How Is Quantitative Easing Going to Get People Borrowing?

By Professor Pinch  SEP 17, 2012 10:00 AM

You can lead a horse to water, but you can't make it drink. The Fed can give money to banks to lend, but they can't make consumers or companies borrow it.


Long road to ruin there in your eyes
Under the cold streetlights
No tomorrow, no dead end in sight

-- Foo Fighters, "Long Road to Ruin"
A lot of people have already weighed in on the Fed's latest course of action, QE3. I'm going to throw my two cents in as well, because I don't think some things are being taken into account with respect to monetary policy that need to be. Honestly, I didn't want to have to write this, but given the nature of the discussion taking place, there are some things that need to be considered, even though we should already know how this story goes. It's all there in those Foo Fighters lyrics and in the title of that song.
Here's the key snippet from the Fed's announcement where they do their level best to take the Foo Fighters' lyrics and apply it to monetary policy:
The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.
Based on that statement, it's obvious the money and bond markets will be subjected to QE beatings until morale improves. Time horizons and exit strategies be damned. How will the Fed know when they've done their job and won't need to do more? They're using the old definition applied to pornography: They'll know it when they see it. It's ironic -- and hilarious -- that for all the Fed's models and their data-intensive approach to understanding the economy, they're going to eyeball the success of this program. What strange times we live in.
The reason the Fed is going to commit to this policy is fairly straightforward: They want to see marked improvement in the labor market. The pace of job creation isn't quick enough and people are sick and tired of being sick and tired. But how is this supposed to work? How is quantitative easing supposed to translate into job growth? Here, Cullen Roche from The Pragmatic Capitalist pulled out this response that Chairman Ben Bernanke gave to Pedro da Costa at the Fed's press conference:
The tools we have involve affecting financial asset prices.  Those are the tools of monetary policy.  There are a number of different channels.  Mortgage rates, other rates, I mentioned corporate bond rates.  Also the prices of various assets.  For example, the prices of homes.  To the extent that the prices of homes begin to rise, consumers will feel wealthier, they’ll begin to feel more disposed to spend.  If home prices are rising they may feel more may be more willing to buy home because they think they’ll make a better return on that purchase.  So house prices is one vehicle.  Stock prices – many people own stocks directly or indirectly.    The issue here is whether improving asset prices will make people more willing to spend.  One of the main concerns that firms have is that there is not enough demand…if people feel their financial position is better they’ll be more likely to spend….

Ah. Channels and policy transmission mechanisms. Now we're getting somewhere. Ahead of Jackson Hole, former Minyanville editor-in-chief Kevin Depew (@kevindepew) shared this chart on Twitter:

You can see from the chart, a number of these channels by which monetary policy is transmitted are broken. Still. In Chairman Bernanke's answer to da Costa's question, we really see what the Fed wants to do: Its best chance at kick-starting a recovery right now is to make people feel wealthier. And if they feel wealthier, they will want to spend more, and borrow more money while they do it. This is all about trying to instill confidence in the broader economy and in the process, re-establish the Fed's transmission mechanisms (i.e. credit). Cullen goes on to explain why Chairman Bernanke's view is misguided, and I agree with him.
The Chairman's hope is a false hope. Especially when we've seen successive bubbles in stocks and real estate burst, wiping out valuations people pinned their hopes and dreams on. As Peter Atwater talked about in his book, many times confidence breaks down at the worst possible moment. Confidence isn't needed at troughs, it's needed the most when we're over-stretched, over-leveraged. Atwater is fond of saying we reach the most at the top, because at that moment, we feel that those peak conditions will apply to everyone, everywhere, forever.
At those moments of peak confidence, we feel that downside risk isn't only miniscule, we feel it doesn't even exist. And then we get blindsided by a bus and that confidence is shattered. The question is how do you rebuild confidence once it has been broken? The Fed would be better off building a plane big enough for all of us to fly from New York to Hong Kong (it's a 16-hour flight) or from Los Angeles to Singapore (even longer at 18 hours) and share a dream with us, Inception-style, that goes four layers deep into our subconscious minds and plants the idea in our heads that we should be full of confidence and it's OK for us to spend and borrow more.
So let's consider housing for a second and how that view of housing affects Fed policy. If people change their view of housing from "housing as an investment" and "housing prices never fall" to housing as simply "shelter" -- four walls and a roof -- what then? You're probably not going to care about borrowing to buy a house if you can just rent one instead. Or if you do borrow, you're not going to borrow as much as someone who sees their house as an investment. These are individual choices people make, but they are definitely shaped by the level of confidence we have in the world around us. 
Now, let's a take a look at the personal savings rate:

You'll see that right around the time when house prices peaked, the savings rate bottomed. Now, the savings rate has been in an upward trend for about seven years. We've made a break from the old patterns of consuming and borrowing, and as these have become more and more entrenched, you can see just what kind of headwind the Fed is facing if they want people to revert to old behaviors with respect to spending. This is what makes the Fed's latest decision so difficult to understand. They can leave monetary policy extremely accomodative. They can go out into the market and buy all sorts of assets, giving them liquidity that may not have existed without their purchases. But once they give that money over to the banks, it's all out of their hands. The Fed can give money to banks to lend, but they can't make people borrow money from banks. And as the chart shows, people don't want to borrow. Companies don't want to borrow, either. As for inflation, it has been relatively subdued, mostly because all of that liquidity the Fed has created has not been getting used in the form of new borrowing. If people were actually increasing their borrowings to consume, we'd see inflation. And lots of it. But between people not wanting to borrow to buy houses or cars like they used to, and the negative social mood around banks that still persists, we may not see a big uptick in inflation anytime soon. Food and gas prices have never responded to monetary policy and they probably never will. That's one of the biggest reasons why the Fed looks at inflation excluding food and gas. But having said that, rising gas prices are a tax on consumers and when gas breaches $4/gallon, growth slows.
But the question that hangs on many people's minds is simply this: If the Fed is doing this now, where there is no sign of a recession at the moment, what will they do when we are confronted with one? That answer isn't so clear. I guess they can ramp up purchases of assets and seek to liquefy the markets even more than they already have or keep rates lower even longer. But I don't know how much good it will do then. It's not that the Fed is out of ammunition; they can choose to liquefy as many assets as they want. The question is one of effectiveness. At some point, the business cycle might just stare down Bernanke the way The Matrix's Neo stared down Agent Smith, hold its hand up, and stop all the Fed's bullets in midair. Then what?

Friday, I heard Jim Cramer say on CNBC that you have to "suspend disbelief" about a recession looming on the horizon and just push your chips into the middle of the table and go all-in on stocks. I think that's a good way to describe what is happening out there and what is being demanded of markets now. But that doesn't make it a prudent way to view risk and return. While this may benefit stocks for now, the question is where will returns come 12, 18, or 24 months from now. Predicting the future has always been less than exact, but with the announcement of this new round of Fed actions, that knot in the pit of your stomach may have just gotten a little bit bigger.
Todd Harrison is fond of saying, "The path we take is more important than the destination we arrive at." At this place and time, both the path and destination seem to be awfully foggy, especially since the Fed's tools have been – and still are – blunted by our changing views on the value of credit.
Twitter: @japhychron
No positions in stocks mentioned.

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