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What Will Replace QE?

Janet Yellen is the presumed next chairman of the US central bank, the Federal Reserve (Fed). As part of the confirmation process she defended the bond buying program known as quantitative easing or QE. She said that the program has "made a meaningful contribution to economic growth and to the improving outlook," The financial press took this as a 'vigorous defense' of the QE program. It was taken as further proof of Yellen's dovish monetary bent and that the long delayed QE tapering would not occur until spring of 2014. It is doubtful that she should have said anything else. To cast aspersions at the Fed's signature program would hardly have been politic even if she had believed that it had problems. But are the general assumptions about QE correct?

Vice Chairman Yellen at least paid lip service to some of the risks of QE. She said that "there are costs and risks associated with the program. We're monitoring those very carefully." Still it is at some level embarrassing if other central banks think your programs are the cause and not the cure for global economic instability. The European Central Bank (ECB) on Wednesday issued a stark warning that the coming taper will most likely cause severe market shocks. The ECB is not alone. In its October minutes the Fed specifically stated that the taper was going to start in "a couple of months".

The reason for ending QE is simple. It hasn't worked all that well. The US economy is growing, but not by much. The employment situation is getting better, but slowly. The employment rate is down, but only because people are dropping out of the market. Pushing more money into a market without demand tends forces banks and other investors into riskier assets rather than stimulating businesses. US banks have recently increased their holdings of "sliced and diced" securitized securities to a record amount.

Mortgage real estate investment trusts are a more perilous example. These so-called mREITs make money by borrowing short term at low interest rates and buying mortgage-backed securities offering higher yields. They are leveraged with debt to equity ratios of 8 to 1. Their investors include banks, pension, mutual funds and specfically taxable bond funds, some of which hold as much as a third of their holdings in mREITs. mREITS were specifically mentioned by Fed Governor Jeremy Stein and have been the subject of a recent Fed study.

The longer QE goes on the bigger the risks become and the harder it is to exit. Yellen herself acknowledged this in conversations with QE foe, US Senator Robert Corker (R-TN). According to Senator Corker, she said that QE was a "blunt object" that caused distortions. She also said that the Fed may have become a prisoner of its own policies.

Although the Federal Open Market Committee (FMOC), the main instrument for implementing Fed policy will become noticeably hawkish in 2014, there is still continued support for alternative forms of stimulus. So rather than obsessing on the end of QE it might be a better idea to ask what will replace QE. Right now the Fed is in the process of brainstorming. One option was possibility was a cut in interest paid on bank reserves.

Right now the Fed pays banks interest of 0.25% on their reserves including excess reserves, the so called interest on excess reserves rate (IOER). If this were to be cut to zero or 0.1% it would discourage banks from the risk free strategy of banks parking money with the Fed. According to the most recent minutes 'most' officials thought this was an option worth considering.

The potential success of this program seems far less than QE. Ben Bernanke himself criticized this policy three years ago. He said that the benefits would be small and that the program "could disrupt some key financial markets and institutions," and "could lead short-term money markets . . . to become much less liquid." The policy was considered both in 2011 and 2012 and rejected each time.

US banks were also not happy with the idea. They said that a cut in the IOER could result in banks charging companies and consumers for deposits. They warned that a cut in the 0.25% rate of interest on the $2.4tn in reserves they hold at the Fed would lead them to pass on the cost to depositors. Perhaps the fact that 'most' officials even considered a rejected program is a measure of their desperation.

A better idea has been the focus on short term interest rates. The present QE focuses on purchases of mortgage securities and Treasuries with maturities between four and 30 years. A recent Fed study showed that short term interest rates had a larger effect than long term interest rates. One of the objectives of QE was to bring down longer term interest rates, flatten the yield curve by lowering the term and risk premiums. But the study showed that a sustained decline in long term interest rates by lowering the premium had half the effect of a similar decline brought about by a decline in short term interest rates.

The preferred method of keeping short term interest rates low is through the policy known as Forward Guidance. Basically the Fed promises to keep short term rates near zero for three years. If the market doesn't believe the promise, the Fed can simply buy more short term notes. The bond market may already reflect this change of policy. Interest on 2 year note has fallen steadily from 0.52% in early September to 0.29%. The 10 year note was also high at the beginning of Septem.ber at 2.93%. It fell to 2.48% at the end of October, but has since risen back to 2.74%. The drop of short term interest rates may also be a crucial signal for a December taper.

This threat has worked well for the ECB. Their promise to buy unlimited quantities of government bonds maturing in one to three years from nations that met certain criteria related to their debts was successful in stabilizing interest rates for southern European. The threat was so successful that not one bond was ever bought.

Markets are pushing ever higher on the premise that QE will continue almost indefinitely. The danger here is complacency. The Fed and even Janet Yellen have clearly indicated that the program will end, not necessarily because they are happy with the results, but rather they are afraid of the risks. When the program does end, which will probably be sooner than the market thinks, it will most likely be replaced by something else. The question is whether the new program will be unambiguously favorable for equities and other risk assets. The answer is probably not.