One theme we hear about constantly in the news is about how the global economy is growing slower than policy makers would like, that inflation is coming in less than expected, and without fail Government X has spent more than it earned.
And yet, stock markets are hitting record highs, unemployment is at historical lows, and whenever a new crisis hits, it’s no problem because monetary policy will just fix it.
How can this be? How is it that, on one hand we have seemingly increasing risks posed by mounting national debts, aging populations, and rising distrust towards other countries, while on the other hand, having record-low interest rates, record-high stock markets, and fairly little volatility?
Have we really learned how to have out cake and eat it too? Is monetary policy a gift from the gods that has banished recessions and constraints to the underworld for good?
To understand the paradox of our time, we must go back to the last time we looked over the precipice of doom and declared “double or nothing?”. We must go back to 2008.
2008 was the trough of the modern Great Recession, when the loose monetary policy of the 2000s came to a screeching halt with the collapse of the US housing market, which threatened to collapse the entire global financial system.
In response to rapidly deteriorating asset quality held by most major banks and the ensuing liquidity crisis, the Federal Reserve launched an unprecedented tactic to intervening in the market when it launched its first tranche of Quantitative Easing.
QE, as it became colloquially known, was composed of 3 distinct periouds between 2008 and 2014, which oversaw the Federal Reserve purchase $4.5 trillion in assets comprising U.S Treasuries and Mortgage Backed Securities (MBS).
The chart below shows the Fed’s balances of MBS and treasuries held prior to and following the Great Recession.
The aim of these two programs was to put a floor on demand for MBS and treasuries in order to drove yields down and help spur economic activity.
The fact that the Fed had to intervene to create artificial demand in the Treasury market is somewhat astonishing considering this is one of the most liquid markets in the world and is considered a safe-haven asset.
Nevertheless, the intervention was widely considered a success and acheived its objectives. US Treasuries are still considered a safe-haven asset and the US has enjoyed an economic expansion for 10+ years at the time of writing. But one question that remains is whether there are any ramifications to the $2 trillion in treasuries and $1.5 trillion in MBS the Fed has accumulated.
To understand future ramifications, I think it’s important to first understand why this move worked in the first place. There was no guarantee that buying treasuries would have the intended effects of lowering interest rates. Yields could have actually gone up if market agents interpreted “the accompanying rise in reserve balances as inflationary or if the Fed were viewed as accommodating fiscal expansion by “monetizing the debt”.” But the move did work, and I would argue for a couple of reasons: 1) The strategy of buying Treasury and MBS assets was seen as the most efficient way of intervening in the market to achieve stabilizing effects. 2) Other central banks were doing the same thing.
The second point is what I would like to examine further.
As shown in the chart below, the Fed’s asset buying program was on par with what the ECB was doing and matched the trajectory of Japan’s own QE program. In other words, the world’s main economies were purchasing their own debt in order to keep their respective financial systems solvent and asset pricing increasing.
So what’s the problem? We’ve seen slow but steady growth and rising retirement funds. There’s been no runaway inflation and until we start surpassing our inflation targets, shouldn’t we keep stimulating our economy further?
That’s an understandable argument, but if we examine the KIND of growth that is acheived through monetary stimulus I believe some warning signs emerge.
What kind of warning signs?
To understand the warning signs, we have to think about about what happens during recession and what the Central Bank is doing when it intervenes.
Recessions can come in different flavors, but a common situation is when consumer demand growth is exhausted and companies cannot continue to grow their earnings. This in turn leads to job cuts, asset price declines, and bankruptcies. It’s an unpleasant situation for most participants, but it is a positive for savers. Savers “enjoy” recessions through increased purchasing power, and ability to deploy their capital towards more sustainable business models. Recessions are also favorable to strong companies, who find themselves with less competition and with more influence on price-setting and expansion. Theoretically, a small recession could actually be healthy in that it shakes out moral hazard and bad business practices.
However, when central banks intervene in order to prevent recession, they do so at the expense of savers. Because of the mechanics of how QE works, the biggest benificiaries of this process are banks. Banks have been ordained by central banks as being the gatekeepers of how money is distributed in society since they are the direct recipients of monetary stimulus.
This is not a bad approach because banks generally take a prudent approach to circulating money. They do things like credit checks, business model evaluations, and have large compliance and regulation teams that act as stewards of a society’s means of transaction. On the whole, I can see how this is more productive than crediting everyone $500 for a new TV.
However, when central banks create artificial demand for government debt through repurchases from private banks, they end up distorting the perceived level of risk. By buying government debt, centrla banks transfer risk from banks to taxpayers. While interest rates are decreasing, this works well because the central bank can show a profit on their purchase and be heralded as returning money to taxpayers. However, if interest rates were to increase
problems with lower interest rates: —Keeps bad companies alive –encourages govt spending –decreases flows into bonds which need to be made up by someone.
Data via aaii.com/assetallocationsurvey
As of 2019, the Fed holds ~11% of all US debt via Treasuries.