Oops, I Did It Again

Sorry for the Britney Spears reference.  But honestly, Ms. Spears would probably make about as good a Fed Chairman as the one we've got.

As a brief aside, I used to think Jim Cramer was probably a pretty smart guy.  Annoying as can be, yes, and the Chief Rally-Monger of Bubblevision, but smart.  Then I watched him try to explain quantitative easing last night.

Not only did the Mad One butcher the attempt - I hope he didn't really believe what he was saying - but he praised Ben Bernanke in the process.  Oh my.  Only a lover of bubbles could think highly of the job Helicopter Ben is doing.

So let's talk about what Ben did yesterday, which relates to the title of this post.

Ben, as expected, launched QE3 (that's the third round of quantitative easing, not a transatlantic ship).  Before we talk about that, though, a primer on the Fed.

The Federal Open Market Committee, or FOMC, is the rate-setting arm of the Federal Reserve Board.  It consists of Chairman Bernanke and the other six members of the board, and five of the presidents of the 12 regional Fed banks, who serve on a rotating basis (except that the president of the New York Fed bank is always an FOMC member).  It's dominated by doves at present, with only Jeff Lacker of Richmond falling in the hawk camp (doves favor easy monetary policy, while hawks favor fighting inflation).  The FOMC meets eight times a year to set monetary policy, and their primary tool is interest rates - specifically, the Fed funds rate, which is the rate at which banks with excess liquidity lend it to banks that need more liquidity.  With me so far?

The FOMC has been handed a dual mandate by Congress: use monetary policy to (a) limit inflation and (b) ensure full employment.

That's a bit like being handed a dual mandate to (a) jump in a swimming pool and (b) don't get wet.

When the economy is heating up, people are buying more stuff.  As the demand for stuff increases relative to the supply, we have the classic definition of demand-pull inflation: too much money chasing too few goods.  So the FOMC will raise the Fed funds rate, which raises banks' borrowing cost, which leads to the banks passing the higher cost of borrowing along to its own borrowers in the form of higher rates, which curbs demand: people won't borrow as much money at high rates to buy more stuff as they will at lower rates.  So inflation is held in check.

So far, so good.  But as the economy then slows due to declining demand, companies are selling less stuff, and they start laying people off.  If the cuts are sufficiently draconian, a recession could ensue.  Thus, the Fed will begin - hopefully before a recession starts - to cut the Fed funds rate, so that banks can borrow more cheaply, and pass the lower rates on to their own borrowers, who will now be willing to borrow more money to buy more stuff, thus stimulating the economy.

Makes perfect sense, right?  Except that our last couple of recessions have been caused not by normal business cycles of the economy heating up, the Fed raising rates, and then the economy cooling, but by the bursting of asset bubbles (dot-com stock prices in the 2000 recession, housing prices in the latest downturn).  And those bubbles have been fueled by low interest rates, i.e., easy monetary policy.

That begs the question: if policy is already easy, and a recession happens anyway, what can the Fed do to stave off the recession or at least spark a recovery?

The answer, as we're seeing, is not a whole heck of a lot.

The Fed cut the Funds rate to "zero to 25 basis points" (bp; a basis point is 1/100 of a percent) in late 2008.  The Fed had begun cutting rates in the third quarter of 2007, when the funds rate started at 5.25%.

So we've now seen rates near zero for nearly four years, and what has been the effect on borrowing and the economy?

Virtually nada.  Borrowing has contracted, as people are more reluctant to take on debt now, especially credit card debt, having seen the error of their ways.  Auto loans are growing some, but not like they were before the housing bubble burst.  Student loans are way up, because if you can't find a job, you can always go back to college and borrow your living expenses, to pay the piper later, if at all (and student loans are brewing to be the next credit bubble).

Mortgage borrowing?  Renting is the new owning, so there's not much purchase borrowing going on.  And refis have largely run their course; those borrowers who can qualify, now that lending standards have returned to normal, have already refinanced, and it would take significantly lower rates to offer an incentive to refi from, say, a 4% mortgage - with rates currently at 3.5% for a 30-year fixed-rate mortgage, there's not much incentive to pay the fees to refi.

And the economy has sputtered, with much of the recent data showing a slide toward recession, whether the EU drags us there or not.  So cutting rates hasn't done much to stimulate the economy, and there's precious little room to cut further.  Cutting all the way to zero is the last bullet in Barney's - er, Ben's - pocket, and he doesn't want to chamber it until he absolutely has to.

Enter quantitative easing, or QE.  All that is, is the Fed buying bonds of various types to keep interest rates down.  How does this work?  Glad you asked.

If the Fed commits to buying bonds - and they're not price-sensitive; after all, they're paying with your money - that creates demand for those bonds, which is significant: there's now a large, price-insensitive buyer of size in the market.  So the price is bid up.  When bond prices go up, bond yields - interest rates - go down.

In December of 2008 - at about the same time the Fed cut rates to near-zero - it launched QE1, a program of buying bonds that lasted until March 2010.  During that span, the Fed nearly tripled the size of its balance sheet, from less than $1 trillion to about $2.3 trillion.  That's a lot of money that got printed.

QE1 worked so well that when the economy still wasn't picking up in late 2010, the Fed launched QE2, buying more bonds.  That round lasted until June 2011, and grossed up the Fed's balance sheet further, to about $2.9 trillion.

Now, with QE1 and QE2 having failed to stimulate the economy, which is showing increasing signs of weakness (Chairman Bernanke recently commented that the unemployment rate was a "grave" concern, which reminds me of Col. Jessup's response to McCaffey in "A Few Good Men," when McCaffey asked whether Jessup thought his soldier was in "grave danger" - "Is there any other kind?"), what's the best course of action?

Why, launch QE3!  Buy $40 billion of mortgage-backed securities a month!  That'll keep mortgage rates low, which should set off a wave of mortgage borrowing!

Yeah, like QE1 and QE2 did.

What it will do is gross up the Fed's balance sheet to $4 trillion.

At the same time, the Fed promised to keep rates at their current level until at least mid-2015.  I heard one pundit yesterday forecast that the Fed won't raise rates until 2017.  (I'm still trying to figure out how Bernanke, whose term expires in 2014, can promise anything beyond that.  Of course, if he keeps rates low enough, long enough, to get Mr. Obama re-elected, he stands a good chance of being re-appointed; could it be that ... nah.)

That means, at a minimum, we'll have seen the Fed funds rate at an unprecedented 25 bp for an unprecedented six and a half years, maybe as much as eight or nine years.  To put that in perspective, the Greenspan Fed held the funds rate at the then-ridiculously low level of 1% for four quarters in the wake of the dot-com bubble.  (And that comparison will be the topic of my next post.)

Now, who benefits from quantitative easing?  The stock market, for one, and I'll address that in the next post as well.  But more specifically, who benefits from low rates?  Savers?  Hardly.  Banks?  Well, yeah.  But who is the primary beneficiary?

Borrowers, of course.  And who's borrowing these days?  You?  Me, neither.  Students, I guess.  But not much more than that.  Companies?  Sure, and I'll also talk about their debt in the next post (my, but I'm a tease today.)

But who's the biggest borrower in the US?  If you said, "the government," give yourself a gold star.

With $16 trillion in debt, the US government has more debt outstanding than all Americans in total.  Add in state and local government debt, and you have a total that's nearly as much as all US citizens and companies combined.

Interest rates influence the cost of servicing debt.  And when your debt burden is $16 trillion, it costs you, at 25 bp, $40 billion a year just to make the interest payments.  Note that the government's debt service burden is much higher than that, as it's not paying the Fed funds rate, but higher rates for longer maturities.  In fact, the federal government's monthly debt service burden is larger than the annual budget for the Department of Labor (ironic, when everyone in Washington is talking about how to create jobs).

For the sake of comparison - again, actual government borrowing costs are higher than the funds rate - at a Fed funds rate of 1%, where Greenspan held rates after the dot-com bubble, the debt service burden would jump from $40 billion a year to $160 billion.  At 3%, it would be nearly a half-trillion dollars.  And at 5%, we'd basically double the deficit every year, just paying the interest on the debt we've got.  Can you say "Weimar Germany?"

Now, am I suggesting that the Fed is keeping money as easy as possible just to help the boys and girls in Washington run record deficits?  I'm not a conspiracy theorist.  But, hmmm ...

By the way, don't look now, but the Fed's current policy is a tax - a hidden tax on you and me.  To keep those borrowing costs down, savers have to pay the price.  And that brings me to an interesting unintended consequence of the Fed's policy.

Retirees typically live on a fixed income - meaning interest income.  With interest income virtually non-existent, an increasing number of would-be retirees are remaining in, or re-entering, the labor force.  They're experienced, and they're willing to accept a lower wage than they demanded in their peak earning years.  So they're crowding out jobs that would otherwise be held by younger workers.  So much for the Fed keeping money cheap to create jobs.

Also, by promising that rates will remain low through 2015, the Fed is signaling would-be homebuyers that mortgage rates won't go up.  So with home prices not appreciating, why be in a hurry to borrow now?  Thus the Fed is also keeping a lid on housing activity.

Does this make sense to you?  Me, neither.  So that's why I assert that Mr. Bernanke is the worst Fed chairman in the history of the role.

Hey Britney, what are you doing these days?