Take It To The Limit

It’s been nearly a fortnight since Federal Reserved announced what has become known as QE3 – (a third round of quantitative easing) to support economic growth. In the FOMC statement, policymakers explained that they undertook the action because of concerns that the economy would not gain the momentum necessary to generate jobs. Unlike many other central banks that focus only on keeping inflation low, the US Federal Reserve has two mandates – to keep prices stable and maximize employment.  They plan to purchase mortgage backed securities (MBS) at regular intervals ($40 billion for the next six months) as part of an effort to maximize employment generation and price stability.  They also anticipate their benchmark Fed Funds rate will remain close to zero into 2015 (assuming a modest inflation environment).  Interestingly, the European Central Bank (ECB) also articulated its policy of purchasing government debt in the secondary markets, in an effort to reduce borrowing costs for countries laden with slow growth, gaping budget deficits, and high borrowing costs.

So, as former Mayor Koch would say, how are they doin’?  It depends on who you ask.  Investors decided that if the Fed was putting money on the line to spur growth, they would do the same with stocks, and major equity indices rallied sharply on the news. But US Treasury prices – particularly for 10 and 30 year maturities (which are used to price many mortgages) declined and yields rose sharply – the opposite of what the Fed intended.  Why?

  • Some say the central bank’s actions could ignite inflation – and look at rising money supply growth as a warning.  While this is a central tenet of monetarism (and Milton Friedman), this relationship has changed over time.  Consider that inflation, excluding food and energy prices, declined 0.1% in August, and in spite of a large jump in energy prices this summer, remains below the Fed’s 2% target.

  • Others are concerned that even if headline inflation remains moderate, the policy rewards banks, punishes savers, and could inflate asset prices (stocks, houses, etc).  Over the course of his tenure as Fed Chairman, Alan Greenspan lowered short term rates to support markets through downturns or market crises and kept short term borrowing costs low for an extended period after the 2001 downturn – which in hindsight helped fuel the housing bubble.  Traders had a phrase – the Greenspan put – (that the Fed had their back) which gave them a ‘green light’ to buy.  More recently some traders now talk about a ‘Bernanke put’. While some concerns may be justifiable about financial asset valuations, the housing market has only recently begun to show signs of life.  Given tighter standards, higher costs, and fewer questionable products, home values look unlikely to get out of hand anytime soon.

  • This links into a third concern – that the Federal Reserve’s intervention may not accomplish much and risks longer term damage to the Fed’s balance sheet – and credibility.  Buying tens of billions of dollars in mortgage backed securities adds more debt and timing is questionable (it could influence the election and/or makes no sense to act now when the economy is still growing).  In the past the Federal Reserve officials were known to ‘take away the punchbowl when the party gets going’, but now they seem to be playing the role of bartender.  Others, like IMF Managing Director Christine Lagarde, applaud central banks for their actions, but warn growth is slowing and urge officials to do more not less

Chairman Bernanke, who has studied the Great Depression at length, has committed to do whatever he and the Federal Reserve can to avoid a repeat of the 1930s.  And in the wake of ongoing evidence that growth momentum has softened, markets have reversed ground in recent sessions and bond yields have moving lower, acknowledging that for now, the inflation boogey-man is at bay.  But it looks increasingly like central bankers have just about ‘taken it to the limit’ in terms of what they can (or in the view some, should) do.  If politicians don’t address budget and debt imbalances soon, we may all be in for a rude awakening this winter.  Lisa Kaess

** Take It To the Limit – was one of the top hits for the Eagles in the 1970s.


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