All eyes are on the Fed today because markets across the globe in bonds, equities, commodities and forex want to know how much quantitative easing (QE) the Federal Reserve will do and what assets they will buy. As US short-term interest rates are now near zero percent, the Fed is out of bullets; traditional monetary policy has reached the end of the line. QE is the next big thing. It is widely believed that the Federal Reserve will offer a QE program of about $100 billion dollars per month for at least 5 months. Anticipation of this has led to serious asset price inflation in the U.S. and in commodities markets as the dollar has fallen. Therefore, QE has already had a huge effect on financial assets without having been implemented.
However, the effects on the real economy are another story (see here to take a poll on that issue). Martin Feldstein, a leading US economist, believes QE is risky and should be limited for that very reason.
Mr Bernanke’s argument for QE is based on the “portfolio balance” theory which stresses that, when the Fed buys bonds, investors increase their demand for other assets, particularly equities, raising their price and increasing household wealth and spending. Equity prices have already risen by 10 per cent since Mr Bernanke discussed this approach. But how much further will equity prices rise and what will that do to GDP?
Neither theory nor past experience can answer the first question. Much of the share price increase induced by QE may already have occurred based on expectations. An optimistic guess would be another 10 per cent. Since households have about $7,000bn in equities, that would imply a wealth gain of $700bn, raising consumer spending by about one-quarter of one per cent of GDP, a welcome but trivially small effect on incomes and employment.
The other ways in which QE would raise GDP are also small. A 20-basis-point reduction in mortgage rates would have little effect on homebuying at a time when house prices are again falling. The increase in banks’ liquidity would do nothing since banks already have massive excess reserves. Big corporations are sitting on vast amounts of cash. Small businesses that are not spending because they cannot get credit will not be helped, because the banks on which they depend have a shortage of capital.
So, is the Fed hanging its hat on getting people into the risk-on trade? It seems so. But as Marshall Auerback told me, ” private portfolio preference shifts are very hard to gauge and can’t really be ‘modeled’ in any respect.” Therefore, QE and asset prices is purely about speculation rather than investment.
I am starting to take the view that the Fed is reducing net interest margins. Back in 2008 and 2009, US banks benefited from low rates as their net interest margins were huge. For the first quarter of this year, JPMorgan Chase even had a negative net borrowing rate of interest while it made 324 basis points in net margin. They were effectively paid to borrow, leading to a more than 3% interest rate spread on loans. That’s a great story. Can it last, though?
The short answer is no. As the long end of the yield curve comes in due to either QE or what I have been calling permanent zero (PZ), as zero rates become a permanent state of affairs, interest margins have compressed. Rates will compress even more the longer rates stay at zero percent because the expected future rates will start to come down (see here on bootstrapping the yield curve).
What’s more is that PZ will be a big problem in a Shiller double dip scenario because banks will be set up for huge loan losses despite recent under-provisioning. Meanwhile they will have no way to make it back on net interest as long rates come down in a recession while short rates remain at zero percent, killing net interest margins.
This is the problem with QE and PZ money: it works in the short run, but is toxic in the longer-term. Now if liquidity was the real problem for banks, then the banks will have enough capital to ride through this. They will recover as many did in the early 1990s during the last banking crisis in the US.
If solvency is the banks’ problem, QE and PZ will be toxic.