My main investment and research interests are in medium to long term shifts and discontinuities in the global economy. However, after years of quantitative easing (QE) and with its imminent end, in fits and starts, I wanted to write a piece exploring whether QE’s end could fuel discontinuities. Some, including me, could argue the case that QE’s end will be as uneventful as its start. But, it might not be, and its effects might also not have been as mild as many of us presume. I want to explore those possibilities here, partly in retrospect and partly looking towards the future.
When QE was proposed, a group of prominent economists wrote an open letter to the Wall Street Journal, warning it would debase the currency and cause inflation. They were wrong, and their wrongness reflects an unfortunate reality that economists often talk about money without understanding the financial system. QE was, and was designed to be, asset inflationary. To be CPI inflationary would require clear channels from asset to consumer markets. There are very few, with most blocked in normal times in “normal” economies. When an institution sells an asset to a central bank under QE, they use the proceeds to buy other assets, increasing demand in the asset markets where the purchases are made. They don’t go out and buy cars and meals and other stuff that would increase demand, and the CPI, in consumer markets. That’s embezzlement under most circumstances. A handful of channels could funnel QE-driven increased demand in asset markets into consumer markets, but few were open at the time.
Leaving this point aside for a moment, how did QE affect the real economy? In short, we don’t know for sure. That’s too bad because the answer would help in understanding the end of QE (not to mention the nearly inevitable future rounds of it). There are lots of ideas, but in truth no set of theoretical or empirical tools will definitively tell us whether QE did or did not drive lower unemployment, higher incomes, and increased GDP. However, we can poke around for some ideas, using this same exploration of channels within which money moves through the financial system.
QE is designed to drive asset inflation and decreased yields in a range of medium-term monetary instruments. In fact, yields on corporate bonds, medium to long term government bonds, and other instruments reached historic lows. Success! That’s basic supply and demand. Did lower rates stimulate the economy? Again, the question is related to the structure of the financial system. There are different channels through which interest rates can affect an economy. Not all operate at any point in time, effect the economy in the same direction, or work the same during periods of increasing and decreasing rates. The effect of interest rates on the economy site lays out some of the main channels, and these and others will help in examining what might happen as QE peaks and wanes.
This intro sets the backdrop to explore:
- The channels that were open and closed over the duration of QE that could allow increased liquidity and lower rates on interest bearing assets to translate into greater wage, employment and/or output growth
- The effects of QE ultimately, both on economic growth and on the economy and financial system more widely
- What might happen to markets and the economy when QE is “tapered” or unwound, and how markets, politicians, and central banks might react
Channel Surfing for Dollars
A macroeconomics textbook staple has central banks lowering interest rates to stimulate an economy, presumably meaning lower unemployment and increased output. We can probably take the intention at face value. Whether and when lower rates stimulate and how the rate tools work are more ambiguous. Central banks don’t just move a dial that says “rates” that’s connected by a big gear to growth and employment. In the case of QE, the post great recession tool of choice, central banks became a massive buyer of both distressed commercial and highly rated government medium-term interest-bearing assets. The reliable laws of supply (decreasing as assets were retired to central bank balance sheets) and demand (increased liquidity as purchases were made) meant asset values increased, and their yields (realized interest rates) decreased. So far, nothing new.
Getting to the next layer, what did sellers of assets to CBs do with the proceeds? The short answer is they bought other assets, thereby at the margin increasing prices and decreasing yields in those markets. And the sellers of those assets bought other assets, and so forth until we must admit to losing track of the full extent of it all. We are pretty sure that QE increased asset values and decreased yields in the distressed and medium-term government debt markets where it was mainly executed. It was supposed to. Economists thankfully still agree on supply and demand. They don’t agree on the degree that QE driven asset inflation spread outside its target markets. Evidence varies, but it almost certainly did.
To that extent QE succeeded. The yield curve flattened, medium and longer-term rates dropped as asset values increased. The economy also recovered simultaneous with the QE program: growth returned, and unemployment dropped. The bigger question is whether QE and the resulting lower rates drove the recovery and if so, to what degree. Empirical analysis even with good data is can only establish correlation since we can’t know the counterfactuals. Below, I look at some channels that QE-driven lower interest rates can take through an economy, and admittedly, speculate heavily on the economic effects as lower rates move through those channels.
Channel 1: lower interest rates can spur consumption, the main component of GDP. For the channel to work, consumers borrow and lenders lend for increased consumption. After a debt crisis, like in 2008, lenders may not be able (due to regulations or capital requirements) or willing (after getting burned) to lend, and consumers may be deleveraging. Lower policy rates may also not carry over into rates charged on consumer debt. Effects of this critical channel can be quickly muted, and after a debt crisis is perhaps not a prudent way to stimulate an economy anyway. This channel can work, but probably less in the early stages of a recovery when the conditions noted above are most acute.
Channel 2: the wealth effect of higher asset prices can stimulate asset holders’ consumption. Portfolio values did increase as asset values rose across a range of markets, though how much QE as opposed to other factors affected which asset markets is uncertain. The wealth driven consumption effect is initially limited to those with sizable investment portfolios, but spending on high-value consumption goods and services can stimulate employment and further consumption (and increase GDP). All other things equal, wealth (but not income) inequality can increase if this channel is dominant and gains concentrate with those with large asset portfolios. On a slightly longer horizon, the wealth effect can spread as lower mortgage refinance rates and higher home prices increase real incomes and net worth for a much larger segment of the population.
Channel 3: lower interest rates can lower costs of and increase demand for investment. Effects can be unclear and probably differ at different points in the recovery cycle, with effects muted at the beginning and accelerating later. For recently lowered rates to work, an investment all other things equal must still yield a good return, which is less likely in a weak economy when low interest rates prevail. Investors will need to adjust their WACC to the new rates, though evidence indicates they may not. Banks’ ability and willingness to lend, as with consumer lending, may be complicated by post-recession bank and regulatory policies. More clearly, lower rates can increase existing companies’ profits as interest costs fall, assuming they can still access credit. Whether companies distribute (higher impact) or retain (lower impact if not invested) profits will influence final economic effects. Many companies post-2008 retained profits or even borrowed at low rates to buy back their shares. The latter can have a wealth effect like Channel 2 if share prices rise, however.
Reduced investment hurdles can be a double-edged sword that we will get back to. At the margin, lower rates can help both in funding and maintaining leveraged businesses that would otherwise not get funded or go bankrupt if rates were higher. These businesses do employ people and their production contributes to GDP, or their not failing can keep GDP from falling. But, if their survival is dependent on QE- driven low rates, dangers may loom. The collapse of the risk premium is perhaps more a factor than QE, though the two are almost certainly related. Risk premia declines seem to happen later in recoveries as investors seek yield in a low rate environment and re-embrace risk.
Channel 4: working in the opposite direction, lower interest rates can lead to higher saving and decreased consumption in some cohorts, lowering growth. Lower interest rates decrease income from fixed assets, decreasing their compounding and anticipated retirement income. Incentives may be to consume less both in retirement and while saving for it to achieve an increased “target’ wealth. The channel mainly affects older consumers (say 50+), who are an increasing percentage of the population, and/or those reliant on insurance/annuity products with payouts at risk from low rates. The effect may also incentivize retirees to put off retirement, potentially putting downward pressure on wages and consumption in other parts of the economy. Lower interest rates can drive prices upwards in a range of fixed assets, particularly housing, small business purchases, and small business leases. Effects are complex, but higher costs can lead to more saving and less consumption to reach the hurdles required for acquisition.
There are other channels, some of which may be open at different times. The above is hopefully illustrative enough to make the point that “it’s complex,” when talking about how lower interest rates and particularly those driven by QE affect an economy. There are any number of partial conclusions, open questions, paths to follow, and points to make when looking at the complexity of this problem. I am only going into one more in this section.
It may well be that QE mainly affected asset markets, by increasing the value and decreasing the yield of existing assets. It is questionable how much that helps stimulate an economy, but it can initially through the wealth effect (not without other consequences) and later by keeping marginal companies afloat and get new ones floating. I am searching for better data on the various stocks and flow in asset markets during the relevant period and leading up to the present one. QE would presumably have stimulated best if mainly new investments were made and new investment assets created in response to the lower rates, rather than increased liquidity circulating around bidding up prices of existing assets. Given the weak investment response of major companies sitting on cash hoards, a lack of investment capital was probably not the reason the economy did not grow faster, sooner. It is also not clear that QE really was stimulating through other channels, though it may have been.
We need to figure this out, partially so that QE or central bank policy can be better understood and executed more effectively in the future, or perhaps not executed at all. We also need to better understand what will or will not likely happen as QE unwinds. That gets to the next section.
To Tantrum or not to Tantrum, that is the QE
Five years from now, the pundits will be looking back and saying how obvious this all is. It’s not.
As QE comes to a halt and starts to wind down (U.S.), lightly tapers (NYSEARCA:EU), or continues (Japan and maybe China) at the end of 2017, what happens? No one knows no matter how loudly they yell either nothing or apocalypse. There are too many variables, many of which are driven by human behavior and/or are completely unknown. At the same time, if the previous discussion at least somewhat justifiably tracked effects of QE through various channels, then presumably clues about halting and/or reversing QE can be found in the same channels.
Since the above hypothesized that the asset inflation channel was wide open during QE, that’s a good start. The bazillion dollar question is whether Fed withdrawal will mean a net decline in aggregate demand in asset markets, and if so which ones. Supply and demand would say yes, but supply and demand in 2018 is more complex than in 2009 when demanders were in short supply. Now there are a lot of them. The question is whether ongoing and growing demand for U.S. assets from other sources will balance the slow withdrawal of QE. If the basic supply and demand equation does not change, little may happen. Let’s look at where “substitute” demand might come from.
Foreign QE programs are one place to look. We don’t know what assets sellers to EU and Japanese central banks are turning around and buying. However, if there is a reckoning to be had with the end of Fed QE, ongoing global QE can at least delay it. Any doubters whether foreign QE matters should consider that the SNB alone has acquired over $80 billion in U.S. equities through their program. U.S. interest rate increases can ironically amplify the effects of non-US QE related asset purchases, as sellers of assets to foreign central banks seek yield outside their own low interest markets.
Years of QE in the U.S., record corporate profits, and asset sales at record levels (among other things), have led to considerable liquid assets on balance sheets. Some refer to this as an “ocean of cash” or “cash on the sidelines,” but in fact it’s all invested somewhere. It just may not be invested where its owners ideally want it. The nearly $1 trillion un-invested in PE funds are one case. The funds are presumably sitting in short term, liquid markets, looking for a higher value longer term home, but its current home is the best it can find. Redeployment could presumably help keep a floor under equity markets, though the effect on bond markets is even less clear. Entry from short into medium term bond markets as rates rise may help balance the Fed’s relatively slow withdrawal there. It may also keep rates from rising further down the yield curve.
Some believe that following the new U.S. tax bill, gobs of money will enter the U.S. further driving up asset prices. In fact, most of that money that the companies want in the U.S. is already in U.S. assets. It just happens to be registered in a foreign name. What repatriation might do is substitute for companies’ borrowing for share buy backs and lead to a retirement of debt (increasing liquidity) just as the Fed is trying to tighten it. A perhaps more important effect of the tax bill will be to put more money in the hands of the wealthy and upper middle-class investors who are already struggling to deploy it productively. This increase in asset market liquidity could help counter the effects of unwinding QE.
Chalk some more points up here for the “ain’t nothin bad gonna happen” camp.
If broad asset prices (outside of those intended) should drop, the Fed itself may reappear on the demand side in the notorious Greenspan Put. Asset price growth has been popular, and asset price deflation will be even more unpopular than that. Central banks should be independent of the political process, but really? A sharp drop in asset prices across the board, especially if inflation remains tame, could trigger a slowdown in the taper or even a restart of QE. For fans of behavioral economics who have not figured out what to do with it, consider Prospect Theory. Punters have no patience for tanking markets. Recall, a major reason for increasing rates is so the Fed can cut them again. The real issue is not whether bond prices will drop, with an increase in short term interest rates, they will, but whether drops extend outside short-term bond markets.
Taking the above, the end of Fed QE may have little asset market or economic impact, at least through the dominant asset price channel. Even with IOER increases, little may happen outside short-term interest rate markets. Barring inflation, that’s OK. If inflation rises, that’s a different problem. It’s also barring any other event: a slowdown in corporate profit growth, defaults in a major market, trade war with China, baby boomers’ selling assets to pay for retirement, some global shock that raises (or lowers) risk premia again and wreaks havoc in (or stimulates) the repo markets, or any number of other factors including many we cannot even guess at. Even if aggregate supply and demand for U.S. assets roughly stay where they are, more can happen as QE unwinds. A lot depends on whether policy and/or other rates go up or not. The Fed has some, but in no means full control over this.
The Fed is trying to raise short-term policy rates, not just unwind QE. Outside QE wind-downs, available Fed interest rate levers may have built in stops. Each 1 percent increase in the IOER leads to about $24 billion annually in cash payouts (not reserve increases, inside money) to banks. That at very least will make excellent press, and perhaps more populist calls for independence revocation. Though the technocrats at the Fed will try to “do the right thing,” preservation of the institution is an incentive that is never on the sidelines.
At this point, to try to make progress we assume (this is not assured), that when the Fed unwinds QE and increases the IOER, that other than short term rates will follow. Here is the really guessy part because it depends on highly unpredictable investor behavior and movement of funds through our “channels.”
The terms to get into this conversation are liquidity, volatility, and risk premia. Others have argued persuasively that assets markets’ apparent liquidity is delusional. Much of the QE liquidity that entered markets drove up prices and then stopped trading. Banks are no longer making markets the way they used to, many quant funds are trading rangebound, and the ever-popular ETFs’ infrequently trade in the underlying securities whose index they track, just their own shares. Liquidity looks good, until you really need to trade. That’s an age-old problem, but indications are its gotten worse.
A QE driven shift in interest rates may tip certain markets to reveal the liquidity delusion. It won’t take much, just a little shift away from high yield markets back to now higher yielding safer assets. Low liquidity in those markets means volatility, and the subsequent return of the risk premium. Basically, it means a return to “normal” markets that traders are no longer used to. The most vulnerable markets are perhaps in high yield, emerging markets debt, possibly emerging markets equity, leveraged and low profit tech stocks, stocks leveraged with high yield debt, anywhere that risk premia have been compressed out of relationship to risk in a “normal” environment.
The effects are mutually reinforcing, and we have seen them before. Volatility begets risk premia begets illiquidity begets volatility, round and round. The S&P 500 and AAA corporate markets may be unaffected, depending on leverage and collateral considerations that are largely unknown. Markets will become bifurcated by risk, unlike now. The elephant in the risk room is that no one really believes that the, for example, 100- year Argentinian bond is going to make it 100 years, but in the current market it does not need to. But, it should. You just hold it, rake in the interest payments, and hike it to a greater fool before the party is over. The Argentinian bond is a caricature for a whole range of risk assets whose owners have a very twitchy finger on the sell button.
Let’s look at the reversal of a couple of effects. The first is in channel 2, and the wealth effect. If the wealth effect only moderately stimulated GDP by driving consumption and investment spending, then a reversal should be similar. In theory that is correct. However, investors and consumers tend to react more negatively to a decrease in wealth than they do positively to an increase in it. That brings us back to Prospect Theory. If correct, then a QE driven run up in asset values can be a devil’s bargain: even if inflationary asset markets are mildly stimulating, deflating markets can be proportionately more depressing. Again, outcomes depend on what else is driving the markets and economy forward. If it is enough, the withdrawal of QE may not matter. I own a company that works on high end building projects on the California coast. When the markets jitter, wealthy people balk at investments (read GDP) even though they are still way ahead of where they started.
The business financing effect of Channel 3 can kick in. As rates go up, companies in marginal markets and sectors can struggle with higher interest payments. They can also see their loans called or not rolled over as investors see other, lower risk options. If there are defaults, or the perception of risk, risk premia will increase, further increasing rates, further increasing distress, and so on. At very least, interest and risk premia increases will stymie further investment in marginal, high risk areas. And it should. Effects on repo and money markets, flash back time, will depend on how repo lenders have been pricing high risk collateral.
A channel not previously mentioned is interest rates’ effect on government spending, mainly because this is less of a concern when the economy is depressed. Lower rates don’t directly stimulate spending, though may make it easier to sell politically. When rates go up, extensive short-term government borrowing drives up interest expense. Either the deficit increases, or spending on other items decreases. As a major component of GDP, a reduction in government spending would all other things equal reduce economic activity.
It was noted that lower rates have not been particularly good for retirees or those getting close to it. The asset base may be worth more, but yields are down. If rates go up, presumably so will yields, but on newly purchased assets. Existing assets will just be worth less. Again, if you heed Prospect Theory, higher yields may not make the 50+ crowd spend more, but rather double down on savings to get to “the number” they think they need to retire.
In sum, this is extremely complicated with outcomes highly uncertain. One conclusion we could perhaps draw is that the distribution of volatility as QE unwinds might well be lopsided, with much of it piled up on the downside. Rates and risk premia are not going down, bond prices are not going up, at least some liquidity is leaving the system with replacement uncertain, taxes are not going down again, and a wide range of asset values are at historical highs. Though indications of increased global growth are positive, ironically having more global options may hasten an exit from U.S. based risk assets. Though the status quo could continue for some time and no immediate triggers are apparent, risks appear asymmetric at this point.
Even if you agree, the above does not lead to exciting portfolio designs. My current portfolio is comprised of 30 percent risk free, 40 percent high quality financial preferreds that I hope will be on the right side of risk premia effects, and 30 percent higher risk, mainly domestic and foreign equities. Any comments are welcome.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: My portfolio is balanced as noted in the piece