May 19
The Case for More Monetary Elixir
The surprise in 2011 may be lower rates as Treasuries and fixed income securities rally in the midst of growing uncertainty. Further down the road, if price pressures moderate, employment remains slow to recover, and fiscal headwinds mount, then Fed Chairman Ben Bernanke may fire up the printing presses once again.
In 1958, Harvard economist John Kenneth Galbraith was looking for a term to describe certain ideas that were commonly held, intellectually accessible, and yet fundamentally flawed. To define such widely spread misconceptions Galbraith wrote: “I shall refer to these ideas henceforth as the conventional wisdom.”
As an asset manager, I’ve come to view conventional wisdom as the surest path to investment underperformance. One might even amend the old Wall Street saying to read: bulls make money, bears make money, but conventional wisdom gets slaughtered. Consensus opinion is generally a sign to get on the other side of the trade.
Recently, I’ve noticed a critical mass of groupthink growing around the expiration of the Federal Reserve’s asset purchase program dubbed QE2. After tripling its balance sheet in 2.5 years, the conventional wisdom is that the era of quantitative easing should now give way to the era of inflation. As a result, the foregone conclusion is that U.S. interest rates will rise and bonds will underperform significantly.
While I acknowledge the potential for rising rates, I don’t think the expiration of QE2 is the catalyst that most believe it to be. In fact, I believe U.S. rates should remain range-bound at historically low levels for an extended period of time. I find it surprising how the majority of market watchers, lost in the obsession with QE2’s expiration, have so quickly dismissed the possibility of QE3.
As evidence, consider the Taylor Rule, an economic formula that the Federal Reserve uses to model the appropriate Fed funds target interest rate. Given the current levels of unemployment and inflation, the Taylor Rule says the Fed funds rate should be negative 1.65 percent, which of course is not practical. With the Fed’s target rate already at the zero bound, this suggests that Dr. Bernanke may need to take further action at some point after QE2 expires. At a minimum, it means the Fed should refrain from any rate hikes until such a time that unemployment drops below 7.0 percent (from 9.0 percent currently) or core inflation more than doubles.
The case for extended low rates and possibly even QE3 grows stronger given the recent sharp declines in agricultural and energy prices. If price pressures in food and energy prove transitory, as Bernanke predicts, then inflationary expectations are likely to ease by the end of the year. A decline in inflation would certainly make the risk/reward trade-off for QE3 more attractive to the Fed Chairman.
What would be Bernanke’s motivation to endure the political fallout of QE3? The same motivation for QE1 and QE2: namely, stimulating growth to help employment recover. If economic growth stalls, this will become the Chairman’s primary motivation. Looking ahead, the expiration of tax cuts in 2011 and a government deficit reduction program (likely to take effect as early as 2012) will present real headwinds to growth. Layer on top of that the fact that 2012-13 would likely be the end of the expansionary portion of the business cycle, and what’s left is a recipe for a serious economic slowdown or possibly even another recession. Unless, of course, the Fed serves up another round of its monetary elixir, which is why I believe the end of QE2 in June is nothing more than a pause to watch what happens in the real economy. In fact, despite his rhetoric down playing any further expansion of its balance sheet, Bernanke was careful in his recent press conference not to close the door entirely on QE3.
To be sure, there are fears that the balance sheet of the Fed may be too large to support QE3, but this doesn’t square with the experience of Japan. At $2.6 trillion dollars, the current Fed balance sheet represents approximately 18 percent of U.S. GDP.
By comparison, the balance sheet of the Bank of Japan equals approximately 30 percent of Japanese GDP. If the Fed were to hold as many assets on a relative basis, it could conduct another $1.8 trillion worth of quantitative easing. That would amount to QE3, QE4, and QE5 (at the same size as QE2) just to get to where Japan is today. If U.S. economic growth stalls Bernanke, an expert in all things deflationary, could view Japan as an imperfect but relevant precedent for further quantitative easing.
In his concluding thoughts about conventional wisdom, Dr. Galbraith said that “the ultimate enemy of conventional wisdom is circumstance.” The surprise circumstance in 2011 may be lower rates as Treasuries and fixed income securities rally in the midst of growing uncertainty. Further down the road, if price pressures moderate, employment remains slow to recover, and fiscal headwinds mount, then Bernanke may find a compelling reason to fire up the printing presses once again. Then, just like a bad Hollywood film series, we may end up talking about a sequel to QE1 and QE2. In other words, quantitative easing isn’t dead; it may just be slumbering. ▫