By Mike Whitney
Ben Bernanke has made a serious mistake and the country is going to pay dearly for it.
Since 2009, the Fed Chairman has launched 3 rounds of his bond buying program called quantitative easing or QE. He also initiated a similar program called Operation Twist in which the Fed changes the duration of its portfolio by selling short-term US Treasuries and buying longer-term ones. Like QE, Operation Twist is designed to reduce borrowing costs for businesses and consumers by pushing down long-term interest rates. All told, the Fed’s various unconventional easing programs have more than doubled the Fed’s balance sheet (now approaching $3 trillion) while tripling the amount of liquidity (base money) in the financial system. At present, those excess reserves pose no danger to overall price stability, but if the economy rebounds–as it eventually will–then the Fed will either have to mop up the extra liquidity quickly or face an inflationary tsunami unlike anything the country has experienced in its 230 year history.
Bernanke is expected to announce an extension of Operation Twist later this week following a meeting of the Federal Open Market Committee or FOMC. Analysts expect the Fed to continue to purchase $45 billion per month in USTs via Operation Twist, and another $40 billion in mortgage-backed securities (MBS) per month via QE3. All told, the Fed is on track to buy $85 billion in financial assets per month “indefinitely” to maintain the status quo, that is, to sustain grossly-inflated stock prices and a real economy that is barely treading water 4 years after Lehman Brothers defaulted. Here’s how Barron’s sums up Bernanke’s progress in restoring the economy to financial health:
“….the Fed not only has failed to spur real growth but mainly has pumped up prices. That’s been a boon for wealthy investors who have benefited from lift in asset prices, but a bane for middle- and lower-income consumers who have to pay more for food and fuel…..
During QE1 and QE2, wholesale gasoline prices jumped 30% and 37%, respectively, while the food component of the Goldman Sachs Commodity Index rose 7% and 22%, respectively. Meanwhile, the Standard & Poor’s 500 gained 36% and 24% during those respective spans. ….
The unintended consequence of higher prices, and reduced workers’ real incomes as a result, actually has been to slow economic activity, he argues. The wealth effect, meanwhile, has been confined to upper-income households, whose spending is hardly affected by asset prices. According to one estimate Hunt cites, a $1 increase in wealth generates less than 0.5 cents in incremental spending.” (“Don’t Blame Us, Bernanke Says”, Barron’s)
QE is not just an ineffective way to stimulate the economy, it’s actually counterproductive. (as we’ll see) $1 increase in food stamps, unemployment benefits, public infrastructure programs or other forms of fiscal stimulus all have greater impact on economic activity. Bernanke’s large-scale asset purchase program has done nothing to reduce unemployment, boost demand or increase growth. It is a straightforward reflation project designed to prevent a restructuring (and, perhaps, nationalization) of the banking system by propping up prices on complex financial assets which, otherwise, would be worth just a fraction of their original value. But there is a cost to the Fed’s aggressive easing programs, and that cost will be paid in terms of bond market ructions and a sharp slide in the value of the dollar.
At some point, the Fed will have to reverse-field and sell the stockpile of unwanted assets on its balance sheet. That, in turn, will put pressure on stock prices, slow economic growth, and (in Barron’s words) “crash the bond market.” Of course, no one knows whether these dire predictions will come to pass or not, since the Fed’s programs and balance sheet expansion are without precedent. Simply put: We are in uncharted waters. One would think that that fact alone would spur greater caution among the Fed governors whose explicit task under its charter is to ensure “price stability”. But that hasn’t been the case. Led by “Great Depression expert”, Bernanke, the Fed has upped-the-ante at every turn exchanging hundreds of billions in reserves for complex bonds of uncertain value (MBS) and distorting prices on benchmark 10-year yields by dominating the market for USTs. Check out this article in Bloomberg titled “Treasury Scarcity to Grow as Fed Buys 90% of New Bonds“:
“Even as U.S. government debt swells to more than $16 trillion, Treasuries and other dollar fixed-income securities will be in short supply next year as the Federal Reserve soaks up almost all the net new bonds…… the Fed, in its efforts to boost growth, will add about $45 billion of Treasuries a month to the $40 billion in mortgage debt it’s purchasing, effectively absorbing about 90 percent of net new dollar-denominated fixed-income assets, according to JPMorgan Chase & Co.
“The shrinking amount of bonds in the market is lowering rates and not just benefiting the Treasury, but providing lower rates for private-sector decision-makers as well,” Zach Pandl, a senior interest-rate strategist in Minneapolis at Columbia Management Investment Advisers LLC…
Deposits at U.S. banks exceed loans by $1.91 trillion, marking a turnaround from 2008, when loans exceeded deposits by about $200 billion. Much of that surplus money has been used to buy Treasuries and government agency debt such as that issued by Fannie Mae, Freddie Mac, boosting holdings to a record $1.86 trillion, Fed data show.” (“Treasury Scarcity to Grow as Fed Buys 90% of New Bonds“, Bloomberg)
Notice how enthusiastic Bloomberg is about the fact that the Fed is “absorbing about 90 percent of net new dollar-denominated fixed-income”, even though consumer loan demand has remained weak. In other words, Bernanke’s extremist policies have not produced the credit expansion he anticipated.
And where are the other buyers of US Treasuries? Have they moved their money into equities as Pavlov-Bernanke intended or have they merely opened savings accounts in order to hunker down and reduce their debt-load? (Bloomberg: “Deposits at U.S. banks exceed loans by $1.91 trillion”)
And how can one accurately assess the value of USTs or MBS when the price is effectively set by Central Bank intervention? One must assume that the price of these assets will fall precipitously when the Fed stops its meddling and market forces are allowed to work.
So, what’s in store for US Treasuries and the dollar? Are we on the brink of a currency crisis and a bond market cataclysm that will dwarf the Crash of ’08?
Former Fed governor, Kevin Warsh, pointed out the potential pitfalls of the Fed’s strategy in an article in the Wall Street Journal titled “The New Malaise”. Here’s an excerpt:
“The Fed’s increased presence in the market for long-term Treasury securities also poses nontrivial risks. The Treasury market is special. It plays a unique role in the global financial system. It is a corollary to the dollar’s role as the world’s reserve currency. The prices assigned to Treasury securities–the risk-free rate–are the foundation from which the price of virtually every asset in the world is calculated. As the Fed’s balance sheet expands, it becomes more of a price maker than a price taker in the Treasury market. And if market participants come to doubt these prices–or their reliance on these prices proves fleeting–risk premiums across asset classes and geographies could move unexpectedly. The shock that hit the financial markets in 2008 upon the imminent failures of Fannie Mae and Freddie Mac gives some indication of the harm that can be done when assets perceived to be relatively riskless turn out not to be.” (“The New Malaise”, Kevin Warsh, Wall Street Journal.)
The dollar may be the foundation upon which the US Empire rests, but the bond market is the bedrock beneath the buck which keeps the entire economic, political and military scaffolding in place. To admit, as Warsh does, that the Fed is price-fixing on a global scale (“more of a price maker than a price taker”) suggests that the “nontrivial risks” of which he speaks could be an erosion of US dominance in the world vis a vis the dollar’s position as the world’s reserve currency. This is a theme that has been explored by many journalists, including former undersecretary of the Treasury, Paul Craig Roberts, who made these observations in a recent article in CounterPunch:
“The Federal Reserve is purchasing not only new Treasury bonds issued to finance the more than one trillion dollar annual federal deficit but also the banks’ underwater financial instruments, taking them off the banks’ books and putting them on the Federal Reserve’s books.
Normally, debt monetization of this amount results in rising inflation, but the money that the Federal Reserve is creating in its attempt to manage the public debt and the banks’ private debt is hung up in the banking system as excess reserves and is not finding its way into the economy. …
However, the debt monetization poses a second threat that is capable of biting the US economy and consumer living standards very hard. Foreign central banks, foreign investors in US stocks and financial instruments, and Americans themselves observing the Federal Reserve’s continuous monetization of US debt cannot avoid concern about the dollar’s value as the supply of ever more dollars continues to pour out of the Federal Reserve….The world is abandoning the use of the dollar to settle international accounts, and the demand for dollars is falling as the Federal Reserve increases the supply of dollars.” (“The Coming Crash of America” Paul Craig Roberts, CounterPunch)
If the world is losing confidence in US stewardship of the de facto global currency, then the blame rests squarely with the Fed. Bernanke’s misguided policies have backed the Fed into a corner. There’s no way that Bernanke can escape his present predicament without pushing the economy back into recession or triggering currency crisis.
Here’s how former FDIC chief Sheila Bair summed it up in an interview with Reuters 2 weeks ago. Her comments were made in reference to, what she called, “The Mother of all bond bubbles”.
BAIR: “Fundamentals do not support current current Treasurys prices…This is what we saw in the housing bubble, a massive underpricing of risk. Eventually, it’s going to correct, and that’s going to create long-term problems for our kids and our country as well as short-term problems for the financial sector”
Indeed. Eventually, the distortions will work themselves out and the market will correct, but at what cost?
There’s bound to be an “Ah ha” moment when market participants realize that Central Bank managers have no idea of how to mop up the trillions in liquidity they created through QE. The FOMC’s can-kicking deliberations (At present, the Fed does not plan to trim its balance sheet until mid-2015) are just a way of delaying the “adverse impact of liquidity draining operations” (Richard Koo) Those operations pose a significant risk to the financial system, the economy, and, perhaps, to the existing order.
Unwinding the Fed’s bulging balance sheet is not going to be easy or painfree. There’s a good chance that yields on USTs will skyrocket while the hobbled dollar goes into freefall. As economist Michael Hudson likes to say, “There’s no free lunch.”