Unwind QE, not the US economy

January 21, 2018

 The Federal Reserve faces a difficult year: as it prepares to scale back its vast unconventional monetary programme implemented after the Financial Crisis, the complications thrown up by the current Republican administration are immense.

 

If you were to compile a list of words describing the current state of US economic policy, ‘coherent’ would probably be bringing up the unflattering rear. The depoliticisation of monetary policy, for all its benefits, has produced an economically illiterate Congressional generation, who focus on ad hoc silo policy that stands directly at odds with the targets of the Federal Reserve. Quantitative easing, which buoyed the US economy at a time of political impotency in the face of financial collapse, is finally being reversed and the consequences are yet to be seen. One long-overdue impact of the Fed slimming down its balance sheet will hopefully be the dampening of rampant global asset markets – a bubble being pumped full of hot air by Congressional Republicans. These conflicting targets not only represent the dire lack of awareness in Congress, but will also leave future generations without a fiscal or monetary cushion if the economy turns sour as it did ten years ago.

 

One of Mr Trump’s favourite tweeting topics is the current strength of US stock markets, and superficially this may appear to be a good thing. US equities are enjoying a remarkable run of trading days without a 5 per cent decline, the second longest run in history, and treasury notes are performing equally well. The standard 10-year treasury note peaked at 2.642% recently, a high dating back to September 2014. All of this indicates a swelling market, but there is evidence to suggest that the markets may in fact have exceeded their saturation point. The price to sales ratio of the S&P 500, which can be a useful measure of whether companies are over-valued or under-valued, is reaching similar peaks to that of the Dotcom bubble. Lee Ferridge, the head of macro strategy at financial firm State Street, argued that the current gains in asset markets can be ‘pretty easily explained by QE’, as large-scale purchasing of assets by the Fed put significant upward pressure on asset prices. This artificial inflation will persist until the point that the Fed finally unwinds its vast balance sheet, and it appears that time has finally come.

 

Slowly removing this upward pressure on prices is therefore a necessary short-term economic target to avoid a dramatic crash which can have far reaching consequences. However, the recent tax reforms passed by Congress are likely to add further fuel to the fire burning in asset markets. It is expected that the increased profits from Republican tax breaks will largely not be spent on productive investment, but rather on share buybacks which will further inflate prices. This will undermine one of the necessary effects of tightening monetary policy because political objectives are prioritised over the mandates of the Central Bank.

 

Furthermore, the unwinding of QE is necessary for the US economy as it will help to increase interest rates to pre-crash levels. It is important to note that interest rates cannot stay at such current low levels indefinitely, and it would therefore be naïve to subvert monetary necessities in the interests of short-term political objectives; interest rates must be raised at some point. This is not to say that it will be an easy ride, with the impacts being acutely felt by consumers as well as investors. Consumer debt peaked at $1.021tn in June 2017, the highest level since financial collapse in 2008. Raising interest rates will eventually translate to higher interest payments for these consumers, and that poses the risk of mass defaults on unsustainable loans. Increasing long term interest rates will also steepen the yield curve, increasing the returns gained by investors in long-term assets. This can cause short-term economic activity and liquidity in the market to dry up, hampering investment and economic growth. However, the potential for an economic downturn is precisely the reason why interest rates need to be raised. While there may be short-term damage, slashing rates was one of the few remedies to the collapse of 2008. Without higher rates in normal times, Central Banks will be left impuissant if another crash were to occur.

 

The tax reform passed by Congress will only exacerbate the issues of unwinding QE. Not only has $1.5tn been sucked out of the Treasury’s coffers in the vain attempt to stimulate investment by Congress, but slimming down the Fed’s vast balance sheet will significantly reduce the interest paid on securities held by the Fed, which are currently going to the Treasury. In 2017 the Treasury received $80.2bn worth of these payments, a 12% decrease from the previous year. This is not an insignificant part of government revenue, and while it is necessary to unwind QE and lose out on this income, the Republican tax reform is not. Gratuitously creating a vast fiscal black hole, at a time when monetary stimulus is being scaled back, is short-sighted and dangerous.

The collective image of tightening monetary policy and a large fiscal deficit is not a pretty one for the USA. Emergency monetary solutions were effective in the short-term, but their unwinding requires cooperation from legislators that simply does not exist in the current climate. It is about time the Fed and Congress enacted congruous policy for the benefit of the entire economy.

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