With economic data seemingly improving as of late, the Federal Reserve Open Market Committee is set to debate this week the Fed's current asset purchase program which began in 2008. The FOMC is widely expected to keep interests rates at 0%. Additionally, the Fed is expected to continue its $85 billion in asset purchases such as U.S. Treasuries and mortgage debt.
As economic conditions accelerate to the upside, some economists and market strategists are of the opinion that the Fed may begin to signal a shift in language, indicating a possible tapering off of Fed stimulus at some time during the year. This opinion is shared by only a limited number of market participants as the recent sequester has certainly thrown the idea of near-term changes to the Fed's asset purchase policy out the window. Long-term effects of the sequester can't be adequately measured presently and will take some time to weave into the fabric of the economy. It has only been a few months since the Fed expanded its balance sheet further to add another $45 billion in asset purchases each month. Why did the Fed nearly double its QE policy? We will answer that question a little later. However, with this in mind, it would be very unlikely that the Fed would change course, taking the equity markets down with it and otherwise going against its stated goals of inflating asset values. "The Fed told us they want asset values to go up, stock prices and housing prices to go up, and that's one of the main goals of QE and that's working," said Scott Wren, senior equity strategist at Wells Fargo Advisors.
In the light of recent economic indicators showing positive momentum, some Fed officials are becoming increasingly worried about the current course the Fed is on and how it will ultimately play out unless the Fed curtails its involvement in the bond markets. Minutes from the Fed's January meeting showed many Fed officials are worried that the bond buying, along with the low interest rates, are setting the stage for higher inflation and overheating in some markets. Those Fed officials offering dissension would be well advised to do so.
Fed officials are worried because they understand fully what is at stake for the Fed and for the economy as a whole should its course of action that began in 2008 not work as assumed. I use the term assumed because given the laws that govern economics, there is very little room for error in the Fed's course of action as it relies on extremely low interest rates coupled with modest GDP growth. Fed officials also know who is buying U.S. debt, who they are participating in the bond market with. Unfortunately, the reality is that when the Fed does take its foot off the pedal, there is a limited amount of buyers there to backstop U.S. treasuries from witnessing yields rise dramatically. At this point, the incremental profits the Fed has been taking in begin to rapidly disappear and the Fed becomes at risk of its balance sheet, for lack of a better phrase, blowing-up.
With the national debt ballooning to over $16 trillion, the Fed has become a one-man show without a backstop of its own. Essentially, the Fed is trapped and almost has to keep reinventing itself in the form of monetary stimulus as the government simply doesn't have the political or monetary strength to supersede Fed policy and while the "shadow banking system" continues its 4-year long deleveraging process which has no end in sight, in part because of the Fed's intervention, but we'll also get to that a little later. The Fed's balance sheet has ballooned to nearly $3 trillion and will likely touch $4 trillion by year's end, a drop in the bucket by our estimations, which see the Fed likely doubling its balance sheet over the next couple of years.
Many have asked how the Fed came into all this money to buy up all of the bonds and mortgage debt over the last few years.
It's really very simple and easily explained. The Fed created it with its printing press, nothing more and nothing less. Well, it didn't really create physical monies, but rather created it with a click of the mouse, electronically. It would have been far too expensive for the Treasury to actually print all the money the Fed is pumping into circulation.
For those of you who still don't understand what Quantitative Easing is, I will attempt to simplify the strategic objective of this otherwise abnormal and never proven to be effective monetary policy deployment. QE is nothing more complicated than the Fed buying "assets" from commercial banks and other private financial institutions. Why quote "assets" you might ask? Well, for something to be classified as an asset, it has to have a hard value that I would argue not a single monetary U.S. backed instrument currently has, thanks in part to the deployment of QE. Quantitative Easing is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank implements quantitative easing by buying financial assets from commercial banks and other private institutions, thus creating money and injecting a pre-determined quantity of money into the economy.
Now under normal economic and financial conditions, the Fed's monetary policy would usually lower rates and increase the amount of money flowing through the economy. However, there are a couple of problems with the current monetary policy: 1. Rates are already at 0 percent. 2. The money which has been pumped into the supposed economy through "asset" purchases by the Fed isn't finding its way into the general economy or the middle class. The newly printed money by the Federal Reserve which was aimed at buying bonds and MBS from banking institutions and private lenders is not getting loaned out to consumers for the most part, but stays with the banks, and the banks invest the newly printed money in stocks for quick profits which has served to push the stock market higher. Wonder why we haven't gotten a pullback in the markets for months, don't wonder any longer. Natural human conditioning regulates a healthy dose of profit taking when markets become seemingly over stretched to the upside. However, banks don't necessarily need to take profits while their balance sheets swell with hard assets such as equities which have a finite quantity. It's as clear as the nose on your face who is buying up equities. This practice of rolling reserves into equity positions is dangerous in that it continues to serve to drive a wider gap between the middle and upper class also, a dynamic which never ends well.
Here is the major problem with QE whether it is QE1, 2, 3 or infinity. The problem is it simply can't work. There is a reason we ended up in the predicament we found ourselves in during the financial crisis of 2008. Leverage is a huge problem which is allowed and promoted by our financial system, and the Fed is using their private leveraging system called the printing of and devaluation of money. It never has and likely never will work this strategy of leverage. Printing money is just another form of saying the Fed is leveraging its balance sheet by adding a value-less "asset" to the economy, which never actually hits the economy, but rather hits the big banks. Furthermore, this asset doesn't exist except on a computer screen and if that non-existent asset actually comes to maturity, well, we have a big problem on our hands which has already been proven in the shadow banking system in the past.
Getting back to the major problem with quantitative easing; at some point, and probably when the economy starts to heat up, the Fed will need to begin unloading these "assets" it has purchased over the years, right? So where's your buyer now that the Fed is selling as interest rates will inevitably begin climbing and inflation will likely set in? UBS suggests that the Fed will likely not be able to unwind its excessive balance sheet under normal liquidation strategies as noted below:
- Asset sales/maturation. The portfolio shift to a longer average maturity means that the Fed is unable to reduce its balance sheet only by letting securities mature. There would be no material reduction until at least 2016 and even then the reduction would likely be under $250bn. Outright sales face a different problem - expectations. Unlike purchases where announcing a certain amount of purchases reinforces the Fed's goal of lowering rates via expectations, any sales would likely result in the market pricing in a fully normalized balance sheet. As such, an initial sale program of just $200bn would not be credible as the expectation would be that the sale announcement signals a desire to return to normality requiring an addition $2.5tn in sales at some point.
- Reverse repurchase agreements. This tool is swamped by the magnitude of the drain required. At present money fund assets are roughly $2.5 trillion, $200 billion less than the excess balance sheet we anticipate by the end of 2013. However, this statistic does not tell the full story as reverse repurchase agreements only make up just over 20% of money fund assets, or just $500 billion. The other primary counterparty the Fed would rely on, the Primary Dealer community, are unlikely to be able to participate in anything close to that size. While these figures do not prevent the Fed from using this tool, they do suggest it can only be a part of the overall solution.
- Interest on reserves. Although interest on reserves theoretically creates a floor on rates in the interbank market, it does not prevent banks from using funds to make loans. Loans eventually end up as deposits somewhere and, as such, the overall level of deposits at the Fed provide little guidance as to whether the funds are circulating in the economy. The only way to prevent lending would be for the Fed to raise this rate sufficiently to make banks prefer depositing the money at the Fed to lending to their client base.
I briefly mentioned the likelihood of inflation setting in even though it hasn't through the duration of QE, leading many to believe the Fed not only knows what it is doing but will be effective in its long-term strategy of utilizing QE. One of the reasons there has not been explosive inflation is that there is a little known shadow banking system where "credit-money" is created by the banks, for the banks and does not enter the real economy by so being a safeguard against inflation. The shadow banking system has escaped regulation and serves as a deflationary system primarily because it does not accept traditional bank deposits. As a result, many of the institutions and instruments were able to employ higher market, credit and liquidity risks, and did not have capital requirements commensurate with those risks. Subsequent to the subprime meltdown in 2008, the activities of the shadow banking system came under increasing scrutiny and regulations. The shadow banking system has a $30+ trillion funding mechanism where the bottom line is that there are increasingly less and less hard assets (i.e., cash-flow generating), funding ever more and more liabilities, and where one's assets are another's liabilities in a "fractional reserve" recursive loop, and which the loop can go on and on until something breaks the loop such as an excess of investors desiring to be made whole all at once like in 2008. Essentially, the shadow banking system has broken and thus it continues to delever, adversely forcing the Fed to continue with QE.
The shadow banking system, which is simply the traditional banking system without the deposits and without the threat of monetary redemptions from the banking system (and the threat of a collapse of fractional reserve banking): It is the essence of bank transformation funded by "faith", or a system in which credit money is created, but without an offsetting money equivalent unit. It is a system in which assets and liabilities are the same concept. In other words, shadow banking creates credit money which can then flow into monetary conduits such as economic growth or capital markets, however, without creating the threat of inflation.
Since the financial crisis in 2008, the shadow banking system has been forced to deleverage and operate more openly in the marketplace and this will ultimately have an effect on the Fed's ability to unwind its balance sheet. It's the world's biggest Ponzi scheme folks because there is no real, hard asset attached to these credit monies which are created out of thin air and here is what is happening today.
We've come a long way since the financial crisis … or have we? Since 2008, the shadow banking system has deleveraged significantly to where it currently holds roughly $15 trillion in liabilities. I want to repeat this now so it is clear to investors and serves to underscore the potential disaster looming for the Fed and our economy; "the shadow banking system acts as a buffer to inflation as its' credit monies are not matched by deposits and flow into the capital markets." No matched-deposits serve to mitigate interest rate pressures to the upside as the shadow banks perform the duties that would otherwise cause inflation if performed by traditional banks. Here comes the problem. Traditional banking system's liabilities, which continue to grow due to reserve creation by the Fed during periods of unsterilized QE, and which amounted to a record $15 trillion as well, have reached parity with the shadow banking system. That normal buffer which has served to offset inflationary pressure via the shadow banking system is no longer present and inflation will start to creep in.
Because interest rates are historically low due to current monetary policies, bank profits are being squeezed to the point that they are moving away from more costly long-term debt in favor of the repo market-overnight loans between banking or bank-like entities that use securities as collateral. The risk of increasing dependence on the repo market is that any market disruption by an unregulated shadow banking entity could have a ripple effect across the regulated banking system that would create funding problems. The easy monetary policy of the Federal Reserve is starting to cause financial distortions and investors should monitor banking liabilities and how they are changing.
The Fed has been eyeing this anomaly closely and understands that this poses a huge underlying threat to the entire financial system. The Fed is trapped and has no choice but to continue with QE until the system breaks down from QE. As the shadow banking system delevers, the Fed has no choice but to re-lever traditional bank liabilities, via reserve injection to keep the system at near equilibrium, but unless the psychology changes surrounding the shadow banking system, which is nearly an impossibility after the 2008 debacle of the financial system, this effort by the Fed is simply futile and only serves to exasperate the problem. The Fed is undoubtedly at a crossroads and will continue to do what it does, reflating traditional liabilities, creating reserves, deposits, and currency, all of which have a greater inflationary propensity that the circular liabilities continued within shadow banking. For every dollar the Fed is pumping into the traditional banking system, the shadow banking system is offsetting those efforts and then some.
It would be simple to suggest that at some point the shadow banking system will reach equilibrium and find itself no longer needing to deleverage, but the Fed's involvement creates a psychological framework suggesting that without its involvement in the financial system and markets, the U.S. banking system can't function on its own accord. This has and continues to result in investors liquidating credit assets in favor of hard assets, a trend that seemingly has no end so long as the Fed commits to its QE policy. To be fair though, the Fed has no choice.
The chart below shows how all the Fed's efforts are futile:
What this chart clearly shows is that as the shadow banking system has been deleveraging and the Fed has been adding reserves onto the traditional banking system balance sheets, it has created a hole that needs to be filled. The chart indicates that at the very least, the Fed will undoubtedly have to pump another $3.9 trillion into the traditional banking system as the shadow banking system continues to delever. Eventually the Fed will reach its limitations with regards to fighting the good fight against inflationary pressures, but it will ultimately lead to inflation.
Hard assets are the key to lending, unless you want to spur parabolic growth, in which case you would decide to leverage assets. That is where the shadow banking system came into play. Credit growth over the last 30+ years was dependent upon collateralized lending. Unfortunately, that led to a credit bubble for which there is no plausible recovery, just a deferment of an inevitable collapse. Very simply put, without real, hard assets, the system collapses in on itself due to hyperinflation.