QE3 And Bernanke's Folly - Part I
Earlier this year, as the markets were expecting QE3 from one Fed meeting to the next, I was stating another program would not come until September after data for Q2 GDP could be analyzed. However, as we moved into August, and the markets were rallying strongly on "hope" of further balance sheet expansion programs, I moved my estimates out until the end of the year. The reasoning, as I stated, was under the assumption that Bernanke would save his limited ammo for a weaker market/economic environment. Clearly I was wrong.
Much to my surprise, and against all of what seemed logical, Bernanke launched an open ended mortgage backed securities bond buying program for $40 billion a month "until employment begins to show recovery." That key statement is what this entire program hinges on. The focus of the Fed has now shifted away from a concern on inflation to an all out war on employment and ultimately the economy. However, will buying mortgage backed bonds promote real employment, and ultimately economic, growth. Furthermore, will this program continue to support the nascent housing recovery?
Employment - Where's The Demand?
During the Fed's announcement today Bernanke repeated several times that the primary concern of the Fed is now employment. One of the Federal Reserves primary legal mandates is to foster full employment in the economy. However, after two previous Large Scale Asset Purchase programs (QE), and a Maturity Extension Program (Operation Twist - OT), has employment meaningfully recovered.
The chart below shows the net gains in employment since the beginning of 2009 as compared to the number of individuals that have moved into the "No Longer In Labor Force" category where they are no longer counted. There has been an increase of 3.4 million jobs since the lows of mass firings and layoffs post the last recession. That increase is far lower than would have been expected in any normal economic recovery. At the same time, however, more that 8.4 million individuals have just "given up looking for work" or "retired." during the same period. There is NO evidence that bond buying programs have any effect on fostering employment. However, at the current rate of individuals leaving the work force Bernanke could likely get his wish of "full employment" in the next couple of years. Of course, economic prosperity will have deteriorated much further as the rise of the "welfare state" continues.
The next chart shows the number of individuals, since 2009, who are now claiming disability and food stamps.
The point here is the manipulating the bond market, and inflating reserves for the major banks, does not create end demand for businesses. In our recent report on the NFIB survey we stated: "While there has been some improvement since the peak of the "Great Recession" - poor sales still provide an overriding concern for U.S. businesses when it comes to making decisions to increase employment or expand operations. While the concern over 'poor sales' remained stagnant last month the number of businesses saying this is a "good time to expand" fell from 5 to 4 and remains near the lowest levels since the end of the last recession." QE programs do not address the problem aggregate end demand on businesses. In fact, it makes it worse.
Diane Swonk tweeted after Bernanke's comments that: "Fed move to stimulate with open-ended MBS purchases 'unprecedented.' Focus on unemployment over inflation marks new era" While the move may be unprecendented by the Fed to focus on employment over inflation - the chart below shows you that he should be focused on the latter.
From a consumer's perspective the effect of food and gasoline as a percentage of wages and salaries is crucially important. As food and energy consume more of wages and salaries it leaves less available for consumption within other areas of the economy. It is evident that not only do balance sheet programs create inflationary pressures on the aggregate but more specifically in commodity related areas. The chart below shows the consumer conundrum where declining wages meet up with rising costs of food and energy.
It is notable that during the Maturity Extension Program (Operation Twist or OT) the inflationary pressures subsided for the consumer. This is due to the fact that OT did not increase excess reserves at the banks which were then funneled into risk assets. Apart from the recent spike in food prices due to the drought in the U.S. commodities have languished post the last QE program easing consumer pressures in many areas.
The important point, however, is that for businesses to hire employees it will require an increase in aggregate end demand. As the concern over "poor sales" diminish - hiring will pick up. Unfortunately, history shows that balance sheet expansion programs create the opposite effect of that intended by Bernanke. Rising inflationary pressures in food and energy only act as retardants to consumption thereby reducing the need for employers to add to payrolls. With corporate earnings and revenue weakening, rising healthcare costs and taxes on the horizon, and exports slowing - it is unlikely that the Fed's purchases of mortgage back securities will spur businesses to hire.
Housing - Set For A Fall
Bernanke's also stated that by buying mortgage backed bonds he hoped to support the nascent housing recovery. There are two major problems with his thought process that a simplistic look at the data would have revealed. First, and most importantly, is that interest rates have already been at historically low rates and very little housing activity has occurred. The chart below shows our housing activity index which measures the housing components that are most sensitive to the creation economic throughput.
Despite trillions of dollars of liquidity, support programs and "forgiveness" for every criminal act in the book, there has yet to be a real recovery in housing. The most recent upticks, primarily due to speculative investor demand for rental properties, will rapidly dry up as rising interest rates makes buying much less attractive. It is important to remember that people buy payments - not houses. The lack of employment, lower incomes, excess debt and poor credit history will keep a large chunk of the remaining population from qualifying to buy for quite some time. If you couldn't spur a massive house buying binge with the lowest mortgage rates in recorded history - what will another quarter point, or so, actually accomplish?
However, Bernanke's folly is in believing that QE programs lower interest rates. There is no historical evidence that yields fall during balance sheet expansion programs. It is evident, in the chart below, that during liquidity driven programs such as QE, money flows from bonds and into stocks chasing market performance. As a function of this rotation yields have risen sharply during past programs. Only during OT did yields remain suppressed along with inflationary pressures.
Putting It All Together
While the most recent bond buying program will push liquidity into the equity markets pushing asset prices higher - it will do little to help the economy, employment or housing. The evidence is abundant that the only beneficiary of these balance sheet programs is Wall Street. As shown in the chart below the average level of excess reserves for banks was roughly $19 billion from 1984 to 2008. Since 2008 excess reserves held at banks has swelled to more than $1.5 trillion currently.
With the consumer weak, unemployment high, foreclosures and deliquencies still burdensome, and businesses constrained by lack of demand - there is little desire, or need, for credit. This is unlikely to change anytime soon as businesses are forced to pullback even more as demand is further reduced by rising inflationary pressures.
Bernanke was correct about one point - monetary policy has a very limited reach economically and, while up to Congress, it is fiscal policy measures that are needed to promote economic growth. The recent program by the Fed has all but ensured two things from a political perspective: 1) The incumbent President is likely to win the next election, and; 2) that the current gridlock will continue on the fiscal front for another four years.
Clearly, the Fed's actions, and statement, signify that the economy is substantially weaker than previously thought. While Bernanke's latest program of bond buying was done under the guise of providing an additional support to the "recovery," the question now is becoming whether he has any ammo left to offset the next recession when it comes
In Part II we will discuss the markets advance this year, prior to the most recent bond buying program, which comes with a full 2-point increase in valuations. This is not healthy as the markets are advancing in the face of declining earnings. While the markets could very likely advance further from here it leaves one to ponder if the Fed has not just embarked on the creation of its third asset bubble in the last 20 years.