Investors’ on/off love affair with risk assets has characterised financial market behaviour all year. Indeed, the bullish sentiment evident in rising stock prices early in the year succumbed to ‘double-dip’ fears during the second quarter, which precipitated a sixteen per cent drop in the major market averages from their cycle-high in late-April by mid-summer.
Bearish concerns have since been all but dismissed, and stock prices have staged an impressive advance as expectations that the Federal Reserve is set to embark on a fresh round of quantitative easing (QE2) have gained traction. The recent enthusiasm for risk assets confirms that investors are confident not only that the Fed will begin further purchases of long-term assets financed by money creation, but also that the so-called QE2 will rouse the economy from its inertia. Could such optimism be misplaced?
The minutes of the September 21st meeting of the Federal Open Market Committee (FOMC), alongside the various speeches delivered by members of the FOMC, indicate that investors are correct to surmise that the central bank will announce the launch of QE2 in the policy statement that is released after its two-day meeting concludes next Wednesday. However, market participants appear to be overlooking the fact that a decision to begin further long-term asset purchases represents an admission that the economy remains extraordinarily fragile and is in urgent need of additional monetary stimulus.
The acknowledgement also confirms that the record monetary stimulus provided since the crisis erupted in the autumn of 2007 has failed to produce a self-sustaining economic recovery. Despite a near-zero policy rate and previous injections of liquidity that saw the size of the Fed’s balance sheet jump from $900 billion pre-crisis to roughly $2.3 trillion today, economic activity remains below the previous cycle peak and the sizable output gap has seen the Fed fail to deliver on its dual mandate of price stability and full employment.
Core consumer price inflation (CPI) is running one percentage point below the desired two per cent year-on-year rate and too close to zero for comfort, while the slack in the labour market is several percentage points above the optimum level and unlikely to register a meaningful improvement anytime soon. Monetary policymakers at the Marriner Eccles Building in Washington D.C. are feeling the pressure, and they hope that QE2 will prevent deflation via increased inflation expectations and greater economic activity.
Quantitative easing or the purchase of long-term assets financed via an expansion of the monetary base will enhance economic growth if the money multiplier and the velocity of money do not decline. A stable money multiplier requires that the excess reserves in the banking system created by the central bank’s asset purchases are passed through to household and business accounts. However, to induce banks to accept the large expansion in reserve balances in the first place, the central bank must make them sufficiently attractive to hold relative to other low-risk short-term paper.
The Fed began to pay interest on reserves in October 2008 and excess reserves are currently remunerated at the target policy rate. Since the opportunity cost of holding excess reserves is now zero, they are equivalent to low-risk short-term paper such as Treasury bills, and further, since they are a liquid asset of the banking system, they have little role to play in the lending decision. This observation is corroborated by QE1, which precipitated a surge in the level of excess reserves from less than $2 billion before the interest-on-reserves regime was introduced to almost $1 trillion today. Consequently, the first round of quantitative easing had minimal impact on the banking sector’s willingness to lend and it is difficult to see why QE2 should be any different.
Meanwhile, the non-financial business sector’s demand for money remains high, as the credit freeze apparent at the height of the financial crisis precipitated an upward shift in the demand for precautionary balances. Liquid assets amounted to seven per cent of total assets in the past two quarters, the highest level since 1963, and the huge cash reserves confirm that the economy’s ills have little to do with liquidity. The corporate sector is still beset by excess capacity, which is well below its historic average, and attractive investment projects are scarce even at current borrowing rates.
The household sector is not in a position to borrow given near double-digit unemployment rates and overleveraged balance sheets. Indeed, almost one-third of the U.S. population is not creditworthy, while the remainder are likely rebuilding their balance sheets following the collapse in house prices and the value of retirement assets.
QE2 is on the way next week and investors have embraced risk assets in anticipation. Quantitative easing reads well on paper, but the Fed’s own experience to date is less than encouraging. Robust economic growth requires a new credit cycle, but this is an unlikely development amidst ongoing deleveraging. The stage for disappointment is being set; investors would do well to remember that it’s better to travel than arrive.