable prices and achieve full employment. It is also responsible for regulating our largest financial institutions and monitoring systemic risk. It is fair to argue that financial market stability is also a responsibility that falls on your shoulders, especially when you are attempting to influence market prices. Yet there has been no meaningful financial reform to date that prevents our too-big-to-fail banks from repeating the malinvestment that led to the last crisis. The excess reserves you have created, which are rapidly approaching $2 trillion, are not producing the demand for goods and services that our economy needs. They are instead being misallocated towards investment into financial markets. We have no idea what types of investments these banks hold or how much leverage is being employed.
My greatest concern is how you intend to centrally plan the smooth transition for investors from the bond market to the stock market in what is being coined "the great rotation." I see the potential for a repeat of 1994. I was a financial consultant with Merrill Lynch at that time, and vividly remember the most experienced of my piers being stunned by the extent of the losses in the bond market and the speed with which those losses occurred. I do not believe you have accounted for the loss of wealth that would result should a disorderly exit by banks, institutional investors and the investing public occur from the bond market as a result of current or future monetary policy.
If you were an investor, I would advise you to hold some of what everyone else hates -- cash. I would advise that you sell some of what everyone else wants to buy -- equities. Finally, I would recommend positioning your fixed-income holdings so as to be prepared now for a rise in interest rates and deterioration in credit quality that is as inevitable as the next stage of the business cycle.