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Since 2007, I have generally been a strong supporter of the US Federal Reserve's exceptional measures to address the extraordinary stress faced by the US financial and economic system. I fully supported both rounds of QE, ZIRP as well as various other measures aimed at addressing one of the most dangerous financial and economic crises in American history.

However, I believe that starting in mid 2011 with the announcement of the first round of "Operation Twist," the Fed lost its way and has ever since been engaged in a misguided policy course that threatens America's monetary and financial stability. In that same vein, the Fed is currently considering another round of QE, a policy which I believe would tend to dig America deeper into a hole that will be very difficult for the nation's economy to escape from.

Three Reasons Fed Policy Is Putting America In a Dangerous Hole

1. Excessive and artificial, interest rate repression begets future crises. By repressing interest rates at artificially low levels for too long, the Fed is sowing the seeds of a future crisis that will occur when interest rates inevitably normalize. Two examples:

  • Business financing shock. Business activity that is today viable because of extraordinarily low interest rates will shut down and/or severely slow down when interest rates increase to more normal levels.
  • Consumer financing shock. Consumers that currently live in homes acquired through variable mortgage financing will experience a massive economic shock when interest rates normalize.

In sum, the longer the Fed artificially suppresses rates, the larger the future economic shock will be when rates normalize.

2. "Fed put" sows seeds of future financial instability. The "Fed put" increases the demand for stocks on the margin, spurring stock price increases and stimulating economic activity in the short term. However, over the long term, the "Fed put" sows seeds for financial instability for two reasons:

  • Complacency leads to panic. The Fed put and the relative stock market stability it engenders entices investors with low risk tolerance that would not normally invest in stocks to acquire these fundamentally risky investments. When Fed policy eventually normalizes, and the "put" is withdrawn, future market declines that would normally be taken in stride by market participants are more likely to become major routes as investors that had no business investing in stocks attempt to exit the market in droves.
  • Portfolio effects. Fed purchases of Treasury securities via QE cause a "portfolio effect" whereby investors progressively adjust their portfolios toward riskier asset allocations. Likewise, future normalization of interest rates will tend to trigger allocation away from risky assets, thereby triggering potential stock price instability.

3. Excessive Treasury purchases erode monetary credibility. Trust and credibility gained with great effort over many decades can be very quickly obliterated. By engaging in QE at a time when there is no financial or economic distress caused by tight monetary conditions, the Fed is playing with fire in two ways:

  • Eroding backing of base money. First, the value of any monetary base is premised largely on the value of the assets held by the central bank as collateral or "backing" for its monetary liabilities (note that the main liability of a central bank is base money). By purchasing Treasury securities that are clearly overvalued, the Fed is dangerously compromising the value of the monetary base. Purchasing overvalued assets with money effectively implies devaluing the purchasing power of money. And as history can attest, compromising the value of the monetary base in this way can have potentially catastrophic consequences for the currency of a nation.
  • Eroding monetary independence. Second, by engaging in continual financing of the nation's fiscal deficit, the Fed is dangerously compromising the perceived independence of monetary policy. Once the independence of a central bank is in doubt, the value of a nation's currency is existentially compromised.

Conclusion

When monetary conditions are tight, it is appropriate for a central bank to implement measures - extraordinary if need be - to alleviate liquidity constraints. Actions to accommodate the demand for liquidity do not, in and of themselves, compromise monetary integrity and/or stability. For example, under conditions of financial distress, when the central bank provides liquidity to solvent economic agents by either loaning funds in exchange for adequate collateral and/or purchasing assets at fair value, the integrity and/or stability of the monetary system and currency can in fact be enhanced.

However, monetary integrity and financial stability is fundamentally compromised when a central bank engages in policies that attempt to "create something from nothing" - in this case by trying to stimulate economic activity through provision of excess liquidity and repression of interest rates at artificial and unsustainably low levels. In the long run, such policies only cause more problems than they solve by compromising the value and credibility of the currency, which is the lifeblood of any economy.

Under current conditions, another round of QE aimed at further repressing interest rates would simply dig America in a deeper hole that will be more difficult to get out of in the future. From that "hole," normalization of interest rates (i.e. getting out of the hole), which should ordinarily be thought of as a positive symptom, would perversely be transformed into a threat to economic/financial stability and a source of a future crisis. In this same sense, rapid QE-driven gains in stocks and ETFs such as Amazon (AMZN), (XHB), (XLY) and index ETFs such as (SPY), (DIA) and (QQQ) may well be sowing the seeds for future stock market instability.

Caution is advised for the purchase of stocks and/or bonds.

Source: The Fed Putting America In A Hole