30 January 2013 – Macro Insight

Macro Insight: Third Time’s the Charm

Never before has the world been awash in so much liquidity. Having slashed interest rates to the bone, the major central banks have repeatedly inflated their balance sheets to spur growth, thus far with mixed results. Leading the way, the US Federal Reserve has launched three rounds of quantitative easing, the last of which is now hitting its balance sheet. As it happens, prospects for growth are turning up. So is inflation.

The Fed targets the interest rate that banks charge each other to borrow reserves held at the Fed, which then radiates through the broader economy. The Fed pays for assets it holds on its balance sheet with money that it creates itself. In theory, when the Fed buys assets, interest rates go down and the money supply goes up … and vice versa.

The Fed can monetize anything but historically it has favored US government securities and other high quality assets, which added up to just under $1 trillion before the financial crisis. When the crisis hit, the Fed swiftly brought interest rates down to zero and then turned to the balance sheet itself to arrest the financial system’s freefall. In mid-2008, the Fed began swapping Treasuries for toxic assets that no one else wanted but which the Fed could monetize. Then came quantitative easing: QE1 more than doubled the size of the balance sheet. Two years later, QE2 expanded the balance sheet again. Last year came QE3, which is just now showing up: The Fed’s assets recently hit a record $3 trillion.

The Fed has said it will keep monetary policy super easy at least until unemployment dips below 6.5%, provided inflation is under 2.5%. The current unemployment rate of 7.8% is still some distance from the Fed’s new 6.5% threshold. But the pace of economic growth is quickening, despite the distortions from the fiscal cliff imbroglio that interrupted growth in the fourth quarter. With underlying demand holding up, the big drags like housing and local government spending are rapidly fading and, at least for housing, becoming a source of strength. Perhaps the best single high-frequency data point for the economy is the government’s weekly report on initial jobless claims, which was just reported at a five-year low.

Meanwhile, the consumer price index is up just 1.7% from last year, well below the Fed’s 2.5% new trigger. But long-term inflation expectations are beginning to stir. For instance, the spread between Treasuries and TIPS in the bond market has priced in an inflation rate of 2.3% for the next five years and a rate of 2.8% for the five years after that, above the Fed’s trigger.

Monetary policy comes with lags that are long and variable, as Milton Friedman showed years ago. In this cycle, the lag has been extraordinarily long. The Fed began easing in 2007; five years later, they are still at it. The obvious risk is that by the time the Fed is satisfied that the economy’s growth is secure, inflation returns with a vengeance and it takes just as long to fight that battle.

At some point, the Fed’s balance sheet will peak and monetary policy will start returning to normal, an inflection point that will undoubtedly be traumatic for markets addicted to stimulus. But that remains a distant prospect. For now, stocks are up, putting the S&P within spitting distance of an all-time high. The Wilshire 5000 is already there. With all that liquidity sloshing around, there’s more rally to come.

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