QE, Uncertainty and CPI

by Doug Noland

March 28, 2014 


Equity market internals have turned increasingly unsettled.

In last Wednesday’s press conference, Janet Yellen upset the markets with her comment suggesting that the Fed might commence rate adjustments as early as six months after it concludes its latest QE program. Several officials have since tried to reassure market participants that the Fed has not moved forward its plans to raise rates. Even hawkish Fed officials went to pains to communicate that rate moves were not in the immediate offing.

Clearly, the Fed’s strategy is to do its utmost to reduce market uncertainty. The FOMC is moving forward methodically to wind down its balance sheet operations, while telegraphing an ultra-cautious rate policy (future, future littlebaby steps”).

The Fed has good reason to worry about the markets and fret the issue of “uncertainty.” And it’s difficult to envisage a more transparent – and market-friendly - interest rate policy. When markets are in a good mood, it’s virtual nirvana. Financial markets – in particular stocks and corporate Creditcan enjoy splendid market excess without concern that the Fed might choose to “lean against the wind” of destabilizing speculation. And for the Fed to actually get rates to what would be considered slamming on the brakes” – harsh enough to puncture powerful market Bubbleswell, that would be years away (most likely never).

Yet I would argue the notion that the Fed is capable of bridling market uncertainty is a Bubble mirage. Thus far, our central bank has been successful in keeping the markets focused on rate policy. Meanwhile, a great uncertainty furtively lurks: What will the end of Fedmoneyprinting mean for U.S. and global markets, the emerging economies and the U.S. and global economies more generally?

The entire QE (quantitative easing) issue/analysis is incredibly fascinating. Since September 2008, the Fed’s balance sheet has ballooned from about $900bn to $4.227 TN. If tapering runs its expected course, QE will end late this year with the Fed’s balance sheet near $4.5 TN. This would leave the latest round of QE totaling almost $1.7 TN, with the Fed’s balance sheet having expanded (a parabolic) 60% in two years. This would also place total Fed asset growth at $3.6 TN, or 400%, in six years.

And why do I posit that the notion of the Fed harnessing uncertainty is a mirage? Because the Fed doesn’t have a clue as to the consequences of the $3.6 TN of liquidity it has pumped into the markets since 2008. And I don’t say this flippantly. Best I can tell, the Federal Reserve has not even attempted a comprehensive study of how this massive liquidity injection has flowed through the Treasury and MBS markets, U.S. financial markets more generally, global markets and financial systems, and economies at home and abroad. They have just been determined to keep pumping it out there, supposedly to fight heightened deflationary forces. The Bernanke Fed had a theory.

In admittedly superficial analysis (from my perspective), I’ve in past analyses tried to differentiate the widely-divergent effects of QE1, QE2 and (“open-ended”) QE3. Past analysis tried to explain how QE1 was largely a shift of positions from leveraged players onto the Fed’s balance sheet. While this had a profound impact on sentiment, it didn’t really function as a direct injection of liquidity into the markets. QE2, on the other hand, was injected directly into a marketplace with a powerful propensity (“inflationary bias”) for purchasing/speculating in U.S. fixed income and the emerging markets. QE2 fueledblow offexcesses, proving most destabilizing for EM markets and economies. QE3 has been an altogether different creature. With bond and EM Bubbles having already begun to falter, the Fed’s (along with the BOJ’s) liquidity onslaught predominantly spurred speculativeblow offdynamics in U.S. equities and corporate debt.

When addressing QE effects, Fed speakers (and papers) focus on basis point declines in Treasury and MBS yields, along with adjustments in the structure of term premiums (the yield curve). Dr. Bernanke’s theories held that Fedmoneyprinting could ensure a rising rate of inflation (i.e. central banks could inflate away problematic debt loads). Now, as the biggest QE yet begins to wind down, most notions of how Fedmoneyprinting operations actually function are (over)due for a thorough reexamination. After all, in the face of what will be $1.6 TN of new liquidity, bond yields rose and CPI declined. Stocks, on the other hand, went on a historic moonshot. In corporate Credit, it became 2007 reincarnate.

When the Fed was discussing its so-calledexit strategyback in 2011, I was writing there would beNo Exit.” Well, the Fed has since doubled the size of its balance sheet. And I just don’t see how the Fed can inflate liquidity from $900bn to $4.5 TN and then just shut down the “printing presses” – that is, without some major consequences for the general liquidity backdrop. The history of monetary inflations provides unequivocal support for this view.

Conventional thinking, well, it simply could not see things more differently. Most believe that QE has had minimal effect, so ending the program will be inconsequential. The bulls (these days that means just about everybody) believe stock prices have been driven higher by robust earnings. The economic recovery has seen a superior economic structure generate outsized corporate profits. The economy drives the markets – and not vice versa. From this viewpoint, QE is for the most part insignificant.

The commonly held view of limited QE impact is driven by another momentous flow of fundsmisperception. Even top Federal Reserve officials these days believe that QE has thus far exerted minimal impact because Fedliquidity” has been sitting inertly as “reserveson the banking system balance sheet. I sayanothermisperception, because I am constantly reminded of how the profound market impacts of Fannie, Freddie and the FHLB went unrecognized for years (especially 1994-2004) during a protracted Bubble period. The view then was that only banks create money and Credit.” Somehow, a historic inflation in GSE Credit unfolded with barely a notice from Wall Street analysts or the Fed. The view today is that there is little impact from the Fed’s balance sheet so long as QE is held as “reserves” by the banks.

There is definitely confusion on the issue of “flowversuslevelanalysis. In QE operations, the Fed Creditsaccounts with new purchasing power as it consummates purchases of Treasury and MBS securities in the marketplace. Essentially, the Fed creates new electronic liabilities (“IOUs”) that provide immediate liquidity/purchasing power (“money”) to the seller of securities. Importantly, these liabilities will exist until the Fed liquidates securities and uses the proceeds to pay down its IOUs. To be sure, Fed operations dictate the “level” of its liabilities. Moreover, these liabilities by design are held by financial institutions that have a clearing relationship with the Fed, largely U.S.-operated financial institutions.

At a point in time, the “level” of “reservesliabilities created by the Fed will be held as banking system assets (it’s justaccounting”). But this basically tells us nothing in regard to the transactions that took place between the Fed’s purchase and the eventual deposit of this liquidity into the banking system. Moreover, the “level” of “reservesinforms us nothing about the “flows” – flows that could be in the hundreds of billions or more on an intra-day basis (who knows?). And it is these transactionalflows” that have profound impacts on market dynamics and pricing.

From my perspective, it’s all rather obvious that the greatest QE3 impact has been the stoking of Bubbles in U.S. equities and corporate Credit. I’ve used the example of the Fed purchasing Treasuries and MBS from a rather largebondfund suffering redemptions. In this case, Fed liquidity would then be used to fund bond investor outflows that find their way to, say, a major U.S. equities ETF. The ETF then uses this liquidity to buys stocks, providing the sellers the liquidity to buy other securities (or things). Another example would have Fed liquidity accommodating a rotation of hedge fund positions from bonds to equities. In this example, a hedge fund might sell a (underperforming) 10-year Treasury note to purchase an outperforming Facebook stock. And if the seller is Mark Zuckerberg, a chunk of his sales proceeds will boost California and federal income tax receipts (quickly spent by both governments). Zuckerberg’s employees can use stock sale proceeds to buy homes and luxury automobiles (and planes!). And Zuckerberg can use booming Facebook stock as currency to buy companies in a hotly contested industry acquisition boom.

And with 2013/early-2014 too reminiscent of Nasdaq 1999, one should not understate the role QE3 has played in stoking another historic Bubble and “arms racethroughout the broadly-definedtechnologysector. The mad dash for hits, clicks, likes, advertising dollars and revenues throughout “social media,” the “cloud,” 3D printing, solar, etc. even surpasses 1999 whether the bulls are willing to admit as much or not. At this point, it’s a full-fledged mania (again).

It’s ironic – and I believe really important. The Bernanke Doctrine holds that the Fed’s printing press can basically guarantee a rising general price level. Meanwhile, QE1-3 liquidity has ensured that only more and bigger companies from Silicon Valley to China to “Hollywood provide a virtually limitless supply of smartphones, computers, tablets and electronic gadgets, along with a plethora of downloadable content and services. Throughout the markets and the real economy, it’s all leading to unusual price instabilities (which the Fed is expected to counterof course, with only more QE).

As much as it is reminiscent of the late-nineties, the more apt comparison is to the Roaring Twenties. Major technological innovation throughout the 1920’s had unappreciated consequences on the economic structure and price dynamics more generally. Misunderstanding the forces behind the downward pressure on many prices, the Federal Reserve remained too highly accommodative for too long. In the process, the Fed harbored a prolonged period of deep economic maladjustment, while fostering a historic speculative financial Bubble.

From my reading of history, central banks must be especially diligent with respect to monetary stability (“money” and Credit) during periods of profound technological and financial innovation. Repeating mistakes from the Twenties, the Fed and global central bankers have again done the exact opposite (for a long time now).

From my perspective, the downward pressure on the general consumer price level has been exacerbated by QE3. But this is foremost a “supplyissue as opposed to “deflation.” And as much as the Fed speaks of its 2% inflation mandate” – and as much as the markets assume this mandate will eventually justify QE4low inflation should be recognized at this point as predominantly a global issue. The Fed and its now grossly bloated balance sheet do not - and will not - control CPI.

Surprisingly, there is little insightful discussion on an issue of such critical importance. As such, I found interesting comments this week from Mario Draghi worthy of highlighting below.

Question: “To what extent do you (the ECB) have a symmetric (inflation) target and, if so, why not act now to achieve the inflation target of 2.0%?”

ECB President Mario Draghi (speaking Wednesday in Paris): “I actually claim that our targets remain symmetric. The question we should ask is not (about) immediate inflation or immediate low inflation, but a medium-term assessment of inflation. And we should ask which factors are causing inflation to be low. And if we do this exercise we will discover that a great percentage of the factors that keep inflation low don’t have to do with our own euro-area economy. Consider for example, the inflation rate in July 2012that was 1.9% and now its 0.7% in the latest data. Two-thirds of that decline is due to the price of energy. Another way to look at this is the appreciation of the exchange rate. That by itself impinges on inflation by between 0.4% and 0.5%. Also, when you look at exactly why is inflation low in the euro-area you see that a good dealif you exclude energy, taxes and food prices - you see that a good deal of the decline in core inflation has taken place in the so-called stressed countries. Which makes you think that it’s actually a relative price adjustment. Because in these countries’ prices were out of balanceout of equilibrium and clearly these countries had huge imbalances. And we can see the results of this because the so-called stressed countries now are actually showing current account surpluses, trade surpluses and much better economies. So some of this rebalance is taking place. Also let me add, that if you put this in perspective, you see that inflation is actually low globally. In the United States, in spite of the fact they are well more advanced than we are in their recovery, inflation… was not different from what it was in the euro-area three or four months ago. And not to mention Japan of course – or other parts (of the world), even the UK now is low. So, like one of my colleagues said, if you see that demand goes up and price goes down, that is not demand but it’s supply (dictating price). And so the concern for this assessment in the medium-term is different from what it would be if it were an inflation generated by demand factors… But again, you ask us the questiondo we have any evidence that people are actually postponing their spending plans with a view to buy the same commodities at lower prices later on” – which is the definition of deflation. We don’t see any evidence of that. When we look at the percentage of commodities that (have seen prices) grow at or less than 1% or even decline… we see that the percentages, even in some stressed countries, are way lower than what they were in Japan, for example the late nineties and into 2000. So right now, we think the risks of having deflation are limited. That we have a medium-term assessment. In both cases, both if inflation were too high or were too low, we’d have to charge it through our medium-term. It would not be an instant decision.”



President Putin’s economic Achilles heel

by Gavyn Davies

March 30, 2014 4:34 pm



There are some silver linings. Foreign exchange reserves are high, covering two-thirds of external debt, and the labour market has survived the slowdown in growth surprisingly well. 

Still, the economy appeared vulnerable to the effects of Fed tapering, even before the Ukraine crisis eruptedThe Ukraine crisis has been widely described as the most dangerous confrontation between Russia and the west since the end of the Cold War. Today’s talks between US Secretary of State John Kerry and Russian Foreign Minister Sergei Lavrov offer hope that the crisis might be defused, with the US suggesting what seems like a joint US/Russian demilitarisedprotectorate” in the Ukraine, in exchange for Russian withdrawal from the Crimea.

We shall see whether that satisfies President Putin, whose recent rhetoric about Russia being “cornered for centuriessuggests that he might have much wider plans.



So far, the global financial markets, outside Russia, have been almost completely unaffected by events in the Ukraine. Initially, there was some decline in the stock markets of European economies with significant trading and banking links with Russia, including Germany, but recently these losses have been reversed.

The low probability of direct military confrontation between Russia and the west in the Ukraine is obviously key to this. Perhaps the markets also believe that the crisis will blow over without a major outbreak of tit-for-tat sanctions, beyond the limited restrictions on individuals which have been announced so far. Or perhaps they have concluded that, while the west can greatly damage the Russian economy, the same cannot happen in reverse.

What has become obvious is that the Russian economy itself is very vulnerable indeed to a worsening in the crisis. The burgeoning capital outflow since the start of 2014 has, in effect, imposed a form of economic sanctions” on the Russian economy, without the need for western governments to take much action of their own. Western leaders clearly believe that this could turn out to be President Putin’s Achilles heel, though this reckons without the possibility that he will opt for riskier foreign adventures in an attempt to distract attention from economic weakness at home.


The Russian economy has been in difficulty for several years. After the boom in the last decade, largely based on rocketing energy prices, economic growth has slowed sharply since 2010. (The IMF’s latest medium term economic projections are summarised in the thumbnail graphic on the right.)

The structural reforms needed to boost private sector growth outside the energy sector have been disappointing, and the exchange rate has been over-valued from the point of view of the manufacturing sector. Excluding oil revenues, the budget deficit has been running at around 10 per cent of GDP, so living standards have become heavily dependent on oil prices remaining above $100/barrel. In recent years, the rate of credit expansion to households has been explosive (over 30 per cent per annum), as it has in many other emerging economies. Whether the banking system could survive an economic downturn is an open question.

Since then, capital outflows, both by Russian citizens and by foreigners, have become serious, running at over $60 billion in 2014 Q1, according to Economy Minister Alexei Ulyukayev. These outflows may weaken the banking system, and withdraw funding for many of the capital investment projects that were critical to a recovery in GDP growth. The growth rate had already declined to only 1.3 per cent in 2013, compared to about 7-8 per cent in the miracle years of the last decade. The capital outflows have also forced the CBR to raise interest rates by 1.5 per cent, something which would otherwise have been unnecessary, given the broadly stable outlook for inflation.

As a result of the crisis, the economy now stands on the brink of outright recession, the first in any of the BRIC economies since 2009. Last week, the World Bank published a frank assessment of the impact of the crisis on the economy, and the Economy Minister surprisingly said that he basically agreed with its conclusions, which are summarised here:



The World Bank figures confirm that Russia’s main vulnerability at present stems from the capital account of the balance of payments, working both through lower investment, and through weaker consumption, which had earlier seemed to be the main hope for economic expansion. Consumer sentiment has plummeted since the crisis started, despite the sharp increases in the President’s personal political ratings.

The World Bank suggests that, if the crisis continues, then private capital outflows would reach $133 billion this year, and real GDP would decline by 1.8 per cent. This would surely result in a sharp reversal of recent declines in the unemployment rate, currently at 5.2 per cent of the labour force.

Of course, the Russian government will take steps to alleviate the problems caused by capital outflows. Deputy Prime Minister Igor Shuvalov said last week that there was an “action plan for the roughest scenario”, even though he hoped not to have to use it.

Russia certainly has some financial weapons it can deploy. Its foreign exchange reserves stand at $510 billion at the end of 2013, enough to replace all of the foreign exchange losses from capital outflows.

Furthermore, the government’s overall budget (including oil revenues) is close to balance, implying that it can afford to finance some fiscal easing, as long as oil prices do not fall. And many western companies, including Siemens for example, are obviously very reluctant to cut their historic ties with Russia if they can avoid it.


Nevertheless, the outlook for the Russian economy in a condition of full or partial isolation from the major developed economies in Europe and America would be bleak.

There would also be economic losses incurred in the west, since Russian gas could not quickly be replaced in many European economies, and bank exposures to Russian assets are not entirely negligible in Austria, Italy and France. But exports to Russia represent much less than 1 per cent of GDP in all of the major European economies, including Germany, which is the most exposed.

Whether the global financial markets could turn a blind eye to this crisis if Russian troops enter the eastern Ukraine seems doubtful. But, in any likely eventuality, President Putin must know that the Russia would be the main economic loser.