Can QE be reversed?

I just read a post on the subject of reversing quantitative easing.  Just a quick few points:

For a given velocity of asset focussed money supply and a given preferred allocation of money within the “asset portfolio”, the withdrawal of liquidity will impact the demand for assets via a) increased supply of certain assets, b) the reduced amount of money and hence readjustment of preferred percentage money allocation and c) via changes in asset preferences, in particular preferences for assets that may have increased in supply as QE was taking place. 

With QE, we have the introduction of higher levels of portfolio focussed cash with a reduction in relative supply of higher quality assets and this would cause problems if this also skews the universe of demand and supply for higher risk/less liquid assets: that is the universe pushes outwards.

As QE is reversed and money is withdrawn and lower risk/more liquid assets are injected into the asset portfolio, demand for higher risk/less liquid assets may drop as these assets are displaced within the asset portfolio: that is the asset universe contracts. 

The issue here is that we risk a secondary asset impact over and above the expected price adjustment of all assets as portfolio liquidity is withdrawn.  Unconventional monetary policy is likely to have altered the asset profile of the asset portfolio and this adjusted profile is likely to be hit most at its weaker newly developed extremities . 

The risk is that certain asset classes get crushed in the rush for the exits.  The question is how much does the market for these asset classes at the outer edge of the universe get impacted and to what extent will this likewise impact consumption and future consumption expectations?  If you cannot sell an asset you bought at a certain price with an expectation over a future value with any degree of certainty, then we have a discounted present value demand shock.  If QE is substantial and the potential reverse substantial too, this shock can be quite large.

QE may not just have impacted pricing but also market structure, liquidity, and introduced larger amounts of higher risk/less liquid assets into core portfolio destinations than would have occurred without it.

This is not a complete analysis by any means but we have changed the nature and structure of asset markets and therefore the relationship with asset markets and consumption functions. 

I discussed some of these issues in another related post:

A brief “thought” on debt defaults, asset prices, MS velocity and consumption expenditure risks.

A brief “thought” on debt defaults, asset prices, MS velocity and consumption expenditure risks.

When a private non bank debt collapses the money supply itself is not impacted.  There is however a collateral impact on future expenditure and the velocity of money supply itself.

Asset values are extremely sensitive to portfolio cash allocations.  A given reduction in preferred cash holdings relative to other assets, all other things equal, raises asset prices by a much greater magnitude and vice versa. 

However not all transactions represent closed loops: a disposal of an asset for future consumption transfers asset focussed money supply to consumption focussed money supply.  With money also being transferred in to the asset portfolio the net impact on asset values of consumption related transactions tends to be much smaller.

A default in non bank debt, or loss of any asset, should therefore have an impact on future MS velocity and expenditure while also possibly increasing the asset focus of money supply (all else being equal).  In the event of default, assets/collateral are no longer available for sale in exchange for money for consumption expenditure purposes (and of course investment expenditure purposes) and the potential velocity of money supply falls, specifically with respect to consumption and possibly also with respect to assets. 

Likewise a fall in asset values, especially the significant declines seen in recent decades, also impacts expenditure and MS consumption focussed velocity. Typically asset price declines have been short lived and given the fact that marginal transfers out of the global asset portfolio for consumption purposes has tended to be small in % terms, the impact of price declines etc on expenditure has also historically been small – this is especially so where asset focussed money supply growth has been expanding, demand for assets have been expanding (+ve population growth and demographic dynamics), where there is increasing income inequality (less MS flows out of the asset portfolio etc), but much less so in the reverse scenario.  

QE on the other hand has tended to focus primarily on supporting the financial system and high quality assets with minimal risk of default.   Whether it impacts expenditure decisions depends on the liability profiles of asset holders in general.  In a world of increasing income and wealth inequality asset price support may have only declining marginal benefits for consumption expenditure even though the resulting increase in asset focussed MS has affected a much wider range of asset prices. 

QE and low interest rate policy may well have supported potential expenditure based relationship loops from assets to consumption via asset price support based solely on asset valuations (not re yields) but may also, via increased risk taking within the higher yield/shadow banking asset spectrum, have increased the consumption sensitivity of assets; higher yielding assets are likely to be more consumption sensitive than lower yielding equity type assets.  

QE and lower IRs may well have increased the exposure of consumption and possibly also investment expenditure to future asset price shocks via two routes:

Increased exposure to leveraged loans, emerging market debt, high yield bonds, collateralised debt/loan investments, “wealth management products” (China) etc, exposes future consumption expenditure to higher default based risks, especially in high debt/low growth environments.  This depends on the extent to which QE has pushed investors out of lower risk higher yielding assets into higher risk/relatively higher yielding assets and the changing composition of the market portfolio especially with respect to those investors exposed to higher future liability demands.

Higher asset prices in low growth environments with increasing debt to GDP ratios also exposes consumption and investment expenditure to greater asset price volatility: we have seen quite extreme fluctuations in asset prices since the late 1990s.  As populations age the sensitivity of expenditure to asset prices increase.

The issue of default and asset price shock is compounded by issues of liquidity, especially with regard to many shadow banking products that investors may confuse as being cash like and therefore exposed to greater liquidity risks in risk events.

It is probable given the higher debt to GDP ratios, slower growth profiles and the many transition risks in the global economy, that global asset price consumption risks are not insignificant.  Another reason to support asset prices, another reason for QE and negative IRs, but not necessarily a solution.

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I am not a fan of outsized monetary accommodation in a declining growth frame…but what can you do?

Irrespective, deflation is not the issue, but slowing growth within a complex frame over burdened with financial excess and key structural imbalances. 

A recent speech by Andy Haldane has kept the interest rate/zero lower bound debate “bubbling”.   In this speech, “How Low Can You Go”, Haldane broached the issue of monetary policy in the event of another demand shock.  He is quite right to do so since monetary policy would have little room for manoeuvre with interest rates only a scuff mark away from 0%.  His musings suggested getting rid of cash and bringing in negative rates.

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The China Crisis may be signalling the end of the “rationale” for zero lower bound asset price support.

I do not think that anyone really suspects that we are at the start of an aggressive tightening of interest rates by the Federal Reserve.   A 1/4 point increase in rates would be unlikely to do anything much to growth even at today’s relatively low rate of GDP growth.

In truth, the problems with GDP are not necessarily to do with interest rate costs in the sense that growth is not being held back by the cost of money.  Today’s low interest rates are here pretty much as part of an asset price support operation, as is QE.  The reason why they have remained so low, post 2008 (in the US at least), is because of the increasing importance of asset market stability (given debt levels) to the financial system in a low growth, post financial shock, environment.  

As such, interest rate and monetary policy have been supporting the asset price/GDP disconnect post the financial crisis on the assumption that the shock to growth was temporary and transitory.  Unfortunately the impact of the financial crisis on growth was neither, partly because debt levels were higher than could be supported by GDP growth pre crisis, but also because underlying growth, ex monetary/debt stimulus, was declining, for a number of reasons.

Post crisis, what we have had globally is an increase in debt levels, while pre crisis growth levels have not recovered.  The temporary asset price support operation has lasted longer than expected and has facilitated a further increase in asset focussed MS (increasing instability of the financial system), asset prices and asset focussed debt.

Do interest rates need to rise to prevent inflation surging ahead in the US economy? 

Wage growth remains weak and there does not appear to be material capacity constraints at any level.  The only real concern is rising consumer credit: consumer credit relative to income growth, especially non revolving credit, has been rising at historically high levels post crisis.  This hearkens back to fundamental issues in the structure and distribution of key growth drivers that are independent of interest rate factors. 

Low interest rates/QE have enabled further divergence between assets and debt and GDP and income growth, something that I do not believe was originally intended by Fed monetary policy.   The key decision factor for the Fed is not whether this is the right time to raise interest rates at an economic level, but whether there are other more critical forces restricting growth and, as such, whether it is prudent to continue to juice asset/debt markets.  In a low growth environment a ZLB interest policy is only going to create further divergences between asset prices, asset focussed MS/debt and GDP and other key flows supporting GDP.  

I also believe that China’s current problems are signalling an end to the belief that weak growth post crisis was temporary and that unconventional and unusual monetary policy supporting asset prices/debt was valid and the risks containable.  Otherwise, well, interest policy is no more than a “hope and pray” one that supports the build up of market and financial risks relative to growth. 

Thus the Fed when deciding whether or not to raise rates is ultimately deciding the size and timing of the end game: a greater risk later or a lesser, but by no means small, risk now.  I suspect the Fed realises it has delayed a rate rise for far too long, but I also question whether it wishes to sustain the impression that it can be swayed by short term market movements forever.  Does it want to be looked upon as Sisyphus eternally dropping the interest rate ball?   

“Marketplace lenders step out of the shadows in Canada — should we be worried?”

Brief thoughts re a recent Barbara Schechter article: Marketplace lenders step out of the shadows in Canada — should we be worried?

I tweeted on this. Some additional comments.  Peer to peer lending is different from bank lending in that it does not result in an increase in money supply growth.  It may result in an increase in velocity of money supply, something which has been dropping of late in many economies as a result of quantitative easing and a number of other dynamics.  It should also increase the efficiency of the intermediation system by offering lower interest rates and quicker access to credit to many borrowers.   There are some cons: one of which is that it will increase the liquidity risks in the system in the event of an economic downturn/ financial market crisis.  This of course depends on how many may view their loans as money like when they have been transformed and how this market place securitises the loan book.   At the present moment in time it may also increase the amount of consumer debt over and above safe levels, although this would not necessarily be an issue in less leveraged environments.  

Re Andy Haldane: my brief comments on deflationary risks and interest rates

This is a quickly penned thought on Andy Haldane’s recent comments on interest rates and deflation:

In a recent speech Andy Haldane of the Bank of England suggested that interest rates may well need to fall as opposed to rise following on from recent falls in inflation.   I would agree that the secondary impacts of price declines need to be seen before we can assess whether or not these price falls could indeed trigger stronger deflationary forces.

For one, price declines may lead to lower revenues (note US retail sales) and lower revenues may impact on wage increases.

Secondly, lower revenues impact cash flows and cash flows impact asset prices, especially for high yield debt in sensitive sectors.   Global markets remain especially sensitive to asset price movements and factors which may impact asset prices.

Thirdly, we are in a complex deflationary frame where aging populations, slowing population growth and relative weakness in corporate investment (note buybacks) is already a significant drag on the global economy.  Falling prices could well trigger latent dynamics in this structure.

And finally, areas of the world which could well create the demand necessary to reinvigorate the frame, for example China where growth appears to be slowing sharply, may also be adding to tensions within the global growth frame.

So yes, interest rates could fall, in the sense of defending asset prices and attempting somehow (I do not quite know how) to reinvigorate or at least support demand, or rather maintain marginal cash flows.

But in reality we do not know because we lack at the moment a measure of the sensitivity of the frame to short term shocks of any financial or economic nature.  We know the frame is weak and has been for some time but as to its sensitivity, we know very little.

Calls for higher inflation targets

In a recent post,”There’s nothing left-wing about a higher inflation target”, Tony Yates called for an increase in the Bank of England’s inflation target from 2% to 4%.  Raising the inflation target for some reason would allow for higher interest rates that would provide the necessary leeway to combat economic downturns without being hemmed in by the zero lower bound.

While I do not necessarily agree with the statement I do agree with the dynamics that quite possibly underlie it.   Yes, if the inflation target had been higher central banks may not have been as aggressive keeping inflation under control and possibly inflation may not have fallen to current levels.   Interest rates may therefore not have trended down from the early 1990s to their pre crisis levels.

If interest rates had not moved downwards over this period then it is likely that we would have seen much less asset focussed debt creation and the foundations of the crisis that led to a precipitous immediate drop in growth and weaker growth post crisis would likely  have been somewhat curtailed.   The fact interest rates are hemmed in at the lower bound though has more to do with the dynamics of high levels of debt and their relationship with high asset values amidst the constraints of low economic/income growth.  In other words it is the past that has the greater weight, not the future.  So yes, clearly, without the debt accumulation and with higher interest rates we would possibly not be at this particular chokehold. 

But, interest rates did not fall solely because inflation fell, they fell because growth rates were also falling and because of a number of financial shocks to growth starting in the late 1990s.   In a sense interest rates fell to stimulate growth and anything that stimulates growth also risks stimulating inflation.   That it did not is a very moot point. 

In reality, all other things being equal, where inflation is caused by imbalances between supply and demand, the higher the inflation target you have the lower the interest rate target, and since I believe that lower interest rates have helped foster successive financial bubbles I am concerned over the integrity of higher inflation targets per se given the dynamics.   I would have preferred higher interest rate targets and less monetary stimulus even if this had meant a lower growth trajectory.   I can see little wrong with low inflation within a structurally stable economic framework.   

But let us suppose the argument is one of expectations and by raising the Bank’s own inflation targets so will the general public.  I think if this was the case the article should have clearly expressed it.  I do not personally feel that today’s deflation is led by individuals delaying expenditure in the expectation of lower prices tomorrow, although this does not mean it could not start to happen.   The question is, after all the best efforts of central banks the world over to stimulate growth over the last 20 years have led to the present moment in time of low interest rates and falling prices, how will putting an expectation of higher inflation into CB policy actually raise both inflation and interest rates?

Perhaps by raising inflation expectations we may cause consumers to spend more and save less.   But this assumes that people are spending less than they are capable of (the wealthy “1%” perhaps, but do they need to spend more?) as well as the fact that deflation is impacting the saving/spending decisions of consumers. 

Personally I would rather have seen a higher interest rate framework and reduced asset focussed money supply growth with lower potential inflation implications than the situation we are currently in.  It has less to do with inflation and more to do with structural economic integrity.   Trying to stimulate expenditure via every manner possible has led us into all sorts of problems.

Bank of England Stress Test

“..the stress-test results and banks’ capital plans, taken together, indicated that the banking system would have the capacity to maintain its core functions in a stress scenario. Therefore, the FPC judged that no system-wide, macro prudential actions were needed in response to the stress test.”

My main concern with the stress tests is that the explanatory document came bereft of the underlying economic scenarios!   How far did GDP fall, for how long and what was the recovery like?  Did IRs stay at an elevated 4+ plus from current levels or did they fall?  I have not got a clue as this exercise seemed to focus on fairly extreme contractions in domestic property markets, higher interest rates and some assumptions re mortgage, personal debt and CRE defaults.

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An addendum to “Sword of Damocles”

Money supply and monetary transmission are important entities and functions within our system.    Usually, even broad money supply is well defined, but I was getting to thinking about shadow banking assets and the identities they may have in the minds of those who supply the funds.   Shadow banks are not deposit takers so they do not actually hold “money”, but they do hold assets that their investors may consider to be money like, i.e high yielding cash substitutes, within their portfolios.

Now if perceived money supply is actually higher and we have an asset price shock, we also have a monetary shock by default.  Now this is just a quick “throw the thought out in the air”, but if the shadow banking system is also messing with identities and virtual money supply, things may well be more complex than we think they are as things start to unravel.

Just 30 second blog….

With monetary transmission impaired we may be in a perpetual “Sword of Damocles” moment

It may be that the monetary transmission mechanism is impaired through the structural imbalances that have developed within global economies over the last 20 years (+/-). If the transmission mechanism is impaired then we are in a perpetual “Sword of Damocles moment.”

The recent IMF blog, “The New Global Imbalance: Too Much Financial Risk-Taking, Not Enough Economic-Risk Taking” introduces a well known pre existing dynamic as “a new global imbalance”:

Policymakers are facing a new global imbalance: not enough economic risk-taking in support of growth, but increasing excesses in financial risk-taking posing stability challenges

We have been in a declining capital and human investment scenario for some time (discussed in many a recent blog), in many key developed economies, and we have been in a paradigm of increased financial leverage/asset focussed money supply growth.  This is not new and is the primary reason why we are pinned to the economic floor with the proverbial boot pressed to our throats.  I discussed this also in a recent blog…  

The IMF rightly points to the risks posed by the shadow banking financial system:

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The economic crisis was not a Monte Carlo event. My comments on Prof Sufi’s statement to Senate Sub Committee on Banking, Housing and Urban Affairs

I must admit I have not read the House of Debt, but I did read Professor Sufi’s statement to the Senate Subcommittee on Banking, Housing and Urban Affairs Subcommittee on Economic Policy.

While I agree with a lot of what Professor Sufi says about the impact of debt (I also share his concerns about income growth and about the worrying trend in auto loans) I disagree with the angle of a number of his statements:

How did we get into this mess? And why is it taking so long to recover? My research with Atif Mian at Princeton University suggests that the culprit is the devastation of wealth suffered by middle and lower income American households during the Great Recession.  The weak recovery is due in part to the lack of any rebound in wealth among these households since the end of the recession.

It was not the devastation of wealth per se but the accumulation of debt combined with invigorating domestic and global structural imbalances that led to the crisis.  The increase in the value of homes prior to the housing collapse was a consequence of excessive asset focussed money supply growth, lax lending standards and attendant growth in consumer debt.  To pin the blame on asset prices incorrectly ascribes blame to the natural risk and volatility of asset prices.

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Comments on Bank of England’s Quarterly Bulletin on Household Debt and Spending

The Bank of England report “Household debt and spending” stated that “it is difficult to evaluate whether debt has had any impact on UK household spending using aggregate data alone. Indeed, UK consumption grew at roughly the same rate between 1999 and 2007, when debt was rising rapidly, as it did between 1992 and 1998, when debt did not increase relative to income. This, together with the fact that increases in household debt were largely matched by a build-up in assets, is consistent with the suggestion that increases in debt did not provide significant support to consumption.”

First of all household expenditure did not grow at roughly the same rates over this period:

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I have used the start point for the analysis as the peak of the previous economic cycle given that part of the growth in the early 1990s would have been due the rebound in consumption from this earlier recession.  In fact, we can see that growth initially accelerated to Q4 1994, but then set off again on a second substantial leg that peaked between Q1 2000 and Q4 2001.

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Shadow Banking:The Money View.. An Office of Financial Research paper

Shadow Banking:The Money View.. An Office of Financial Research paper..

A must read for anyone concerned with systemic risk issues to factors impacting asset class return and anyone interested in a comprehensive primer on the operation of today’s money markets.   As the following two quotes surmise, the shadow banking sector has developed to the extent it has by virtue of certain structural economic imbalances and financial system checks and balances are not set up to manage the risks of this new plumbing.

one way to interpret shadow banking is as the financial economy reflection of real economy imbalances caused by excess global savings, slowing potential growth, and the rising share of corporate profits relative to wages in national income.

From a policy perspective, the fundamental problem at hand is a financial ecosystem that has outgrown the safety net that was put around it many years ago. Today we have a different class of savers (cash PMs versus retail depositors), a different class of borrowers (risk PMs to enhance investment returns via financial leverage versus ultimate borrowers to enhance their ability to spend via loans) and a different class of intermediaries (dealers who do securities financing versus banks that finance the economy directly via loans) to whom discount window access and deposit insurance do not apply.

The document also discussed the need to have better measures of “money supply” than the narrow money measures of insured deposits.  

I for one am concerned over the large shadow banking cash pools and the financing mechanisms of today’s repo markets.   At the top of my mind is a large question mark over the interplay between QE and today’s money/collateral/derivatives markets and the impact monetary tightening will have on the shadow banking system.

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Is the balance sheet recession over? Financial sector debt…

Financial sector debt (and as noted consumer debt) has fallen significantly since the crisis:

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Yet, if we look at the financial sector assets with respect to non financial sector credit market debt, we start to see an interesting picture:

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Central Banks and bubbles..

I do find it funny to see how many rely on the words of central banks to determine whether markets are or are not in bubble territory.   Central banks these days are in the business of mind manipulation for the furtherance of asset price stability and economic survival and to expect them to malign the object of their obvious intent would be insanity.  Central banks are supporting asset prices for balance sheet purposes and to suggest these prices were in bubble territory would be counterintuitive.  

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China Growth: when gross investment obesity is supposed to be a good thing!

Investment is key to maintaining production, growing production, increasing the productivity of employees, in allowing goods to be transported quickly and efficiently, in providing better health care and education and all types of infrastructure key to allowing an economy’s resources to be used efficiently.  Growing investment typically leads to growing output and incomes, but capital investment also requires return, and a good part of that return is private consumption expenditure.

So why should we be concerned over the most recent quarter’s large capital investment component of current Chinese GDP?  Much too large an investment component, a much smaller private consumption component and a decline in net exports.

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An exercise in going where your thoughts lead! “Perhaps, perhaps” says the Fed about QE!

On its own, I would not place too much weight on today’s movements in US securities: people have been building up the pricing risk of a change in Fed Strategy for some time and today’s movements reflect only a very miniscule readjustment. 

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US Industrial/Manufacturing Production and cars per capita..

We know the main PMI index weakened in April and the two most recent regional PMIs also disappointed (Phil Fed/NY Empire State) and March industrial/manufacturing output confirmed a weaker manufacturing picture.  The most recent NFIB report, while showing improvement, was still decidedly gloomy.

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As it came to pieces in my hands…

Paul Weller: “I stood as tall as a mountain; I never really thought about the drop; I trod over rocks to get there; Just so I could stand on top; Clumsy and blind I stumbled;…I didn’t stop to think about the consequences; As it came to pieces in my hands.”

The 2008 crisis told us that there was a mismatch between asset values and debt, asset values and future return, and debt and economic growth as well as some rather large structural economic imbalances.

We have tried to delay the eventuality implied by the difference in the hope that the “true” magical economic growth rate should return. Have we built up a bigger monster, and if so, how do we slay the beast?

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Aggressive, desperate or, by necessity, both? Is this the last throw of the dice?

I hate the phrase quantitative easing, it is a bit like calling an apple, Malus Domestica-Borkh.  But QE is no apple, it is a rigged game as far as investors are concerned, and the Fed is playing on the market’s irrationality, and its passion for the short term, to pump a little more blood into the valves. 

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B of E June 2012 Financial Stability Report

A good read which details all the main balance sheet issues for UK and, by implication, international banks:  Bank of England Financial Stability Report June 2012:

The outlook for financial stability has deteriorated. Stresses have persisted due to increasing concerns about sovereign debt sustainability, banking sector resilience and imbalances across the euro area. Past efforts by UK banks to build resilience through higher capital levels and stronger funding structures have provided some insulation from strains in the euro area. And higher liquid asset buffers provide significant protection against potential future funding strains. But progress in building capital has slowed recently and, despite a continuing reduction of structural funding vulnerabilities, UK banks’ funding costs remain high, partly due to investors’ concerns about potential future losses. The pass-through of higher funding costs to lending rates could lead to a further tightening of credit conditions, exacerbating a potential adverse feedback loop were the economy to weaken and the quality of bank assets to deteriorate. Various policy measures have been announced aimed at reversing this process, notably the ‘funding for lending’ scheme.