Wednesday, April 23, 2014
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The Trapdoors at the Fed’s Exit

MUMBAI – The ongoing weakness of America’s economy – where deleveraging in the private and public sectors continues apace – has led to stubbornly high unemployment and sub-par growth. The effects of fiscal austerity – a sharp rise in taxes and a sharp fall in government spending since the beginning of the year – are undermining economic performance even more.

Indeed, recent data have effectively silenced hints by some Federal Reserve officials that the Fed should begin exiting from its current third (and indefinite) round of quantitative easing (QE3). Given slow growth, high unemployment (which has fallen only because discouraged workers are leaving the labor force), and inflation well below the Fed’s target, this is no time to start constraining liquidity.

The problem is that the Fed’s liquidity injections are not creating credit for the real economy, but rather boosting leverage and risk-taking in financial markets. The issuance of risky junk bonds under loose covenants and with excessively low interest rates is increasing; the stock market is reaching new highs, despite the growth slowdown; and money is flowing to high-yielding emerging markets.

Even the periphery of the eurozone is benefiting from the wall of liquidity unleashed by the Fed, the Bank of Japan, and other major central banks. With interest rates on government bonds in the US, Japan, the United Kingdom, Germany, and Switzerland at ridiculously low levels, investors are on a global quest for yield.

It may be too soon to say that many risky assets have reached bubble levels, and that leverage and risk-taking in financial markets is becoming excessive. But the reality is that credit and asset/equity bubbles are likely to form in the next two years, owing to loose US monetary policy. The Fed has signaled that QE3 will continue until the labor market has improved sufficiently (likely in early 2014), with the interest rate at 0% until unemployment has fallen at least to 6.5% (most likely no earlier than the beginning of 2015).

Even when the Fed starts to raise interest rates (some time in 2015), it will proceed slowly. In the previous tightening cycle, which began in 2004, it took the Fed two years to normalize the policy rate. This time, the unemployment rate and household and government debt are much higher. Rapid normalization – like that undertaken in the space of a year in 1994 – would crash asset markets and risk leading to a hard economic landing.

But if financial markets are already frothy now, consider how frothy they will be in 2015, when the Fed starts tightening, and in 2017 (if not later), when the Fed finishes tightening? Last time, interest rates were too low for too long (2001-2004), and the subsequent rate normalization was too slow, inflating huge bubbles in credit, housing, and equity markets.

We know how that movie ended, and we may be poised for a sequel. The weak real economy and job market, together with high debt ratios, suggest the need to exit monetary stimulus slowly. But a slow exit risks creating a credit and asset bubble as large as the previous one, if not larger. Pursuing real economic stability, it seems, may lead again to financial instability.

Some at the Fed – Chairman Ben Bernanke and Vice Chair Janet Yellen – argue that policymakers can pursue both goals: the Fed will raise interest rates slowly to provide economic stability (strong income and employment growth and low inflation) while preventing financial instability (credit and asset bubbles stemming from high liquidity and low interest rates) by using macro-prudential supervision and regulation of the financial system. In other words, the Fed will use regulatory instruments to control credit growth, risk-taking, and leverage.

But another Fed faction – led by Governors Jeremy Stein and Daniel Tarullo – argues that macro-prudential tools are untested, and that limiting leverage in one part of the financial market simply drives liquidity elsewhere. Indeed, the Fed regulates only banks, so liquidity and leverage will migrate to the shadow banking system if banks are regulated more tightly. As a result, only the Fed’s interest-rate instrument, Stein and Tarullo argue, can get into all of the financial system’s cracks.

But if the Fed has only one effective instrument – interest rates – its two goals of economic and financial stability cannot be pursued simultaneously. Either the Fed pursues the first goal by keeping rates low for longer and normalizing them very slowly, in which case a huge credit and asset bubble would emerge in due course; or the Fed focuses on preventing financial instability and increases the policy rate much faster than weak growth and high unemployment would otherwise warrant, thereby halting an already-sluggish recovery.

The exit from the Fed’s QE and zero-interest-rate policies will be treacherous: Exiting too fast will crash the real economy, while exiting too slowly will first create a huge bubble and then crash the financial system. If the exit cannot be navigated successfully, a dovish Fed is more likely to blow bubbles.

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  1. CommentedSteven Wartofsky

    It's instructive to re-read this a few months later, after the latest US stock market rattle.

    It's probably a good thing that BB's statements took a little air out of the current market, even though the timing of events described really aren't that different from the ones described here.

    A solution to the "precarious exit" may be exactly these kinds of narrative foreshadowings, as a means of blowing on the froth when it starts to look dangerously excessive.

  2. CommentedVan Poppel charles

    sir, you are writing allways the same story about the perniciuos effects of the "QE" operations of the fed to reactivate an andante US economic activity. Do you suppose that cheap money ( the opening of the credit spigot by central banks at a low price)can by itself bring about an adequat economic recovery with rising empmoyment. But you never have formulated any advice to US government what poliy she should apply: stimulation or austerity, acting pro-fed or contra-fed; in the last case we should not be astonished consumers follow this advice by increasing their savings( reducing their expenses!. Should you remember the keynesian advice " the boom, not the slump is the right time for austerity"

  3. CommentedProcyon Mukherjee

    Doubts continue to emerge on both sides of the argument; if we go by monetary base, then Fed is clearly the winner compared to ECB or BOJ, in terms of the increase (as we have seen the monetary base shrinking in the case of ECB between July 2012 to now). The argument then shifts to what is stemming from this monetary base, is there a money multiplier that puts more money into circulation in the real economy? Quite not so, as we see Commercial Banks parking their excess reserves in Fed liability side of the balance sheet.

    So the jury is still out.

  4. CommentedJan Smith

    It appears that Andrew Mellon was right. Labor is being liquidated (dropping out of the labor force). Countless financial and producer firms and households will be liquidated (bankrupted) when interest rates rise. The Fed has been applying an enormous monetary expansion, and the Treasury an even larger fiscal expansion (starting with the first round of Bush tax cuts), and yet the "liquidation" goes on and on.

    Why so? After his long sojourn in the global South and East, Malthus is coming home, riding on the back of the world market system, and the macroeconomic "toolkit" is utterly powerless to stop him.

    Recent history suggests that modern mercantilism ("export-led growth" in the obscurantist vocabulary of -liberal economics) might be able slow Malthus for a while in
    nations that are adept at practicing it. But of course, if all nations were to become adept mercantilists, emulating, say, Germany or Japan or China, the world would not need its ongoing population explosion to return to its stable Malthusian state.

  5. CommentedJ Henry

    The Fed’s QE program has been ineffective at generating economic growth and jobs. However, QE will continue otherwise bond yields and interest rates would rise and the interest payments of the $16.8T of public debt would soar above $1T. The Fed is in a box and there are no viable exit plans that could avoid a financial meltdown.

  6. CommentedPaul A. Myers

    I think the political resistance in Congress to a rapid increase in interest rates will be immense and beyond the Fed board's power to resist. So I would first expect inflation, which might be tolerated for a long time, and then possibly a recession-inducing increase in interest rates.

    Inflation will devalue a lot of government benefits. Price controls in the health care sector?

  7. CommentedGordon Xavier

    Roubini Says S&P 500 May Drop to 600 as Profits Fall (Update2)
    By Jeff Kearns - March 9, 2009 16:12 EDT

    March 9, 2009 (Bloomberg) -- The Standard & Poor’s 500 Index is likely to drop to 600 or lower this year as the global recession intensifies, said Nouriel Roubini, the New York University professor who predicted the financial crisis.

    The benchmark index for U.S. stocks would have to slump 12 percent from last week’s closing level to meet his forecast. Roubini is assuming that companies in the S&P 500 will report profit of $50 a share this year and investors will pay 12 times that for equities.

    “My main scenario is that it’s highly likely it goes to 600 or below,” Roubini said today in an interview at the Chicago Board Options Exchange Risk Management Conference in Dana Point, California. A level of “500 is less likely, but there is some possibility you get there.”

  8. CommentedKen Presting

    How odd is it for a column about an impending bubble to open with "deleveraging ... continues apace?" So what is the problem, credit growing or credit shrinking?

    It's most discouraging to read yet another economics column which treats the economy as if it consists entirely of investors, and no commerce. It should not be an exotic thesis to suggest that intelligent economic policy should address both fiscal and monetary issues.

    The Fed is keeping rates down because that is its only way to influence employment. But where is dis-employment happening? Private sector jobs have risen steadily while public sector jobs declined. The problem is not just "austerity" in the abstract. The problem is that governments lave laid off vital public employees, while also neglecting public investments.

    If fiscal policy were sane, the Fed would not be left grasping at straws, trying to keep Americans employed. If the rentiers are making so little money in safe investments that they are foolishly pouring cash into excess risk, we know just what to do: decrease their leverage.

  9. Commented Elizabeth Pula

    While the Fed is down to about 0 percent for corporate financial transactions etc., the common citizen is charged up to 25% for credit card transactions. Over especially the last 10 years, effective common wages for common citizens have decreased substantially (generalization or fact?). I don't think trapdoors even need to be considered when the majority of citizens are being pushed into a very solid brick wall! There's no fiscal cliff for the majority of US citizens either. In fact, the brick wall looks increasingly like quick-sand, or tarpits of yucky black goo created by a relative few unmentionables that the majority of US citizens cannot escape from at all. The kinky stuff is getting more transparent. The real US economy is trending more and more into Mumbai. No wonder, this article by Roubini just coincidentally used that little "word", a very unpretty teeny weeny, possibly historically, possibly significant, pre-predicting fact, besides just being a typical very old and very large city on the planet. A lot more cities, especially in the US, are repeating a very old pattern.