On March 12, the Wall Street Journal published an opinion piece by Professor Alan Blinder, currently a Princeton faculty member in economics, the former Vice Chairman of the Federal Reserve from 1994 to 1996, and rumored to be on the short list to replace Ben Bernanke in 2014. In his column, "Easing Angst about Fed Easing," Blinder downplays widespread concern in financial circles (including this small one) that the Fed is painting itself into a corner via its ongoing efforts to stimulate the U.S. job growth quantitative easing.
With its balance sheet now having grown to $3.1 trillion, or about 20% of U.S. GDP, the Fed has vowed to keep up its $85 billion per month of bond purchases (or, $1 trillion per annum) "until the outlook for the labor market has improved substantially," with 6.5% being the magic number mentioned by several key members of the FOMC. In the face of these staggering numbers, Blinder counsels one and all to adopt the stance of Mad Magazine's Alfred E. Newman: "What, me worry?"
Critics of the Fed's QE program worry that as trillions in monetary stimulus accumulate it becomes increasingly difficult for the Fed to reverse its easing policy and shrink its balance sheet from its current size back down to its pre-2008 level of about 6% the size of U.S. GDP. With the current unemployment rate at 7.6%, Morgan Stanley estimates that it will take between 5 and 6 years at a monthly job creation rate of 150,000 new jobs per month. In dollar terms, if the Morgan Stanley analysis is to be believed, the Fed balance sheet will have grown from $3 trillion to $9 trillion, about 50% of annual estimated U.S. GDP in 2019, assuming a minimally satisfactory 2.5% annual GDP growth rate over the next 6 years, though we note that the current rate of GDP growth is in the 2.0% range.
Would the Fed really hold its course on monthly bond purchases for years beyond its estimated "exit date" from QE in the middle of 2015? We doubt it: the Fed is mostly likely looking for the earliest possible time to declare victory and stop the bond purchases. Vice Chairman Yellen has indicated that two consecutive quarters of employment growth resulting in a drop in unemployment of 0.5% or more is probably enough to for the Fed to declare that the economy has reached "escape velocity" (their phrase) and thus begin to wind down QE.
Of course, a reduction in unemployment does not mean an increase in jobs. We have seen a disturbing number of able-bodied jobseekers simply give up looking for work over the past 4 years. The U.S. Labor Participation Rate (LPR) has gone from 65.6% in March 2009 to 63.3% in March 2013, meaning about 3.5 million workers have dropped out of the labor force. Real, sustainable economic growth can't be achieved by increasing the number of permanently unemployed depending upon welfare programs.
Returning to the question of the size of the Fed's balance sheet, according to Blinder size does not matter, whether it's $3 trillion or $9 trillion, "the basic exit mechanism remains the same. The Fed builds a big balance sheet by buying assets. It will shrink this balance sheet by selling assets and by letting assets run off as they mature."
He makes it sound awfully easy, does he not? The truth is, when it comes to selling anything, the more you have to sell of it, the harder it is to sell without offering more and more price concessions to move the volume of items remaining in the warehouse. At some point, increasing discounts results in losses for the seller. This is basic supply and demand theory. But if Blinder is correct that scale does not matter when it comes to Fed finances, liquidity, market impact, etc., then all this worrying about "too big to fail" is a waste of emotional distress and we should all chalk up what we witnessed in the 2008/2009 global financial crisis as a mirage witnessed on a mass scale.
Blinder goes on to write that when the time for the Fed to "exit from its super-easy monetary policy," it can simply "induce" its member banks to hold more reserves by paying higher interest rates on the reserves the Fed requires those banks to hold. It does not matter, says Blinder, if the rate needed to induce member banks to hold more reserves is higher than the rate the Fed earns on its holdings, thus causing it to lose money and erode its capital. Nor is Blinder concerned about the losses the Fed will incur as its sells the long-dated, low-interest rate bonds purchased in the course of QE or if those sales inflict very large capital losses on retirees, pensions, and foreign governments. Quoting Blinder: "At first glance, it sounds horrible. A central bank with negative net worth and losing money? But hold on. The Fed isn't a private corporation that seeks profits and goes out of business once its net worth turns negative. It can still perform all of its essential functions with negative net worth. Indeed, some banks have done so. (our emphasis)"
On his first point, Blinder is correct: the Fed isn't a private corporation and because it has the taxing power and guns of the U.S. Government behind it, it is not likely to go out of business (unless Andrew Jackson rises from the dead and wins the Presidency again). Many of us may go out of business or see our real standards of living erode as a result of a Fed meltdown and subsequent recapitalization, but we, the purported beneficiaries of the existence of a U.S. central bank, don't seem to feature on Blinder's list of concerns.
However, common sense and the history of global finance dating back to the first coins minted by the ancient Greeks tell us the key ingredient for any sustainable and successful monetary authority boils down to one thing: credibility. And central bank credibility is determined by two things: First, the central bank must have some material amount of independence from the governmental body that creates it, and, second, that independence must be insured and protected by a strong and sustainable balance sheet. Without credibility based on political and financial independence, a central bank is nothing more than a minter and a printer at the mercy of mercurial (and possibly malicious) politicians (see Argentina, Zimbabwe, Venezuela, North Korea, etc.).
As to Blinder's second point, that "some (central) banks" operate perfectly well with negative capital balances and ongoing losses, we ask the natural follow-up question, "Which ones?" Blinder provides no examples. If he is talking about the Swiss National Bank, the Monetary Authority of Singapore, or the Central Bank of Norway, then, by all means, let the Fed run on negative capital.
More likely, Blinder is talking about this rogues list of central banks, all of which have run or are still running on negative capital and incurring annual losses: Argentina, Bolivia, Costa Rica, Dominican Republic, Ecuador, Guatemala, Haiti, Honduras, Jamaica, Nepal, Nicaragua, Paraguay, Peru, Philippines, Sri Lanka, Uruguay, and Venezuela. This latter group is surely not worth emulating, particularly if the Federal Reserve wishes to continue to oversee the world's reserve currency, a huge advantage in the game of global economics.
Having exhausted his rather meager defenses of massive QE, Blinder finally admits, "It's not a pretty picture. But then again, neither is unemployment lingering above 7% indefinitely. This is why Ben Bernanke and the FOMC majority keep plugging away." Of course, Einstein defined insanity as doing the same thing over and over expecting to get a different result. And, by Bernanke, Yellen and other Fed board members' admission, there are a chain of loosely connected, and sometimes disconnected, links between money supply, interest rates and unemployment, certainly when compared to the other half of the dual mandate, inflation. So, we are back to the classic human urge to "do something, rather than nothing" when it comes to our economic weakness, even if that "something" later forces the Fed to undertake equally dramatic and disruptive actions to quell inflation.
To his credit, Bernanke has been less cavalier in his comments about the risks involved in the Fed removing liquidity from the system and returning the Fed balance sheet to a "normal" size. Perhaps his relaxed attitude stems from his knowledge that his successor (Blinder?) will be the one tasked with cleaning up the Fed's balance sheet. Either way, Bernanke admitted that his "highly accommodative monetary policy also has several potential costs and risks," one of which is the potential to severely impair the Fed's capital base. While Bernanke insists that these "potential costs and risks" can be avoided or mitigated, he also concedes that no central bank has ever had a comparable increase in the size of its portfolio nor has any central bank had to then reduce its size "in the precisely analogous way" in which the Fed proposes.
One possibility is that the Fed simply holds its current portfolio of debt securities (Treasuries and mortgage backed securities) to maturity, rather than incur the losses of selling fixed income instruments at higher interest rates, which would inevitably lead to capital losses. But even fellow members of the Fed such as Charles Plosser, President of the Philadelphia Fed, have countered Bernanke's "Buy and Hold" solution: "I don't know how we can commit to never selling. We don't know the answer to that, so it's hard to pre-commit, to say we can't sell assets even in the face of rising inflation." According to a Goldman Sachs estimate based on this hold-to-maturity strategy and assuming the Fed continues to purchase bonds into 2014, it will take until 2022 for the Fed's balance sheet to return to "normal," in the meantime leaving the Fed hamstrung in its ability to control inflation. That's not much of a solution.
Our angst over the Fed's balance sheet expansion and, presumably, its eventual return to a more normal scale and scope of operations is not eased by either would-be Fed Chairman Blinder or actual Fed Chairman Bernanke's soothing words. We continue to be concerned that the current and growing scale of the Fed balance sheet will itself turn into an impediment to economic growth and stability over the next 2-3 years. That said, we anticipate the Fed will begin slowing, but not eliminating, its QE purchases later this year, barring another severe downturn in the intervening period. As such, we expect macro-economic factors such as currency, interest rates, growth, and inflation to continue to be a significant influence on stock market returns and that the long-term benefits of active portfolio management and individual company performance will continue to be masked by these macro influences.
4 "Federal Reserve May Do U-Turn on Asset Sale," Reuters, March 8, 2013m here.