In recent days, numerous central bank bureaucrats have given us hints that another round of pump priming is more or less imminent. It started with John Williams, president of the San Francisco Fed who mused about 'QE without a limit'. The FT reported:
„The US will make little progress tackling high unemployment before 2014 unless the Federal Reserve eases policy further, one of the central bank’s leading officials has warned in the run-up to a meeting next week where the option of “QE3” will be on the table.
The comments by John Williams, president of the Federal Reserve Bank of San Francisco, show how the weak economy is pushing the central bank towards action to support growth.
If the Fed launched another round of quantitative easing, Mr Williams suggested that buying mortgage-backed securities rather than Treasuries would have a stronger effect on financial conditions. “There’s a lot more you can buy without interfering with market function and you maybe get a little more bang for the buck,” he said.
He added that there would also be benefits in having an open-ended programme of QE, where the ultimate amount of purchases was not fixed in advance like the $600bn “QE2” programme launched in November 2010 but rather adjusted according to economic conditions.
“The main benefit from my point of view is it will get the markets to stop focusing on the terminal date [when a programme of purchases ends] and also focusing on, ‘Oh, are they going to do QE3?’” he said. Instead, markets would adjust their expectation of Fed purchases as economic conditions changed.“
Mr. Williams, so the FT, is thought to be 'close to the center of gravity' on the FOMC. We take this to mean that he has the helicopter pilot's ear.
So if indeed the Fed were to embark on 'open-ended QE' that is predicated on developments in the vaunted 'economic data', or putting it differently, is dependent on recent economic history (a method also known as 'driving forward with one's eyes firmly fixed on the rear-view mirror'), what happens if said data fail to improve?
Will the Fed then just keep printing forever and ever? As an aside, financial markets are already trained to adjust their expectations regarding central bank policy according to their perceptions about economic conditions. There is a feedback loop between central bank policy and market behavior.
This can easily be seen in the behavior of the US stock market: recent evidence of economic conditions worsening at a fairly fast pace has not led to a big decline in stock prices, as people already speculate on the next 'QE' type bailout. This strategy is of course self-defeating, as it is politically difficult for the Fed to justify more money printing while the stock market remains at a lofty level.
Of course the stock market's level is officially not part of the Fed's mandate, but the central bank clearly keeps a close eye on market conditions. Besides, the 'success' of 'QE2' according to Ben Bernanke was inter alia proved by a big rally in stocks. Such increases in stock prices are seen as a spur to spending, as the perceived wealth of stockholders increases. In the view of Bernanke and his colleagues, spending is what it's all about. The central bank chief holds that we can consume ourselves to prosperity. It follows from this that one should also be able to print and deficit spend oneself to prosperity, but oddly enough, it hasn't worked thus far. A reason to revisit long-cherished beliefs? Not at all! We must 'do more' of what hasn't worked thus far.
Following an unexpected earnings miss by market bellwether AAPL, the stock market had a perfect opportunity to sell off, but went sideways instead. Mr. Hilsenrath's piece I the WSJ (see further below) may well have provided the rationale - click for better resolution.
The remarks of Williams were then given another boost by Sarah Bloom Raskin, who announced the the upcoming FOMC meeting would be used to 'debate the benefits of a new bond buying plan'.
„Federal Reserve Governor Sarah Bloom Raskin said the Fed next week will debate whether to begin a program to speed economic growth and reduce unemployment through large-scale purchases of bonds.
„Federal Reserve officials, impatient with the economy's sluggish growth and high unemployment, are moving closer to taking new steps to spur activity and hiring.
Since their June policy meeting, officials have made clear—in interviews, speeches and testimony to Congress—that they find the current state of the economy unacceptable. Many officials appear increasingly inclined to move unless they see evidence soon that activity is picking up on its own.
Amid the recent wave of disappointing economic news, conversation inside the Fed has turned more intensely toward the questions of how and when to move. Central bank officials could take new steps at their meeting next week, July 31 and Aug. 1, though they might wait until their September meeting to accumulate more information on the pace of growth and job gains before deciding whether to act.
It seems pretty clear from all this that mortgage backed bonds will be the vehicle of choice (see also comments by Alan Blinder in an op-ed at the WSJ, were he discusses the methods the Fed could use to get bank credit inflation going again). This is probably the preferred option because of the perceived shortage of highly rated collateral in the market. Moreover, it doesn't smack so much of the Fed financing the government, even though technically speaking it only ever buys already existing treasury debt from third parties – albeit sometimes within days of it coming into existence.
To the extent that the Fed buys securities from non-banks, deposit money in the system will increase directly. If it buys securities only from banks, it may well end up mainly increasing excess bank reserves deposited at the Fed. However, banks are avid buyers of treasuries themselves, so the funds do indirectly tend to support government spending (it is easy for fractionally reserved banks sitting on a mountain of excess reserves to create deposits in favor of the government).
Treasury securities held by commercial banks - click for better resolution.
Given that the only goal of more 'QE' can be to goose the money supply (failing that, it would have zero effect), the question should be: is there too little money in the economy? Judge for yourself:
The US broad true money supply TMS-2, via Michael Pollaro. It has increased from $5.3 trillion at the beginning of 2008 to $8.719 trillion as of the end of June 2012 - click for better resolution.
Of course the above is a bit of a trick question. The money supply can never be 'too small'. Any size of money supply will be as good as any other to render the services money is supposed to render. Numbers in accounts are really meaningless per se – it is not important how much money there is, but what it can buy. Today, a dollar buys 97% fewer goods and services (a rough estimate) than 100 years ago. Evidently if things that cost $100 today were to cost $3 as they did in the year of the Fed's founding, we could make do with a far smaller money supply.
Increasing the money supply however always has ill effects, even though a temporary 'sugar high' for the economy can often be bought that way. If increasing the money supply were a good thing, then everybody should be allowed to contribute to the exercise, since one can never have enough of a good thing. We should all have the right to run our private printing presses – after all, what difference can it possible make whether the Fed prints the money or the commercial banks create new deposits, or everybody gets in on the act? If additions to the money supply are desirable, why should Joe Six-Pack's privately printed notes not also be desirable?
It is by posing such simple questions that one can immediately unmask the absurdity of the Fed's activities.
What Printing Money Does – The Credit Cycle versus Government Directed Inflation
Of course money is not 'neutral'. If the Fed were to increase everyone's money holdings pro rata by the exact same percentage on the same day, then it would be clear to all that it would make no difference – nobody would be any richer, and merchants would raise all prices by this exact percentage on that very day. We would expect them to, and they would be foolish not to do it.
However, money enters the economy at discrete points. This has redistributive effects, as the early receivers will profit at the expense of later receivers. It also means that a price revolution will inevitably occur: it is irrelevant whether 'CPI' rises or not. Prices will be altered relative to one another. Once the money has percolated through the economy, the price structure will be different from what it was before and from what it would have been absent the inflation.
If commercial banks create new deposits by granting credit, then to the extent that such credit creation is new money from thin air 'backed' by fractional reserves, we will experience the usual trade cycle: factors of production will be drawn to higher order goods production at the expense of the middle and later stages of the production structure and once the boom is underway, consumption will increase as illusory accounting profits are spent. Capital will be ultimately be consumed. The inter-temporal coordination between production and consumption will be disturbed, as the fiduciary media that come to the loan market lower interest rates and create the false impression that the pool of voluntary real savings is larger than it really is. More distant stages will tend to be added to production structure, i.e. very long term investment projects that suddenly appear to be profitable. However, the real resources to bring these projects to fruition do not really exist – eventually many of them will have to be abandoned (countless ghost towns in Spain are testament to this fact). It will also invariably turn out that businesses have invested in the wrong lines. Whether they disagree with actual consumer demand or must be abandoned for lack of complementary capital, countless malinvestments will inevitably be unmasked when the boom ends.
The case of a central bank and government directed inflation is slightly different. If banks lend to money from thin air to businesses and consumers, the market interest rate will tend to be depressed below the societal rate of time preference. The business cycle briefly outlined above will result. Since a feature of the business cycle is that a production structure is erected the length of which can not be supported by the economy's pool of real funding – a production structure that ties up more consumer goods than it releases – we speak of intertemporal discoordination. The discoordination is between consumption and production schedules: had consumers really saved more, then it would be clear that they are abstaining from consumption in the present with the aim of being able to consume more in the future. But the market interest rate is falsified. It only appears as though they were abstaining from present consumption, in reality their desire to save and thus their consumption schedule has not changed. However, the lower interest rate interferes with production – a lengthened production structure will require more time to produce consumer goods. If sufficient savings were indeed available, it would eventually produce more consumer goods than previously. In an artificial credit cycle, the expected future consumer demand will never materialize.
If banks lend directly to the government (a process which the buying of securities by the Fed aids and abets), then the government spends those funds directly. It does not offer them as loans to businesses, it spends them on government consumption. This will also distort the production structure, but the disturbance will be an intra-temporal discoordination. Certain business branches that are favored by government largesse will see rising prices and will be induced to expand. The result will once again be a production structure that fundamentally disagrees with the wishes of consumers. A good example of this are the failed investments in 'green energy' the government has undertaken in the course of its stimulus program. These projects certainly squander scarce resources that could be put to better use in satisfying actual consumer wants. Profit and loss accounting for such projects is a fiction. We have discussed examples of these failed projects in more detail here (scroll down to 'Stimulus Fail').
Ludwig von Mises explains the process as follows (in Human Action, p. 568):
“Legally the bank becomes the treasury's creditor. In fact the whole transaction amounts to fiat money inflation. The additional fiduciary media enter the market by way of the treasury as payment for various items of government expenditure. It is this additional government demand that incites business to expand its activities. The issuance of these newly created fiat money sums does not directly interfere with the gross market rate of interest, whatever the rate of interest may be which the government pays to the bank. They affect the loan market and the gross market rate of interest, apart from the emergence of a positive price premium, only if a part of them reaches the loan market at a time at which their effects upon commodity prices and wage rates have not yet been consummated.”
An explanatory note: the 'price premium' is the premium on interest rates that accounts for the expected future decline in money's purchasing power. At the moment this price premium is very low, as economic uncertainty has led to an increase in the demand for money (cash holdings). It is e.g. well known that corporations hold large amounts of cash. At the same time, the inflationary policy is still widely thought to be a temporary phenomenon. 'Inflation' in the sense of a rise in the 'general price level' as measured by CPI is held to be a phenomenon that the central bank has 'under control'. It remains to be seen whether this faith persists if 'QE' becomes open-ended.
The ECB's and BoE's Failure to Inflate The Money Supply
Contrary to the Fed, both the BoE an the ECB have been unable to spur money supply inflation since the crisis in the euro area began. Banks are under pressure and are calling in loans in an attempt to shrink their overleveraged balance sheets. Moreover, in the euro area, they find themselves constrained in making loans to governments that are themselves at risk of insolvency and can no longer print their own money. These governments in turn are forced to adopt austerity measures, so there is no way for additional money to enter the economy in the absence of private sector credit expansion and concurrent reductions in government spending.
Countries like Spain that have experienced massive credit booms and malinvestment orgies prior to the onset of the crisis are therefore feeling the full brunt of the contraction that follows on the heels of such a bubble. Unfortunately this has so far not meant that unsound credit was liquidated. The euro-system still allows for the surreptitious funding of de facto insolvent banks via ELA (emergency liquidity assistance) and moreover enables deposit flight and current account deficits that are financed with central bank money through TARGET-2. This blunts the severity of the economic downturn only marginally, but it clearly delays its resolution.
Although ECB board members including Mario Draghi himself often reiterate that they 'see no risk of deflation' for the euro area, the risk is far greater in the euro area than in the US. They refer to prices and not the money supply, but as we have often pointed out, money supply inflation has slowed to a crawl after the initial burst in growth following the 2007/8 GFC. In the UK, year-on-year money TMS growth has fallen to zero, while the broader measure M4 has declined by 3.5% over the past year. In the euro area, year-on-year growth of money TMS stands at 3.4% as of June which is an interim high actually, as even lower growth was observed throughout 2011.
UK money supply growth stalls out in spite of a massive increase in BoE credit via 'QE' - click for better resolution.
Euro area money supply growth and ECB credit – another example of a central bank 'pushing on a string' - click for better resolution.
Presumably at least some people at the central banks must be aware of this and are likely thinking about ways to counter it. After all, deflation is thought to be 'bad'. The BoE is introducing a scheme in concert with the treasury that is designed to spur lending to businesses by allowing the banks to discount corporate loans with the central bank.
The ECB is mulling various other methods of prodding banks into increasing their inflationary lending. Among the measures considered is , this is to say imposing a penalty rate for holding excess reserves with the central bank. The lowering of the deposit rate to zero at the last ECB meeting was apparently only the first step, but it has already shown why this method probably won't work.
The banks have simply transferred excess reserves to their current accounts in the euro system. This combines operational flexibility with the same degree of safety, while from an interest rate standpoint the situation is the same: they get zero. Investors are even prepared to endure penalty rates of varying sizes by lending short term funds to certain governments such as Germany's and Switzerland's at negative interest rates. They pay a small price for perceived 'safety', while at the same time placing a bet on eventual currency appreciation.
Note also that excess reserves are the equivalent of cash assets to the banks. If the central bank imposes a negative interest rate on such holdings, and e.g. imposes a limit on the amounts that can be held in the current account facility, the banks may simply begin to hoard vault cash. While this is inconvenient, there is no legal impediment to such an operation. We would certainly see an increase in the money supply then, as the currency component would climb, but if this money is simply put into vaults to gather dust, then it may as well sit on the ECB's deposit facility – this is to say it would have to be considered as remaining outside of the economy. This would change only if depositors became nervous about the euro's future purchasing power and began to withdraw money in order to spend it before it loses its value.
The latest proposal – which to be sure is not new, but was hitherto considered 'DOA' – was voiced by Austrian central bank governor and member of the ECB council Ewald Nowotny, who appears to be warming to the idea to give the planned ESM bailout facility a banking license. This would allow the bailout vehicle to function as the ECB's 'QE' arm, as it could for instance buy the bonds of Spain and Italy, and then rediscount them with the central bank and pyramid new loans atop the ones it can extend by using its own capital.
“European Central Bank council member Ewald Nowotny said there are arguments in favor of giving Europe’s rescue fund a banking license, reviving the debate on bolstering its firepower as leaders face the prospect of a full- scale Spanish bailout.
Granting a banking license to Europe’s permanent bailout fund, the European Stability Mechanism, would give it access to ECB lending, easing concerns that its 500 billion-euro ($602.5 billion) cash pot won’t be enough if Spain or Italy require aid. While ECB President Mario Draghi said on May 24 that such a move amounts to the central bank financing governments, which is prohibited by European Union law, publicly-owned credit institutions such as the European Investment Bank are exempt.
Addendum: A Few Interesting Charts
Below are a few charts we have come across that we believe our readers may find interesting. UK GDP fell rather unexpectedly sharply, and the pound fell with it. Recent food price increases have yet to spark the interest of a wider swathe of the internet population. Germany's business confidence is in steep decline and lastly, gold looks like it may break higher in dollar terms soon.
The intraday move in the British pound after the release of GDP data showing a rather severe contraction on Wednesday - click for better resolution.
Agricultural prices versus Google searches for 'food inflation'. A curious gap has opened up.
Germany's IFO business climate indexes. All three indexes have declined to lower lows.
The gold price in US dollar terms – is a breakout coming soon? – click for better resolution.
Charts by: Bloomberg, IFO, St. Louis Federal Reserve Research, Michael Pollaro, BigCharts
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