Q&A on QE3 – Part 2

Sorry for the delay on the last of the answers here, but I’ve been swamped lately.  If you missed part 1 see here.  So here goes nothing….

Colin – Cullen, Have you looked at the IMF paper revisiting the ‘Chicago Plan’? I don’t understand how private banks would operate under such a system.

CR – I haven’t read that entire paper, but I believe it’s a 100% reserve proposal.  I don’t understand how that fixes anything.  Banks don’t lend their reserves so if you force them to have a 100% reserve requirement then that just means they’ll borrow from the Fed when they need to.  So I don’t see what this resolves?  Maybe I am missing something?  

2contango – If I understand it correctly, QE3 is designed to boost optimism. But in my mind, it signals we are headed into more turbulent waters. Does anyone else read it this way? And if so, won’t it negate any positive impact?

CR – Maybe the best way to think of QE3 is pre-emptive.  For instance, had they been implementing QE before the housing bust we might not have seen some assets fall as much as they did because the Fed would have been in there actively putting a floor under markets.  That’s essentially the idea behind the Bernanke Put.  The problem is, it can cause distortions in markets which, in my opinion, only delays the inevitable.  I wrote more about this here.  

Dunca Cap – Can you explain, for those of us who wear conical hats, how the fed buying morgtage securities will lower mortgage rates?

CR – There’s some differing opinions on this.  Some people actually say that QE should result in higher rates as the increased economic confidence will filter through the market and impact rates upward.  Others claim it works by lowering rates through the  Fed’s purchases which put downward pressure on rates.  There’s a lot of controversy over these points and which one is accurate.  I tend to believe that QE as it’s being implemented has not had a huge impact on the markets and price is generally remaining a function of the short-end of the curve and the weak economic environment.  Since banks hinge all their rates off the overnight rate then Fed policy influences most rates in the economy by setting the spread on how profitable bank loans are.  So when the Fed eases mortgage rates come down.  If the Fed is seen as being easy for a long time then banks feel comfortable making longer loans at lower rates.  That’s the general gist of it.  

Calvin – Cullen, yesterday when QE3 was announced you said this is hugely bullish for T-bonds. But the last 2 days T-bonds have fallen in price, probably due to rising inflation expectation and asset allocation shift from bond to equity. Today you even had an article that mention the HA-CPI is a bit hot.

So how do you square away these conflicting positions (or are they just a case of short-term vs. longer-term situation)?

CR – This isn’t a short-term story.  We’re talking about multi-years here.  The Fed has been very clear that they’re going to remain easy until “at least mid-2015”.  To me, that’s bullish for the bond markets.  Now, that doesn’t mean prices can’t fall a bit in the near-term, but my thinking is this – if you are averaging into a bond position right now and continue to do so over the ensuing 6 months I think you have a very high probability of generating a respectable return until the Fed changes their easing stance.  

Anonymous – who has “agency mortgage-backed securities”?

CR – Mostly banks and investment firms.  

Tom – What did you think of Egan Jones comments which seemed to be MMT based 

Some market observers contend that a country issuing debt in its own currency can never default since it can simply print additional currency. However, per Reinhart & Rogoff’s ” This Time Is Different: Eight Centuries of Financial Folly ” , p.111, 70 out of 320 defaults since 1800 have been on domestic (i.e., local currency) public debt. Note, US funding costs are likely to slowly rise as the global economy recovers or the FED scales back its Treas. purchases (75% recently).

CR – I am not an MMT advocate, but this is one thing they certainly have correct regarding the USA.  The USA has an institutional design in place in which it uses its banking system as a funding source through the requirement of Primary Dealers to bid at auction and maintain reasonable markets in government debt.  This allows the government to always be able to procure funds.  Additionally, even in a worst case scenario, the Fed can fund the government directly by buying debt on the primary markets.  So there is no risk of insolvency in the USA.  Only a risk of inflation possibly leading to hyperinflation.  But this is a very different form of default than “running out of money” as many people seem to think we have….

yourejammingmeup – In light of this QE3 announcement, how do you think this new FED policy will affect the fiscal cliff, and more importantly, real estate?

CR – I don’t see any connection between QE and the fiscal cliff.  Regarding real estate – again, I don’t see how QE has a lasting impact.  Real estate has been in the dumps because private sector balance sheets have been wrecked and there’s no demand for credit.  QE3 won’t directly fix private balance sheets because it’s a pure asset swap of bonds for reserves resulting in no change in net financial assets.  So again, I don’t see how QE3 can bolster real estate unless you believe it’s having a substantial impact on rates and spending through confidence.  

Alberto – Why Scott Sumner is the hero of the day, a professor with dubious or modest scientific background and zero market (that is human behaviour) experience, while this site which is proposing a different path which is much more sound and grounded on reality has still a few followers ? Is it (may be) because people like Sumner are essentially proposing an easy “look at this big pie in the sky” solution which is therefore much easier to accept ? Is it because the people who should lead are still in denial (and so we’re essentially fucked) ?

CR – I think a lot of people blew this out of proportion by connecting Sumner to the Woodford comments.  Woodford came out after QE3 and said Sumner had zero impact on his work.  So that’s that.  

Bernie – This might be asking a bit much, but it’s worth a try. Do you have any perspective on legal issues affecting MBS? Based on this Reuters article it sounds like there may be troubles.

https://www.reuters.com/article/2012/09/14/us-foreclosures-courtcase-washington-idUSBRE88D1OF20120914

CR – I don’t think we should read too much into the ruling from one state….

Onthemoney – Where Egan-Jones goes, S&P and Moody’s follow…https://www.zerohedge.com/news/egan-jones-downgrades-us-aa-aa .  Echoing Tom just above, I’d also be very interested in your response to E-J. I understand why it is theoretically impossible for a nation with a printing press and its own currency to default. I presume, not having Rogoff’s book to hand, that the defaults they refer to must therefore have been a result of runaway inflation.

Can you enlighten?

CR – Egan Jones just flat out has the operational realities wrong on this.  They say:  

“Issuing additional currency and depressing interest rates via the purchasing of MBS does little to raise the real GDP of the US, but does reduce the value of the dollar (because of the increase in money supply).”

QE does not add money to the private sector.  It does not increase net financial assets.  There is no evidence that it reduces the value of the dollar or causes sustained inflation.  The trade weighted dollar index is flat since QE1 started.  Treasury yields are down 1.5% since QE1.  The annual inflation rate is flat since QE1.  So no, I don’t think Egan Jones has this correct at all.  Like most people, I think they’re completely misinterpreting the operational realities here.  

jt26 – What’s your thoughts on gold and gold+TLT given the announcement? Personally, I think gold will be in a trading range unless stocks trade down or oil+Ag trade up.

CR – I’ll summarize my long-time bullish thesis on gold – negative real interest rates.  I’ll also summarize my long-term bullish thesis on treasuries – as long as the Fed keeps short rates low the long rate will remain low.   

John Wlikins – You have explained before that QE is an asset swap meaning, I think, exchanging cash for longer-dated Treasuries or other type of security, like MBS. Are those securities, when held by banks and other private sector considered part of the money supply. If they are not pat of the money supply doesn’t the payment of cash from the Fed to the private sector entity that the Fed buys the security from, increase the money supply? I have read many times, even from the Fed itself, that QE is not inflationary from a money supply standpoint (not counting psychological reasons or changes in the value of the dollar). So my question is, does QE change the money supply (disregarding potential changes in private lending due to interest rate reduction) or does the money supply remain the same?

CR – QE is an asset swap.  The Fed buys assets from the private sector in exchange for bank reserves.  This results in no change in private sector net financial assets.  Before QE, the banks held a bond.  After the sale they hold bank reserves.  This does not change their net financial asset position as both reserves and bonds are an asset for the bank.  Therefore, the money supply remains exactly the same.  Banks do not lend out reserves so unless QE results in more lending due to some other reason then there is no reason to expect the money supply to increase from this.   

jt26 – Do you think targeting unemployment and consumer deleveraging via QE is correct?

CR – It’s a supplemental policy.  It is not the optimal policy.  During a debt de-leveraging balance sheets are impaired which results in reduced spending and income.  The optimal way to fix this is to increase the flow in the economy through fiscal policy.  Lower taxes or more govt spending.  This helps speed up the balance sheet repair process by increasing the flow of income as well as adding net financial assets to the private sector via bond sales.  So no, I do not think QE is the optimal policy here.  Hence my frustration with its repeated attempts….

jt26 – One thing that has been bothering me is that QE3 may actually prevent further lending …

CR – Lending is part supply, but mostly demand.  If there’s no demand for loans then there are no loans to be made.  During a balance sheet recession credit demand is weak because there is too much credit already relative to incomes.  So you need to fix the balance sheets first.  QE doesn’t do this.  It’s a silly supply side policy that helps the banks clean their balance sheets and totally neglects the consumers whose balance sheets are the ones needing repair.  

Wantingtoretire – What will Romney and Ryan do with QE3 as soon as they get in to power and what will be the consequences of these assumed actions…..?

CR – Sounds like Romney will give Bernanke the boot and end QE because they think it’s “money printing”.