Diary of a Financier

Credibility Trap: Markets Imposing Accountability for Quantitative Easing

In Economics on Wed 12 Sep 2012 at 00:20

I’ve been holding this entry in a drawer for more than a week, but I thought it needed to air out, to see the light of day. The developed world’s central bankers will continue their habit of disinflation with another round of Quantitative Easing, an extension of monetary policy with rates at the zero-bound (ZIRP). That being said, I doubt QE3 arrives with the FOMC meeting on September 13.

The Fed seems pleased with the effectiveness of its recent jawboning. After all, policymakers haven’t had to enact QE3, they’ve just had to threaten implementation. As such, the FOMC’s mere promise of proximate intervention has sufficiently guided expectations (and a desired market reaction) so as to not warrant actual action.

To wit, Michael Woodford, an economics professor at Columbia University, recently presented about “Accommodation at the Zero Lower Bound” at the global central bankers’ summit in Jackson Hole on August 31. Therein, Mr. Woodford asserted that balance sheet expansion (a la QEs) was not the most effective means of policy intervention within a ZIRP regime. He suggested that verbal commitments to targeted outcomes–such as nominal GDP targets–would be most effective.

That reminds me of currency pegging. Foreign Exchange pegs never work, because market participants eventually come to anticipate interventions after central banks have to repeatedly defend stated floors or ceilings. Hence, investors frontrun every subsequent intervention, their preemption occurring earlier and earlier until the actual intervention itself has no effect. Then, the central bank is considered impotent in affecting its target market, and the whole charade unravels. This feedback loop is a credibility trap.

Via the explicit promise of QEs–as destinct from the implicit “Bernanke put”–the Fed is progressing toward such a denouement. Upon Chairman Ben Bernanke’s first intimation of QE3, 5y5y forward inflation breakevens bounced higher from the low end of their range (~2%, which is a deflationary scare) to the high end of their range (~3%). Expectations have started frontrunning policy actions so far in advance that the Fed has questioned the efficacy of actually carrying-out its intervention. Currently, incremental POMOs are unwarranted by not only inflation expectations ~2.81%–a large number¹ relative to nominal interest rates–but also by asset values. In the history of Keynesian theory, this would be the first instance of material monetary easing ever conducted at market highs. More precisely, every other stimulus has been implemented at economic troughs. Yes, the S&P 500 is at four year highs, not to mention the commodity complex. Über procyclicality.

After all my blue-faced insistence, the main stream has begun to realize that the scope of monetary policy is limited. It’s an effective tool for building bridges over troubled waters, but it can’t propel the economy onward & upward. (Governments can try to aid such propulsion with fiscal stimulus, but economic sustainability depends on demographics and organic innovation.)

When the QE experiment fails, it won’t be becuase the market doesn’t discount the effect. The S&P 500 (SPX) will not repudiate stimulus; stocks won’t fade the Fed or crash. Rather, certain markets will force accountability back unto the Fed. Commodities like Crude Oil (CL/) will ratchet higher in anticipation. 5y5y breakevens and CPI will join in too. The Fed can not will not enact reflationary policy when the reflation has already occurred. In such an instance, implementation would push energy & commodity inflation too high, cannibalizing growth by preying on the country’s largest demographic consumers.

I want to be clear: inflation spurred by a shift in expectations is not the same as inflation by an increase in the money supply. I discussed this topic back in March 2011, when Mr. Bernanke himself mentioned the power of exploiting expectations:

I agreed with Ben Bernanke that inflation expectations are what matters most. I’ve asserted that actual inflation wasn’t alarming; rather, inflation expectations contributed to the reflexive feedback loop that pushed commodity prices higher.

Expectation-driven inflation is ephemeral. It fades upon the realization that a demand shock hasn’t occurred. After all, QE isn’t necessarily inflationary. The banks are the transmission mechanism through which the stimulus is funneled, and the banks aren’t lending. I’ve discussed this a few times before. QE stimulus is on deposit with the Fed, playing the carry trade in excess reserves. The Fed almost needs those excess reserves to remain there, not in the real economy, to avert material inflation. Plus, the liquidity granted the banks by the Fed is sterilized, although the term profile of such sterilization (T-bill/T-bond/MBS maturities from POMOs) is increasing via Operation Twist. So far, there’s little but expectations to materially push commodity prices higher; it’s certainly not justified by the fundamentals.

The Fed will never sell their POMO assets from QEs. That being said, there are only two outcomes here. First, rates normalize (rise out of ZIRP)–most likely due to accelerating growth rather than inflation. In this instance, the Fed would start remitting losses to the Treasury (e.g. taxpayer). That could create a cash[flow] shortfall for the government, which gets remedied by either more debt issuance–higher deficits that engender real inflation–or more currency printing from the Fed–also inflationary. Now, the Fed’s balance sheet is only ~20% of US GDP.  Were the Fed Funds Rate to rise 3%, I calculate ~$35B in losses, but the duration convexity steepens beyond that (e.g. 4% rise in rates = $140B in losses). Since the Treasury would reap higher income tax collections from rising growth, such losses aren’t enough to stymie the US government or economy.  However, I would worry about the duration risk in Europe (ECB balance sheet ~30% of GDP) and Japan (~35% GDP).  I don’t see how global developed markets will rise from ZIRP in concert. 

Second, the Fed may do everything in its power to avert such loss remittance, which permanent ZIRP characterized Japan’s lost decades (i.e. liquidity trap). Rock and a hard place.

If Mr. Bernanke were a market-fearing gentleman, which he is, I still think he’d give the market what it wants, just not this week:

‘These operations will focus on Agency Mortgage Backed Securities (MBS) with the flexibility to purchase other government/government sponsored assets–all on the long-end of the curve. This operation does not have a term limit. Its end-date is indefinite. Hence, the Federal Reserve will only deploy on an “as needed” basis.’

That’s open-ended and technically unlimited. He wouldn’t deploy it today, with Oil at $97 and SPX at 1433; he could deploy it nimbly if the market and the economy slip.

With the ECB’s Outright Monetary Transactions (OMT) having been announced already and QE3 expected (by the market) on Thursday, a lot of pundits are asking ‘to what end?’ The answer: ‘once the market demands accountability.’


¹5y5y forward inflation breakeven= 2.81%; 5y Treasury Yield (FVX)= 0.663%; 10y Treasury Yield (TNX)= 1.695%.

  1. Nice, clear piece. Thank you.

  2. […] for more information to push or pull it one way or another. It’s an anxious state of which I warned: “[M]arket participants eventually come to anticipate interventions after central banks have […]

  3. […] policy. Lately, that means emplying unconventional tools like Quantitative Easing. Yet, as I commented in September (just before the announcement of QE3), the Fed has created a credibility trap for […]

  4. […] necessarily make or break a long trade in Oil, but I’d prefer to have it on my side. As I’ve discussed before and you can see in the accompanying chart, 5y5y inflation expectations and WTI Oil normally […]


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