The Fed’s announcing the taper was supposed to be an earth-shaking event. But that actually sorta happened last summer when Bernanke first used the “t” word and interest and mortgage rates made an impressive upward march in a short period of time.
From my considerable remove, what was noteworthy about the Fed’s announcement yesterday is how terrified it seems to be of creating an upset. This in and of itself is pretty odd, since other central banks are still engaged in QE and/or aggressive liquidity creation (Japan is going to do even more soon) so as to make the impact of any move by the Fed not that consequential in isolation.
And that’s before you consider the historical evidence that undoing QE did all of…bupkis. As Philip Pilkington writes:
There are two things that are particularly odd about all the tapering talk — two things that are tied up with one another. The first is that there is talk at all. If tapering evidently makes rather little difference to the markets and the economy then why do the press and financial analysts talk about it endlessly? The answer to this is rather simple: it is the nature of the press and wider society to talk about people and institutions that are perceived to wield power…
The second thing that was rather odd about all the tapering talk was the constant reference to the supposed fact that it had never been done before, that we were entering uncharted waters and that it was hard to predict what effect such tapering might have. This was just complete and utter rubbish.
In actual fact, as I noted on FT Alphaville back in April, a far more extreme version of tapering was undertaken by the Japanese central bank (JCB) in early 2006. In this period the central bank didn’t just slow the rate of purchases as the Fed are now doing but instead shrank their balance sheet. And what were the effects? I cannot find any serious effects in the data.
As I noted in that post there was no obvious correlation between QE and inflation or the exchange rate or GDP growth. The shrinking of the JCB’s balance sheet also appears to have had no effect on the stock market which continued to rally until the onset of the financial crisis in late-2007/early-2008.
So, why is no one reporting on this? Surely this should be a worthy news item. Given that barrels upon barrels of ink that are expended daily reflecting on the significance of the taper surely the press should be interested in considering a far more substantial move away from QE. Not really. That would be the equivalent of revealing that the emperor has no clothes.
Now I’ll differ with Pilkington a tad. QE did have some effects, but I doubt NC readers would seem many of them as significant or all that salutary, given where unemployment sits. Unlike Japan, US mortgages are mainly fixed rate but borrowers can refinance freely. The refi boom provided banks with income and some consumers with lower mortgage payments. So this was a prop to bank income and an indirect and not very strong form of stimulus (the banks take a lot out in fees, so the consumer relief was not as great as you might hazard). We also had other behaviors you would not have seen in Japan, such as corporations issuing bonds like crazy and building up large cash hordes, and in many cases buying back their own stock. Oh, and it did encourage private equity firms to rush out and buy a lot of single family homes to rent. We suspect in many cases the results will not be pretty.
But even if the Fed now recognizes that QE wasn’t terribly effective, their desperate signaling to the market that they won’t do anything to rattle it is really unseemly. Income inequality has risen dramatically since the crisis, and using the wealth effect to try to provide some lift to the economy is perverse, an indirect entrenchment of this aspect of a bad status quo. The Fed seems reluctant to recognize that low interest rates no longer provides much stimulus to the economy because the housing model, which was the main transmission channel in past recoveries, is broken (See Matt Stoller’s Fordham Fordham Urban Law Journal article, The Housing Crash and the End of American Citizenship, for a long-from discussion). Low household formation, high debt levels among the young (and student debt as senior debt!), distrust of housing (rational given predatory servicing and undue emphasis on “housing as an investment”) and ironically, the success of the “prop up housing prices” effort limiting affordability all contributed to the limited impact of QE (not that I am certain it would have worked even then; the Bank of Japan was first to experiment in the late 1980s with using the wealth effect to boost consumption, and we know how that movie ended).
The Fed also weirdly never seemed to get that banks aren’t lending primarily because there is little demand for loans among small businesses (they borrow to exploit opportunities, which are few in the new normal, unless you are in a countercyclical enterprise) and because banking has become so concentrated. The central bank has happily allowed banks to become fewer and bigger even before the crisis. But megabank run their branches like stores, and allow manager little discretion. That means they don’t engage in character-based lending and aren’t able to use local market intelligence to inform small business lending decision. The result is that they’ve pretty much ceded that business to community banks and credit unions, but they aren’t as big a channel as in the old days when there was more diversity in banking and the bigger banks had some participation in this sector.
The Fed has undergone a complete reversal since I was a young thing in the finance business. It used to relish the role of taking the punchbowl away. It now seems terrified of even reducing the alcohol level of the brew. This all goes back to Greenspan. My pet theory is he was very much imprinted by the stock market crash of 1987, which was early on his watch, and he got lots of praise for handling it well. He was also obsesses with how stock market prices were formed and apparently set a lot of Fed talent to studying that question. And Bernanke clearly embraced Greenspan’s equity-fixated view. Recall that Bernanke’s famous 2002 speech about deflation, in which he set forth the extreme measures the Fed could use to fight deflation, was triggered by fear that the dot-com bust would trigger deflation. This was an astonishing belief, since the stock market bubble did not involve a significant amount of borrowings and its implosion did not blow back to the financial system.
The final problem is mission creep. The Fed has abandoned its independence (despite its claims to the contrary; an independent Fed would stay silent on matters like Social Security and budget policy) and has also unwisely allowed itself to be seen as the possible savior of the economy, when any heroic efforts should be made thorough government programs, not unaccountable central bank initiatives. But since Greenspan, the Fed enjoys its Oz-like image, even if it had deployed its stage-magical powers to fight chimeras.