Why QE has not been stimulative
The Fed's Quantitative Easing program—which so far has consisted of the purchase of some $2.3 trillion worth of Treasury, MBS, and Agency bonds, thereby more than tripling the size of the Fed's balance sheet—has been so gigantic as to have been inconceivable before it started, yet it has not done anything to stimulate economic growth or push up the inflation rate. The economy is still mired in the Weakest Recovery Ever, and inflation has dipped to its lowest point since the early 1960s. How to explain this?
Perhaps the Fed should have done more?
Or perhaps it's because QE was never designed to be stimulative in the first place.
As I've argued since October 2008, the main objective of QE was to satisfy the world's sudden and huge demand for money in the wake of the disasters that unfolded in 2008. This, after all, is one of the key functions of a central bank: to supply liquidity in times of crisis. If the Fed (in concert with other central banks) had not acted as it did, a shortage of money could have been plunged the world into a deflationary depression lasting for years. No one could have foreseen, in 2008, that the Fed would eventually have to supply over $2 trillion in liquidity to the banking system (in the form of bank reserves) in order to accommodate the world's demand for money, but that's what has happened.
By late 2008, the specter of years of deflation was very real. The chart above shows nominal and real yields on 5-yr TIPS, and the spread between them, which is the market's expected annual inflation rate over the next 5 years. This measure of inflation expectations plunged from 2.5% in July 2008 to a low of almost -0.5% in November 2008. The bond market, in other words, was braced for years of deflation.
Plunging home values, collapsing equity markets, soaring default rates, massive margin calls, and the near-collapse of the global financial system all combined to sow widespread fear and panic. As I estimated back in November 2008, the bond market was priced to the expectation that 24% of all corporate bonds would be in default within 5 years, which would have implied an economy much weaker than the Depression, and the equity market was priced to the expectation that corporate profits would decline by two-thirds.
As the first of the above charts show, the Vix index (a good proxy for the degree of fear and uncertainty that pervades the equity market) rose from 20 in late August 2008 to 90 by late October. As the second chart shows, credit spreads soared to unprecedented levels. Fear and uncertainty have remained relatively high since the Great Recession, and that has contributed to keeping the demand for money strong.
The surge in fear, uncertainty, and doubt that accompanied the near-collapse of global financial markets triggered several predictable responses: a desire to de-risk, a desire to boost cash holdings, a desire to deleverage, and a desire to seek out safe havens. The common denominator was a huge increase in the demand for money (cash and cash equivalents) and safe assets. Until the Fed launched QE1, however, cash and cash equivalents—the object of everyone's sudden affection—were becoming scarce. Strong demand for T-bills began early in 2008. From late 2007 through mid-2008, the Fed sold almost its entire holdings of T-bills—about one-third of the Monetary Base—in an attempt to satisfy the world's demand for safe assets. But it wasn't enough.
As the above chart shows, gold fell 25% from March through October 2008, a clear sign that money was in short supply and deflationary pressures were building. The CRB Spot Commodity Index plunged 37% from July through early December 2008. Shortly after the Fed began QE1 in October 2008, gold resumed its rise, and commodities resumed their rise several months later. QE1 was exactly what was needed to avoid deflation.
The monthly net flows of equity and bond mutual funds are evidence of a four-year virtual stampede out of equities in favor of the relative safety of bonds. The investing public shunned equities throughout 2009, 2010, 2011, and 2012 despite their spectacular recovery. Risk aversion has been the dominant theme in the markets for the past four years.
Households' efforts to deleverage began to bear fruit beginning in 2010, as the chart above shows. Household financial burdens (monthly payments as a percent of disposable income) fell 13% from the end of 2009 through March of this year, and they are now at record lows.
As the chart above shows, individuals' desire to boost cash holdings is evident in the nearly $4 trillion increase in bank savings deposits since the end of 2008. Strong deposit inflows, in turn, have put banks in a difficult position, since it's hard these days to find relatively safe investments that offer any appreciable yield. 3-mo. T-bills yield a mere 0.04%, 1-yr T-bills 0.12%, and 90-day AA Commercial Paper 0.14%. Traditional safe investments pay almost nothing, which is another way of saying that the demand for money (cash and cash equivalents) has been and continues to be intense.
This is where bank reserves come into the picture. Thanks to Quantitative Easing, the Fed pays interest on reserves, currently 0.25%. Bank reserves essentially are just as bullet-proof as 3-mo. T-bills, the former risk-free standard, but they pay substantially more interest. Banks thus find it attractive to invest a portion of their deposit inflow in bank reserves. How does that work? Banks simply use some of their deposit inflows to purchase the Treasuries and MBS that the Fed buys every month as part of its QE program. Then the banks turn around and sell the bonds to the Fed in exchange for having bank reserves credited to their account at the Fed, where they earn 0.25% with essentially zero risk. Bank reserves are the new T-bills, and that's why banks have been content to accumulate $1.9 trillion of "excess" bank reserves (reserves that are sitting idle at the Fed, and not being used to support increased lending) since late 2008.
Banks are lending, but they are still somewhat cautious; required reserves (reserves required to support increased lending) are up only $75 billion since QE1 began. At the same time, the private sector has been trying hard to deleverage, so the net demand for loans has not been very strong. As the chart above shows, C&I Loans (a proxy for bank lending to small and medium-sized businesses) have only recently recovered to the levels that preceded the Great Recession.
Despite the addition of massive amounts of bank reserves, which banks could have used to support a virtually unlimited amount of new loans and money creation, the M2 measure of the money supply has not shown any unusual or excessive growth. As the above chart shows, M2 has been increasing at about a 6% annual rate since 1995, during which time the annualized rate of inflation according to the Fed's preferred PCE Core Deflator, has been a modest 1.8%; for the past 12 months this measure of inflation has risen by only 1.1%.
M2 has been increasing a lot faster than nominal GDP, however, which means that, as the chart above shows, the demand for M2 money has increased by 25% since the end of 2007. This is arguably the most dramatic demonstration of just how strong the demand for money has been in the wake of the Great Recession. On average, the world now holds 25% more money (in the form of retail money market funds, small time deposits, currency, checking accounts, and savings deposits—see second chart above) relative to total spending than it did just six years ago. Bank savings deposits account for the vast majority of the increase in money balances.
In a sense, QE helped provide banks with the wherewithal to support a huge increase in the public's desire to hold more money. All the extra "money" that the Fed has created via its QE program has simply been absorbed by the a world that was terribly anxious to acquire more money—not to spend it. That's why QE has not been stimulative and has not resulted in increased inflation: the Fed has supplied exactly as much money as was required to meet the world's demand for money. As Milton Friedman taught us, inflation is a monetary phenomenon that only happens when the supply of money exceeds the demand for money.
I see preliminary indications in the charts above that the world's huge demand for money is beginning to subside. The big decline in gold prices over the past nine months is a reflection of a big decline in the world's demand for safe assets—gold being the classic refuge from political, economic, and financial uncertainty. Real yields on 5-yr TIPS (which are a great "safe" asset since they are immune to default risk and inflation risk) have moved inversely with gold prices, which means that the demand for TIPS has closely tracked the demand for gold. TIPS prices have plunged of late because the world is less worried about inflation (5-yr breakeven spreads are down to 1.93% from a recent high of 2.6%) and less worried about the chances of recession (or, if you will, more confident that the economy can continue to grow at about a 2% rate). As the second chart above shows, real yields tend to track the real growth rate of the economy. Inflation concerns are subsiding, and demand for safe assets is subsiding, and that adds up a world that has become less uncertain. Reduced uncertainty can also be found in the Vix Index, which is once again approaching levels that are historically "normal." With reduced uncertainty should come a reduced desire to accumulate money, and higher prices for risk assets.
The huge net outflow from bond mutual funds last month is yet another sign that the public's demand for safety is beginning to decline—that markets are becoming less fearful and somewhat more confident about he future.
If recent trends continue, then the Fed's proposed "tapering" and eventual unwinding of QE would be fully justified, and in fact required to avoid a rekindling of inflation. If the world's confidence builds, even marginally, and money demand begins to decline, we could see the beginnings of stronger nominal GDP growth as the world attempts to reduce its idle money balances.
Since QE was never stimulative, the end of QE should not be depressing. The economy is very likely capable of growing without any further "stimulus" from the Fed. Higher interest rates are the best sign that the outlook for the economy is improving, however marginally. There's no reason to fear higher rates, because they will only happen if the economy improves.
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