Monetary Policy vs Fiscal Policy & the Fed’s Losing Battle

The recent market declines have been pretty one sided – investors are worried about the impact of fiscal policy on the economy.  But what’s most interesting about the recent decline is that it comes right on the back of QE3.  For many weeks in the late summer it seemed like the only driver of market price was anticipation of QE3.  In early September we got the Hilsenrath leak about QE3 and then the official announcement just a week later.  The market peaked the day after the FOMC announcement on QE3.  Within days many economists were proclaiming Fed policy a huge success as the economic data appeared to validate the market rise and the illusion of the “wealth effect” was in full effect.

Of course, a lot has changed since then.  Earnings have been worse than expected, economic data has been tepid at best and the risks to future economic growth have increased.  And the primary driver of the fears have been concerns over fiscal policy and the fiscal cliff.  It’s dangerous to extrapolate broad conclusions from a few months of equity trading, but I think the last few months have been quite telling as worries over fiscal policy have dominated euphoria over monetary policy.

I think this makes perfect sense.   Anyone who understands the balance sheet recession knows that fiscal policy has played an inordinately important role in recent years.  Viewing the markets through this macro prism and thinking ahead like a chess player made the conclusion rather obvious as the election neared.  Would the market experience a relief rally due to the pro-QE3 President winning or would the market sell-off due to the post-election concerns over the fiscal cliff?   In a research note several weeks ago at Orcam I described why the election of the President mattered far less than concerns over the fiscal cliff:

…”As we’ve discussed in recent notes, the market is likely to turn to the matters of investment tax treatment and the fiscal cliff as soon as the elections results are digested. Goldman Sachs esmates that the capital gains tax rate is likely to increase to 23.8% under both candidates. And the fiscal cliff is unlikely to be settled before early December when Congress comes back from recess. These are market negatives and will persist through November regardless of who wins tomorrow night.”

“while the election might reduce some near-term uncertainty, the fiscal cliff is a far larger issue for 2013 than the Presidential election. And the markets will immediately begin to focus on that outcome come Wednesday morning.”

What we’ve seen since the election results proves that the market is far less concerned with monetary policy than it is with fiscal policy.  After all, Obama was the pro-monetary policy, pro-QE3 candidate as Romney made it clear he disapproved of the Fed’s actions.  But the re-election of President Obama resulted in about 6 hours of euphoria over the certainty of continued Fed policy.  And as soon as the market realized that fiscal policy was at risk of being tightened the market panicked and has sold off over 4% since the election and 8% since the FOMC’s QE3 announcement.

This makes perfect sense.  Now, I’m not in the camp that says Fed policy has done nothing.  QE1 had a substantial impact on balance sheets and I think the Fed’s easing has helped the private sector considerably.  But I think the government’s continual trillion dollar + deficits have had a far larger impact.  Particularly on corporate profits where we can quantify the impact of fiscal policy with relative ease (see our previous analysis for more on this).  Austerity and cratering corporate profits (and stock markets) in Europe also confirm this view.

All of this makes me wonder – what if we’re finally seeing definitive evidence that the Fed is far less powerful in this environment than many presume?  More importantly, will economists and pundits finally begin to give credit where credit is due with regards to the anti-austerity policy in the USA that has helped bolster the economy?  Fiscal policy in a balance sheet recession is far more impactful than monetary policy….It’s time we all realize it.  More importantly, it’s imperative that the politicians in Washington realize it and take the necessary steps to stop playing political chicken with the US economy.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • The Undergrad

    “What we’ve seen since the election results proves that the market is far less concerned with monetary policy than it is with monetary policy.” – What you meant i “What we’ve seen since the election results proves that the market is far less concerned with monetary policy than it is with fiscal policy,” no?

  • The Undergrad

    Also I find it annoying, to say the least, that you have a better sense of the economic reality than do our top policy advisers.

  • http://www.stableinvesting.com Ryan Melvey

    The worst part about it is that congress blames Bernanke for their own failure. “His band-aids are taking too much pressure off of us!” It’s like the idea of simultaneous fiscal and monetary policy is too much for them to comprehend.

  • http://www.orcamgroup.com Cullen Roche

    Yes, thanks for the proofread!

  • DanH

    Seriously. No offense to Cullen, but how is it that a non-economist 30 year old seems to have a better understanding of our monetary system than the gray beards steering the ship?

  • http://www.orcamgroup.com Cullen Roche

    No offense taken. The fact that you think I am only 30 is a compliment! :-)

  • Will

    “QE1 had a substantial impact on balance sheets and I think the Fed’s easing has helped the private sector considerably.”

    Cullen – I thought QE was the monetary “non-event,” a mere exchange of financial assets with no net benefit for the economy, only affecting asset prices through speculation…

    Now you say “substantial impact on b/sheets” and “considerable” help, please elaborate.

  • http://www.stableinvesting.com Ryan Melvey

    I will give it a shot…

    QE1 involved buying very toxic assets that were illiquid. The markets for these securities were opaque, so the Fed (probably knowingly) was overpaying for this junk. If you look at as a mere swap you will see 1M of cash traded for 1M of bonds. The thing is, those bonds probably weren’t worth 1M… When they do these swaps in more liquid markets such as the Treasury market, the “overpaying” is not nearly as extreme, giving it minimal impact on the financial positions of the banks.

  • Greg

    Well, Id just say that the greybeards are too caught up in their old econ training. Its like the pre quantum physicists. They were smart guys, at the top of their field but the world changed (actually the world stayed the same we just started to grasp it more correctly)

    If you arent young and nimble of mind, not too wed to some idea, you will get left behind. And then youll just be an angry old coot, snarling and snapping at everyone.

  • Johnny Evers

    A lot of questionable assumptions here.
    You’re assuming that the fiscal cliff will really result in less federal spending. In truth, most federal spending is entirely outside the budget process. Instead of running a deficit of $120b in January, like we did in October at worst it will be $100b. That’s if we go over, which I doubt.
    Second, still with the same assumption that deficits drive corporate profits. But the deficit grows every month and corporate profits are now declining.
    Last, still assuming that QE3 was an attempt to get cash into the economy, rather than what it is, getting toxic assets off the bank’s books.

  • Alberto

    Markets wants at the same time:

    1) easy money
    2) low interest rates
    3) low to zero taxes (apple real tax rate was less than 5%, ge less than 10% etc…)
    4) low budget deficit so “we” don’t have to fear about long term
    5) low public debt because the goverment is boo boo, bad, bad
    6) higher incomes so people can spend more but with low inflation
    7) low oil prices so inflation will stay low and high oil prices so oil industries can pay a large dividend
    8) etc…

    oh yes, the markets, ah !

  • J Dukate

    The recent market declines have been pretty ONE SIDED – investors are worried about the impact of fiscal policy on the economy. WRONG!!!! This is not one sided. Go look at the charts again Cullen. This top in the market is the EXACT same top range the market was at in Nov 2008. You are totally ignoring the fact that this sell off is ALSO a technical selloff. Yes technical selloffs DO OCCUR!

  • Cowpoke

    QE1 was differnt in the fact that LSAP (Large Scale assets Purchases) were taking place by by the FED Expanding it’s balance sheet.

    The FED in the past bought US treasuries, with QE1 the FED bought a Lot of MBS’s (Mortgage Backed Securities) and Commercial Paper (I think). The FED became the lender of last resorts for these insturments thus easing credit markets and keeping the whole sytem from locking up.

    http://blogs.wsj.com/economics/2012/07/30/a-look-inside-the-feds-balance-sheet-14/tab/interactive/

    Notice how the Bulk occured in during QE1, where as QE2 and QE3 were more of an asset swap

  • http://www.orcamgroup.com Cullen Roche

    It depends on the environment. 2008 was a very odd environment with asset prices collapsing. In that sort of environment the Fed was able to have more of an impact simply by making a market in markets that were totally frozen. So, with MBS falling 75% the Fed comes in and says they’re going to buy and that gives others the confidence to move into the space. In an extreme disequilibrium QE can “work” in that it has this powerful psychological effect. I say the psychological effects are far more muted once we’re back in a market resembling normalcy.

    So, aside from the 1% of the time when the market looks like it’s going to crash through the floor, QE is given way too much credit.

  • coolhead

    Just wonder if the FED buys all the U.S government debts and give people enough money to pay off their primary residents, what kind of impacts it would be, since the FED can get any amount of money from the thin air.

  • Geoff

    The Fed could buy all the U.S. govt debt, but they can’t just give people money.

  • Obsvr-1

    finally getting to the point where there is an understanding that the FED creates the bubbles, usually causes the problems and when the bubble gets out of control the FED is powerless to solve the problem.

    Fiscal issues of over spending and running deficits into magnitudes of biblical proportion is magnifying the problem … now we are faced with the culmination of the Slow Motion Train wreck that started in 2007 …

  • coolhead

    But the FED could buy all the loans from lenders which essentially eliminates the payment from home owners. I am not saying the FED should do this. I am just wondering what the impacts it has.

  • Johnny Evers

    The Fed, or Fannie Mae (now run by the Treasury?) can buy your loan, but it will still collect the interest.
    So if you default on your loan, the lender has been made whole, but if you lose your home, you lose your principal.
    We should have rescued the borrowers, not the lenders.

  • SS

    The Fed is buying repackaged loans from the banks. The Fed buying MBS is not the same as the Fed buying your loan. They’re buying the securitized mortgage product from the bank. So the bank technically swaps reserves for MBS and you basically pay your interest to the US government (who packaged the loan through Fannie or Freddie to begin with).

  • hangemhi

    “But the deficit grows every month and corporate profits are now declining.” First, stating that something “drives” something else doesn’t make it the only driver. Everyone knows that when corporations fire workers, don’t restock inventory, slash spending, etc, their profits rise. Second, how on earth can you be the #1 commenter here, having read this blog for many months, can you continue to ignore how private sector deleveraging offsets the impact of deficits?

  • Johnny Evers

    Private sector deleveraging is very important. When the consumer deleverages and the unemployed go back to work, that will be a good thing, we all agree.
    But I don’t see how deficits are helping the working person do this. (The unemployed have already deleveraged … they’re broke!) I could understand if our policy was to rescue the consumer (forgive student loan debt, for example.)
    Also, deficit spending is being driven by rising spending on entitlements. It’s not a calculated response to the balance sheet recession.
    Deficit spending is not going to crank up the economy, imo. And replacing an economy that grew only because the consumer borrowed with an economy that grows because the government borrows — well, I really don’t see how that works, either.
    Oh, I think Mikael from Sweden is the No. 1 commentator!

  • Cowpoke

    The FED creates SPV’s like Maiden Lane to do it’s bidding..

  • Pierce Inverarity

    Entitlements, like social security and medicare etc…where do you think that money goes? I’m not disagreeing there are other, more productive uses for our deficit spending, but that money that gets doled out, it circulates back into the economy and (gasp) gets taxed, too. They don’t just go out into the private sector and get lit on fire.

    The deficit is also not just due to entitlements spending, or even increasing entitlements spending like you say. It is way more nuanced than you ever get into here. Perhaps it’s because you really like beating the drum of your agenda, perhaps it’s because you don’t want to look at all the facets, but it’s not painting a clear picture of what’s going on. The payroll tax cut, which has benefited ALL tax paying Americans, by causing a 2% increase in the deficit AND simultaneously a 2% increase in wage earners’ take home pay.

    I won’t even get into your simplistic equation of a government’s balance sheet to the private sector’s. You know better.

  • Johnny Evers

    My agenda is that I’d like to see specifics and see the tough questions answered. We should challenge Cullen and not be his chorus.
    Does deficit spending really grow the economy?
    How much money can we borrow?
    If taking 2 percent off the payroll tax is helpful, why not cut it entirely?
    How much can we borrow? Put the numbers in the formula — tell me what happens if we borrow $3 trillion next year? What happens if the total debt is $30 trillion 5 years?
    And don’t tell me that the government can’t run out of money. We get that.
    And don’t tell me that Japan’s debt is 200 percent of GDP. Nobody wants to be Japan. Or if you do, own it.
    There are some fascinating ideas in here; it would be wonderful to believe in them. Be nice if we could borrow money and make school free, or health care for all free.

  • Mikael Olsson

    I’m sorry but.. no. You¨re not getting the system.

    The Fed isn’t creating the bubble. Banks with lax lending standards, in combination with deregulation allowing insane profits from said lending, in combination with consumers all-too happy to bid up houses to silly prices that they can’t really afford. That’s the bubble.

    I can see why you’re worried about the fed deficit but.. if it wasn’t for that, the USA would be Portugal/Spain. (Not Greece.)

  • Mikael Olsson

    I don’t see the problem with replacing money being siphoned out of the system with new debt-free money myself. But alas I’m an engineer and not a politician.

  • Obsvr-1

    so sorry, when I say FED I mean the FED in its’ entirety, the cabal of bankers (TBTF banks) in concert with the FED …

    read the history of the FED and who created it … a good start is “The Creature from Jeykll Island”