Lollipops and Tantrums
The Fed is much like a rotten mother who throws her spoiled brat a lollipop as a reward for a temper tantrum says John Hussman in yet another excellent missive: Is the Fed Promoting Recovery or Desperation?
On Friday, the Department of Labor reported that March non-farm payrolls increased by 120,000, falling well short of consensus expectations in excess of 200,000. For our part, we continue to expect a deterioration in observable economic variables, with weakness that emerges gradually and then accelerates toward mid-year. On the payroll front, our present expectation is that April job creation will deteriorate toward zero or negative levels.
Immediately after the payroll number was released, CNBC shot out a news story titled “Disappointing Jobs Report Revives Talk of Fed Easing.” Of course it does, because this remains a market dependent on sugar. And with little doubt the Fed will eventually deliver it – perhaps following a market plunge of 25% or more – but with little doubt nonetheless, because like the indulgent parent of a spoiled toddler, the FOMC can’t stand to see Wall Street throw a tantrum without reaching for a lollipop.
How QE “works”
Keep in mind that the U.S. banking system has trillions of dollars sitting in idle deposits with the Fed already. Quantitative easing simply does not relieve any constraint that is binding on the economy. Rather, QE is a method by which the Fed hoards longer-duration, higher-yielding securities like U.S. Treasury bonds and replaces them with cash that bears zero interest. At every moment in time, somebody has to hold that paper. The only way for the holder to seek a higher return is to trade it for a more speculative asset, in which case whoever sells the speculative asset then has to hold the cash. The process stops when all speculative assets are finally priced so richly and precariously that the people holding the cash have no further incentive to chase the speculative assets, and are simply willing to hold idle, zero-interest cash balances.
Why does the Fed want this? Simple. Chairman Bernanke believes that by creating a bubble in speculative assets, people will “feel” wealthier and keep consuming – regardless of the fact that real incomes are stagnant and debt burdens are already intolerable, and despite the fact that there is extremely weak evidence for any such “wealth effect” in the historical record. Undoubtedly, it would be difficult for Bernanke to refrain from these reckless policies when everyone is crying “do something!” But the willingness to tolerate short-term criticism in the interest of long-term benefit is part of what separates leadership from cowardice.
In my view, individuals like Sheila Bair – the former head of the FDIC, Paul Volcker – the former Fed Chairman, and Elizabeth Warren – the former head of the Congressional oversight panel for TARP, demonstrated leadership in elevating the interests of the public over the interests of bank bondholders and entrenched interests. Unfortunately, all of their voices were stifled during the credit crisis – though hopefully some provisions of the Volcker Rule will survive, particularly those related to bank restructuring. We would be far along the road to economic recovery had we dealt with our crisis the way Sweden durably dealt with its own a decade ago (essentially taking a large portion of the banking industry into receivership, wiping out existing shareholders, writing down bad assets, and then taking the banks public to recapitalize them under new owners). Bernanke, in contrast, has been at the forefront of the kick-the-can strategy of bailouts, accounting changes, customizable stress tests, and helicopter money.
Given the bubbling concerns among various FOMC members about inflation risk, the next round of QE is likely to be “sterilized.” Essentially, the Fed would buy Treasury bonds from banks, and would pay for them with newly created cash, but the Fed would then borrow those funds back from banks, holding them as idle deposits with the Federal Reserve. By definition, the additional “liquidity” created by a sterilized round of QE would not be available for new lending (as if there aren’t enough idle reserves in the banking system already). So again, the main goal is to increase the outstanding stock of zero- and low-interest assets in the economy, in order to lower the yields and increase the prices of more speculative investments.
The reason for doing QE through the Fed (rather than simply changing the maturity profile of the new Treasury debt) is that Wall Street – at least – believes that the Emperor is actually wearing clothes. Despite the fact that the main effect of QE is to boost speculation and release brief bursts of pent-up demand, both which immediately soften when the policies are suspended, this recurring pattern is still unclear to many investors and analysts. As long as that delusion persists, we can expect the Fed to periodically exploit it.
Ignore that the side-effect of this delusion is the misallocation of capital toward speculative assets in the belief that the Fed has set a “put option” under the markets. Forget that savings are discouraged, bad lending decisions are rescued, incentives and economic signals are distorted, and the accumulation of productive capital is disabled. We have the most creative, entrepreneurial nation on the planet, but our policy makers are intent on preventing debt restructuring and misallocating scarce capital. As a result, they continue to compromise long-term growth in favor of temporary bouts of short-term speculation.
QE “Appears” to Works Until It’s Obvious it Never Did
Hussman goes on to challenge the notion the Fed’s policies are actually “working”. Certainly the Fed and probably more so the ECB’s LTRO program lifted financial markets, but Bernanke wants consumers to spend more and banks to lend more.
From that aspect, his policies have already clearly failed as I explained in The Real Consumer Credit Story: Virtually No Recovery in Revolving Credit, No Recovery in Non-Revolving Credit.
Strip out student loans and there is absolutely no recovery in either revolving or non-revolving credit.
Non-Revolving Credit Detail
Revolving Credit Detail
If the Fed’s sole intent is to bail out Wall Street, then its policies have been a spectacular success. If the Fed’s mandate is to get the economy back on track, spur lending, stabilize housing, and increase jobs it has failed.
Please note that multiple mandates are sheer nonsense as discussed in Dual Mandates, the Price of Gold, and Tinfoil Hats.
Unfortunately, dual mandates give the Fed all the leeway in the world to take whatever nonsensical actions it wants.
So, in spite of the fact his policies clearly are not working, Bernanke sticks with them. He is a one-trick pony with no common sense and no real-world experience, living in academic wonderland.
Above all, the Fed desperately wants to stabilize housing. The market has other ideas, proving once again the Fed can provide liquidity, but it cannot determine where it goes, or if it goes anywhere at all.
The ECB is in essentially the same boat, desperate to do something except the one thing that makes the most sense: writeoff banking sector losses.
One Lollipop Too Many
One of these times, and I have to admit I expected it long ago, the market will not be satisfied with another lollipop. At that point, instead of cheering another lollipop, the market will throw up like a child who has eaten three donuts and five lollipops too many.
Mike “Mish” Shedlock
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