Once again, we come to that time of year where professional investors count their bonuses, or lick their wounds, and start planning their investment strategy for the New Year. The question on the mind of many is whether 2015 will be a continuation of the liquidity-fueled party of 2014 or whether 2015 will the year that a cruel and unusual hangover begins. Will the Fed take away the booze and what will the world look like when it does?
Let’s begin with a quick review of 2014. The most notable feature of 2014 is that there weren’t many notable features. The US equity market didn’t crash, most government bond portfolios suffered few casualties and even emerging markets were relatively tame (at least by historical standards).
There is a good reason that “not much happened” in investment markets in 2014: a tsunami of newly-created money continued to flood into global securities markets as central banks around the world continued to expand their balance sheets at an unprecedented pace.
Over the past six years, the US Federal Reserve has bought nearly $4 trillion worth of fixed-income securities. It is hard to put such a large number in context, but let’s try.
As at November 2014, there were 147m employed persons in the United States. If we assume that only working people can save money (those not working and the unemployed should, by definition, find it difficult to save money), then the US Federal Reserve’s actions were the equivalent of those 147 million Americans saving and investing an additional $27,210 each in the fixed-income securities markets over the past six years.
How does this compare with the current savings of the average US worker? Well, one newspaper article last year suggested that more than three-fourths of Americans don’t have enough money saved to pay their bills for six months. Is it likely that these Americans could have saved an additional $27,210 over the past six years and invested those savings in the securities markets? And could all of these 147 million Americans have saved this sort of money without causing a severe consumer-driven recession in the US? The easy answer, on both counts, is “no”.
Another way to think about the scale of the Fed’s quantitative easing program is to consider new car sales. Americans buy nearly 16 million new cars each year. According to Kelley Blue Book, the average price of a new vehicle was $32,086 in 2013. If we do the math, then we can say that over the past six years, Americans have spent nearly $3 trillion on new cars ($500 billion annually). Therefore, if Americans were to save the $4 trillion that the Fed has invested in the markets over the past six years, they would have to give up all purchases of new cars during that same period!
The point is that the additional $4 trillion that has been invested in the markets by the US Federal Reserve over the past six years is a “big deal”. The private sector could not have saved and invested this amount of money in this period of time without creating a severe economic recession. Moreover, the Federal Reserve is not the only major central bank that has been using money creation to fund the purchase of government securities.
So, where did this $4 trillion come from? Was it raised in taxation? No. Was it borrowed? No. (Note that borrowing the money would defeat the whole “purpose” of QE.) Rather, this $4 trillion was just “made up”.
As a society, we just decided to “make up” a whole bunch of new savings that we never had and invest them in the financial markets. This may sound like a great scheme, but there is a catch: “nothing in life is free”.
The question that investors should be asking as we enter 2015 is what is the cost of the past actions of the US Federal Reserve? How do we as a society pay for all the extra money that has been created? Moreover, and perhaps more importantly, when do we receive the bill for this grand experimentation in monetary policy?
There are two ways that we can pay for the Fed’s actions: either the Fed unwinds the six-year expansion in the monetary base and the markets crash, or the Fed does not reduce the monetary base and inflation takes off (and the markets crash). There is also a more realistic “middle-way”: the Fed makes a half-hearted attempt to reduce the monetary base, resulting in both a weak economy and higher inflation. Once again, this is a bad environment for most major asset classes.
Let’s consider each of the two major scenarios in turn.
In the first scenario, the Fed would need to sell at least $2-2.5 trillion of fixed-income securities in order to bring the monetary base back to its previous trend path (prior to the 2007/2008 crisis, the monetary base was growing at a roughly 6% annual rate).
If the Fed does reduce the monetary base by $2 trillion, then this will have an immediate and detrimental effect on all asset markets. In effect, the biggest marginal buyer in global asset markets suddenly becomes the biggest marginal seller. Just as many investors underestimated the impact of the Fed’s actions on the way up, so it is likely that most investors underestimate the impact on the markets of the Fed’s actions once those actions go into reverse.
It is worth remembering that this isn’t money that will be recycled through other parts of the economy: the Fed will not be selling bonds and using the proceeds to buy stocks or consumer products. Rather, the proceeds of these sales will simply “disappear” from the economy, just as the money used to make the original purchases magically appeared in the first place.
The second scenario is more interesting because it represents a more realistic path. As the Fed realizes the degree to which its actions have distorted the investment markets, it is unlikely that the Fed will have the courage to “put things right”. Therefore, we need to understand what will happen to the economy if the monetary base is not reduced from it current extended levels.
If the markets realize that the “temporary” expansion of the US monetary base is in fact a “permanent” expansion of the US monetary base, then this will lead to a decline in the market value of the US dollar. This decline may or may not be obvious in foreign exchange cross rates (after all, other nations are on a similar path), but it will become obvious in the general price level. Why? For the simple reason that, all else equal, as the market value of money falls, the price of all goods as expressed in money terms will rise.
The distinction between a “temporary” expansion in the monetary base and a “permanent” expansion in the monetary base is the key to the future of inflation. Quantitative easing was always advertised as a temporary solution to a temporary problem (a “soft patch” in the economy). Naturally, most investors expect that the expansion in the monetary base will be reversed in time. However, if these expectations are not met (i.e., if investors realize that QE was “falsely advertised”), then the market value of money will fall and the price level will rise.
Understanding why expectations are so important is a complicated issue that will be addressed in future posts. The view of The Enigma Series is that money is a long-duration, proportional claim on the output of society. As a consequence, the value of money is highly correlated to expectations of the long-term path of the “real output/base money” ratio.
At the present time, investors are quite optimistic regarding the long-term path of the “real output/base money” ratio. Investors seem to believe that the Fed will be true to its word and reduce the monetary base. Meanwhile, investors expect that this can be achieved with little impact on medium-term economic growth. If this is the case, then the value of a long-duration, proportional claim on the output of society (i.e., money) should be well supported and the rise in “money prices” (i.e., inflation) should be contained.
However, what would happen to the value of a proportional claim on the output of society if people suddenly decided that there would be a lot of more claims outstanding (a permanently higher monetary base) and/or lower growth in real output in the years to come? Clearly, the value of that proportional claim would decline.
The bottom line is that the Fed is approaching the end game. Either it remains true to its word and reduces the monetary base, an action that will lead to significant liquidity pressure on global investment markets, or the markets realize that the Fed has failed to live up to its word and the value of the USD adjusts accordingly.
It seems likely that 2015 will be the year that these issues come to the fore. Fiddling with “interest on reserves” is a distraction that may buy the Fed a little more time, but ultimately the Fed must reduce the US monetary base if it is to avoid putting the reputation and value of the US Dollar at risk.
2015. The party is over. The #Fedache begins.