On Monday, August 27, Federal Reserve Bank of Cleveland President Sandra Pianalto gave a speech at the Central Ohio Business Luncheon. Pianalto was asked to provide an 'insider's' account of how the Fed conducts monetary policy. After giving listeners a quick history lesson on the Fed, delineating the Fed's three main jobs (supervising banks, providing financial services, and setting monetary policy), and describing the table around which the presidents and governors sit with Bernanke at FOMC meetings (they "convene" for a "go-around" at a "big mahogany table"), Pianalto finally gets to the point:
"The remarkably unusual economic environment we are in today calls for a highly accommodative monetary policy, but it requires us to conduct monetary policy somewhat differently. So let me turn to the steps we have taken in response to the financial crisis."
Pianalto does her best to paint both the Fed and Americans in a positive light regarding the setting of appropriate monetary policy and the purposeful reduction of debt respectively. Regarding the public, she claims that after the bursting of the housing bubble vaporized $7 trillion in household wealth, Americans changed "their attitude toward debt in general." She supports this contention with the following analysis:
"...households have stepped up their saving to rebuild the net worth they lost during the housing market collapse, and in the process, they have scaled back on their spending....[and] the average consumer ha[s] fewer open credit accounts than at any time in the past dozen years."
There are three arguments there: 1) increased savings, 2) decreased spending, and 3) fewer open credit accounts. Quite honestly, the first two arguments are of questionable validity. Consider the following two charts, the first shows the U.S. savings rate since 2007 and the second shows retail sales over the same period:
(click to enlarge)(click to enlarge)Charts: YCharts
As you can see, savings have not increased and spending has not decreased. As for the third argument (the average consumer has fewer open credit accounts and, by inference, is deleveraging), Pianalto is relying on a rather narrow definition of the term 'debt'. When one looks at total consumer debt, it is in fact closing in on an all time high.
As for the Fed and QE, Pianalto notes that large scale asset purchases (LSAP) have been successful in bringing down interest rates and keeping deflation in check, but she strikes a notably cautious tone:
"...our experience with these programs (LSAP) is limited, and as a result, they justify more analysis. It is conceivable that...policies designed to promote further declines in rates could interfere with financial stability [and] the Federal Reserve's presence in certain securities markets [c]ould become so large that it would distort market functioning. As a result, [these policies] justify more analysis."
As luck would have it, we in fact have 'more analysis' on hand in the form of a white paper by Bank of International Settlements economist William White published by the Dallas Fed. White's analysis is eye-opening to say the least.
At the outset, White notes that while accommodative monetary policy was indeed justified to avert a "financial implosion", it wasn't entirely clear why similar policies should have persisted once the panic subsided. White says that one likely explanation was the unwillingness of policymakers to employ additional fiscal stimulus to ensure a smooth transition from crisis to recovery. This left monetary policy as "the only game in town." Of course now, we have come full circle and find that, as Bundesbank President Jens Weidemann recently noted, "monetary policy is becoming increasingly beholden to fiscal policy in the eurozone". I would argue the same argument applies in the U.S.
In any case, White goes on to explain that ultra easy monetary policy does not necessarily serve to stimulate aggregate demand to the degree its proponents claim and indeed there are negative consequences associated with such policies. Notably, White says that what I have called "counterfeit credit" (he does not use this term, he substitutes "created credit") ultimately never produces enough in terms of outputs to pay for itself:
"Assets purchased with created credit...eventually yield returns that are inadequate to service the debts associated with their purchase."
In other words, continuing to flood the system with newly minted money can never stimulate enough growth -- can never create the productive capacity necessary -- to produce a net positive effect. The idea that created -- or "counterfeit" -- credit will never pay for itself in the end is the overarching theme of the paper in my opinion and it is summarized by White as follows:
"...monetary policy should be tightened regardless of the current state of the economy because the near term expected benefits of ultra easy monetary policies are outweighed by the longer term expected costs."
I will leave it to the reader to read the full paper (link provided) but I will mention a few of the costs about which White speaks.
Regarding easy monetary policy's ability to exert a stimulative effect on the economy, White mentions that the monetary policy transmission channel does not always function properly as demonstrated by the fact that mortgage rates and corporate spreads have fallen far less than might be expected given the Fed Funds rate. Additionally, low rates have not raised asset prices to the extent expected especially for depressed home prices in the U.S., Ireland, Spain, etc. Furthermore, the need to repeatedly employ 'nonstandard measures' to boost such assets as stock prices speaks to the ephemeral nature of these measures' positive effects. White also notes the Bank of Japan has implemented similar measures in the past and the results (in terms of demand stimulation) have been questionable at best. Finally, White reiterates what I noted in a previous article: central bank asset purchases exert a negative influence by "absorb[ing] collateral needed to liquefy private markets."
Regarding the unintended consequences of easy monetary policy, White first notes that the economic models utilized in academia and in the course of policy making are not very good at approximating how the economy actually functions. While White does note that the odds of a sudden burst of inflation triggered by current policies are (for now) low, he also warns that the implementation of more asset purchases could influence inflation expectations and this could in turn trigger inflation itself, as people's expectations have recently become more unpredictable. White also notes that easy access to cheap credit tends to facilitate malinvestment and eventual crises tend to approximate (in scope) the preceding extension of created credit. These crises are the natural way of purging misallocations of resources and excess debt from the system. When ultra easy monetary policy prevents this purging, it 1) allows misallocations to persist, constraining future growth by keeping capital from flowing to the most productive endeavors and 2) contributes to "serial bubbles" by attempting to fix debt problems with more debt and thus ensuring that the next 'boom' and 'bust' cycle will be more spectacular than the last.
Finally, White notes that low rates tend to encourage greater risk taking (leverage) and, concurrently, looser lending standards. This of course, facilitates the build-up of high risk loans on balance sheets which must be off-loaded to comply with regulatory capital requirements and standards. In order to get these assets off the books, they are securitized and sold resulting in a scenario wherein "traditional banking is replaced by a collateralized market system with the repo market at its heart." Thus, low rates and sharp credit upswings contribute to shadow banking and imperil the stability of the entire financial system.
White also convincingly demonstrates that easy monetary policy threatens the notion that the central bank is independent of the government. First, when central banks purchase assets such as mortgage backed securities they imperil the balance sheet and thus risk having to seek the government's aid in recapitalizing it. Perhaps more importantly, the more government paper the central bank buys, the more it opens itself up to criticisms that monetary policy is becoming subservient to fiscal policy (also mentioned above).
Ultimately, White's arguments are difficult to refute. He cites over 100 sources and presents multiple counter arguments which he addresses in turn. The conclusions are clear: it is highly likely that the short term benefits of ultra easy monetary policy will be outweighed by the long term costs. Thus, I reiterate my contention that with each successive round of QE, the Fed reinflates the credit bubble and thus increases the chance that the bursting of that bubble will result in a crisis of even greater magnitude.
Furthermore, I believe White downplays the chances of a spike in inflation by not explicitly drawing a connection between what he calls an increase in the volatility of people's inflation expectations and the sharp increase in the public's awareness of the Fed's actions. In other words, if the public's inflation expectations are increasingly unpredictable and this increase in volatility is accompanied by a widespread realization that the Fed continues to pursue expansionary policies, it seems to me that the conditions are ripe for a sudden increase in expectations followed in very short order by an actual rise in prices. All of this supports my contention that gold (GLD) and hard assets should be the cornerstone of investors' portfolios for the foreseeable future.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.