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Everything You Think You Know About the 'Big Bad Fed' Is Wrong


These five common misconceptions about the effects of QE and how monetary policy works put investors at risk.

Few would still argue against the assertion that the Federal Reserve has been central to the financial stabilization and economic recovery from the 2008 crisis. They fixed the plumbing and are now trying to incentivize animal spirits to pump water through the pipes. The debate has now migrated to exit strategies and whether the accumulating side effects of exceptional monetary accommodation outweigh incremental benefits.

Nonetheless, it is the Fed, so views are heated, and many misperceptions persist. The concept of money-printing resonates strongly and intuitively with almost everyone, but most of the intuitive reactions to the Fed's QE are turning out to have been wrong. Here are some of the major myths that linger.

1. Money printing increases the money supply. The Fed does not control the money supply; they control base money (or outside money), which is a small fraction of the broader money supply. In our fractional reserve system, the banks (loosely defined) control the other 90% or so of the money supply (a.k.a. inside money). And the banks have not been lending. This is why the money supply has not grown rapidly in response to years now of QE.

2. QE is "pumping cash into the stock market." The truth is, little of this money finds its way into the stock market. When the Fed implements QE, they are buying low-risk US Treasuries and agency mortgages from the market, mostly from banks. About 82% of the money the Fed has injected since QE started has been re-deposited with the Fed as excess reserves. With the remaining 18%, banks have tended to buy other fixed income assets of a slightly riskier nature-moving out on the risk spectrum for a bank doesn't mean jumping into equities, especially given the near-death experience that most of them have just experienced.

Of course, not all of the US Treasury bonds (USTs) and mortgage-backed securities (MBSs) injected into the economy were purchased from banks. And some of the money does end up in equities. But, really, not all that much. The other big holders of USTs/MBSs who've been selling to the Fed for the most part have fixed-income mandates too, and they are also unlikely to take the cash from the Fed and cross over into equities with it.

So, the natural question is why-if the above is true-have equities gone up so much in response to QE? The simple answer? Psychology and misconception.

By taking an aggressive stand, the Fed signaled a positive message to markets: "I've got this." The confidence that the Fed would do everything it could to protect our economic downside stabilized animal spirits. Then it slowly but surely enabled risk-taking to re-engage. The fact that so many people believe that the Fed would be "pumping money into the stock market," and because so many buy into the "don't fight the Fed" aphorism (notwithstanding September 2007 to March 2009), the effect of the Fed's message was that much more powerful.

In short, this largely psychological effect on markets-one that I had initially underestimated-bought time for household balance sheets to heal and is allowing fundamentals to catch up somewhat with market prices.

3. QE will create runaway inflation. "Yet" has become the favorite word of the inflationistas. As in, "Oh, it'll come, just hasn't yet." And the magnitude of that expected inflation has been dialed down from 'hyperinflation' to 'high inflation.'

But some continue to hang on. The most extreme inflationistas insist that it is here now and the Fed is cooking the books. The reality, of course, is the Fed has nothing to do with the compilation of US inflation statistics, which is done by the Bureau of Labor Statistics. Moreover, for those who are worried that all departments of government are conspiring against the American people, you would also have to believe the Massachusetts Institute of Technology is in on it, too. MIT runs the Billion Price Project, a means of testing, using broad-based Internet price sampling techniques, the extent to which the government's measure of CPI reflects reality.

But, there really has been no inflation, even with rounds of QE and interest rates stuck at zero. What we have learned in this crisis has driven home the points that the lending and borrowing that drive the money supply are more sensitive to risk appetite than they are to the price of money.

Is it possible that this will end in a bout of inflation? Yes. But the odds are lower than consensus had been thinking and they are dropping fast, as inflation continues to be well anchored and people come to understand better how the transmission mechanism of monetary policy actually works.
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