Hoisington 4th Quarter Review: Failure of the Fed, How QE Acts to Contract the Economy
Lacy Hunt at Hoisington Management emailed their 6-page fourth quarter report (not yet posted on the Hoisington Website).
As always, the report is well worth a good look. One particular section caught my eye. It's on the failure of QE to produce the expected growth. Here are a few excerpts.
In a paper presented at the Fed's 2013 Jackson Hole Conference, Robert Hall of Stanford University and Chair of the National Bureau of Economic Research Cycle Dating Committee wrote "an expansion of reserves contracts the economy."
Causal Mechanism Explains Counter-Productiveness of QE and Forward Guidance
This empirical data [the Jackson Hole presentation] notwithstanding, a causal explanation of why QE and forward guidance should have had negative consequences was lacking.
This void has now been addressed by "Where Did the Growth Go?" by Michael Spence (2001 recipient of the Nobel Prize in economics) and Kevin M. Warsh (former Governor of the Federal Reserve), a chapter in a new book Growing Global: Lessons for the New Enterprise, published in November 2015 by The Center for Global Enterprise.
Their line of reasoning is that the adverse impact of monetary policy on economic growth resulted from the impact on business investment in plant and equipment.
In particular, they state: "We believe the novel, long-term use of extraordinary monetary policy systematically biases decision-makers toward financial assets and away from real assets."
Quantitative easing and zero interest rates shifted capital from the real domestic economy to financial assets at home and abroad due to four considerations:
First, financial assets can be short-lived, in the sense that share buybacks and other financial transactions can be curtailed easily and at any time. CEOs cannot be certain about the consequences of unwinding QE on the real economy. The resulting risk aversion translates to a preference for shorter-term commitments, such as financial assets.
Second, financial assets are more liquid. In a financial crisis, capital equipment and other real assets are extremely illiquid. Financial assets can be sold if survivability is at stake, and as is often said, "illiquidity can be fatal."
Third, QE "in effect if not by design" reduces volatility of financial markets but not the volatility of real asset prices. Like 2007, actual macro risk may be the highest when market measures of volatility are the lowest. "Thus financial assets tend to outperform real assets because market volatility is lower than real economic volatility."
Fourth, QE works by a "signaling effect" rather than by any actual policy operations. Event studies show QE is viewed positively, while the removal of QE is viewed negatively. Thus, market participants believe QE puts a floor under financial asset prices.
According to a Spence and Warsh op-ed article in the Wall Street Journal (Oct. 26, 2015), "... only about half of the profit improvement in the current period is from business operation; the balance of earnings-per-share gains arose from record levels of share buybacks. So the quality of earnings is as deficient as its quantity."
The Fed Has Hurt Business Investment
It is certainly not news in this corner that QE has been counterproductive, but I have never seen a better explanation as to precisely why than the above excerpts.
Digging a little further, and following the op-ed reference above, I located the Wall Street Journal commentary The Fed Has Hurt Business Investment by Michael Spense and Kevin Warsh.
On his recent book tour, former Federal Reserve Chairman Ben Bernanke stated that low long-term interest rates are not the Fed's doing. Low rates result from a shortage of good capital projects. If there were good investment projects, he explained, capital would flow and interest rates would rise. Mr. Bernanke insists that the absence of compelling investment opportunities in the real economy justifies continued, highly accommodative monetary policy.
That may well be true according to economic textbooks. But textbooks presume the normal conduct of policy and that the prices of financial assets like stocks and bonds are broadly consistent with expectations for the real economy. Nothing could be further from the truth in the current recovery.
During the past five years earnings of the S&P 500 have grown about 6.9% annually. As the table nearby shows the current profit picture pales in comparison to prior economic expansions, in which earnings grew significantly faster. Moreover, only about half of the profit improvement in the current period is from business operations; the balance of earnings-per-share gains arose from record levels of share buybacks. So the quality of earnings is as deficient as its quantity. The current economic expansion is also unusual because the stock market and other financial assets have boomed in spite of relatively muted profit gains.
What explains the apparent divergence between earnings and asset prices? The unusual conduct of monetary policy.
A Little Humility, Please, Mr. Summers
In a follow-up Wall Street Journal opinion piece Michael Spense and Kevin Warsh take on Larry Summers in A Little Humility, Please, Mr. Summers.
In a recent op-ed for this newspaper, we proffered an explanation for a phenomenon that most macroeconomic models cannot adequately explain: Why is investment in U.S. financial assets so strong and investment in the real economy so modest?
Former U.S. Treasury secretary and Harvard president Larry Summers took issue with our views on his blog. He was one of the principal architects of the U.S. government's fiscal and regulatory response, and is among the foremost defenders of the recent conduct of monetary policy. So, Mr. Summers is understandably a fierce defender of the current regime. But his breathless defense of the consequences of extraordinary monetary policy reveals a troubling immodesty.
We would suggest more humility in considering the full consequences that may arise from the new tools and tendencies in the conduct of monetary policy.
First, Mr. Summers mischaracterizes what he calls the "Spence-Warsh doctrine." He sets out the straw man for his censure, stating Spence and Warsh believe "overly easy monetary policy reduces business investment." This is an interesting proposition, but it does not happen to be the one we make. Instead, we posit something quite different: "QE [quantitative easing] has redirected capital from the real domestic economy to financial assets."
By conflating low interest-rate policy with the use of QE, Mr. Summers apparently believes that these policy tools are similar in application and effect. We disagree. We believe that QE is fundamentally different in kind than standard-issue low rate policy. And QE, we argue, appears to work through different transmission mechanisms than the standard conduct of monetary policy. Event studies in the U.S. and abroad suggest that QE appears to have far great effect through the asset price channel than the lending, credit and confidence channels. As a result, risk assets like stocks respond to QE more robustly than does the real side of the economy.
Weakest Expansion Ever
Spence and Warsh go on with three other points disputing nonsense by Larry Summers.
It's a welcome breath of fresh air that I previously missed. Here is a chart from the article.
Squawk Box Confessional
Summers, Bernanke, Yellen and their ilk ought to explain former Dallas Fed Richard Fisher confession on Squawk Box "We Frontloaded a Tremendous Market Rally".
In his confession, Fisher admits "We frontloaded a tremendous market rally to create a wealth effect ... The Federal Reserve is a giant weapon that has no ammunition left."
The alleged "wealth effect" is an illusion. It will vanish, with severe consequences, either in the next big downturn, or via a long drawn out process like Japan.
Ben Bernanke stated "In theory, QE does not work, in practice it does."
Bernanke, like summers is wrong. If anyone in this world needs a dose of humility, it's Bernanke and his "we saved the world" nonsense.
The Fed is largely responsible for the Dotcom bubble, the housing bubble, and the current bubble (none of which they have seen in advance), and none of which they have admitted any responsibility over.
I predict Janet Yellen will resign as Fed chair for health reasons.
Summers is so damn arrogant and so damn wrong that he must be considered the front-runner to replace Yellen.
Greenspan, Bernanke, and Yellen have pushed the global economy to the edge of a cliff. It would be fitting in a sense, if Summers, carrying out the exact same policies, pushes us over the edge.