Wednesday, December 8, 2010

The Darkside of QE2

(A version of this posting was sent out to clients of West Coast Asset Management as a part of the firm's monthly letter)

“The Federal Reserve will buy $110 billion a month in Treasuries, an amount that, annualized, represents the projected deficit of the federal government for next year. For the next eight months, the nation’s central bank will be monetizing the federal debt. This is risky business. We know that history is littered with the economic carcasses of nations that incorporated this as a regular central bank practice.”

-Federal Reserve Bank of Dallas President Richard Fisher (November 8, 2010)1

The Backdrop

The US financial discourse over the past few months has been dominated by analysis of what has been deemed QE2. For those of you who are unfamiliar with the concept, QE2 is simply an acronym for Quantitative Easing 2. The first round of QE began in March of 2009 when the Federal Reserve embarked on a plan to buy $1.25 trillion in agency mortgage backed securities (those securitized by Fannie Mae and Freddie Mac) and $300 billion of longer term US treasuries. However, with unemployment still uncomfortably high and the perception that there is only a trivial risk of inflation on the horizon, the Fed is at it again; this time vowing to buy $600 billion of US Treasuries over the next eight months.

Specifically, the Fed’s goal is to reduce interest rates available to individuals and businesses even further. Usually, when it wants to achieve that objective, the Fed uses its Fed Funds Rate (FFR) to manipulate interest rates. The FFR is a rate at which depository institutions (primarily banks) lend money to each other (at the Fed) on an overnight basis. During its periodic meetings, the Fed determines the target Fed Funds Rate based on its views regarding the economy. Then, if the Fed wants to slow down growth or contain inflation, the remedy is often to increase the FFR. By making it more expensive to borrow, banks will be less likely to borrow money that they can then lend to customers and excess credit creation will be forestalled. However, if the Fed wants to stimulate growth or prevent inflation from being too low, the protocol is to reduce the FFR. In other words, by making it less expensive to borrow, banks are incentivized to borrow and lend more freely, a dynamic that increases credit availability. However, the current problem is that the Fed can’t lower the FFR any further. Accordingly, as will be discussed more in depth later, the Fed has decided to purchase other assets in an attempt to prompt an incremental reduction in economy-wide interest rates.

For people who are not professional investors or economists and are not following the markets day to day, the Fed’s recent maneuverings likely elicit a lot of questions. For instance, isn’t inflation generally a bad thing? If, so why is it that the Fed thinks inflation is too low and why in the world would it want to create inflation? Additionally, people may be wondering what exactly the Fed is trying to accomplish by buying more Treasuries. If interest rates are near historical lows, what is the benefit of slightly lower interest rates? Finally, another logical question has to do with what the Fed plans to do with all of the Treasuries and mortgage backed securities it has bought over the last year and a half. If it eventually tries to sell them in the open market, won’t that push up interest rates and impact the economic recovery? But, if the securities cannot be sold without affecting interest rates, couldn’t the increased money supply and credit availability lead to inflation when the economy starts picking up again?

Clearly, there is a lot of uncertainty regarding the quantitative easing initiative and the goal of the article is to address some of those concerns. Specifically, by trying to answer the questions posed above, we hope to shed some much needed light on the inner workings and intentions of the Fed.

Why is the Fed trying to create inflation?

The Merriam-Webster online dictionary defines inflation as “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.”2 In more simplistic terms, as the money supply increases, prices of goods and services tend to rise as well. On the flip side, deflation is defined as “a contraction in the volume of available money or credit that results in a general decline in prices.”3 Deflation occurred in the US during the 1930’s and many historians and economists believe it was a contributor the length and severity of the Great Depression. The kind of deflation that the Fed worries about is not the falling prices of electronics due to technological innovation. Instead, the Fed is determined to prevent falling asset prices and declining wages that lead business to stop investing, consumers to stop spending and the economy to grind to a halt.

Thus, there are a number of metrics that the Fed uses to monitor the level of inflation, especially the Consumer Price Index (CPI) and the Producer Price Index (PPI). Usually, in a stable and growing economy with a moderately increasing money supply, both these and other metrics reflect the fact that wages and the prices of goods increase a little bit each year. But, as a result of the financial crisis and the ongoing unemployment epidemic, Ben Bernanke and a number of his fellow Fed Governors believe that the inflation rate is too low and that destabilizing deflation is a real possibility.

The Fed has a mandate to foster both maximum employment and price stability. But, when it comes to price stability, the truth of the matter is that Bernanke is much more concerned about deflation than inflation. Therefore, in order to prevent a severe bout of deflation, he is more than willing to take measures that stoke minimal inflation but keep inflation expectations from getting out of line with the current rate. In normal times, the Fed can achieve these goals by adjusting interest rates. However, the current Fed Funds Rate is so low (0%-.25%) that the Fed no longer has the ability to cut interest rates in order to stimulate the economy or cause inflation.

We have nothing to fear though, because the Fed has a number of other tools at its disposal. In fact, long before the financial crisis, Ben Bernanke addressed the issue of what to do when interest rates hit what is known as the “zero bound.” In a speech entitled “Deflation: Making Sure “It” Doesn’t Happen Here4,” the future Fed Chairman outlined a number of measures the Fed could take if traditional monetary policy was no longer effective. First, he suggested creating an inflation buffer by officially or unofficially targeting a specific rate of inflation, somewhere between 1% and 3%. Next, he proposed using the Fed’s regulatory powers to make sure the financial system remained both stable and functioning in a normal fashion. And finally, Bernanke presented the following as a potential remedy:

“To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys… For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt.”

As you can see, during this speech way back in 2002, Bernanke telegraphed exactly what he would do if inflation ever got too low for his tastes and interest rate policy solutions were limited. But, the important question is why is he so preoccupied with preventing deflation? Here is a simple example from that same speech that explains the issue:

“To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930s), suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.”

Fast forwarding to the present, given the severity of the downturn we have already experienced, Bernanke and his cohorts are worried that deflation would damage investment and spending and thus push unemployment even higher and the US into a depression. Unfortunately, what this fear of deflation means is that the Fed is likely to err on the side of inflation, which history has shown can get out of control if the monetary authorities are not extremely careful.

What is the Fed’s goal in reducing interest rates further?

This topic has received a great deal of debate recently. Bernanke’s problem is that rates are already so depressed that much of the stimulative benefits of historically low interest rates have already been felt by the economy. Would another .25% decline in mortgage rates cause a wave of refinancing and home buying? Would another .5% decline in Treasury rates lead businesses to start investing and hiring again? Someone skeptical of the Fed’s intentions would argue that the impact of QE2 might be very subdued given the uncertainties regarding the housing market, consumer spending, and the viability of business investments. One such critic is John Hussman of the Hussman Funds, who stated the issue quite eloquently in one of his latest missives5:

“With no permanent effect on wealth, and no ability to materially shift incentives for productive investment, research, development or infrastructure (as fiscal policy might), the economic impact of QE2 is likely to be weak or even counterproductive, because it doesn't relax any constraints that are binding in the first place. Interest rates are already low. There is already well over a trillion in idle reserves in the banking system. Businesses and consumers, rationally, are trying to reduce their indebtedness rather than expand it, because the basis for their previous borrowing (the expectation of ever rising home prices and the hope of raising return on equity indefinitely through leverage) turned out to be misguided. The Fed can't fix that, although Bernanke is clearly trying to promote a similarly misguided assessment of consumer "wealth."”

What Hussman is saying is that by reducing interest rates even lower, the Fed actually has the peripheral goal of inflating asset prices with the hope that the associated “wealth effect” will cause widespread confidence to increase and eventually lead people to start spending and businesses to start hiring. One could also argue that the Fed is enticing investors to take more risk. With yields on government and corporate bonds so low, investors who are looking for returns are forced to buy riskier assets such as stocks. Given that backdrop, it is no surprise that the S&P 500 is up so much since Bernanke signaled the QE2 was likely during his Jackson Hole speech at the end of August. But, just focusing on the S&P obscures the fact that just about everything is up in price. If you are curious, take a look at the price charts for gold, silver, corn, cotton and copper over the last year. For example, gold is up about 23%, silver is up 64% and cotton is up an amazing 75.6%!6

Not only is the Fed helping to inflate stock market prices and to push people into riskier assets, but the near zero Fed Funds Rate and the buying of other assets is forcing people to buy hard assets as an inflation hedge. So, while the Fed believes that inflation is too low, at some point the dramatic price increases in commodities are going to flow through to consumers. And, with stagnant wages, unemployment clearly not declining fast enough and fiscal stimulus winding down, the people who spend a disproportionate percentage of their income on daily necessities (food, clothing, household items) are going to really feel the pain when prices begin to rise.

We also should point out that zero interest rate policy has been a godsend for the banks. First off, the banks can borrow at basically 0% from the Fed and immediately turn around and buy 10 year US Treasuries that yield north of 3%. In essence, the banks can choose to receive a risk free spread of 2.6% on their money as opposed to lending it to consumers and businesses to help jumpstart the economy. In addition, by holding interest rates down the Fed has induced large corporations to issue billions of dollars of long term debt at very attractive rates. Obviously, this is great for shareholders of these companies but it has also led to huge revenues for the banks who underwrite these debt offerings. In summary, it certainly appears that the Fed’s asset purchases have benefited those with large investments in stocks, large banks, and big corporations at the expense of the rest of America.

How is the Fed going to sell all of the assets it has bought?

This, ladies and gentlemen, is the million dollar question. To accurately assess the situation, it is necessary to analyze the Fed’s balance sheet. As of the most recent data available on the Fed’s website, the dollar amount of assets on the Fed’s balance sheet was just about $2.35 trillion7. To that number, you can at least add the $600 billion of Treasuries that will be purchased over the next eight months, bringing the total near $3 trillion. Compare that to the $914.8 billion in assets the Fed held at the end of 2007 and it is possible that the Fed will have more than tripled its balance sheet in three and a half years8. The liability side of the balance sheet consists mostly of balances that banks hold on reserve with the Fed. At the end of 2007 these deposits amounted to $20.77 billion and are now about $1.26 trillion. This is what John Hussman meant when he said that that there are over $1 trillion in idle reserves in the banking system. In other words, banks are hoarding money and leaving it with the Fed instead of lending it out.

In any case, the Fed is going to have to sell assets unless it wants to see the money supply explode when the economy starts to improve on a sustainable basis and banks start lending out those reserves. As a hypothetical, let’s say the Fed wants to get its balance sheet back to where it was at the end of 2007. This would entail selling somewhere around between $1.5 and $2 trillion in assets, assuming the Fed follows through on its most recent promises and then refrains from more quantitative easing (the latter being a very dangerous assumption). Clearly, if the Fed tried to sell these assets all at once the market would not be able to absorb the sale and interest rates would likely go through the roof. So, unless inflation had accelerated to very uncomfortable levels, the Fed would probably try to wind down its balance sheet over a number of years in order to avoid killing a nascent economic recovery and to ensure a somewhat orderly rise in interest rates.

Bernanke did actually hint at the unwinding issue in his speech from 2002. Specifically, he indicated that “[b]ecause some of these alternative policy tools are relatively less familiar, they may raise practical problems of implementation and of calibration of their likely economic effects.” So, it appears that Bernanke was aware of the potential pitfalls at the time of his unfortunately prescient speech. However, the magnitude of the necessary asset sales was likely not even a possible outcome in Bernanke’s mind but unquestionably needs to be addressed sooner rather than later.

Let me try to explain why. As of December 1st, 2010 the Fed had a net worth (total assets minus total liabilities) of $56.02 billion. In addition, the majority of the Fed’s assets base consists of securities held outright, which total about $2.088 trillion. Now, let’s say the Fed wants to sell $1.5 trillion of those assets to reduce the size of its balance sheet. This is not the forum to dive into a deep discussion of bond math and the duration of the Fed’s security holdings. However, the important thing to understand is that if market forces cause interest rates to rise, the value of the previously purchased assets on the Fed’s balance sheet will fall. The Fed likes to claim that it has the ability to hold assets to maturity, a fact that implies that the Fed should not have to mark its balance sheet to current market prices. However, in the event that the Fed was forced to sell in order to combat potential inflation, it could realize losses on those sales. Specifically, with about $56 billion in equity, the Fed would only have to realize a 3.7% loss on the sale of the $1.5 trillion in securities to wipe out 100% of its equity. And you thought Bear Stearns and Lehman Brothers had a lot of leverage.

Smart people can argue about whether or not the Fed can actually be insolvent, but the idea that America’s central bank could have assets worth less than its liabilities does not inspire a lot of confidence. There is no way to know how much interest rates will have risen when the Fed wants to unwind its balance sheet, but the truth remains that a 3.7% realized loss on asset sales is certainly not that farfetched. Thus, the Fed may be unable to sell securities when it wants to increase interest rates unless it wants to realize substantial losses. Then, the fact that the Fed’s balance sheet could be locked in at the current size is very troubling, especially given the implications for inflation.

Will quantitative easing work?

The purpose of this piece is to illuminate some of the risks of quantitative easing. Many talking heads have taken the stock market rise that came about after rumors of QE2 emerged to mean that most investors approve of what the Fed is doing. But recently, two luminaries of the investment world, Bill Gross of PIMCO and Jeremy Grantham of GMO, have published scathing critiques of the Fed’s policies (see link’s below).

However, we should all be careful to not underestimate Ben Bernanke and the Fed. As a group, the members have a lot of influence and a number of tools at their disposal. As such, I am certainly not saying that quantitative easing will unequivocally not work or that the US is on a dangerous path that cannot be reversed. I am also not implying that the stock and bond markets are poised for large declines. Specifically, what I do believe is that the Fed’s attempts to inflate assets may not be sustainable unless the economic fundamentals improve as well. Accordingly, my humble advice is to watch the developing situation very closely, especially when it comes to commodity inflation and rising interest rates.

America is in uncharted territory. It looks as though we will live through at least a tripling of the central bank’s balance sheet in just a few short years. Such a circumstance is unprecedented in modern US history. As such, whether or not QE2 is “working” may depend on who you are and what you are invested in. Therefore, it is the job of investment managers to understand the risks and position their clients in a way that protects them from both the intended and unintended consequences of QE.

3rd Quarter Letter for Jeremy Grantham of GMO:

November letter from Bill Gross of PIMCO: