Category Archives: Intervention

Low Interest Rates And The Formation Of Asset Bubbles

The existence of asset bubbles continues to be among the most critical – and troubling – characteristics of the current-era U.S. economy.  I have written extensively on the subject for a number of reasons, including its monumental importance as well as its poorly understood nature.

There are many theories as to why asset bubbles form.  My own thoughts on the matter are highly complex, especially concerning the current-era bubbles.

One common theory as to why asset bubbles form is the existence of (ultra-) low interest rates.  I have discussed this facet previously, including in the December 2, 2009 post titled “Bubbles.”

One prominent way to measure as to whether interest rates are “abnormally low” is by comparing rates – typically the “Fed Funds” rate – to the rate implied by the “Taylor Rule.”  A simple description of that rule can be seen in the December 20, 2016 Wall Street Journal op-ed (“The Case for a Rules-Based Fed“) written by John B. Taylor, creator of the Taylor Rule.  An excerpt:

Mr. Kashkari’s argument against rules-based strategies focuses on the “Taylor rule,” which emerged from my research in the 1970s and ’80s and has been used in virtually every country in the world. The rule calls for central banks to increase interest rates by a certain amount when price inflation rises and to decrease interest rates by a certain amount when the economy goes into a recession.

While my thoughts on the “Taylor Rule” are complex and aren’t suitably discussed in a brief manner, I will say that I don’t necessarily agree with its theoretical framework and/or the methodologies employed, or implications.  However, I do think that its current readings are both notable and informative.  Among notable aspects, one can clearly see that the Fed Funds rate has been far below the “Taylor Rule” prescription for a protracted time period.

The Federal Reserve Bank of Atlanta provides detailed information concerning the “Taylor Rule,” which includes the chart shown below.  One should note that the readings are influenced by a number of assumptions, and thus it is both possible and likely that the readings of the model can change significantly with changes in the assumptions.

The chart below is updated through December 22, 2016:

Taylor Rule chart

 

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 2270.16 as this post is written

Measuring QE’s Impact

I have written extensively about Quantitative Easing (QE) and Interventions as I believe many aspects of these practices lack recognition and understanding.   My analyses indicate that QE (also referred to as “Large-Scale Asset Purchases” (LSAPs)) in general carries an array of risks, detrimental impacts, and unintended consequences.  It has complex impacts on the economy and markets.

Over time, there have been several studies and estimates made with regard to measuring the impact of QE programs, and those that I have seen indicate a wide range of conclusions. While I don’t necessarily agree with the methods used or conclusions reached in these various efforts, I do feel that the overall topic of assessing the impact of QE is of great importance, given its prevalence in U.S. monetary policy.

Measuring QE can take many different forms, as not only are there different QE programs (e.g. QE1, QE2, etc.) but also a variety of areas that can be assessed, including QE’s impact on the economy, on the bond market, and on the stock market; as well as on numerous other assorted areas, including market expectations and the potential for (mark-to-market) losses in the Federal Reserve’s portfolio, which I most recently discussed in the post of June 26 titled “Potential Losses In The Federal Reserve’s Portfolio.”

One recent study that I found notable, although don’t necessarily agree with, is the Federal Reserve Bank of San Francisco’s Economic Letter of August 12 titled “How Stimulatory Are Large-Scale Asset Purchases?”   This paper discusses the impact of QE2, derived through simulation, and compares these findings to other research. While I believe that this document should be read in its entirety, here are a couple of excerpts:

Our model estimates that such a program lowers the risk premium by a median of 0.12 percentage point. Figure 1 shows the program’s effects on real GDP growth and inflation. The red line is the median effect in annualized percentage points. The shaded areas represent probability bands from 50% to 90% around the median. The estimates reflect uncertainty arising from three factors: the sensitivity of the risk premium to the asset purchases, the degree of investor segmentation, and other model parameters influencing the economy’s response to interest rate changes.

The 0.13 percentage point median impact on real GDP growth fades after two years. The median effect on inflation is a mere 0.03 percentage point. To put these numbers in perspective, QE2 was announced in the fourth quarter of 2010. Real GDP growth in that quarter was 1.1% and personal consumption expenditure price index (PCEPI) inflation excluding food and energy was 0.8%. Our estimates suggest that, without LSAPs, real GDP growth would have been about 0.97% and core PCEPI inflation about 0.77%.

And, from the conclusion:

Asset purchase programs like QE2 appear to have, at best, moderate effects on economic growth and inflation. Research suggests that the key reason these effects are limited is that bond market segmentation is small. Moreover, the magnitude of LSAP effects depends greatly on expectations for interest rate policy, but those effects are weaker and more uncertain than conventional interest rate policy. This suggests that communication about the beginning of federal funds rate increases will have stronger effects than guidance about the end of asset purchases.

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1685.39 as this post is written

Potential Losses In The Federal Reserve’s Portfolio

I have written extensively on the issue of Quantitative Easing (QE) and Interventions as I believe many aspects of these practices lack recognition and understanding.   Quantitative Easing in general carries an array of risks, detrimental impacts, unintended consequences, and complex impacts on the economy and markets.

One such set of dynamics embedded within QE that I believe lacks recognition is the risk of losses that can occur in the Federal Reserve’s portfolio.  I previously wrote of this in the post of March 7, 2012 titled “Dynamics And Risks Of The Federal Reserve’s Portfolio.”

While the subject of potential losses is complex – and quantification of such potential losses is made difficult due to the many factors involved – the sheer size of the numbers involved, as well as various adverse situations that may develop during the course of portfolio losses – make this an issue that deserves recognition.

It should be noted that various parties believe that numerous mitigating factors minimize the importance of the potential for losses from the Fed’s portfolio.  For instance,  it appears that many people discount the risk of losses, as well as the potential for the Federal Reserve to exhaust its capital base, as they figure that the U.S. Treasury can always replenish the capital.  As well, there is the issue of “mark to market” losses vs. accounting losses, and how the markets view the difference.  (Note:  as seen in the FRBSF Economic Letter of April 11, 2011:  “…the Fed values its securities at acquisition cost and registers capital gains and losses only when securities are sold. Such historical-cost accounting is considered appropriate for a central bank that is motivated by macroeconomic policy objectives rather than financial profit and is consistent with the buy-and-hold securities strategy the Fed has traditionally followed.”)  Other mitigating factors are cited as well, including reasoning cited by the Federal Reserve in the above-mentioned March 7, 2012 blog post.

However, if one believes that there is possible adverse impact(s) stemming from mark-to-market losses in the Federal Reserve’s portfolio as well as the exhaustion of the Federal Reserve’s capital, a disconcerting picture appears, especially in today’s rising interest rate environment.

Subsequent to my March 7, 2012 blog post, there have been some published analyses that attempt to quantify the potential for losses in the Federal Reserve’s portfolio.  Two of these include the January 2013 Federal Reserve paper titled “The Federal Reserve’s Balance Sheet and Earnings:  A primer and projections,” (discussed in the Wall Street Journal article of January 30, 2013 titled “Fed Risks Losses From Bonds“) as well as the Bloomberg article of February 26, 2013 titled “Fed Faces Explaining Billion-Dollar Losses in QE Exit Stress.”

While this Bloomberg article contains various interesting commentary, the following excerpts are especially notable:

MSCI’s data showed the greatest losses under the adverse scenario, as 10-year Treasury yields jump to 5.4 percent by the end of 2015 and three-month rates rise to 4 percent. The 10-year yield was 1.86 percent yesterday, and the three-month rate was 0.117 percent.

also:

Losses on the Fed’s portfolio rise steadily under the adverse scenario to $547 billion by the fourth quarter of 2015 in the MSCI analysis, which is purely a measure of interest-rate risk in the portfolio starting from bond prices at year end. It does not take account of purchases or sales the Fed may conduct in the future. The calculations are mark-to-market losses on the portfolio that take account of yield, amortization, accretion, and funding costs.

Also of critical importance is how sensitive the Federal Reserve’s asset portfolio is to an increase in interest rates before the capital base is exhausted.  Cumberland Advisors publishes a CUMB-E Index (pdf) described as a measure of “Percentage  point parallel shift in yield curve needed to exhaust Federal Reserve capital account.”  This CUMB-E Index value as of June 19 stood at .27.  (also of note is Cumberland’s “Total Assets Of Major Central Banks” (pdf) which shows the size, trends, and composition of major Central Bank assets.)

In aggregate, my interpretation of this potential for losses in the Federal Reserve’s portfolio is that the portfolio is highly susceptible (on an “all things considered” basis) to large (mark-to-market) losses.   While the amount of these losses depends upon many factors, the overall dynamics of interest rates and their potential for quick and substantial increases serves to further magnify the potential for large losses.

In addition to the direct (mark-to-market) losses, there are also an array of direct and indirect adverse impact(s) these losses can have on the Federal Reserve, U.S. financial standing, and financial markets.  While the extent of these various adverse impacts depends upon many factors, these impacts can cause many highly complex financial and policy problems.

For reference, here is a chart of the 10-Year Treasury Note Yield since 1980, depicted on a monthly LOG basis since 1980 through June 25, 2013, with price labels:

(click on chart to enlarge image)(chart courtesy of StockCharts.com; chart creation and annotation by the author)

EconomicGreenfield 6-25-13 TNX Monthly LOG since 1980

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1588.03 as this post is written

Notable Statement Concerning Continued Monetary Stimulus

While I don’t necessarily agree with any or all parts of the following statement, released yesterday, from Financial Services Committee Chairman Jeb Hensarling (R-TX), I do think that it is notable, and as such should be recognized.

Here is the statement, which is in response to continued monetary stimulus as announced in yesterday’s Federal Reserve FOMC Statement :

Like a patient who has been administered too many antibiotics, the economy is less and less responsive to the Fed’s continued monetary stimulus.  America is nearly five years into the Fed’s historically unprecedented interventionist policies and there is very little gain to show for it.  12 million Americans remain unemployed — a number roughly equal to the entire population of Ohio.  Many others are so discouraged they have given up looking for work, and our so-called recovery is the weakest in modern times.

It’s time for the Fed to acknowledge the simple truth that the challenges facing our economy today cannot be solved by more monetary stimulus.  If the Fed wants to help the economy, it needs to adopt a more predictable, rules-based policy that aims for long-term price stability.  That is the policy that will promote long-term economic growth.

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1588.41 as this post is written

QE3 Comments

In this post I will make a few (belated) comments regarding QE3, as announced by Ben Bernanke on Thursday. I highlighted notable aspects of that Press Conference, as well as provided links to the transcript, economic projections and FOMC Statement in the September 15 post (“Ben Bernanke’s September 13, 2012 Press Conference – Notable Aspects“)

While I could make many comments about Thursday’s announcement, I will at this point briefly comment on a few aspects.  I have previously written extensively about the characteristics and risks of Quantitative Easing and Interventions as I believe many aspects of these practices lack recognition and understanding.

With regard to Thursday’s Press Conference, one aspect I found disconcerting was the discussion of QE3’s risks.  First, I found it disconcerting that “risks” was not a term used, but rather “costs” (e.g. from the transcript “Of course, in determining the size, pace, and composition of any additional asset purchases, we will, as always, take appropriate account of the inflation outlook and of their efficacy and costs.”)  While some may view this as semantics, I believe that the term “risks” is far more descriptive and appropriate.

Another notable aspect of the Press Conference was Ben Bernanke’s address of “three concerns” regarding additional quantitative easing.  As seen on the transcript:

Before I take your questions, I’d like to briefly address three concerns that have been raised about the Federal Reserve’s accommodative monetary policy. The first is the notion that the Federal Reserve’s securities purchases are akin to fiscal spending. The second is that a policy of very low rates hurts savers. The third is that the Federal Reserve’s policies risk inflation down the road.

As I have written extensively, quantitative easing in general carries an array of risks, detrimental impacts, unintended consequences, and complex impacts on the economy and markets.  The three “concerns” mentioned above, while significant, in my opinion are just a small fraction of areas of concern.

One area of tremendous concern is that of the (eventual) exit from the Quantitative Easing measures.  One of my main concerns with regard to the exit is if it is done under “exigent circumstances” as opposed to under “normal” conditions.  While an exit under normal conditions may – or may not be – orderly and nondisruptive to the economy and markets, an exit under “exigent circumstances” will likely be very traumatic.  I first mentioned this “exigent circumstances” issue in the December 17, 2010 post (“Quantitative Easing Exit Issues“) and it remains a very significant concern.

Another aspect of concern is the impact QE3 will have.  This issue is very complex.  While I don’t necessarily agree with his view on the matter, I found Ben Bernanke’s comments – one seen below – to be very significant:

We do think that these policies can bring interest rates down. Not just treasury rates but a whole range of rates, including mortgage rates and rates for corporate bonds and other types of important interest rates. It also affects stock prices. It affects other asset prices, home prices for example. So looking at all the different channels of effect, we think it does have impact on the economy, it will have impact on the labor market but as again, the way I would describe it is a meaningful effect, a significant effect but not a panacea, not a solution for the whole issue. We’re just trying to get the economy to move in the right direction to make sure that we don’t stagnate at high levels of unemployment, that we’re making progress towards more acceptable levels of unemployment.

Quantitative Easing remains an important and contentious practice, and I intend to further comment on it as conditions warrant.

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1458.59 as this post is written

Articles Remembering Anna J. Schwartz

Two well-written articles remembering the life of Anna J. Schwartz include the June 21 New York Times article titled “Anna Schwartz, Economist Who Worked With Friedman, Dies at 96” as well as the June 22 Bloomberg BusinessWeek article titled “Anna Schwartz, Economist Milton Friedman’s Co-Author, Dies at 96.”

Although both article are well worth reading in their entirety, I would like to highlight some excerpts from the Bloomberg BusinessWeek article:

The first book that Schwartz wrote with Friedman, “A Monetary History of the United States, 1867-1960,” had “critical influence” on the outlook “of a generation of policy makers,” Bernanke said in 2003, when he was a Fed governor.

Published in 1963, the book advanced the idea that the Great Depression had been triggered by the central bank’s reduction in the U.S. money supply from 1928 until the early 1930s. That contradicted the prevailing view that it resulted from the 1929 stock-market crash.

also:

In a 2008 interview with Barron’s, Schwartz said the government needed to stop injecting liquidity into markets and reacting to the credit crisis with ad hoc programs.

“If I regret one thing, it’s that Milton Friedman isn’t alive to see what’s happening today,” she told the magazine. Referring to Bernanke, she said, “It’s like the only lesson the Federal Reserve took from the Great Depression was to flood the market with liquidity. Well, it isn’t working.”

Schwartz said in a July 2009 commentary for the New York Times that Bernanke, the architect of the central bank’s emergency programs, didn’t deserve reappointment as Fed chief.

“Mr. Bernanke seems to know only two amounts: zero and trillions,” she said, referring to his policy of holding the target interest rate near zero and the expansion of the Fed’s assets to $2 trillion in July 2009, more than double the level of early 2008. The U.S. Senate’s 70-30 vote to approve Bernanke for a second four-year term in 2010 marked the greatest opposition to a Fed chairman since the office became subject to Senate confirmation in 1978.

My comments: 

For those unaware, the aforementioned “A Monetary History of the United States, 1867-1960” seems to have had an almost monumental influence on multiple fronts.  While my thoughts on the book are complex – especially with regard to its description and interpretation of The Great Depression – the book appears to have had immense influence on both the putative causes of The Great Depression as well as a preeminent reference as how to avoid Depression conditions.  It strongly appears as if the book has had a strong influence on Ben Bernanke’s economic interpretations and actions.

I highlighted the quotes and thoughts from Anna Schwartz concerning the various intervention efforts from 2007, as well as her thoughts on Ben Bernanke’s actions, as I believe these thoughts deserve greater recognition.

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1331.50 as this post is written

Dynamics And Risks Of The Federal Reserve’s Portfolio

In previous posts I have written extensively of the intervention measures taken by the Federal Reserve, including the many risks involved with Quantitative Easing measures.   One of the risks is the resulting size of the Federal Reserve’s portfolio and its inherent susceptibility to large (on a mark-to-market basis, as opposed to accounting basis) losses.

This risk greatly lacks recognition.  It appears that many people discount the risk of losses, as well as the potential for the Federal Reserve to exhaust its capital base, as they figure that the Treasury can always replenish the capital.  However, I believe that this reasoning is  shortsighted on many fronts.  Compounding the complexity of the potential for large losses in the Federal Reserve’s portfolio is the fact that any action it may take with regard to acquiring or disposing of these assets has to be weighed against the risks or damage that such acquisition or disposition incurs in the economy and/or financial markets.  Given the complexity of the situation, the exceedingly large asset base and its leverage, and the uncertainties inherent in the markets – especially during times of financial stress or crises – asset acquisition, disposition, and willingness to take losses on the portfolio becomes a (very) complex matter.  While I am not aware of any recent Federal Reserve statements on this matter,  a FRBSF Paper of April 11, 2011 titled “The Fed’s Interest Rate Risk” (pdf) contains the following excerpts:

The Fed, of course, strives to be a cost-efficient steward of the public purse. But its statutory mandate for conducting monetary policy is to promote maximum employment and price stability. These macroeconomic goals are the key metrics for judging monetary policy. Financial considerations—even potentially large capital losses—are secondary.

also (under “Conclusion”) :

In its policy actions, the Fed’s primary focus has been on restoring the economy to health and maintaining low inflation. The Fed’s recent securities purchases appear likely to register financial gains, though these are at risk if interest rates rise. However, as then-professor Ben Bernanke (2000) wrote: For a central bank “to allow consideration of possible capital losses to block needed policy actions is misguided.” That is, interest rate risk should be a secondary consideration, subordinate to the macroeconomic goals of monetary policy.

There is also the possibility of exit from QE under exigent circumstances, which represents an adverse scenario fraught with peril.

Accentuating the dangers of the situation are the fact that interest rates are (depending upon the specific instrument) very near – or at – very-long term lows and my assessment (also held by many) that the bond market is an asset bubble.

Cumberland Advisors has published a notable document explaining its CUMB-E Index (pdf) that illustrates some of the main dynamics of the Federal Reserve’s portfolio and their trends, including its capital base / leverage and its sensitivity to increases in interest rates.  As of February 29, the CUMB-E Index is at .438.

One interpretation that could be made is that if this were the portfolio of a commercial bank or hedge fund, with leverage of 50+:1  and with the aforementioned sensitivities and market dynamics – it would represent an exceedingly high risk situation.

As well, there are a variety of other notable risk aspects and dangers inherent in the situation that lack recognition, which I may discuss in future writings.

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1343.36 as this post is written

Federal Reserve Philosophies – Then And Now

On Monday, February 13, John C. Williams, President and CEO, Federal Reserve Bank of San Francisco, gave a speech titled “The Federal Reserve’s Mandate and Best Practice Monetary Policy.”

Although I don’t agree with many aspects of the speech, I found various aspects to be notable.  I would like to highlight one excerpt in particular, as I find it highly memorable and an iconic quote of the period:

With regard to both of the Fed’s mandates, it’s vital that we keep the monetary policy throttle wide open.

I think it is interesting to compare this excerpt to a famous quote by William McChesney Martin, who was Chairman of The Federal Reserve from 1951-1970; Martin declared that the Federal Reserve’s role was “to take away the punch bowl just as the party gets going.”

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Another notable excerpt from Williams’ speech of Monday I would like to highlight as highly significant, especially the second paragraph, which concludes the speech :

We have pushed the federal funds rate close to zero because of the severe recession of 2007 through 2009, and the weak recovery since. We’ve said we expect to keep the federal funds rate extremely low at least through late 2014. Meanwhile, with the fed funds rate near zero, we’ve used some unconventional monetary policy tools to try to push down longer-term interest rates further. Our policy initiatives are a major reason why interest rates across the entire yield curve are at or near record low levels for the post-World War II period.

This is truly an extraordinary time for monetary policy. I’ve talked about some of the tradeoffs central bankers face. But I don’t see such tradeoffs today. Now is one of those moments when everything points in the same direction. The Fed is committed to achieving maximum employment and price stability. And we’re doing everything in our power to move towards those goals. Thank you very much.

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1358.04 as this post is written

QE3 – Various Thoughts

In the July 7 post (“Evaluating QE2“) I mentioned that “…I believe that QE3 or something very similar will be done in the future.”

There are many reasons for this belief.  Among the reasons for additional QE include the recent market tumult, visibly weakening economy, and various confidence measures that have nosedived.

My belief in further QE is an expectation, as opposed to an endorsement of the idea.  While my thoughts on the QE concept are complex, in my extensive writings on the subject I have indicated that I believe that Quantitative Easing carries substantial risks,  unintended consequences, and many complex impacts on the economy and markets.

However, QE3 would provide various markets – especially the stock market – with a significant boost.

For reference purposes, here is a recent chart from Doug Short’s blog post of August 5 (“Chart of the Day: Anticipating QE3“) depicting the movements of the S&P500, 10-Year Treasury Yields and the Fed Funds rate over the periods of QE1 and QE2:

 

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1132.34 as this post is written

Evaluating QE2

On June 30 The Wall Street Journal published a chart titled “QE2:  A Quantitative Assessment.”  It commented on QE2 and showed how various economic and market metrics fared over the course of the program.

The question of QE2’s impact is an important one, for a variety of reasons.  This impact is especially important as I believe that QE3 or something very similar will be done in the future.

How should the impact(s) of QE2 be assessed?

I believe that such an assessment should be broader than what is commonly seen.

Among areas that should be assessed are the risks taken by performing QE2.  I have written extensively about various QE2 risks in previous posts.

Another issue that deserves greater recognition is that pertaining to the risks accompanying the “exit” from QE2.  Until such an exit is orchestrated, I don’t believe that QE2 can begin to be fully assessed.  I wrote about the risks of exit from QE2 in the December 17 post titled “Quantitative Easing Exit Issues.”

Overall, I believe that QE2 has had a complex impact on the economy and markets.

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1339.22 as this post is written