Why QE was a successful failure

Taken at face value, the most massive expansion of a major central bank's balance sheet in history, in which almost $2.5 trillion was added to the U.S. monetary base for the purpose of artificially lowering long-term interest rates in order to stimulate the economy, was a failure. Why? Because 10-yr Treasury yields are no lower today than they were when QE1 was first announced in late November, 2008, and 30-yr Treasury yields are actually a bit higher, and because real GDP has grown at a 1.6% annualized pace over the same period, making this the weakest recovery on record. These facts say that the Fed was incapable of bringing down interest rates, and did absolutely nothing to boost the economy.

The first round of Quantitative Easing involved the purchase of about $1.3 trillion of MBS, $0.3 trillion of Treasuries, and $0.1 trillion of Agency debt. Over the course of 17 months, Fed purchases essentially doubled the monetary base. With the addition of QE 2 and QE 3, the Fed has effectively quadruped the size of the monetary base compared to what it was at the end of the third quarter 2008. The last five years of U.S. monetary history were absolutely unprecedented in both size and scope, and for that reason alone there has been much confusion as to what was really happening. Was the Fed crazy? Did they want to destroy the dollar and bring on hyperinflation? Was the economy so weak that gargantuan amounts of monetary stimulus failed to move the economic needle?

The chart above shows the periods during which each QE program was in effect. In addition, it shows the 15-month period during which the Fed attempted, via what it called "Operation Twist," to bring down long-term rates by selling short-term securities and buying long-term securities. Note how 10-yr yields ended up higher at the end of each round of QE, and how they were unchanged at the conclusion of Operation Twist. There is absolutely no evidence here that quantitative easing has lowered interest rates.

Part of the Fed's balance sheet expansion, almost $400 billion, was necessary to allow the expansion of currency in circulation, which has grown at an 8% annualized pace since the third quarter of 2008. Since the Fed only issues currency on demand, this expansion is not considered to be "stimulative." This is what the Fed needed to do to accommodate the very strong worldwide demand for U.S. currency during a time of financial market and economic turmoil. Most of the remainder of the reserves created by QE is being held today in the form of "excess reserves." Banks have apparently been content to accumulate a massive amount of reserves (which are not money and are held on the Fed's books) because they are functionally equivalent (and in a sense superior) to T-bills. Reserves are virtually as safe as T-bills, since the Fed can't default, and they carry what is presumed to be a floating interest rate. Reserves currently pay an interest rate of 0.25%, which is more than the 0.05% rate of interest that can be had on actual T-bills.

It's hard to believe, but the net result of the Fed's Treasury bond purchases was to restore the Fed's holding of marketable Treasuries to about the same percentage as it held prior to 2008. This obscures the fact, however, that most of the decline in the Fed's holdings of Treasuries in early 2008 was the result of the Fed's sale of most of its T-bill holdings, which in turn was necessary given the world's voracious demand for safe assets at the time; bills were in desperately short supply at the time.

BUT, when viewed from a different perspective, the Fed's balance sheet expansion was a success, since (with the benefit of hindsight) it served to accommodate the world's enormous demand for safe assets. In effect, the Fed's monetary expansion was equal to the world's increased demand for safe assets. Without all that QE, there would have been a serious shortage of safe money in the world, and that could have been deflationary and/or contractionary.

As the chart above shows, there has been no acceleration of inflation since the Fed began its aggressive balance sheet expansion. Indeed, many have worried that inflation in recent years has been too low. To borrow from Milton Friedman's classic description of inflation, we can argue from the evidence (inflation, or the lack thereof) that the Fed's supply of money was not greater than the world's demand for money. It was pretty close to being just about right.

If there is any revelation here, it is that the real point of QE was not to lower bond yields, but to create bank reserves for a world that desperately wanted them. It also follows, I would argue, that the Fed has little or no power to directly influence bond yields. Bond yields are determined by the market's desire to hold the outstanding stock of bonds, which is measured in the tens of trillions, since a good portion of the global bond market trades relative to Treasuries. The Fed's bond purchases have been paltry in comparison to the size of global bond market. Since Fed purchases have little or no impact on bond yields (or the economy), then it follows that the cessation of such purchases should have little or no impact either. Tapering is not something to fear.

Finally, this analysis suggests that bond yields are up over the past year not because the Fed is considering tapering its purchases, but because the market is less eager to hold bonds at extremely yields. The world's declining demand for bonds, in turn, is likely related to the market's growing perception that the U.S. economy rests on a more solid foundation these days—that the economy is more likely to be able to sustain growth in the future. As fears decline, the demand for safe assets declines as well, and this can be seen in the 25% decline in the price of gold over the past nine months and in the 130 bps rise in real yields on 5-yr TIPS.

In this sense, the rise of bond yields and the apparent "failure" of QE is actually a testament to the Fed's success. Bond yields are up because the world is leaving behind the fear and loathing that kept bond yields depressed for the past several years, and the Fed—through its aggressive provision of bank reserves—can take a good deal of credit for vanquishing the fears which have contributed to keep economic growth rates disappointingly slow.

Quantitative Easing: the financial world's biggest, most spectacular, and most successful "failure."

More background on many of the points touched on in this post can be found here, here, here, and here.

Federal budget progress continues

In today's WSJ, Steve Moore echoes my thoughts from last month on the incredible shrinking federal budget deficit. Yes, "The biggest underreported story out of Washington this year is ... the federal budget ... shrinking ... much more than anyone in either party expected." And with the July numbers released today, the story hasn't changed, although the 12-month deficit inched up from $694 to $722 billion. The progress is mostly due to a pronounced slowdown (and even a recent shrinking) of federal spending. At the same time, a growing economy, rising incomes and corporate profits have boosted revenues to new highs. 

Spending has dropped almost 4% over the past year, while revenues are up almost 13%. As the second chart above shows, revenues have been higher than their year-ago level every month for the past several years; this is not just the front-loading of incomes that happened last December in order to beat higher expected tax rates—this is ongoing and likely to continue. It's the sort of thing that happens in every recovery. But we've never seen a slowdown in spending since WW II. That is big news.

The budget deficit is now down to only 4.2% of GDP. Just a few years ago we were all worried that the runaway budget deficit would be the ruin of us all. Now the deficit is back down to levels that are easily manageable. To be sure, entitlement spending promises to reverse this in coming years, but for now things are under control and entitlements are not cast in stone.

This is very good news because it all but eliminates the rationale for higher tax rates, and it has resulted in a serious shrinkage of the relative size of the federal government, from a high of 24.4% of GDP in 2009 to only 20.7% today. That's a whopping 15% reduction in the size and burden of government in just under four years. This gives the private sector some badly-needed breathing room, and that's a good reason to expect somewhat stronger economic growth in the years to come.

Claims keep declining

First-time claims for unemployment came in as expected, but the more important news is that they continue to trend lower.

This chart shows the long-term trend of claims (using their 4-week moving average) and the 52-week moving average of that. Clearly, the trend remains down. There is no sign at all of any deterioration in the labor market as of last week. There is thus no reason to think that the economy can't continue to grow by at least 2%.

As the above chart of 10-yr Treasury yields shows, rates have moved sharply higher in the last few months, and are significantly higher than they were at last summer's low. This, despite valiant efforts by the Fed to purchase Treasuries and MBS. It's worth repeating that this is not really a paradox, since it merely goes to show that the Fed has very little power to artificially depress interest rates. Fed purchases may seem large, but they are very small in relation to the outstanding stock of bonds, all of which are priced off Treasuries. The market sets bond yields. The market has taken interest rates higher because the market has more confidence in the economy's ability to grow. Thus, QE makes less sense, and the tapering of QE seems reasonable. The bond market is even looking ahead to the day when the Fed not only stops buying bonds but begins to raise the interest rate it pays on reserves.

According to Fed funds and Eurodollar futures contracts, the market doesn't expect the Fed to raise rates meaningfully for the next two years (June Fed funds futures currently reflect a tightening of only 25 bps, to 0.5%). According to the market's current thinking, therefore, the tapering of QE may take many months, and the beginnings of a modest tightening could be two years in the making. This is hardly a scary picture. Indeed, if the economy continues with present trends it's difficult for me to see the Fed waiting as much as two years before beginning to adjust rates higher.

The market is getting used to the idea that interest rates are going to move higher, and it's all due to the market's new-found realization that the economy is on more sustainable growth path, even though that growth is very slow compared to what it could be. The more evidence—such as declining claims—we see that the economy is avoiding a recession, the more reason there is for interest rates to move higher. That's not a threat to growth, it's a validation of growth, however modest.