The Bull I am referencing is not the one he raised from the ashes of the financial crisis and continues to feed in hopes of creating jobs and economic growth, but instead the kind he is shoveling when explaining why the Fed must continue to print $85 billion per month to purchase Treasuries and mortgage-backed securities. Despite his coy demeanor, Chairman Bernanke confidently asserts that he has all the answers. If the economic data is improving, it is because of quantitative easing (QE). If it is not improving, then it is because we don't have enough quantitative easing. When the Fed has ultimately met its objectives, it will end and eventually reverse the quantitative easing. If this can't be done without disrupting financial markets, then it will simply retain its holdings and allow them to run off. If only there were a track record for the Fed that instilled confidence in its predictions, or proof of the policy's efficacy with respect to jobs and growth, there might be reason for encouragement, but I see neither.
Consider these prognostications from the Fed minutes in January -
"In 2014 and 2015, real GDP was projected to accelerate gradually, supported by an eventual lessening of fiscal policy restraint."
How is there going to be a lessening of fiscal policy restraint when we have yet to embark on any of the meaningful revenue increases or spending cuts that are necessary to address our debt crisis? And yes, it is a crisis.
"The staff continued to project that inflation would be subdued through 2015. That forecast is based on the expectation that crude oil prices will trend down slowly from their current levels...."
So the Fed expects economic growth to accelerate, and at the same time, crude oil prices are going to trend lower from current levels? This is absurd.
And what of this self-adulation during last week's press conference -
"My inflation rate record is the best of any Federal Reserve Chairman, running at about 2%."
Congratulations are in order! Since his tenure as Chairman began in 2006, we have seen home values and financial markets collapse, as real incomes have consistently declined. No wonder the rate of inflation averaged less than 2%.
There is no evidence that increasing the money supply through QE creates jobs or leads to economic growth, yet this is the sole prescription for remedying our economic malaise. Instead of applying sound and proven reason, Bernanke continues to throw unproven, if not disproved, theoretical mud against the wall, in larger and larger quantities, in hopes that some of it sticks. One step in the right direction would be to acknowledge that his baseline assumptions are horribly inaccurate. I think Jeremy Grantham best described the illusion under which monetary policy is currently operating during a recent interview with Charlie Rose. He suggested that Bernanke is beating a donkey that is growing at 1%, because he thinks it is a racehorse that should be growing at 3%. Unfortunately, this donkey's racing days are over, but Bernanke fails to recognize that fact. Then again, this is the same Chairman who didn't recognize a housing bubble when home prices were more than double their historical ratio to median household income.
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Yet he is considered a hero by the mainstream media and television punditry for having saved the world following the financial crisis in 2008, as if he had been appointed Fed Chairman in the days following the Lehman bankruptcy and orchestrated the master plan that averted another Great Depression.
Let us remember that Chairman Bernanke was the regulator-in-chief in the years prior to the financial crisis. It was his lack of oversight and regulation that allowed the leverage and risk taking on Wall Street to result ultimately in the collapse of financial markets. He was in the driver's seat during the demise of Bear Stearns, Fannie Mae, Freddie Mac, AIG, Merrill Lynch, Washington Mutual, Wachovia and Lehman Brothers. Calling him a hero is like praising a drunk driver for calling 911 after running over a pedestrian crossing the road. Chairman Bernanke claims that the benefits of QE are worth the costs and potential risks, but I don't think he has a grasp of either, any more than he had a grasp of the housing bubble, sub-prime lending, credit-default-swaps, the shadow banking system, or special investment vehicles (SIV) in the years leading up to the financial crisis.
Let me acknowledge the obvious benefits. The benefits of QE are clearly visible in financial markets (SPY). This policy has lowered interest rates across the yield curve, increased the value of fixed-income securities, and lowered the borrowing costs for select groups of consumers, businesses and the government. It has stimulated demand for residential real-estate investment, and made home purchases more affordable for those fortunate enough to obtain loans at prevailing rates. Both of these have modestly elevated home prices. It has also reduced the financial obligations of those with good credit who have been able to refinance. The modest impact on home prices can be seen in the chart below.
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QE has helped finance our deficits during a period in which our foreign lenders, primarily China, are losing interest in buying U.S. debt. It has also subsidized the investment activities, speculative or otherwise, of the large financial institutions that serve as the conduit for the Fed's increase in the money supply, inflating the value of equity markets. This fulfills the Fed's objective of creating a wealth effect, eliminating any dependence on the public to invest in the stock market. This all sounds great. We have lower interest rates and rising paper profits in stocks and bonds. It's a win-win from every angle, so why would anyone complain?
Bernanke sees paper wealth being created when he turns on the printing press, so he keeps printing, with no acknowledgement, or dare I say knowledge, of the costs. There are costs. The benefits of rising stock and bond prices are more apparent and more immediately realized than the costs, so they are believed to outweigh the costs, but that is simply a near-sighted view. The benefits are also more concentrated in the hands of the minority of Americans that don't need assistance, while the costs are paid by the majority who do.
I find it ironic that we have a scholar of the Great Depression, bemoaning the plight of the long-term unemployed and less fortunate, at the helm of a policy that is instigating an unprecedented degree of wealth disparity in this country. QE does nothing to address the plight of the majority of Americans who do not have the means to assume market risk, and are thereby forced to accept negative real returns on what they can save and invest in low-risk investments. They are paying a cost.
So too are retirees, pension funds and investors that either do not trust the faulty framework of our financial markets or are unable to accept the principal risk that comes with the types of investments that offer the potential for positive real rates of return. If a borrower saves $500 a month after refinancing a $500k mortgage at current interest rates, while an investor loses $500 per month in interest income on a retirement portfolio, where is the benefit? The investor is simply paying the borrower, and he must then assume the additional risk necessary to replace the lost income.
Recognizing the greatest cost requires a longer-term perspective. Quantitative easing was initially intended to ignite the flame, when first employed in early 2009, rather than to endlessly fuel the engine of economic growth. It has turned out to be no different than every other consumption-induced stimulus policy we have seen during this recovery, in that it stole forward demand, but in this case, for financial assets. This is why stock prices declined coincident with the end of each program, just as demand waned for homes, automobiles and appliances after each tax-credit expired. It is the open-ended nature of QE that now feeds complacency in Washington and a false sense of security among investors, resulting in what I believe to be the greatest cost. It has undermined the urgency to address deficits, debt and the structural reforms required to insure the sustainability of our social safety net. Concrete plans to address these crises are a necessary foundation to sustainable long-term growth. Instead, we have further entrenched ourselves in the status quo, and further delayed the sacrifices that we will ultimately be required to make. This cost is greatly underappreciated, but then so are the risks.
I would not be so vehemently opposed to QE if the Glass-Steagall Act had not been repealed in 1999. The end of the separation between investment banking and commercial banking is what laid the foundation for the credit crisis and the collapse of our financial markets in 2008. It is an outrage that no legitimate financial reforms have been enacted since the crisis. For this reason, I was aghast by Bernanke's comment during the press conference that followed last week's FOMC meeting, when he said that "we monitor the financial system and regulate the participants to be sure that excessive risk is not taken…." How does he explain the demise of MF Global, which was a primary-dealer bank at the time it was using clients' funds to finance speculative bets on European debt. How does he explain the fiasco at JP Morgan that resulted in a near $6 billion trading loss from speculating with credit derivatives? These are just two examples that make it clear that Chairman Bernanke isn't monitoring anything. Even if he wanted to, he doesn't have the tools to do so, because Dodd-Frank is a toothless piece of legislation drafted by the institutions it was intended to regulate. Now Bernanke is pumping $85 billion per month onto the balance sheets of the Wall Street behemoths that operate as hedge funds, rather than lending institutions. All we can do is hope that they act responsibly this time. The evidence to date proves otherwise, but this risk is never fully appreciated until it results in an adverse event, like a loss, largely because it is invisible and difficult to measure until that loss manifests itself.
The proponents of QE suggest that when the Fed begins to unwind its bond portfolio, it will not have an impact on financial markets, because the economy will be in much better shape as a result of the stimulus, thereby supporting current, if not higher valuations. There are tremendous risks building in financial markets, based on this flawed assumption, that are not being priced into markets today, largely because the pricing mechanism itself is being manipulated. What if the economy doesn't improve to validate the higher market valuations we have already recognized? What if the Fed is unable to unwind its portfolio without destabilizing markets? Few have acknowledged that it is the market, and not the Fed, that will decide when the Fed must soak up the tsunami of liquidity and reduce the size of its soon-to-be $4 trillion balance sheet. It will do so unannounced, unexpected, and with far less gravitas than the Bernanke Fed.
For this reason, I am dumbfounded by the Chairman's sense of calm and confidence, as though he were a puppet master, capable of pulling the strings of the stock, bond and commodity markets as needed. It was with similar certainty that he once said that "the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained." At that time he recognized that there were significant problems, but was unable to grasp the severity of the situation or the risks posed to the economy and financial markets. I believe he is falling into the same trap again with his misguided policy prescription that is fostering behavior that is already destabilizing markets.
We all grew weary of the word games that Alan Greenspan would play with markets during his tenure as Chairman, because he kept investors guessing as to what direction policy might be headed. I now realize that while this less communicable approach created uncertainty, it also dissuaded most participants from taking on too much risk, for fear that the Fed might move markets in the opposite direction. A noteworthy exception to this was Long Term Capital Management, whose failure and loss of $4.6 billion, if it occurred today, would be par for the course. I would argue that Chairman Bernanke's more communicative approach to policy encourages risk taking. How much risk taking is hard to determine, because there is no more transparency today than there was before the financial crisis. Consider that the Fed has telegraphed all of its activities in advance and stipulated exactly what must transpire in order to modify policy moving forward. This kind of predictability invites unimaginable leverage and speculation. If Bernanke is unable to execute his master plan as proposed, or markets force the Fed to change that plan, market instability will soar. Once again, Bernanke was resolute last week -
"The Committee also considered possible risks to financial stability, such as might arise if persistently low rates lead some market participants to take on excessive risk in a reach for yield. In the Committee's view, these costs remain manageable…."
What I hate about QE is that it is a monetary policy tool that is being used as a food source for this economy, rather than the medication that it was originally prescribed to be when the economy was in recession. At the same time, the bad actors from the previous crisis are too-bigger-to-fail today than they were before, yet they are the recipients and primary beneficiaries of the medication-turned-food source. Finally, those charged with policing our so-called free markets and the activities of these bad actors are the same lot that presided unscrupulously over the previous crisis. Nothing has changed.
My measurement of the efficacy of QE boils down to two simple data points-the real rate of growth in the economy and incomes. The rate of growth in both has been declining for the past three years. I don't buy the argument that the status quo would be worse today without the continuation of this program. Without this program things might have been worse earlier on, but we would have realized losses and rid the economy of excesses by now, establishing a legitimate foundation for growth moving forward.
I wish there were more of an outcry to end this manipulative madness, but it certainly won't come from Washington, where stock market performance has become the ultimate measuring stick for policy success, and therefore an excuse for inaction. It also appears that the consensus of investors is unconcerned, for no reason other than that valuations are rising, ignoring the fact that manipulation is a double-edged sword that cuts both ways. No one was concerned about the abundance of credit, speculative activity, leverage and statistical data that stood well outside the historical norm during the housing bubble so long as home prices continued to rise.
I see a lot of similarities between the bubble in housing and the inflation that the Fed is attempting to encourage in financial assets with what it deems rational exuberance. The increase in credit availability and loosening of lending standards has been supplanted by an abundance of liquidity and artificial demand for fixed-income securities through QE. Market prices for certain securities have been distorted well beyond what historical norms would dictate, just as home prices were distorted well above historical norms in relationship to income. These distortions are being rationalized today, just as they were during the housing bubble. The Fed asserts that it is monitoring the developments in the markets and economy and that all is under control. This isn't my first rodeo. I've seen this show before with a similar cast of characters, and the storyline remains the same. I can't tell which act we are watching now, but it is closer to the end of the show than the beginning. I think investors should defend, insure and protect capital in the process of accumulating it, as the unforeseen risks continue to build, so they will be in a position to capitalize when perception realigns with reality.
Additional disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing, including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.