Please help me understand QE

[maybe4less]

I think it's important to reiterate that interest rates are made up of two components: inflation expectations AND real return expectations. 

 

I don't disagree with your analysis of inflation expectations versus the Fed's balance sheet. But real rates started dropping towards the end of QE1 and continued to drop (with some small bumps) straight through QE2, even though inflation expectations increased. (That the spikes in both inflation expectations and real rates during QE2 were transitory is why we got QE3.) Inflation expectations didn't move all that meaningfully after QE3, but we got a big pop in real rates that has persisted. (See attached chart.)

 

The relative stability subsequent to QE3 in both inflation expectations and real rates is likely why the FED has not felt that QE4 was necessary.

Thanks for your response.

In all frankness, the graph you provide could be interpreted in so many ways… If you add another layer about expected expectations it would even be possible to take the modern monetary theory seriously. :)

I will follow you in this rabbit hole and then try to provide perspective.

 

Maybe it's my scientific background bias and expectation that 2+2 usually gives 4 but if 1-easing was used to prevent real interest rates from falling too low and 2-easing eventually caused a "big pop" (more on that later in the perspective), then why tightening has been accompanied by increasing real rates? Why doing opposite things cause the same result? There are a huge number of potential answers and I suspect which one you will come up with. ;)

 

In terms of perspective (looking outside of the time frame of your graph), real interest rates (which are tied to potential GDP growth) have been convincingly coming down since the early 80's (not only in the US BTW) and this is for another thread to discuss but the blips we have seen in the last few years have not changed that trend unless one believes that the times they are changin'. I try to supplement posts with factual or corroborating evidence and I could have supplied you with solid work that contains however derogatory comments but here's one from the Master himself:

https://www.brookings.edu/blog/ben-bernanke/2015/03/30/why-are-interest-rates-so-low/

 

Look, he says, I did what I could and it's up to the other actors to play their role. One of the things that bothers me is the comment, which I agree with, that punctual government spending could cause a short term increase in real interest rates. Mr. Bernanke made those comments in 2015 and perhaps did not envision that the recent administration would put the pedal to the metal in terms of government spending and fiscal deficits in a late cycle. The major thing that bothers me though is that this easing program was to give time to the powers that be to deal with the secular forces and to allow a "beautiful" deleveraging. Deleveraging, what deleveraging? As I sip my coffee in late 2018, we are, on a net basis, on more shaky grouds for debt especially at the public and corporate (hypertrophied BBBs, leveraged loans, high yield etc) levels than 10 years ago. And now we are "ready" for tightening?

 

Sorry long post.

 

Maybe4less, you seem to have an interest in maturity transformation. For a historical parallel, alchemists involved in metal transformation (they called it transmutation then) used the scientific fact related to the differential density of lead and gold. Gold creation was a myth but alchemy was both practice and philosophy. Have you taken a look at which end of the curve the Treasury is selling its debt issues? There is an obvious connection to monetary easing (or absence thereof) as the fiscal/monetary firewall is being tested. An interesting side effect of the tightening mode is that the Fed has been (and will be more and more?) absent from government auctions and, even if the supply of government debt has considerably increased lately, the Treasury, in its great wiseness, has preferentially and to a large extent gone for the 2 year-auctions versus the 10 year-auctions: YTD: 2yr + 55%, 10yr +26% thereby conducting the equivalent of a fiscal operation twist. In my humble experience, for the typical firm with rising debt, short term refinancing may be an ominous sign but I'm just a guy paying his bills every month. Interesting times.

 

As I suggested in an early post, the Fed takes its cues from the state of the economy and financial markets. It is a follower, not a leader. Rising real rates have caused the Fed to reduce its level of accommodation.

 

If we aren't "ready" for a tightening, than the Fed can only try to help to contain the damage (traditionally by lending to solvent financial firms that have a liquidity issue). But this is just how the credit cycle works: debts build up and towards the end of the cycle interest rates rise. The Fed couldn't stop it if it wanted to.

 

The idea that the Fed can control long rates given the size of the US (and global) economy doesn't really make too much sense from a theoretical standpoint as Bernanke explains himself in that article you reference. He describes a system where the Fed tries to determine what equilibrium real rate is and then uses its tools to target the money supply consistent with that equilibrium rate and its inflation target. It also doesn't make too much sense empirically, as "anti-market" government policies (e.g., currency pegs, price controls, etc.) have inevitably failed throughout history.

 

Apologies if it seems like I'm ignoring your other points. I either didn't understand them or they seemed off-topic. Circle back if there are any in particular you'd like to dig into. I will, however, point out on the deleveraging issue is that it was a deleveraging of the private sector (primarily households), not of the public sector. The US largely swapped private debt for public debt.

[Cigarbutt]

As I suggested in an early post, the Fed takes its cues from the state of the economy and financial markets. It is a follower, not a leader. Rising real rates have caused the Fed to reduce its level of accommodation.

 

If we aren't "ready" for a tightening, than the Fed can only try to help to contain the damage (traditionally by lending to solvent financial firms that have a liquidity issue). But this is just how the credit cycle works: debts build up and towards the end of the cycle interest rates rise. The Fed couldn't stop it if it wanted to.

 

The idea that the Fed can control long rates given the size of the US (and global) economy doesn't really make too much sense from a theoretical standpoint as Bernanke explains himself in that article you reference. He describes a system where the Fed tries to determine what equilibrium real rate is and then uses its tools to target the money supply consistent with that equilibrium rate and its inflation target. It also doesn't make too much sense empirically, as "anti-market" government policies (e.g., currency pegs, price controls, etc.) have inevitably failed throughout history.

 

Apologies if it seems like I'm ignoring your other points. I either didn't understand them or they seemed off-topic. Circle back if there are any in particular you'd like to dig into. I will, however, point out on the deleveraging issue is that it was a deleveraging of the private sector (primarily households), not of the public sector. The US largely swapped private debt for public debt.

Thank you for the clarifications.

Value investing, in a way, consists in completing asset swaps. For every buyer, there is a seller and both are convinced of a good deal.

 

In the last few months, I spent perhaps a disproportionate time on the liability side of corporate balance sheets but here are the objective numbers for the private to public swap that you seem to refer to (from 2008 to Q3 2018, over GDP, US numbers).

 

Household debt:      0.86 -----) 0.74

Total federal debt:    0.68 -----) 1.09