There is no exit plan

[Barron]

There was an interesting note from Agora Financial a few weeks ago raising the following question. If Operation Twist and the previous QE programmes were successful, then why is there a need for more? And if they were not successful, then why are they are there going to be more of them?

While the current status of major global currencies is already cause for concern, what’s even more disconcerting is the style of analysis being used by central banks. The crisis began in 2008 and was met with unprecedented amounts of liquidity and easing. Central bankers remain convinced that this is the correct strategy and continue to apply this medicine. But was this really the correct solution and by what metric is it being judged a success?

It’s true that when Lehman Brothers failed, bailouts and easing prevented significantly worse conditions at that time. But at what cost? Europe is on the verge of collapse. The US is still regarded as the safe haven but despite years of zero interest rate policy and a massively expanded Federal Reserve balance sheet the economy is again on the verge of disaster. Yet the only solutions being discussed are more easing and stimulus.

Successful businesses review their actions and results to see which ones were effective and which were not. There is important information in studying these results as it allows the business to determine which activities should be continued and which should be stopped. Applying that same process to quantitative easing raises significant questions about the economic philosophy of central bankers. Exactly what is the event that could occur that would be a sign to the central banks that this policy isn’t working? The same problems continue to occur after each round of stimulus and the extent of the problems get progressively worse. Yet the only solution is to do it again in bigger size. It’s hard to miss the connection between this type of monetary policy and the asset bubbles that continue to develop with ever increasing intensity. Yet if central bankers cannot draw these conclusions when it is this late in the game then exactly what is the event that can occur that will ever lead them to change their minds?

In trading the benefits of the review process become evident very quickly. If a trader makes a mistake they lose money (at least traditionally that used to be the concept). This is the free market’s mechanism to alert the trader that there was an error in analysis. To prevent a future loss, his or her decision-making needs to change. This is the same process that applies to business ventures and allows capital to flow to where it can be utilised most efficiently.

But as Agora points out, this process is not being applied to quantitative easing. Regardless of the results, monetary expansion remains the only tool in the central-bank tool kit. Global markets have not revisited the type of chaos experienced after the Lehman Brothers failure, but that’s simply because the problems have been avoided and pushed into the future. In America the federal debt is expanding as rapidly as the Fed balance sheet. And while government and central bank officials constantly remind the public about the disaster that was avoided, they rarely mention how these short-term solutions will eventually be unwound.

Think about the composition of the Fed’s holdings. These are mainly Treasury and mortgage securities. These are both interest rate sensitive assets. Their value moves inversely to interest rates, meaning that as rates go down they become more valuable. Of course the problem is that as interest rates rise they lose value. The Fed claims that as conditions improve it will begin unwinding this book of securities. But in this environment, interest rates will be rising, which means that the Fed is going to be selling assets that are losing value. A quick look at the composition of their balance sheet requires little advanced math to see that it is hard to construct a scenario in which the Fed is not already currently insolvent. And we are to believe that the Fed will raise interest rates, sell of its balance sheet all while Congress is finally making serious efforts to address fiscal problems as well?

Consider the current state of the housing market. Right now it’s still incredibly weak and that’s with historically low mortgage financing rates. Higher interest rates alone will be a drag on the housing market and if the Fed is also removing itself as a buyer of mortgages then where is the additional demand going to come from? And if housing begins to weaken, it’s very likely that the Fed would step in and say there is a need for more easing.

The fact is that there is no exit plan. This is one of many reasons why the current policy is incredibly reckless. It also sets up a pernicious cycle in that as the problems get worse the temptation to print becomes greater. And as more money is printed the problems will only get worse. It’s a losing hand that is just waiting for the rest of the cards to be flipped over. In 2006 it was hard to find many people who thought that home prices would go down. In 2008 it was not quite as difficult.

The nature of asset bubbles is that it is easy to follow the herd and lose track of what you know must be. Reviewing the past is an excellent practice that allows future mistakes to be avoided. Central banks are having trouble learning this lesson, but it’s still possible for you to avoid the same mistake.

Author: Chris Marcus