Ben Bernanke Got It Right - Is A New Round Of Quantitative Easing Needed?

Includes: RINF
by: Vlae Kershner


As a young academic, Bernanke proposed a controversial explanation for high interest rates.

As Fed chair, he implemented quantitative easing, lifting the country out of a deep recession.

Another round of QE may be needed this year.

The Fed under Janet Yellen doesn't seem to get it.

Long before he became the Federal Reserve chairman who battled the financial crisis, Ben Bernanke was an assistant professor at Stanford's Graduate School of Business, a six-year West Coast sojourn on his way to a full economics professorship at Princeton.

I was fortunate enough to be one of his students.

Californians tend to be laid-back and carefully casual about their appearance. Bernanke, who had gotten his doctorate at the Massachusetts Institute of Technology, talked faster and looked different than most of us, who were about his age or even older. Already mostly bald, his fringe of hair fell over his neck. His beard, to put it gently, was less well-trimmed than the one he sported as Fed chairman.

His stylistic choices became irrelevant, though, when he began lecturing. From the first day, it was apparent he had a gift for making macroeconomic concepts understandable.

One day, he asked the class, "Why are interest rates so high?" In the early years of the Reagan administration, after the roaring inflation of the 1970s, mortgage rates hovered in the mid-to-upper teens.

I raised my hand confidently and answered with the conventional wisdom. "Because inflation is high and investors want to be compensated for that."

"That's not the reason," he responded, coldly. "What is an interest rate?"

Embarrassed silence. I had no idea what to say.

He answered his own question. "An interest rate is the point where the supply of money balances the demand."

He went on to give his theory: The two oil crises of the 1970s, which had increased crude prices more than tenfold, created an opportunity for windfall profits. All an investor needed to do was borrow money, buy some promising leases, hire some rigs, and drill. So much profit could be made that the interest rate, the price of money, was bid way up.

A couple of my classmates tried to argue. No one agreed with him. I still have no idea whether his theory was correct.

Nearly three decades later, as Fed chairman, Bernanke was in a position to do something about the supply and demand for money. After lowering short-term rates to zero in 2008 didn't turn around the economy, he famously reduced longer-term rates through a program known as large-scale asset purchases, popularly known as quantitative easing after a somewhat similar policy that had been used in Japan. During three rounds of QE, the Fed bought about $3.5 trillion worth of securities.

In a lecture at George Washington University in 2012, Bernanke explained:

The basic idea is that when you buy Treasuries or GSE (government-sponsored enterprise) securities and bring them onto the balance sheet, that reduces the available supply of those securities in the market. Investors want to hold those securities and bring them onto the balance sheet, that reduces the available supply of those securities in the market ...

Moreover, to the extent that investors no longer having available Treasuries and GSE securities to hold in their portfolio, to the extent they are induced to move to other types of securities, such as corporate bonds, that also raises the prices and lowers the yields on those securities. And so the net effect of those actions was to lower yields across a range of securities. And as usual, lower interest rates have supportive, stimulative effects on the economy.

And so they did, leading to an expansion of more than six years during which stocks more than doubled.

Critics, though, charged the Fed with printing massive amounts of money to pay for the securities it bought. That's got to be bad, right? Unrestrained money printing can lead to hyperinflation, like Germany in the 1920s or Zimbabwe in recent years.

Actually, no. As Bernanke explains in his 2015 memoir, "The Courage to Act."

The idea (that QE would lead to significant inflation) was linked to a perception that the Fed paid for securities by printing wheelbarrows of money. But contrary to what is sometimes said... our policies did not involved printing money - neither literally, when referring to cash, nor even metaphorically, when referring to other forms of money such as checking accounts... Instead, the Fed pays for securities by creating reserves in the banking system. In a weak economy, like the one we were experiencing, those reserves simply lie fallow and they don't serve as 'money' in the conventional sense of the word.

As the chart below from the Fed shows, currency in circulation (the black line) has risen at a steady pace. What QE did was cause the red line (deposits of depository institutions) to jump. That's the money member banks keep at the Fed, also known as reserves. Reserves have climbed because when investors sell securities to the Fed, they deposit the proceeds in their banks, and it mostly just stays there.

But what would happen if banks used their reserves to make loans? That would actually be a good thing, stimulating an economy that has had a painfully slow recovery.

"If growth in money or credit became excessive, it would eventually lead to inflation, but we could avoid that by unwinding our easy money policies at an appropriate time," Bernanke wrote.

That unwinding is starting to occur. The third and most recent round of QE ended in 2014. Since then, bank reserves have dipped, as the red line shows.

Under Bernanke's successor, Janet Yellen, the Fed raised the short-term Federal funds rate by 0.25 percent to 0.25-0.5 percent in December 2015, fearing rising inflation that isn't there. Inflation remains well below the Fed's target of 2 percent.

More troubling, Fed economists are forecasting four more rate increases this year.

The tightening policy is a mistake. Several signs point to deflation, a troubling prospect because consumers and businesses naturally wait to buy when prices are declining, creating a vicious cycle that proved a major obstacle to recovery in the Great Depression.

These signs include financial troubles in Europe and China, the rapid decline of oil prices, a rising dollar hurting exports, rising public company bankruptcies, a major 2016 bankruptcy in the coal industry, a stock market correction that has our most valuable company, Apple (NASDAQ:AAPL), selling for a measly 11 times earnings, and declining railroad volumes.

All these factors are bearish. True, employment statistics are strong, but that's a lagging indicator. The financial crisis began in August 2007, when the French bank BNP Paribas (OTC:BNPZY) suspended withdrawals from its subprime mortgage funds, but U.S. job growth continued through November of that year.

The unemployment rate at that point was 4.7 percent, lower than today's 5.0 percent. The inflation rate for 2008 was 3.8 percent because of energy price increases. In other words, the economy looked stronger on the surface during much of the last financial crisis than it does now.

That's not to say this is another 2008. The financial system is in far better shape. Still, within a few months, several large energy and materials companies may be staring at bankruptcy and the economy may be tilting toward recession. The solution may require a fourth round of quantitative easing, boosting the economy via Bernanke's simple reliance on supply and demand.

Disclosure: I am/we are long AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.