QE Has Overstayed Its Welcome

The stock market had a small decline on Thursday which was brought about by the collapse in brick and mortar retail stocks. Even with the decline in the S&P 500, the VIX continued its streak of closes below 11. The S&P 500 is still within 1% of its all-time high. The stock market is as quiet as the political landscape is exploding into chaos. I’m not saying that stocks should fall because of political disagreements. What I am saying is that a negative side effect of central bank intervention is political disillusionment. The economy, corporations, and consumers become like zombies when the natural business cycle isn’t allowed to function because central bankers want to prevent recessions. Ballooning stock valuations without real growth, increases the gap in inequality as those who own assets get richer while those who don’t are stuck in the same state. As I mentioned in my last article, rising healthcare costs and rent expenses may mean those who don’t own assets are in a worse state than before the recession.

The chart below summarizes the marginal benefits and costs to central banks boosting their balance sheets. This is the mainstream thought process. I’m a bit more skeptical than Citigroup. The fact that Citi is questioning the Fed’s actions shows that we’re near the end of this new paradigm of central bank interventionism.

The first benefit described is that central bank purchases take the uncertainty risk premia out of the market. This means the central banks can quell economic concerns whenever they arise. The uncertainty risk being taken out can be seen in the VIX being below 11 for 15 straight days which is the longest streak since the VIX was introduced. This is a short-term benefit which leads to long-term pain in the end. It’s same benefit of deficit spending. When the financial bubbles burst and when the government spending hits the limit, prognosticators will begin to wonder if the short-term gains were worth the ramifications the bust will bring.

The second bullet point shows that balance sheet expansion lowers real interest rates. That’s debatable because real rates remain low despite the Fed ending QE and discussing unwinding the balance sheet. It’s tough to grasp the exact effects QE has because while the Fed has stopped purchases, the Swiss Central Bank is buying American stocks and the ECB is buying $60 billion per month in bonds. The situation is dynamic and fluid. If there was a global coordinated pause in QE, we’d have real price discovery and have a better idea of how QE has been effecting asset prices.

The third bullet point on the positive side says the central bank asset purchases cause the wealth effect. Judging from some former FOMC members’ statements, the wealth effect was one of the reasons QE was implemented. This positive effect delves into the point of diminishing marginal returns that the graph is representing. There’s a vast difference between switching from collapsing stock prices to rising prices and pushing stocks higher when they were already in a bull market. QE1 reversed the collapse in the stock market and pushed it higher, while every QE since then has maintained the trajectory of stocks. In this mindset QE1 made sense and the others didn’t. To use an analogy, the pump has been primed too much. QE doesn’t have the same effect as the first time. It’s also debatable how much consumers boost their spending because their 401K is doing well. Retirement money isn’t spent right away. The consumer doesn’t act as the central bank expects. In Q1 of this year, real consumption spending barely grew even as stock prices ballooned higher after the election.

Getting into the negatives on the chart, asset allocation becomes distorted because of central bank buying. The scenario we’re in now is known as “TINA’ (there is no other option). Stocks are the only asset investors can justify buying because fixed income barely provides any returns. Investors need returns even though inflation is supposedly low. As I showed in the last article, medical costs and rent prices are increasing, so money is needed. The reason ‘TINA’ investing is bad is because investors begin to take more risk than they’re normally comfortable will. They’re getting similar returns with way more risk. Some investors who had purchased CDs are now buying stocks. They don’t see the risk because stocks are rising, but the risk is higher than ever because valuations are excessive.

The second bullet discusses distorted incentives. These arise when a central bank buys equity or debt in a corporation. The central bank isn’t buying the debt or equity because it finds it valuable. It’s buying it to manage the economy. This means no matter what the firm does, the central bank won’t sell it. The central bank would only sell it to affect the economy again. This micromanagement hurts the firms who aren’t lucky enough to be invested in by central banks. Apple stock is being boosted by the Swiss Central Bank. If other investors see Apple stock rising, they may buy in thinking that the firm is improving, but it’s just been selected by the central bank. This could cause a bubble in Apple stock.

Pension funds have larger deficits now than after the financial crisis because they invest in fixed income, holding the bonds to maturity. Bonds don’t have much return, so this strategy is being flummoxed. Pension funds are dipping into stocks now which feeds into the changes in asset allocation which I mentioned earlier.

The next bullet about inequality was discussed previously. Those who own financial assets have done well, while those who don’t have any have done poorly. Low inflation helps savers and hurts debtors. The final bullet describes how the banks’ profitability is hurt. Low Fed funds rates rates hurt their net interest margins.

Conclusion

QE has overstayed its welcome as the marginal costs are now exceeding the marginal benefits. The reason why I’m against all QE is because I believe that QE inherently doesn’t have an end game meaning once you start, you can’t stop. That thesis has been proven historically. If the Fed successfully shrinks its balance sheet by a couple trillion dollars with no economic consequences. I will have been proven wrong.

Spread the love

Comments are closed.