As reported yesterday by Jeff Cox of CNBC, the Fed is likely on the verge of making an important policy change (HT: Calculated Risk). Within the next several months, the Fed is likely to announce the tapering of QE. That's not a big surprise, but this time there is an interesting twist: in order to offset the risk that tapering might cause interest rates to move higher - which could slow the still-weak housing market and the still-weak economy - the Fed will also announce a lowering of the unemployment rate threshold that would prompt them to begin raising interest rates. By doing this the Fed would be removing some of the unwinding risk that continued tapering creates, while at the same time keeping bond yields from increasing, since a lower unemployment rate threshold would significantly extend the period during which the Fed would keep short-term interest at or near zero.
The official justification for this move would be to strengthen the economy. But for those of us who believe that monetary policy has little or no ability to create economic growth, the real reason the Fed would make this move is to aggressively weaken the demand for cash and cash equivalents (e.g., currency, T-bills, bank savings accounts and bank reserves). If the Fed succeeds in convincing the world that cash and cash equivalents will pay next to nothing for the next few years (i.e., the time it would take for the unemployment rate to fall to the Fed's new threshold), then the world's demand for that cash is most likely going to decline.
As the chart above shows, there's an awful lot of "cash" out there that pays almost nothing: over $7 trillion of bank savings deposits, $0.7 trillion of retail money market funds, $0.6 trillion of small-denomination time deposits, and $1.4 trillion in checking accounts. And let's not forget the $2.5 trillion of bank reserves, the vast majority of which are held as "excess reserves," that the nation's banks are apparently quite happy to hold and which pay all of 0.25%.
The M2 measure of the money supply is arguably the best measure of the amount of readily-spendable cash in the economy. As the chart above shows, the ratio of M2 to nominal GDP is at record-setting levels. That means that the public's demand for "cash" has never been stronger. Households and businesses have never before held such a large proportion of their annual income in cash. That's remarkable on its own, but it's even more remarkable considering that the yield on all that "cash" has never been so low for so long (T-bill yields have been hugging zero for the past 5 years). It's a fact that the world's appetite for "cash" has never been so voracious.
The flip side of today's strong demand for cash is a high degree of risk aversion. People are apparently content to sit on a mountain of cash earning almost nothing, while any asset with risk attached yields considerably more (see chart above), and total returns on most of the world's stock exchanges have been on the order of 20% so far this year.
There's an old saying: "Don't fight the Fed." The Fed is arguably the most powerful institution in the world, and when they want something, they can get it. What they want is for people to be less risk averse: to spend some of their cash stockpiles, to hire more workers, and/or to expand their businesses. If they succeed, and they most likely will, then the world will attempt to reduce its holdings of cash and increase its holdings of riskier assets. Of course, cash can't simply disappear, so the mere attempt to reduce cash holdings will mean that the relative prices of cash and riskier assets will change: riskier assets will go up in price (and down in yield), while cash will go down in price (and eventually up in yield when the Fed decides that it has achieved its objective).
What I've just described has actually been going on for some time now. What the Fed is likely to announce in a few months won't be anything new, it will just be trying harder to do what they started to do in 2008. As the chart above shows, corporate credit spreads have been contracting for the past five years (i.e., the difference in the yield on corporate bonds and the yield on Treasuries of comparable maturity has been contracting). The world has been willing to pay an ever-higher price for corporate bonds relative to Treasury bonds because risk aversion has been declining. But spreads are still quite a bit higher today than they were before this whole mess started, so there is still plenty of room for improvement.
And of course there is the huge rally in most global equity markets, which directly reflects the decline in investor's risk aversion, bolstered by record-setting corporate profits. Yet PE ratios are still more or less average; despite record-setting profits, investors are still reluctant to pay above-average prices for those profits.
If the Fed gets its way - and I have little doubt that they will - then all of the things we've seen happen over the past several years will continue. The prices of risky assets will continue to rise, nominal GDP will continue to expand, and bank lending will continue to expand. C&I Loans are already up by one-third in the past year. Banks have been slowly relaxing their lending standards for the past year or so, and that is very likely to continue. We could even see a pickup in real economic growth, but it's not likely to be very impressive unless fiscal policy takes a turn for the better (e.g., fewer deductions, lower rates, cuts in the taxation of capital).
As risk aversion declines, the price of gold - the classic refuge from monetary and political risk - could decline as well. Gold is still trading at more than two times its average inflation-adjusted price over the past century.
The end game is still out there on the horizon. That will come when bank lending becomes aggressive and the amount of cash out there starts increasing faster than the world's demand to hold it. At that point inflation will begin to pick up and the Fed will need to start chasing it by increasing interest rates. Eventually the Fed will raise rates enough to boost the demand for cash to such an extent that the world loses its desire to engage in risky behavior, and the economy will turn down. It's the same story that has played out in just about every business cycle in my lifetime.
There's not much new under the monetary sun these days, it just goes by another name. Traditional Fed easing was accomplished by lowering interest rates; nowadays it takes a reduction in the unemployment rate threshold for Fed tightening.