Special Report —
An in-depth analysis from DJ
July 31, 2017
WHAT LURKS UNDER THE "U.S.S. QE"?
Overview
Quantitative Easing, commonly called QE, has been a part of the conversation since 2009 when the first QE
program began. Since that initial program we’ve had QEII, QE 2.5 (Operation Twist), and now QE Infinity. The
Fed doesn’t refer to the program as QE Infinity, but market participants and economists quickly tagged the
program as such since there was no expiration date. The program is beloved by stock and bond traders while
often feared by economists and many market analysts. Both sides of the debating aisle frequently dispense
with the QE term altogether in favor of “money printing” to describe what the Fed’s operation is in a simple,
easy-to-understand term that requires no explanation. The only problem with calling it “money printing” is
that it is wrong. The Fed does not print money. Whatever we call it, the policy has a lot of people concerned
about the longer-term risks.
Before we begin to look at the risk/reward ratio of QE we need to understand a few of the basics of the
monetary system. Only then can we understand what is at stake. For a truly thorough understanding, you
could spend a few hours in an Econ 101 class with some professor far more qualified than I, but I’ll try to boil it
down to the key points. Then we can talk about the possible outcomes and what are some warning signs that
the Fed’s desired outcome of economic growth with low inflation will not be achieved.
QE is not money printing — really
First we’ll start with a few simple definitions. The monetary base is defined as currency in circulation and bank
reserves held at the central bank. Money supply (M2 is the most commonly used measure) is currency in
circulation plus all bank deposits and commercial banks – credit unions too. Currency in circulation is small,
relative to both the base and money supply.
With the exception of currency, money is not money until it enters the economic system as represented in the
money supply. When the Fed buys securities, it acquires an asset in the security and a liability in the form of
reserves when payment is made. Reserves are not money. Money is only created when it enters the economy.
The Fed isn’t truly creating or “printing” money. What the Fed is doing is creating a “base” from which money
can be created. In other words, the Fed has installed new, high-powered printing presses in banks, but the
operation of those presses is still up to banks and their customers. The Fed has created this base to encourage
growth in money which implies growth in the economy (and inflation, too).
Now that we know the definitions of monetary base and money supply, let’s look at the two factors that
determine how money moves in the economy – multiplier and velocity. The multiplier is simply the ratio of
money supply over the monetary base. A higher number indicates strong credit demand, which is indicative of
strong economy. The velocity of money refers to the number of times money “turns over” during a given
period of time. Again, the higher the velocity the stronger the economy is likely to be as money is put to
productive use. In good times companies borrow to build plants, buy equipment and hire employees. Those
companies from whom they buy also hire employees and spend on production needs. The employees spend
new earnings at other businesses that benefit from this virtuous cycle. The faster this process of “velocity”
moves, the better the economy and the more likely that inflation will increase as the demand loop quickens.
The buying of securities by the Fed through the quantitative easing process is an effort to influence both the
multiplier and velocity. The Fed is not printing money, nor injecting money into the banks and the markets.
The Fed is forcing a rise in the monetary base to provide an ocean of liquidity that it hopes will ultimately be
used to fund economic growth – up to a point.
Fear mongers losing battle – but outcome of war still uncertain
From the very first QE in 2009, the howls began: the Fed was printing money that was certain to lead to much
higher inflation. But here we are four years later (and two more QEs) and the year-over-year core rate of CPI is
1.7%. The Fed’s preferred measure of inflation, the Personal Consumption Expenditures price index, is 1.1%.
How did this happen when the Fed was wildly printing money? The secret lies in the multiplier and velocity.
The premier force is the multiplier.
During the peak of the credit boom cycle the multiplier peaked at 9.3. The monetary base (basically the same
as the Fed’s balance sheet) was $800 billion, which gave us money supply (M2) at $7.3 trillion. (For simplicity's
sake I’m using rounded numbers and eliminating minor factors.) The Fed’s QE-pumped-up current balance
sheet produces a monetary base of a huge $3 trillion, but M2 is only $10.5 trillion. What gives? Over this
period of time the multiplier has plunged to a multi-decade low of 3.6 from that 9.3 peak. Without any QE, the
money supply would have plunged, worsening the recession.
The Fed’s balance sheet has more than tripled but money supply is up only about 35%. Along with the plunge
in the multiplier, velocity also hit a multi-decade low. The multiplier fell as consumers and businesses focused
on deleveraging and velocity fell as economic activity took a hit. It can also be argued that even the tepid
increase in the money supply was in large part caused by leveraged investment firms' borrowing in order to
chase stocks and other risky assets. The plunge in velocity seems to confirm this, as the increase in borrowing
has not gone to productive purposes.
The Fed’s QE program to date is still the subject of debate. I don’t think there is any debate that the program
has had a tremendously positive impact on housing, but the impact on the broader economy is harder to
discern. The best thing most everyone can agree on is that the economy would probably be worse without it.
So, Nostradamus — what is the future?
The Fed’s QE policy has not produced hyper-inflation as forecast by many economists and money mavens, nor
the desired positive economic impact Bernanke prescribed, but Bernanke still believes the tide will turn.
Perhaps he is correct. The economy certainly “feels better,” but maybe that is just the smoke coming from the
stock market. There are several possible outcomes. Here are three quick scenarios. First, a year from now we
could be looking back and applauding Bernanke’s dogged determination. The Fed would likely have ended the
QE program with a balance sheet base of $3.25 to 3.50 trillion as the economy has shown steady improvement
and the Unemployment Rate has fallen below 7%. Second, we could also be looking at the very same results
we’re seeing now — slow growth with very low inflation. The Fed would likely have continued buying and the
balance would be roughly $4 trillion. While the former certainly seems the desired result, we’ve learned to live
with and feel okay about the latter. So far so good, but what is the third scenario?
The third and most unwanted possibility stems from what the Fed is risking. The problem is the Fed’s balance
sheet — the source of the monetary base — represents a source of highly combustible fuel. Think about the
multiplier effect and how the decline in the multiplier prevented extraordinary growth in money. It cuts both
ways. Now look ahead a year from now. Let’s just suppose the monetary base is $4 trillion one year from now,
and the economy is finally picking up speed. If the multiplier has fallen to 3 or less, which is in line with the
trend, money supply has grown to a manageable $12 trillion. That is a sizeable increase that would likely lift
inflation; and if that’s the trade-off to finally getting the economy going, that’s a trade the Fed would likely
want to make. If the inflation rate moves to 2.5%, that is a high-grade problem.
Here is the dilemma: As the economy improves and confidence rises, businesses will borrow again for
productive purposes, and consumers are likely to take on more debt. This grows more likely as the stock
market and housing market continues to improve. That will cause the multiplier and velocity of money to
increase. Look at this example of what could happen. The peak in the multiplier was over 9, and let’s assume
the multiplier bottoms at 3. What happens if the multiplier moves to 6, the midpoint? That $12 trillion in
money supply zooms to $24 trillion! The most basic definition of inflation is too much money chasing too few
goods. If this amount of money enters the system, I shudder to think what would happen to inflation. Of
course, this wouldn’t happen overnight, but the timing of the jump could be shorter than we think. It only took
about five years for the multiplier to fall from the peak to the trough. Getting back halfway would not require
more than a couple of years, under the right circumstances.
What would happen to rates in this environment is anyone’s guess. But in this highly-leveraged environment, it
wouldn’t be pretty. Interest rates would shoot higher, ultimately forcing stocks lower, and the table would be
set for a return of the ugly “80’s style stagflation". But how much should we worry about this, the third and
worst possibility?
Bernanke – “Relax, I got this covered.”
Whenever questioned on the topic of when and how the Fed will ultimately reverse course to begin the great
unwinding of the Fed’s massive balance sheet, Bernanke treats the subject somewhat casually. He calmly
states the Fed will start by allowing all principal and interest payments to go un-reinvested. But given that the
maturity structure of the Fed’s balance sheet is very heavily weighted toward the long-end of the maturity
spectrum, the process would be extraordinarily slow. Bernanke adds that if a more rapid response is needed,
the Fed has “other tools” to use without selling securities. I assume he was referring to the use of the reverse
repo market. That sounds good on paper, and I admit I have partially bought into this. But as I’ve looked more
deeply into this, "That dog don’t hunt," as they say in Texas.
The first problem is that Bernanke, or his successor, must be relied upon to recognize when to start taking
away the punchbowl, beyond just ending the buying program. When the Fed first sees the multiplier and
velocity rates move higher, they are likely to be cautious in responding to the early stages of the trend. As
mentioned above, even small upward movements in the multiplier and velocity will have big impacts on the
money supply. The Fed could easily find itself behind the curve. That brings up the second problem.
If the bond market sees the Fed’s response as ineffectual and hesitant, we will at long last see the return of the
bond vigilantes. Rates will soar — along with the psychology of inflation. At that point, the only answer is for
the Fed to return to the days of Paul Volker. As you know, Paul Volker stepped into the Fed when the previous
two Fed Chairmen allowed money to grow to the point at which double-digit inflation emerged. Volker rightly
viewed long-term hyper-inflation as a bigger threat than short-term economic woes that would come with
aggressive, inflation-fighting monetary policy. Volker ramped up rates and choked off the economy, but
ultimately the policy worked and the U.S. embarked on a twenty-plus-year run of economic growth with low
inflation.
This Fed could be faced with the same difficult choice. Paul Volker used raising the funds rate as the sledge
hammer. This Fed would have the ability to raise the funds rates as well, but ultimately the Fed would be
forced to sell securities in order to engineer the necessary contraction in the monetary base. Bernanke has
assured the markets that the Fed will not need to sell securities. He is dead wrong. If the spirit of inflation is
awakened, the Fed will have no choice with a balance sheet of $3-4 trillion fueling the money supply. The
result would be predictable in that interest rates would move higher and the economy would slow, but
unpredictable as to the extent both would happen.
Bernanke is essentially saying “Trust me.” At this point, now that the Fed has already ramped up the monetary
base, we have no choice. It would be nice to hear Bernanke speak more forcefully about his commitment to
act if the inflation outlook changes, but Bernanke has basically dismissed inflation as any threat. Bernanke's
supreme confidence in his mastery of monetary policy is understandable, given the praise from Wall Street
lavished on the Chairman. No Fed Chairman has been so revered since back in the olden days with Alan
Greenspan. Feel free to panic at this point.
With the jury still out, what signs can we look for?
All three outcomes are possible. The good (economy grows but inflation remains in check), the bad (slow
growth with little or no inflation), or the ugly (hyper-inflation and recession). I wish I felt strongly about the
eventual outcome, but I simply can’t definitively proclaim one outcome as the clear winning bet. I will admit
that as I did more number-crunching and pondering while composing this article, I did become more
concerned than I have been about the “ugly” outcome. That’s what I get for thinking.
The other two outcomes are at least equally likely. In fact, since 2008 I have said that what the U.S. has
experienced was a major credit event that spawned secular changes in behaviors. I felt the Fed’s interference
would have little impact on the economy and we would have years of low rates and a sluggish economy as the
credit cycle winds down. So far, so good. Only recently did I sense that next year could be the year the U.S.
finally emerges on a stronger growth path and a trend to modestly rising rates. But I have felt the increase in
rates would be modest and easy to manage through. That is still my best case and most likely outcome, but I’m
beginning to think I need to raise the odds for a worse outcome.
I have been sanguine about any inflation threat as the lack of wage growth argues that inflation could not
flourish in this environment. Then I thought back to the 1980’s, when I was a bond trader." Higher wages did
not lead to inflation. Higher wages came after inflation became ingrained. Inflation became so pernicious for
workers that employers had no choice but to raise wages??. After all, their revenues were rising thanks to
inflation. I am no longer comforted by the lack of wage growth.
There is no single signal that may alert us to how things will play out, but my “go to” indicator will be the bond
market. The bond market had this one right all along since late 2006. The yield curve started to flatten, which
is the first warning flag the bond market waves when the economy is going to slow down. Over the past five six
years, rates have fallen in a steady trend despite steady predictions from Wall Street of higher rates and higher
inflation. The bond market has recently shown signs that confidence is waning that rates will stay near the
bottom, but it is still too early to say the end of the low rate cycle is at hand. In fact, it’s easy to see how the
bond market might have one last hurrah in the next few months.
What we need to watch for is a sharp increase in bond market volatility, which tells us that uncertainty is
creeping into the minds of big bond investors. Rallies will be few and far between, and each rally in bond prices
will be followed by new lows. If rates start moving up in a stair-step fashion, it’s time to move to the sidelines.
Then we will need to observe how the bond market reacts to the Fed’s responses to any increase in inflation or
evidence that money supply is beginning to ramp up. If the market deems the responses as casual and not
forceful, you will see rates surge as confidence in the Fed goes off the rails. In this highly leveraged, low rate
environment, confidence is a huge part of the equation. How high could rates go? Of course, no one knows. I
don’t expect I will be able to buy 10-year notes at 14% as I did in the 80’s, but given we’re coming from the
lowest yields on record, any big jump in rates will be a shock to the system.
While we will have to be mindful of economic data, jobs reports, and the inflation numbers (which haven’t
mattered for years but will again someday), the bond market holds the key.
Managing through the fog
Credit unions are well positioned for rising rates, although a huge, sudden jump in rates would cause angst
among those with heavy concentrations of longer-term mortgages. But a reasonable increase in rates would
be a huge relief for many credit unions, especially smaller credit unions. Regardless of the current balance
sheet structure, all credit unions need to make sure a serious stress test is performed that can help identify the
weaknesses in the balance sheet. Most credit unions already run stress tests, but I wonder how much critical
analysis of the results has been done. If the economic environment shifts to one of higher loan demand and
deposits flowing out and into the stock market, what will your liquidity position look like? What would market
value be for your longer-term securities? Give these stress reports more than a glancing look before you hand
them off to examiners.
The NCUA has recently proposed regulation changes to enable credit unions to more effectively hedge interest
rate risk. I don’t know the timing of the rule changes, but much educational work will need to be done at the
credit union level to properly implement those tools. That is, education that should begin now, if not already in
place. Let’s hope this prep work is all for nothing, but a little education never hurt anyone.
Final thoughts
I hope this analysis has helped in understanding what QE really is, why it has not lived up the hype, and what
the risks of this policy are. If nothing else, you now know that the Fed is not printing money. But everyone will
still call it that, including me. It’s just so easy.
I want to emphasize that at this point in time I have not fully embraced the view that the Fed is sailing QE into
an iceberg. The Fed could continue to grow the monetary base to no avail if the multiplier and velocity
continue to fall. That being said, I think it is time to have Plan B in the drawer in the event of a surprising
outcome. I don’t believe anything will happen this year or in most of the next, but as the Fed continues to build
printing presses in the banking system, the risk grows.
***
© 2013 Dwight Johnston Economics