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Will the Feds disengage from QE

October 6, 2017
Farm News

A trillion here, a trillion there, and pretty soon it adds up to real money. Global central bankers the world over responded to the Great Recession with something they coined Quantitative Easing, QE for short. Essentially that was what they used to call in previous generations, "turning on the printing presses" to print money. One gets flashes of bushel baskets full of deutschmarks needed to buy a loaf of bread in depression Germany in the 1930's.

It is a lot more sophisticated today. The money is digital. It was issued in yen, euros and dollars as Central bankers around the world coordinated monetary policy with one another to avoid a deflationary collapse of the global financial system. The Fed now holds a portfolio of $4.5 trillion of mortgages and Treasury bonds that they just "bought," meaning that they just put them on their books creating the cash going into the financial system. That then is a $4.5 trillion infusion of liquidity. That is how that we got an economic recovery.

Congress was locked in their partisan gridlock failing to help with fiscal stimulus in any way so the burden fell almost entirely on the Fed and other global central banks to provide the liquidity for a recovery. Zero percent interest helped but the added liquidity from QE played a strong role. CNBC estimates that the global total QE produced by central banks totaled over $12.3 trillion, plus nearly $10 trillion in negative-yielding global bonds. Most of the later was issued by the European Central Bank and bank of Japan. This returned the US and world economy to growth although there has been disappointment in the US growth rate. What has surprised Global central bankers the most was that they could create this much unprecedented QE and a loaf of bread still costs the same as before, as the currency did not inflate. I think that was exemplary of the depth of the financial morass that the economy had fallen into.

Central bankers want 2 percent inflation because that level of inflation is what is seen as optimum to keep forward thinking momentum going for economic activity. It encourages investment. With 2 percent inflation, "buy today" and there is an inherent increase in value to be had. Both Japan and the EU have struggled with deflation and the Fed has been surprised that US inflation has not reached its 2 percent target.

The Fed is particularly pleased with US employment although they are again surprised that more wage pressure has not been generated. First the unemployed get new jobs and then eventually labor market tightness begins to increase wages. They call it 'wage' and price inflation. Higher wages give business a reason to increase prices. I think that wage inflation is coming for the Ag sector at least where we live. New packing plants are struggling to find workers and competition for these workers is heating up. Tighter immigration rules, reducing the labor pool of supply, should contribute to wage inflation. That is why business is so supportive of DACA. Both supply and demand is working to tighten the labor pool that will increase wages that will show up in higher consumer costs of living. Granted, the tightening labor supply is uneven. It has the potential to become a crisis in the Ag sector.

The Fed is happy enough with the economic recovery that it has created and therefore is looking to disengage from and reverse the QE contribution to liquidity. It also expects the federal government to step up with some fiscal stimulus that has heretofore been lacking, i.e. tax reform. The Fed thinks that the market can begin to absorb the bond purchases that it has been assuming and is looking to reduce its contribution to funding debt with digital cash. I think that the Fed as an institution has performed remarkably well during the financial crisis and while many complain about this and that, it is hard to argue with success. The problem is that we are only half way through this exercise and they don't want to screw it up now. The Fed cannot depend on a dysfunctional Congress.

They have enough confidence now in the US economy that they have begun to "normalize" interest rates along with the wish to begin disengaging from QE. They have been maintaining the $4.5 trillion portfolio by rolling maturing bonds into new ones. Their plan to shrink the Fed portfolio is simply to slow repurchases of bonds, starting with $10 bln next month working up to $50 bln a month by October 2018 if all goes well. That will essentially be withdrawing liquidity from the market making the economy fund more of its debt essentially stopping the printing press and letting their portfolio shrink by attrition. The BOJ and ECB will watch how this goes for the Fed before they consider doing likewise.

There are a lot of scenarios as to how this will play out. Will governments step up with fiscal stimulus?

If they withdraw QE and the economy slows they may have to reserve themselves again. They tightened too much too quickly in 1937 during the Great Depression and derailed that recovery for a period of time. Hurricanes and gas price spikes are transitory but wars fought between militaries and over trade agreements would disrupt the Fed plan. The current Fed under Bernanke and now Yellen has functioned as a competent institution pretty much as it was meant to work. A change of personal will bring inherent uncertainty as several board seats including Chairman Yellen's are open or opening.

President Trump has not been a friend of most US institutions but even he may not want to rock the boat on this one. The Fed laid out its plan to tighten monetary policy this week while admitting that it is subject to revisions as they respond to events and data.

David Kruse is president of CommStock Investments Inc., author and producer of The CommStock Report, an ag commentary and market analysis available daily by radio and by subscription on DTN/FarmDayta and the Internet.



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