The 'Bernanke Put'

In its September meeting, the Federal Reserve said it anticipated keeping the Fed funds rate near zero through mid-2015. It approved a new program of quantitative easing, dubbed QE3, to purchase agency MBS (mortgage backed securities created by Fannie Mae and Freddie Mac and guaranteed by them and the U.S. government) at a pace of $40 billion per month. The Fed also said it is continuing Operation Twist (in which the Fed sells shorter-term Treasury notes to buy longer-term notes and bonds) through year-end. By itself, the $40 billion size of the new monthly purchases is relatively small — below the monthly rates during the $600 billion MBS purchases launched in December 2008, the $1.75 trillion in follow-on QE1 purchases starting March 2009, and the $600 billion in Treasury bond purchases in QE2. However, the Fed’s purchases are large in the context of the agency MBS market. On the Fed news, the market heavily bought agency MBS, generating substantial profits for market participants and driving the MBS price up and the yield down in anticipation of the Fed’s becoming a major new buyer. Mortgage rates are already very low, but the Fed’s hope is to lower them a bit more to encourage the housing market. The market also put emphasis on the open-ended nature of the Fed’s $40 billion in monthly purchases and the ambitious Fed statements that it would expand its QE policies until the labor market improves and would continue very low interest rates even after the economic recovery took hold. Equities and gold rose materially while Treasury yields rose on the inflation implications of QE3 and the absence of Treasury bond purchases in the Fed’s new program. The Fed statement said: “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency MBS, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.” We think the Fed shouldn’t think of itself as a job-creator and is causing damage by expanding QE. It’s also causing damage by making promises about expanding more in the future based on the labor market outlook, which is heavily influenced by other government policies that can’t be offset by Fed expansion. The Fed’s statement also implied even slower rate hikes once the economy accelerates: “The Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” This goes beyond the rate hike timing that Chairman Bernanke laid out in his July congressional Q&A: “It will be a similar pattern to what we’ve seen in previous episodes where the Fed cut rates, provided support for the recovery, and when the recovery reached a point of takeoff where it could support itself on its own, then the Fed pulled back, took away the punch bowl.” In his September 13 press conference, Bernanke emphasized the importance of the Fed’s communication techniques in the effectiveness of the Fed’s tools. He said that assuring the public that the Fed will take action if the economy falters should increase confidence and boost the willingness to spend. This Fed assurance that it can protect the economy from slowdowns is often described as the "Bernanke put," a reference to a financial derivative that increases in value when equities go down, providing insurance against losses. It is named after the "Greenspan put," which equity and housing markets relied on in the 2000s, on the view that Greenspan would stop hiking interest rates or would lower them if prices stopped going up — dance until the music stops. Bernanke seemed to expand the sweeping nature of the Bernanke put in his press conference comments about the fiscal cliff. He said he doesn’t think the Fed has the tools to offset the resulting downturn if the fiscal cliff occurs, and “we’d have to think about what to do.” We don’t think monetary policy can or should share the responsibility for the economic consequences of the fiscal cliff. Economic performance in the U.S., Europe, and China will probably continue slowing in coming months, and the Fed developments don’t improve the outlook. In his analysis, Bernanke put more emphasis on the public’s willingness to spend than on its willingness to invest and start new businesses. We think the latter is more important in hiring and future growth and also in meeting the Fed’s dual mandate of full employment and price stability. In expanding Fed bond purchases, the risk is that the Fed is actually weakening the economy’s output by misallocating capital, not strengthening it. The Fed’s policy channels capital into agency MBS, other government bonds, gold, and commodities rather than allowing a market-based allocation of capital to job-creating businesses. In the September statement, the Fed strengthened its forward guidance on the view that it will encourage spending, but it may instead discourage business investment — the weaker the economy, the more bonds the Fed says it will purchase, in effect threatening the private sector with a more distorted capital allocation process. If bond purchases distort capital flows, then forward guidance is harmful, creating an unstable feedback loop that discourages productive investment and adds to gold prices. We expect markets to shift their focus from the Fed’s purchases to problems elsewhere — Europe, the year-end U.S. mega-tax increase, slowing growth in corporate earnings, and economic weakness in the U.S., Europe and China. The market’s mantra is “don’t fight the Fed,” but that applied when the Fed was cutting interest rates, which added to asset values by reducing the financing cost of leverage. With rates already near zero for the whole front end of the yield curve, it’s hard to see that the Fed will have as much upward impact on asset prices as when it could cut interest rates. The Fed funds rate has been near zero for almost four years, unique in history. Real GDP has slowed year by year, from 2.4% in 2010 to 2.0% in 2011 to 1.8% so far in 2012. At the same time, the Fed has expanded its balance sheet by $2 trillion (to $2.9 trillion from $900 billion) through large-scale asset purchases during QE1 and QE2, and lengthened the duration of its assets during Operation Twist as it worked to push interest rates down toward zero for longer maturities. In effect, the Fed is operating as a giant, heavily leveraged speculator, borrowing short and lending long while ignoring the conflict of interest this creates when it also sets the interest rate. The Fed finances most of its long-term assets with $1.5 trillion of overnight funding from commercial banks, while maintaining only $55 billion of equity capital. Meanwhile, the current policy is causing a weak and artificial environment and a progressive breakdown in the functioning of important financial markets. The value of loans outstanding in the interbank market has fallen to $10 billion from an $80 billion level prior to the 2008 crisis. Similarly, the value of loans outstanding in the Fed funds market (in which banks lend to each other with the Fed as counter-party) has fallen to $100 billion from a $400 billion level prior to the 2008 crisis. Once viewed as critical to efficient capital allocation, these markets will take time to rebuild when interest rates normalize. With the Fed a heavy buyer of longer-maturity Treasuries, the yield on a five-year Treasury fell to 0.5% in July. Except in the highly distortive monetary policy of the 1970s and the bubble policy of 2002-2005, the five-year yield has generally tracked or exceeded nominal GDP growth, which is now running at 4.0%. The large gap gives a measure of the credit market distortion. Treasury’s July 19 auction of 10-year TIPS (inflation-protected Treasury bonds) showed a negative yield of -0.637%, meaning the federal government is borrowing money at an annual rate of CPI inflation minus 0.6%. As a result, investors are locking in 10-year total pre-tax returns that are below CPI inflation, further evidence of a massive market distortion. Five-year TIPS yields generally reflect the economy’s real growth prospects, yet have fallen to worse than negative 1.7% per year real returns, a sign of either a massive monetary distortion or a very bad economic outlook. By under-pricing credit, it has to be rationed — in effect, the regulators overseeing the banking industry impose a quota (financial repression) in their choice of capitalization requirements for different types of lending. As low rates are pushed out along the yield curve, capital is increasingly misallocated toward government and big corporations. This shows up in slower growth and less economic dynamism. The latest GDP data show the massive shift in income underway in the economy toward government payments and corporate profits, and away from small businesses, sole proprietors, dividends, and interest earnings. Conclusion: The longer the current monetary policy persists, the more the risk of unintended consequences and the greater the difficulty unwinding the distortions.