Everybody, calm down. Not just a deep breath, but lasting calm. Markets, new data, and three extraordinary leaders today conspired to bring peace.
We added 312,000 new jobs in December, the prior two months revised up, and to remind us of the approximate nature of the world, unemployment rose to 3.9%. Wages have risen 3.2% year-over year. If that’s an economic fade, please give us more fade.
Stocks found bottom on the news, and so did rates. Mortgages are still below 5.00%, but maybe not for long. Evidence accumulates that the principle trouble in stocks is having gone too far too fast, too deep in Apple-flavored Kool-Aid, and not a forecast of economic trouble to come. If it does come, odds are high that the source will be overseas, or foot-shooting here (tariffs).
The most reassuring, calm-inducing event in months, proof that able, occasionally brilliant, non-political people are hard at work in most parts of our government: this morning’s one-hour round table discussion by Jay Powell, Janet Yellen, and Ben Bernanke at the American Economic Association. Watch it here. Better to feel pleasure than frustration at the difference between this show and public appearances by some other senior officials.
Powell delivered one policy note. He used the P-word. Not pause, but patient. The Fed’s tilt is still toward more rate hikes, but less predetermined than markets thought after the Fed’s December 19 meeting.
The best line at the round table, in Bernanke’s wicked sense of humor while observing that this economic expansion will soon be the nation’s longest: “Expansions don’t die of old age. They are murdered. That’s what we do.” (Hearty laughter)
Given the global market upsets at hand, and possible economic ones, I’ve got to take a whack at explaining quantitative easing (QE), how and why it got us out of the last mess (and perhaps the next), and why reversing it now is NOT “quantitative tightening” -- today’s favorite financial scare story. Put this issue at the top of your “don’t worry” list.
QE is hell to explain and to understand correctly, but easy to twist into anti-Fed propaganda. Name names. The most common twisters: Lacy Hunt, John Mauldin, Jim Druckenmiller, Kevin Warsh, and Rick Santelli, joined by a host of anti-government opinionators.
Begin with vocabulary and definitions: liquidity, bank reserves, capital, and quantitative tightening. I can’t tell how many of the critics actually understand the issues but can’t resist a juicy target, and how many don’t understand, or don’t want to. But the frequency and volume of their misinformation is stupendous.
“Liquidity” is slippery. In markets it means the ability to sell something without a big discount from value established by prior trades -- literally, the ability to liquidate. The more liquid a market, the greater the volume of a security can be sold all at once. As liquidity diminishes, the spread widens between the price which sellers will accept and the price buyers will pay -- bid/offer spreads are the primary marker of health or distress in any market. Liquidity is not the same as cash, and the two have little to do with each other.
Beginning in 2007 and then all the way through 2008, bond market spreads widened, especially mortgage-related ones relative to Treasurys. As panic deepened, Treasury yields fell and fell, but mortgage rates did not. At crisis onset in July 2007, the 10-year T-note traded at 4.71%, 30-fixed mortgages 6.73%. One year later, just before Lehman crashed, 10s had fallen to 3.74%, and mortgages still cost 6.50% -- the widest spread in the record. Treasurys were liquid, but nothing else was. May you never stare at a screen of the bond market which has gone “no bid” -- no buyers at any price.
Banks, investors, pension and life funds all had tons of cash but were too fearful to buy anything. That’s the difference between cash and liquidity.
The Fed announced at Thanksgiving 2008 that it would enter the market to buy bonds and MBS. Markets lost fear and began to function immediately, spreads narrowing: by January 10s yielded 2.65% and mortgages cost 5.12%, still historically wide but the level down and spread within a half-percent of normal.
If QE1 worked so well, why rounds QE2 and QE3? “Capital” is why. Losses in the financial system after Lehman were immense, and only about half from mortgages. Under Greenspan’s bizarre Ayn Rand self-regulation banks had created huge piles of bad IOUs which would take years to write off. “Capital” resembles the net worth in your house, the excess of asset value over mortgage liability. In 2008 the system had been de-capitalized, all lost and then some, and capital levels had been too low to begin with. It took until 2013 for banks to replenish enough capital to make loans and to meet new, doubled standards for capital. Until then the second purpose of QE was to supply credit around a broken banking system. That worked, too.
Oh-by-the-way: the third purpose of QE was/is called “portfolio effect.” Assets of all kinds had crashed by the end of 2008, and QE helped them to recover value, which in turn got us out of recession.
QE had one trouble spot. The Fed bought the QE bonds (over $3 trillion) with “printed” money -- a thin-air credit to the bond-selling banks’ reserve accounts at the Fed. That’s what all central banks do to stimulate economies, but if overdone can create hyperinflation. The Fed had to make sure that only proper doses of booze made it from reserve accounts into the economy. (NOTE: “reserves” are not capital; they are a fixed percent of bank deposits which in turn must be deposited in cash at the Fed).
So the Fed invented a booze sponge: it would pay interest on bank reserves, helping banks to accumulate new capital, but keeping the printed money from reaching the economy. The printed money remained inert reserves, a big liability on the Fed’s balance sheet matched by the asset of the bonds it bought from banks.
The Fed began the process of unwinding this year, simply by stopping its purchase of new bonds as old ones mature and pay off. This unwinding is almost as neutral as the inert printed money. When a bond matures, the Fed uses the cash to pay down its liability to the banks’ reserve accounts. No external effect, except that the Fed has disappeared as a buyer of new bonds. But, today’s markets have healed, bank capital the biggest and best quality since the Depression, so far markets easily absorbing the Fed’s runoff.
There is no such thing as “quantitative tightening” -- that would happen only if the Fed dumped its holdings into markets, which if inflation had gotten going it would have done and still could. On the other hand, if QE begins to damage markets, the Fed will see it (spreads again) and can slow or stop its runoff altogether.
Today’s jackdaws complaining about the unwinding of QE are the same ones who thought it would be inflationary in the first place. They caw that QE didn’t cause a faster or bigger recovery, but it takes time to rebuild after these same birds wrecked the place. Their false arguments exposed, they retreat to the last screech: “It was all the Fed’s fault in the first place.” No, actually it was your fault. If you would behave yourselves, the Fed would not have to save the rest of us so often.