An earlier version of this commentary contained typographical errors - the dollar signs and certain amounts were missing from the text. This was the fault of Advisor Perspectives. It was corrected on February 13 at 4pm ET.
Why Quantitative Easing Didn’t Work
FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
February 11, 2014
IN THIS ISSUE:
1. Why Fed’s Quantitative Easing (QE) Didn’t Work
2. Velocity of Money Plunged During Financial Crisis
3. Should Bernanke & Company Have Done More?
4. QE Was a Huge, Dangerous Experiment That Failed
5. Fed Begins to “Taper” QE Purchases in January
6. Conclusions – What Happens Next?
While equity investors yearn for the Fed’s QE policy to continue, it’s actually a good thing that this unprecedented stimulus looks to be coming to a halt by the end of this year or early next year. Why is that a good thing? Because QE hasn’t worked, certainly not as intended.
One of the most frequent questions I get from clients, business associates and even friends is: “Why didn’t quantitative easing work to stimulate the economy and create jobs?” It’s a complicated answer, but today I will do my best to explain why.
Why the Fed’s Quantitative Easing (QE) Didn’t Work
Ben Bernanke, the outgoing chairman of the Federal Reserve, must recognize that he was the victim of the law of diminishing returns. In the initial days of the 2008-09 financial crisis, he mobilized the Fed as the “lender of last resort” and began the process known as “quantitative easing.” This helped quell an intensifying financial panic and, arguably, averted a second Great Depression.
Bernanke’s role during the financial crisis has been much praised, and it’s doubtful that anyone else would have done much better. Yet Bernanke’s ambitions went beyond crisis prevention. He believed the Fed could jump-start the economy by keeping short-term interest rates near zero, along with unprecedented QE purchases of Treasury bonds and mortgage-backed securities (MBS).
Bernanke believed that ZIRP (zero interest rate policy) and QE would help reverse the plunge in home prices, boost stock prices, stimulate corporate investment in plants and equipment and thereby generate millions of new jobs for unemployed Americans.
That, of course, did not happen as we all know. Since the recession ended in mid-2009, the economy has grown at a below-trend annual rate of 2.4%. Payroll jobs are still 1.2 million below their 2007 peak, and seven million Americans have left the labor force entirely. Yes, some retired but around half, by most estimates, dropped out because they were discouraged about finding work.
So, what went wrong with Bernanke’s high-minded plans? Why didn’t zero interest rates and massive QE purchases send the economy into overdrive? What Bernanke should have realized is that US consumers, who account for apprx. 70% of economic growth, were scared out of their wits by the financial crisis and were in full deleveraging mode by late 2008 – meaning they were intent on paying down their debts rather than taking on more.
As it was, interest rates fell below 2% on 10-year Treasury notes and near 2½% on 30-year Treasury bonds. Traditional 30-year home mortgages briefly plunged to below 4% in late 2012 and early 2013. The stock markets exploded, more than doubling since their March 2009 lows.
Yet the connections between these financial events and the “real” economy of spending, production and job creation proved frustratingly weak. Higher stock prices should have caused consumers/investors to spend more, but memories of the Great Recession limited this so-called “wealth effect,” again as consumers opted to pay down debt rather than spend more.
Mortgage lending suffered from tougher credit standards, imposed in part by stricter government regulations that banks were all too happy to accept. How was that supposed to help the economy? It wasn’t. Bernanke should have known that too.
Meanwhile, in a 2012 survey of 517 Chief Financial Officers, 68% said that lower interest rates would not cause them to increase their plant and equipment spending. Some CFOs said they financed new investment from internal funds, not borrowing. In short, everyone was scared following the financial crisis.
Velocity of Money Plunged During the Financial Crisis
Simply put, the velocity of money is the number of times a dollar is spent to buy goods and services per unit of time. Put another way, it is the rate at which the same money is exchanged (changes hands) from one transaction to another, and how much a unit of currency is used in a given period of time.
Consider this oversimplified example of the velocity of money: you have a farmer and a mechanic with only $50 between them.
- The farmer spends $50 on a tractor part from the mechanic.
- The mechanic buys $30 of corn from the farmer.
- The mechanic also buys a dog from the farmer for $20.
In these three transactions, a total of $100 changed hands, even though there was only $50 between them. Velocity of money attempts to measure how fast the same unit of money is changing hands.
If the velocity of money is increasing, then more transactions are occurring between individuals, which is good for the economy. If velocity is declining, then fewer transactions are occurring. As you can see in the chart below, the velocity of money has plunged since the late 1990s.
This decline in the velocity of money was directly related to the recession in late 2000 to 2001 and even more in the Great Recession from late 2007 to early 2009. Since the Great Recession was so much more severe, it should not have been a surprise that velocity fell so much more than in 2000 and 2001.
More than four years after the recession ended, you’d think money would be cycling through the economy at a faster rate than a few years ago. But according to the Fed’s data, the velocity of the M2 money supply – which includes cash, checking deposits, savings accounts, money market mutual funds, and CDs – was only about 1.5 times last year. That’s down from 2 times in 2006 and a high of 2.2 times in 1997.
As noted above, consumers were deeply frightened by the Great Recession and were intent on deleveraging. Given this, it should have been no surprise that the velocity of money has fallen significantly and remains at the lowest level in the last 50 years. This is not good for the economy.
Should Bernanke & Company Have Done More?
Surprisingly, some Bernanke critics (largely those on the left) say the Fed should have done more to stimulate the economy. What exactly? Since 2008, the Fed has purchased over $4 trillion in Treasuries and mortgage bonds. Would $5 trillion have saved the world? Come on, really? The simple fact is that QE didn’t work, certainly not as intended.
In addition, Bernanke failed to realize that the Fed lacked the sort of economic control that was taken for granted after Alan Greenspan’s nearly two-decade run as Fed chairman. As Bernanke learned in the later years of QE, the ability of the Fed to steer the economy was largely eviscerated after the financial crisis. As a devoted student of the Great Depression, most analysts assumed that Bernanke knew this.
QE Was a Huge & Dangerous Experiment That Failed
At the end of the day, Bernanke’s weapons were less powerful than assumed or hoped. What subverted their effectiveness was shifting public psychology. The financial crisis and Great Recession changed the way consumers, bankers, business owners and managers thought and behaved.
Before the financial crisis, there was a widespread belief in the economy’s resilience that greatly encouraged spending, borrowing and lending. People unconsciously assumed basic economic stability. After the crisis, there was a residue of fear and caution. Gone was the faith in automatic stability.
As the economy weakened, so did public trust. In 2007, half of Americans expressed confidence in the Fed, but by 2012, only 39% did. Bernanke struggled to make the unpopular case that the Fed’s efforts to prop up the banking and financial systems (aka – “Wall Street”) protected average Americans (aka – “Main Street”) from greater harm.
The consumer mindset of deleveraging and paying down debt weakened the Bernanke Fed, and still does today. This explains why Bernanke’s massive exertions to improve the recovery have so far yielded paltry returns. Monetary policy – the influencing of interest rates, credit conditions and the money supply – is still powerful, but it is no longer some potion that can magically stimulate the business cycle and mechanically restore full employment.
The fate of Bernanke’s easy-money policies is also uncertain. Through the massive QE bond buying and a firm commitment to keep short-term interest rates near zero until the job market strengthens convincingly, he has tried to instill public confidence. Perhaps the lagged effects of these policies will eventually boost more robust economic growth, but so far, it hasn’t.
While it is premature to judge Bernanke’s legacy, his unprecedented QE policies will have ongoing consequences that, for good or ill, will shape his ultimate reputation, which I think will be mediocre at best.
Fed Finally Begins to “Taper” QE Purchases in January
The Fed should have begun to taper QE purchases when Bernanke first floated the idea in May of last year. But the stock market plunged and so he decided to wait. But the point is, he knew in May/June of last year – if not much earlier – that QE wasn’t working.
For the last several years, Bernanke has argued that these unprecedented policies could be withdrawn without disruption. That was a smokescreen all along. He knew better, at the very latest by last spring when he hinted of “tapering” QE and the stock markets tanked.
The first taper occurred in January of this year as the Fed cut its purchases of T-bonds and mortgage securities from $85 billion a month last year to $75 billion. We all remember how that went over in the stock markets – January was a downer.
The market downturn in January was largely attributed to financial woes in many developing countries. I wrote about that in detail last week. Yet I also believe that the Fed starting to taper its QE purchases last month was also a significant factor in the market sell-off, which saw the Dow Jones plunge over 5%.
The Fed Open Market Committee (FOMC) met again in late January and voted for another cut to $65 billion in monthly QE purchases starting in February. We’ll see how that plays out in the stock markets over the next few weeks.
The FOMC meets seven more times this year. If the current $10 billion per meeting reduction in QE purchases continues, the program would end in December of this year. That remains to be seen, of course, but that is the general expectation – IF the economy continues to grow at least modestly.
That’s a big IF. Economic growth slowed from 4.1% GDP in the 3Q to only 3.2% (advance estimate) in the 4Q. Most forecasters expect GDP growth to slow a little more in the first half of this year and then rebound somewhat in the second half, with overall growth of around 3% for all of 2014. That remains to be seen, of course.
The next FOMC meeting will be on March 18-19, after which Janet Yellen will hold her first press conference as the new Fed Chair. It will be interesting to see if the FOMC reduces QE purchases by another $10 billion at that time to $55 billion per month.
Even if QE purchases are ended in December – which remains to be seen – the Fed’s balance sheet is very likely to be near or above an incredible $5 trillion in assets. This is simply mind-boggling!
Who knows what will happen if the Fed decides to SELL some of this $5 trillion in assets on its books starting next year. That could be even uglier. As a result, there is another perception that the Fed will simply hold onto these securities until they mature, which will be years and years from now.
The lingering question is, what happens if there are further surprises, from unanticipated inflation to another financial crisis? The Fed and others have repeatedly erred in their economic forecasts and policy decisions.
Conclusions – What Happens Next?
Given the magnitude of the financial crisis in 2008, most analysts agree that the Fed had little choice but to initiate some kind of stimulus program to avert another depression. Yet the fact that the Fed continued its unprecedented QE purchase program for five years and counting – with very limited results – simply defies logic.
The severity of the Great Recession and the financial crisis, especially the housing debacle, deeply altered Americans’ spending and borrowing habits, as noted in the discussion above, including the plunge in the velocity of money. This is the primary reason why the Fed’s massive QE program did not work. In my opinion, Fed chairman Ben Bernanke should have foreseen this outcome.
If the Fed continues its plans to end QE purchases by the end of this year, that could well manifest into a continued drag on the equity markets, or worse, a new bear market. I don’t pretend to know which it will be, but I have most of my money invested in professionally-managed strategies that can move to cash if it is the latter. “Long-only” strategies that were the big winners since March 2009 could get clobbered in the next couple of years.
Hopefully, this discussion has helped to explain why the Fed’s QE policies have not worked. Arguably, Bernanke’s policies may have helped save the US economy from another depression in 2008, but QE has not resurrected the economy sufficiently to put Americans back to work. The Fed has $4.1 trillion in bonds on its books today – on the way to $5 trillion before it’s over – with not much to show for it, and no perceived way out.
Gary D. Halbert