James Bullard, President of the St. Louis Fed, last week issued a public statement suggesting that the Fed consider resuming its Quantitative Easing program. The trial balloon has since kicked up a storm of interest among investors and pundits.
"Quantitative Easing" is a currently voguish term for a central bank practice that has actually been around for a long time. In both the U.S. and Europe the idea was dusted off in 2008 and employed as one prong of the coordinated attack governments unleashed against the threat of deflation. Within the context of its Quantitative Easing program, the U.S. Fed nearly tripled the size of its balance sheet during 2008, simultaneously stabilizing the banking system with a massive injection of new reserves and supporting the mortgage market with the acquisition of illiquid assets that threatened to clog it.
What is the Quantitative Easing though? And what does it mean that monetary officials are floating the idea again, even before the impact of its earlier implementation has been fully understood?
The concept is simpler than the obscure technical term suggests. Central bank operations routinely involve dealing in very short-term government securities as the primary tool of monetary policy. The U.S. Fed trades short-term Treasuries as necessary to keep the inter-bank lending rate, i.e., the Fed Funds rate, in line with its policy target. When the system is working according to spec, bank lending and money supply growth respond in a predictable fashion, and longer-term rates align themselves in a rational, if at times erratic, relationship to the base rate.
The problem is that the system does not always work according to spec. The Fed directly controls the quantity of reserves in the banking system and, somewhat less directly, the level of short-term rates. In managing the money supply and the level of longer-term rates, however, the Fed must rely on the interaction between its own programs and the behavior of private banks and bond market investors. These other players have priorities which at times run counter to the Fed's objectives. The resort to Quantitative Easing in 2008 was an unmistakable indication that the Fed's conventional tools had stripped their gears and that financial markets, along with the real economy, were cutting loose from its rein. With Quantitative Easing, the Fed re-asserted itself by intervening in non-traditional sectors and acquiring longer-dated securities.
Quantitative Easing is a potentially radioactive tool that central banks have with good reason used rarely and cautiously in the past. The fact the Fed is now considering a second round of it in less than two years highlights the severity of the double-bind we are now in. Policymakers are obviously beginning fear that failure to pull the lever a second time risks near-term deflation and everything that entails. Moving forward with a second round, however, threatens later unintended consequences.
What are these, and why worry?
The most obvious danger is inflation, since Quantitative Easing by its nature entails debt monetization. While this threat seems the farthest thing from most of our minds at the present time, its very remoteness is what aggravates the risk. If pulling the lever hasn't triggered any obvious ill effects, yet hasn't really done the job either, the temptation becomes overwhelming to pull it again and harder. This syndrome made its appearance with Mr. Bullard's recent announcement. The prevailing belief that the Fed can easily reverse course whenever necessary to forestall inflation surely underestimates the complexity of the forces likely to be at work if monetary easing is pushed to extreme proportions.
The more insidious danger from accelerated monetary intervention on the part of the Fed is that critical market signals start becoming lost in the noise. One does not have to be a market purist to believe that market-driven interest rates convey information that is vital to rational investment allocation. While short-term rates are, of course, already policy-driven, the Fed's unlimited power to create fiat money is likely to become a rogue force if used to hammer down longer-term rates as well. Neither Mr. Bullard nor any responsible official is advocating anything to this degree, but the danger is in the incrementalism seemingly underway now.
We do not have to look very far back in our history to understand the hazard here.
For several years leading up the 2008 financial crisis, the markets were awash with cheap money yet deprived of prudent investment vehicles for putting it to work. Institutional investors were desperate for the returns needed to satisfy assumptions built into pension plans or insurance policies. Individuals were trying to build portfolios and plan for retirement. All wanted to invest profitably and to limit risk. Understanding what was expected of them, investment bankers became adept at creating investment options that seemed to offer relatively high returns and manageable risk. As we know now, the real risks were often simply submerged and the realized returns disastrously negative. If investment bankers are indeed the devils of currently popular imagining, however, we need to have a little sympathy for the systemic pressures that drove them.
Economic policy disconnects are becoming commonplace in the present environment. Our policymakers and our politicians routinely chastise market players for the reckless investment behavior believed to have been at the root of the 2008 crisis. Few of them acknowledge, or even seem to understand, the role that official monetary policy played in setting the stage for the crisis.Presently, the official monomaniacal war against deflation threatens to create some of the preconditions for another crisis. Deflation is indeed a real threat, but it's certainly not the only one. The possibilities of inflation and another financial collapse cannot be ignored. Should either or both of these scenarios materialize, the renewed crisis is likely to be more severe and harder to fix than anything we've experienced to date. Investors need to plan accordingly.
Disclosure: No Positions