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The Virtuous Circle

Posted on March 19, 2019

“Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” – Ben Bernanke

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This series on the Federal Reserve was originally published in 2013 but was recently refreshed for a presentation we gave to the Kissing Camels Coffee and Donuts club. In our last post we took a look Behind The Curtain at the various tools the Fed uses to implement monetary policy. This week we continue our series with a brief summary of the Fed’s unconventional and controversial policy response to the Global Financial Crisis. 

It’s important pause and remember how terrible everything was in the throes of the crisis. The disease of subprime mortgages was the first in a long line of dominoes, and by the time the meltdown was in full swing the contagion seemed to be impacting every corner of the world economy. The US Federal Reserve, in a coordinated effort with central bankers and government leaders around the globe, opened the tool bag and began getting creative in its response. 

Credit Easing

One strategy used by Bernanke and the FOMC was to put on the “lender of last resort” hat and begin extending credit in all sorts of unconventional ways. They effectively opened up the coffers and began flooding the financial system with liquidity. This entailed lending to institutions that otherwise wouldn’t qualify, in greater amounts than they normally would allow, against collateral of all sorts that typically wouldn’t be accepted. They even funded special purpose vehicles that were established with the express purpose of buying problematic assets on the open market in order to boost prices. The goal with these programs (see graphic below) was to draw a line under the contagion and ultimately restore some confidence.

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Zero Interest Rate Policy (“ZIRP”) 

The second thing the Fed did was to drop short-term interest rates quickly to as low as they could get them. This policy, known as Zero Interest Rate Policy, or “ZIRP”, entailed pushing the fed funds rate down to a target range of 0.00-0.25%. (See last week’s post for a more detailed discussion on how this is accomplished.) Once rates were lowered to this level they were left there for seven years. In hindsight this policy is seen as having been relatively impotent, at least in the midst of the worst parts of the crisis. Supply and demand for credit was so dysfunctional during this time, simply lowering the cost of debt didn’t have much of an impact on borrowing until the financial system and economy had later recovered and credit demand strengthened. 

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Quantitative Easing 

Quantitative easing was probably the Fed’s primary policy tool in the aftermath of the financial crisis. It is one of the most widely misunderstood, hotly contested and broadly influential policies implemented anywhere on the globe in recent history. We will try to provide a balanced analysis by boiling this policy down in a simple, understandable way. 

Quantitative easing, or “QE”, is related to the central bank’s practice of buying securities in the open market with money that was created ex nihilo – out of nothing. Quite literally, the Fed purchases the security from a private market participant by crediting their account electronically with US Dollars that didn’t previously exist. In one sense this practice is not that unusual. As we saw last week in Behind The Curtain, one of the primary ways in which the Federal Reserve implements its monetary policy is through open market operations – the buying and selling of government-backed securities on the secondary market. These operations are typically confined to the ultra-short term interbank lending markets where they add and drain reserves out of the banking system in order to manipulate the fed funds rate to a target level. So it is through open market operations that the Fed even has the ability to set short-term interest rates. 

According to Wikipedia, however, “Quantitative easing (QE) is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective.” So what makes QE so unconventional? It’s the fact that the securities being purchased are longer maturity and might even include bonds other than US Treasuries. 

The stated goal of QE is to put downward pressure on long-term interest rates. Lower interest rates encourage borrowing which in turn lead to investment. The influx of money into investable assets lifts the price of those assets which creates a “virtuous circle” by spurring more borrowing and spending in the economy. Bernanke referred to this cycle in a 2010 article he penned for the Washington Times: 

“…higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” 

So while the stated objective of QE is to impact interest rates, the ultimate motivation is much more psychological. Simply put, the Federal Reserve is in the mood management business. Inflated asset prices should lead to more optimism and looser wallets amongst American consumers. The theory (and hope) is that this will become a self-fulfilling prophecy of economic growth that will gain momentum and eventually stand up on its own two feet without any further stimulus from the Fed. 

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There is a widely held view that quantitative easing is essentially money printing, and that “Helicopter Ben” might as well be dropping dollar bills from the sky. While there are certain elements of this argument that are true, it’s important to know what is meant by the term “money printing.” We believe most people’s definition is somewhat misinformed, so let’s bring some clarity to this issue by considering what actually happens when the Fed purchases an asset in the open market as part of its QE program.

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The net impact of a QE transaction is not to increase the financial account of the private sector. Rather, what occurs is essentially an asset swap in which the bank trades a $1,000 asset for $1,000 in cash. The composition of the private sector’s assets has changed, but the total amount of private sector net worth has remained the same. Meanwhile, the Fed’s balance sheet is expanding in size as both the assets and liabilities side increases in tandem with every QE transaction. The chart below reveals the significant expansion that occurred during the Fed’s various QE programs.

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It’s widely believed that every dollar of QE adds a dollar to the money supply, but this is not the case. In order to understand why, it’s important to know the distinction between the monetary base and the money supply. The monetary base case be thought of as the raw material that the banking system starts with, and the money supply is what that base money is multiplied into via the lending and deposit cycle. Assuming a 10% required reserve ratio, the banking system can take $1 of base money and turn it into $10 of money supply. (See fractional reserve banking for a more detailed explanation.) 

Every dollar of QE removes a dollar of bonds from the system and adds a dollar of base money, thereby expanding the potential money supply. But until that base money begins getting lent out it sits idle in the form of excess reserves and the impact on the money supply is limited. This is exactly what happened in the years following the financial crisis, and it is probably the reason why we still haven’t experienced the rampant inflation that so many predicted would be one of the byproducts of QE. As the chart above shows, the Fed has since allowed its balance sheet to begin tapering off and head towards a more normalized level. 

The Fed’s aggressive and creative policy response to the financial crisis is one of the most controversial and widely misunderstood financial topics in the modern era. The impact of the Fed’s actions on the real economy is debatable, but few would argue it has had significant influence on the psychology of financial market participants. The Virtuous Circle has certainly been hard at work over these past ten years. In the end will the policy response be hailed as the effort that shifted the tide and propelled the US economy out of its worst recession in a century, or will it be seen as a fool hearted attempt to “play god” that led to only temporary relieve and a host of longer-term unintended consequences? We probably won’t know the answers to these questions for many years to come, but hopefully this discussion has provided some clarity around the nuts and bolts of the Fed’s response during a very difficult time for our country.


david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.


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