Never before did unemployment at current levels justify extending massive QE or 0% interest rates. Can the Fed and ECB ever stop QE, or are we trapped in a perpetual QE regime?
In the US, the news about slowing job creation came just in time to help the Fed postpone its tapering (or reduction of asset purchases). Initially, inflation was clearly picking up and calling for such a removal of stimulus. But the reality is that markets, no matter what the inflation levels are, don’t want to see an end to stimulus anytime soon.
Now the Fed has a convenient excuse – the latest disappointing jobs report – to buy time and postpone tapering to year-end or beyond, so that it can pursue its bond purchases of 120 bn $ or so every month, which have brought its balance sheet to 8350 billion $ at the end of August. This is double its 2019 size, and is ten times its 2007 size. Since 2009, we have entered an era of constant stimulus, with only a three-year stabilization from 2015 to 2018.
Only a short-lived experience, initiated by Janet Yellen in 2018, attempted to reduce the Fed bond buying, and to sell some balance sheet assets. But as you may remember, as early as the end of 2018, US short term liquidity markets showed signs of liquidity shortage, because of their huge dependence on borrowing. That’s when Jay Powell jumped in to restart the stimulus, well before the pandemic broke, doubling the volume of purchased assets.
Markets have become deeply dependent on constant liquidity provision. For the same reason, we doubt that the ECB is going to taper before the Fed. Inflation has also surged in the eurozone to the highest levels in a decade, and ECB policymakers have started to hint at tapering. But even analysts who believe the ECB will taper forecast that this will mean injecting 60 or 70 bn € a month, instead of 80 bn €. Which still represents a strong stimulus.
Can the Fed and the ECB ever stop purchasing assets on markets? The frightening answer is: probably not. What lessons have been drawn from the 2018-2019 Fed experience with the failed quantitative tightening? We know little of the Fed's conclusions.
The idea of a «perpetual quantitative easing» had been envisioned by Fed critic Jim Rickards as early as March 12, 2011. «QE will be with us for an ‹extended period› no matter what the Fed announces», he said, ten years ago. Peter Schiff, another vocal Fed critic, also mentioned the prospect of «perpetual QE» several times during the last decade, before anyone could imagine such a scenario was possible. I have been holding the same theory about interest rates since 2016: can the ECB and the Fed ever raise interest rates again, without causing the same stress that was caused by the freeze of asset purchases and the attempted reduction of those assets?
In other terms: can US and Eurozone markets survive a monetary context in which there is no central bank intervention, and in which interest rates are normalized? The answer seems to have been persistently negative for 12 years now. Quantitative easing seems to have become the norm, the standard policy, the «perpetual temporary» action to prevent the implosion of the US financial system, and the European one by extension. The market dependency on Fed policy is well summarized in these CNBC charts:
In this discussion, the level of unemployment actually doesn’t matter much. In US history, the unemployment rate was above 5.2% numerous times. Never in history were such levels of unemployment used to justify 120 bn $ a month in bond purchases, or short term rates kept at near 0%.
This kind of monetary policy is not aimed at price stability or job growth as much as it is aimed at ensuring market liquidity. The whole issue is about short term liquidity markets and keeping them afloat. These short-term credit markets are now the lungs of the financial system, and they are dependent on a kind of instant liquidity and pyramidal leverage which can’t bear the risk of rising rates, rising yields, or quantitative tightening conditions. Even when asset purchases stopped for three years between 2015 and 2018, interest rates didn’t rise much. They went from 0.25% to 1.5%, which means that easy monetary conditions were still there, and that normalization was never complete.
And when asset sales started, while rates rose at the same time to 2.50% during 2018, markets went on red alert. Combined rate and QE tighening has been proven to destabilise credit and derivative markets, which aren’t solvent and provisioned enough to bear it.
Despite this situation, we keep reading articles everyday saying that «the Fed will soon embark on a path to ceasing asset purchases altogether», and that at some point, it «will look to raise short-term interest rates», even though this has never been attempted (except for one period of six months) during the last 12 years. Normalization has been on the horizon all along. And the horizon has been drifting away.
Our bet is that both the ECB and Fed will continue to buy bonds and maintain low short interest rates, not anywhere near the 3% «normal» rate that was never approached for the last 12 years. By the way, the Fed futures market foresees that rates (which are at 0.25% now) won’t rise beyond 1.5% if ever they were raised. And that hikes will have to stop «as growth will probably stall». Which will be the perfect occasion to put all tightening «on ice» and resume QE. Being bearish about the economy has never been so bullish for markets.