I've long argued that the Fed's three Quantitative Easing episodes were never really about "stimulus." Instead, I thought QE was the correct response to a surge in the world's demand for money, money equivalents, and safe, risk-free assets that followed in the wake of the financial crisis of 2008. In recent months, I have argued that the Fed was justified in raising short-term interest rates, because the world's demand for money and safety appeared to be slowly declining.
Unfortunately, it looks like both I and the Fed have been wrong of late. I'm not sure what the exact underlying cause of the latest "panic attack" to hit the markets is, but signs point to: 1) the ongoing slowdown in the Chinese economy; 2) the collapse of oil prices; 3) rising geopolitical tensions in the Middle East; and 4) a sense that policymakers are clueless. In this latter category, we have the rise of Bernie Sanders and Donald Trump, and the apparent tone-deafness to all these problems on the part of the Fed as reasons for investors to worry about the future economic and policy direction of the U.S. economy. At a time when major economies appear to be wallowing in turbulent seas, it's terrifying to think that the ships' captains might be clueless.
Many commentators have argued that we're also in trouble because central banks are "out of ammunition", since rates are at or near zero. Those who believe this were cheered when the Bank of Japan announced negative interest rates.
However, I think that's the wrong way to think about monetary policy, because it assumes that moving rates up or down is a way of slowing down or goosing economic activity, respectively. As we've seen, central bank purchases haven't had the intended effect on interest rates, and they have not resulted in any meaningful stimulus to any economy. It bears repeating that monetary policy cannot create growth out of thin air; growth only happens when productivity rises, and productivity rises only as a result of more work and more investment. Fiscal policy needs to focus on increasing the rewards to risk and investment; lower interest rates are not the cure-all for chronically weak economies.
Trying to manipulate interest rates hasn't helped, but the Fed's provision of additional reserves to the banking system via QE has addressed liquidity issues and systemic risk issues. U.S. banks have effectively invested $4 trillion in deposit inflows into bank reserves, bolstering their balance sheets in the process. More QE purchases can be a good thing, especially in times like these when markets are very nervous, because the demand for money and safe assets has increased meaningfully. What's needed now is not lower interest rates, but more T-bills (aka bank reserves in an IOR regime).
Things began to heat up beginning right around the end of last year. Since then - just over 5 weeks ago - gold is up some $130, HY spreads are up 150 bps (led by HY energy spreads, which have spiked to 1850 bps), crude oil is down 20%, 10-year Treasury yields have dropped 55 bps, real yields on 5-year TIPS are down 30 bps and global equity markets are down 10-20%.
The chart above shows the total of retail money market funds, one of the components of M2. After declining for years, it has spiked by over $100 billion in the past few weeks. Thanks to the fact that the Fed is paying interest on bank reserves - which has been extended, via reverse repo agreements, to non-major banks and other financial institutions - money market funds now pay some interest, whereas before they paid almost nothing. That may be the reason for the huge increase in demand for these funds, but it may also be that a lot of money is fleeing China and Europe, and these funds look like easy-to-get, attractive safe havens.
The chart above shows required reserves (reserves that the Fed requires banks to have to collateralize their deposits). This component of the monetary base has soared at an annualized rate of 350% in just the past month! It also explains why the much broader measure of money supply, M2, is up at an annualized rate of 15% in the past month, after growing for 6-7% per year for the past several years.
When the world rushes for the risk exits and into the welcoming arms of banks and money market funds, central banks need to respond by increasing the supply of money. If the Fed doesn't accommodate increased money demand with increased money supply, that can lead to deflation and other sorts of nasty consequences.
Fortunately, there are some offsetting factors which today make the situation less than critical. Total Bank Credit (now $11.8 trillion) is rising at a relatively strong clip (8-10%) in recent months, and Commercial & Industrial Loans (now over $2 trillion) are rising at double-digit rates. Oil prices are still weak, but the CRB Raw Industrial commodity index (no energy included) is up over 6% in the past few months. Meanwhile, the dollar has declined because the world figures that the likelihood of further Fed rate hikes has gone down dramatically - and a weaker dollar should provide good support for all commodity prices.
Still, it would be very helpful if the Fed were to make it clear that at the very least, rate hikes are off the table for the foreseeable future, and that it probably makes sense to fire up another round of QE. Adding more risk-free money to the system at a time when risk aversion has spiked is just what the monetary doctor would order.
The chart above tells the big-picture story of money demand: the ratio of M2 to nominal GDP. Think of this as being roughly equivalent to the percentage of the average person's annual income that is held in liquid form (cash, savings accounts, checking accounts, money market funds). I've been expecting this ratio to top out for the past several years, but it just keeps growing. The world just keeps stockpiling cash and cash equivalents for a variety of reasons, with fear and uncertainty likely topping the list. People want to hold more and more money even though it pays a paltry rate of interest. We won't be out of the "fear" woods until this ratio stops rising and starts declining.
The chart above tells the story of the Fed's three rounds of Quantitative Easing. The Fed always told us that the purpose of massive purchases of notes and bonds was to depress interest rates, which, in turn, was supposed to stimulate borrowing and thus boost the economy. But that's not what happened. Note that during each period of QE (green bars), interest rates actually rose. I think that was because the bond purchases, which effectively transmogrified notes and bonds into T-bill equivalents, was just what the world needed. QE satisfied the world's demand for safe assets, and that lubricated the wheels of finance; rates rose because risk aversion declined and the market felt more comfortable about future growth prospects. But after QE1 and QE2 were discontinued, yields plunged, which was a sign that the Fed hadn't done enough and/or had ended its QE purchases prematurely. Recall that the periods between QE1, QE2 and QE3 were dominated by the emerging PIIGS crisis in the eurozone. There was a lot of panic in Europe, and a lot of money that fled to the U.S. as a consequence. Each time the Fed started a new QE program, the markets breathed a sigh of relief and interest rates rose as a result.
Note that interest rates were relatively stable following the end of QE3. Until recently, that is. I think the recent decline in yields on 10-year Treasuries is the market's way of saying "Help!" to the Fed. We can only hope that Janet Yellen and her fellow Fed board members hear this and respond before too much time goes by.
I've been showing the chart above for a number of years, since it helps to visualize the market's demand for safe assets (and, by inference, the market's level of FUD). The red line is the price of gold, while the blue line is a proxy for the price of 5-year TIPS. (I use the inverse of the real yield on TIPS as a proxy for their price.) The demand for safe assets has been declining ever since the PIIGS crisis was resolved in 2012, but it has jumped since the end of last year (i.e., the price of gold and TIPS has jumped). The jump is significant, but it's still relatively tame compared to what we saw back in the 2010-2012 period.
The chart above is also helpful, since 2-year swap spreads are a good proxy for financial market liquidity and systemic risk. As two wrenching episodes of the PIIGS crisis unfolded in 2010 and 2012, swap spreads soared, especially in the eurozone. Fortunately, today swap spreads are well behaved, and that suggests that systemic risk is low and liquidity conditions are still healthy.
With a some more QE help from the Fed and some more time for markets to adjust, there's reason to think we can survive the current crisis.