Assessment of Easy Money and Fed Exit Strategy Revisited

By the Curmudgeon with Victor Sperandeo




"We must be getting close to the point where everyone will realize that the Fed will not be able to hike would be a major shock to the economy," Fiendbear wrote the Curmudgeon in a text message.   That implies the economy has become so addicted to ultra-low interest rates for such a long time that a rise in rates could create shockwaves that would ripple through the economy and financial markets.


Michael Pento agrees.  He wrote in a recent blog post titled Another Phantom Recovery Fails:  "Unfortunately, the economy is now completely addicted to zero percent interest rates and the endless expansion of Fed credit." More from Mr. Pento below in the section on Assessment of Easy Money....


This article first examines the prospects for monetary policy shifts in the U.S. and the possibility of a rate increase in the U.K.  We then provide an assessment of the disappointing effects of central bank easy money policy on the economy and what might happen next.  As usual, Victor weighs in with his incisive, on-target comments.


Will the Fed's Easy Money Policy Ever End?


The minutes of April’s meeting of the Federal Open Market Committee indicate that the Fed has started to consider the complexity of reducing asset purchases, ending the rollover of maturing debt it owns, and eventually raising interest rates.  The complication arises due to the Fed's bloated balance sheet of more than $4tn, which has ballooned by repeated rounds of asset purchases over the past five plus years. 


The April minutes imply that the Fed could provide forecast dates for raising the Fed Funds rate and/or a set of economic conditions that might trigger a halt to reinvestments. 


"In addition, a few participants judged that additional clarity about the Committee’s reaction function could be particularly important in the event that future economic conditions necessitate a more rapid rise in the target federal funds rate than the Committee currently anticipates. A number of participants suggested that it would be useful to provide additional information (i.e. forward guidance) regarding how long the Committee would continue its policy of rolling over maturing Treasury securities at auction and reinvesting principal payments on all agency debt and agency mortgage-backed securities in agency mortgage-backed securities."


Don't hold your breath; it appears that raising the Fed Funds rate won't happen anytime soon.


"To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate."


"The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate (0 to .25%) for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2% longer-run goal, and provided that longer-term inflation expectations remain well anchored."


As if the above paragraph wasn't good enough to satisfy monetary doves, the minutes end with this statement:


"The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”


Please see Victor's comments below for his interpretation of the above statement.


NY Fed's William Dudley's Opinion:


One prominent Fed official seemed to disagree with the last quote from the April Fed minutes.  In a speech to the New York Association for Business Economics on May 20th, New York Fed President William Dudley said the U.S. central bank should keep reinvesting in its mortgage backed securities (MBS) portfolio after it raises interest rates. The current exit strategy calls for ending reinvestment before short term rates go up.


Mr. Dudley stated he was content with Fed tapering of asset purchases at the current pace of $10bn per monthly meeting and with current market expectations for the first rise in short term interest rates in the middle of 2015.  However, he said that raising interest rates would give the Fed the flexibility to cut them again if the economy gets into trouble.  Therefore, it is more important to raise rates, than to reduce the Fed's MBS portfolio by ending reinvestments.


In other words, Dudley believes that when the economic conditions justify a monetary policy tightening, it seems preferable to carry that out via a Fed Funds/Discount rate hike, rather than a halt to the Fed's reinvestment policy (which would shrink its balance sheet).  


“Enhancing confidence in the Fed’s ability to control money market rates, and hence, inflation, might also help keep inflation expectations well anchored....Delaying the end of reinvestment puts the emphasis where it needs to be – getting off the zero lower bound for interest rates,” said Mr. Dudley.  “In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer...“My goal would be to clarify our intentions later this year, long before we begin to contemplate raising short-term interest rates,” he added.


Once the Fed stops reinvesting in MBS and Treasuries, its balance sheet will start to gradually shrink, reducing the amount of stimulus it adds to the economy and financial markets.  Stopping reinvestments would allow its portfolio to decline gradually.  The financial markets attention would then focus on this "end of reinvestment" signal and not on the initial rate hike. 


Dudley's call for the Fed to keep its mortgage portfolio larger for a longer time period suggests that the Fed's exit strategy has become a very active policy debate at the U.S. central bank.  The possibility of sustained Fed demand via continued reinvestments may boost the market for mortgage-backed securities and thereby buttress the real estate sector of the U.S. economy.


In conclusion, Dudley said: "But, that topic is putting the cart far before the horse.  First, we need an economy that is strong enough to more fully utilize the nation’s labor resources and to begin to push inflation back towards the Federal Reserve’s long-term objective.  Only then can the monetary policy normalization process proceed.  Although we are making progress towards our goals, we still have a considerable way to go."


 Is a U.K. Rate Rise in the cards?


The Fed’s deliberations come as the Bank of England (BoE) appeared to move closer to a rate rise after some members of the interest-rate setting Monetary Policy Committee indicated they stood ready to vote for an earlier than expected rate increase. 


The BoE, which has kept interest rates at the historically low rate of 0.5% since 2009, would be the first major central bank to increase rates since the European Central Bank tightened its monetary policy in the summer of 2011.  Britain’s quarterly growth has averaged close to 0.8% in the past year while property prices are surging, prompting fears of an incipient U.K. housing bubble.  Meanwhile, U.K. inflation edged up to 1.8% in April, approaching the Monetary Policy Committee's 2% target.


George Buckley, UK Economist at Deutsche Bank, said the debate was “clearly shifting in favor of moving rates in the not too distant future.”


Assessment of Easy Money Policies on the Economy and Possible Next Steps:


1.  "Central banks have done a 'Jedi trick' – conning markets that they will do whatever it takes to ensure a self-sustaining recovery,” Société Générale's Albert Edwards told the Financial Times.  “Maybe the bond market is starting to sniff out that this is going to end very badly.”   [Global bond yields have fallen this year in anticipation of continued weak economic growth]


2. Stephanie Pomboy, President of MacroMavens in a Barron’s interview titled, The Fed Will Have to Reverse Course (on-line subscription required):


“Investors have underestimated the cost that tapering QE will have, and that is starting to come into focus.  People will realize that the (U.S.) economy really has not achieved any self-sustaining momentum and that it requires continued stimulus. . . . . . If you look at a chart of nominal consumer spending, which is 70% of GDP, it has continued to decelerate, even in this period of unprecedented monetary accommodation and rampant financial-asset inflation. . . . . . QE had a legitimate, positive economic impact [on housing], to say nothing of the benefit to the financial sector. But all of that came to an end when Ben Bernanke just talked about the possibility of tapering last May. So a full year has gone by, and the housing market has yet to recover its footing from just the threat of tapering.”


"One chart that really summarizes my entire view compares net worth with consumer spending. Of the $25 trillion expansion in household net worth since March 2009, $21 trillion was financial assets, and $3 trillion was real estate. So the $21 trillion helps a very small segment of the population, while the $3 trillion has a much broader impact. But it is a massively disproportionate benefit for the high end. Even though people in that group are the marginal drivers of the economy because they spend a lot more, overall consumer-spending growth has continued to slow. In the past 50 years, we have never seen household net worth increase this much without spending growth accelerating materially as well. This time, though, spending growth has decelerated, and each year it takes another step down. With asset prices still not girding spending, we need income gains. And unfortunately, employment isn't ready to take the handoff (and produce those income gains)."


3.   Marie-Hélène Duprat, Sr Advisor at Société Générale says normalization of monetary policy poses new challenges:


"It will be necessary to re-absorb the extraordinary amounts of liquidity injected into the system to prevent bubbles from forming and inflation from accelerating. The key is knowing when and how to put away these monetary grenades. Ending these policies too early or too abruptly would bring with it the risk of slowing or halting the economic recovery and increasing deflationary pressures. It might also abruptly destabilize financial markets. Every investor remembers the bond crash of 1994, triggered by the (modest) increase in the Fed's rates. Returning monetary policies to normal could also cause substantial capital outflows from emerging countries to developed countries, leading to exchange rate crises in those emerging countries."


4. Inna Mufteeva and Thomas Julien of Natixis on Federal Reserve Policy: Exit strategy 2.0


"The lack of surprise in the Minutes from the Fed’s latest FOMC meeting - where a recovery scenario for the US economy was confirmed - tends to reinforce expectations that the QE purchases are coming to an end (expected in October). Against this backdrop, the attention is now turning to the Fed’s exit strategy. Given the development of new liquidity management tools, and improvements in communication policy, some of the exit strategy principles that were presented in June 2011 are likely to be revised. Within this new operational framework the Fed will be able to shift the focus to a conventional monetary policy (based on steering the short-term interest rates), while the issue of balance sheet management will become less of a priority thanks to the help of liquidity management tools."


5.  Former Fed Vice Chairman Alan Blinder, in a Wall Street Journal article titled: Fed Hawks vs. Doves: The Sequel (on-line subscription required)


"Once the Federal Open Market Committee (FOMC) announces a few more $10-billion-a-month "tapering" of asset purchases, the financial markets will fixate completely on the Federal Reserve's eventual "exit" from its current extraordinarily easy monetary policy. It will be all Fed, all the time....My guess is around July 30, when the FOMC reduces its monthly purchases to $25 billion. But it could happen sooner or later. And it will probably be accompanied by a revival—likely a loud revival—of the hawk-dove wars at the central bank. Right now, an uneasy truce prevails, as everyone has signed on to the strategy of gradual tapering. That truce won't last.......The FOMC will have to figure out how and when to exit from two main policies: its near-zero interest rates and its bloated balance sheet (which should be around $4.5 trillion when the asset purchases end)."


6.  Michael Pento in the above referenced blog post--Another Phantom Recovery Fails:   


"And the economy will continue to disappoint until governments allow a healthy deleveraging to take place in both the public and private sectors. Asset prices need to fall, bad debts need to be restructured, and central banks need to allow the market to set interest rates.....perhaps by allowing free markets forces to work, first-time home buyers may once again be able to afford a new house, rather than being constantly outbid by hedge funds."


7.  Tyler Durden in a blog post titled Remember... 


"All that printed money, all those bailouts, all those promises and Bernanke's statement that "Fed actions did not favor Wall Street over Main Street..." and this is what we end up with... "not" all-time highs in what really matters...Remember -- Bernanke told us "The US economy is heading back to a full recovery" -- then a few months later explained that interest rates would not normalize in his lifetime..."

                                                                                       Chart Courtesy of


Victor's Closing Comments:


It is most important to pay attention to William Dudley's remarks. As a former Goldman Sachs Partner, Chief Economist, and Managing Director (1986-2007), Dudley is in charge of the NY Fed, which executes the central bank's open market operations.  This makes him the ultimate insider.  The holdings of his personal portfolio would be a better information source than any other investment I can think of in the world.


Is Dudley close to telling the truth in his speeches?  Or is he telling you what he wants you to hear, and hopefully believe?  I suggest it's the latter. 


Today, no one believes the Fed will ever do anything wrong.  The bulls that are long stocks feel protected by the perpetual "Fed Put.”  Ask the question: what in world is causing the Fed to maintain ZIRP policy from 2008- 2015 + and perhaps into the ever after?


Clearly, the Fed's policies have failed "Main Street." We should ask ourselves each day:  Has the Fed's huge monetary stimulus (the QE's, Operation twists, and ZERO INTEREST rates going on six years -predicted to be seven and maybe longer) resulted in economic growth or higher employment?  (See the Zero Hedge chart above for the answer).  The U.S. economy -- from the June 2009 low to date - is growing at a stated 2.2%!  Mr. Dudley's speech forecasts 3% GDP growth rate for the rest of the year, but we've heard that many times before and it didn't occur.


Instead of helping "Main Street," the Fed's money printing has inflated the value of stocks, bonds, art, real estate, and other investments.  These are not the typical things used to compute the manipulated PCE or CPI inflation indexes.  The Fed created money has not gone into new business creation, which causes jobs and wages to increase.  I wonder if raising taxes, costs, and regulations on business has something to do with that not happening.


My interpretation is that the U.S. economy is in a "death spiral" and the important leaders inside the Fed are well aware of this.  They know the facts and are desperately worried.  The economy is like a zombie (or the "walking dead") and any economic downturn would kill the zombie permanently.


The model for growth in the US is best seen by Hewlett Packard's actions:  fire workers and use the money saved to buy back stock to keep the price up in the short run and pray in the long run?            


Editor’s Note:  HP announced last Thursday that it would slash an additional 11,000 to 16,000 jobs (in addition to 34,000 cuts previously announced) after its revenue dropped again in the quarter. That was HP's eleventh consecutive quarter of declining revenues.


Please re-read the last quote from the April Fed minutes: "....keeping the target federal funds rate below levels the Committee views as normal in the longer run.”


While I don't believe they mean this, think about the Fed having the need to say those words.  Is there a real "cancer like sickness" of the economy to have to maintain a "reward" to investors?  To effectively plead them to stay long stocks and imply they don't ever need to sell, because "we got your back," even when the economy achieves normal levels of employment and the 2% inflation rate target?


The bottom line is the ideology of redistribution (eating the pie) controls current fiscal policy; not real growth which would make more pies.  Therefore, monetary policy is the only game in town to keep the zombies walking.  Yet nothing is really changing in the economy, which continues to stagnate.


I still believe the risk is the "known" unknowns -geopolitical risks (as described in last week's Curmudgeon column) --and not the Fed.  Janet Yellen is a very proud Progressive who would never dare upset the leaders who appointed her "Queen" of the world's money and power.


An historical quote vividly re-states the basis to current U.S. monetary policy:  "The bank never goes broke.  If the bank runs out of money it may issue as much as may be needed by merely writing on ordinary paper." Rules of Monopoly, by Parker Brothers - 1936.


Curmudgeon's Postscript:


In last week's post, Victor commented on anti-Europe parties gaining ground in the upcoming European Parliamentary Elections.  He was right on the mark as that's exactly what happened! There was an unprecedented surge in support for anti-EU parties across Europe that is set to reverberate far beyond EU politics.


·         France’s far-right National Front NF) stormed to victory in the May 25th vote.  It was a stunning defeat for the Socialist and UMP mainstream parties in Europe’s second-largest economy.  Manuel Valls, the French prime minister, called the FN victory “a shock, an earthquake that all Europe’s leadership must respond to."

·         Nigel Farage’s UK Independence Party (UKIP) achieved an historic victory as UKIP tops the polls in the UK elections, with Labour second and the Liberal Democrats losing all but one of their seats.  

·         Eurosceptic parties also gained ground in Greece (far-left Syriza), Italy (Five Star), and Denmark (Danish People's party).

The outcome means a greater say for those who want to cut back the EU's powers, or abolish it completely.  UK PM David Cameron said the public was "disillusioned" with the EU.  The European Parliament, the EU’s only elected institution, works with the European Commission and the 28 national governments to debate and pass laws.  They now have to contend with a much stronger Euro-dissenting bloc than ever.


Till next time........................


The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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