Few would still argue against the assertion that the Federal
Reserve has been central to the financial stabilization and
economic recovery from the 2008 crisis. They fixed the plumbing and
are now trying to incentivize animal spirits to pump water through
the pipes. The debate has now migrated to exit strategies and
whether the accumulating side effects of exceptional monetary
accommodation outweigh incremental benefits.
Nonetheless, it is the Fed, so views are heated, and many
misperceptions persist. The concept of money-printing resonates
strongly and intuitively with almost everyone, but most of the
intuitive reactions to the Fed's QE are turning out to have been
wrong. Here are some of the major myths that linger.
1. Money printing increases the money supply.
The Fed does
control the money supply; they control base money (or inside
money), which is a small fraction of the broader money supply. In
our fractional reserve system, the banks (loosely defined) control
the other 90% or so of the money supply (a.k.a. outside money). And
the banks have not been lending. This is why the money supply has
not grown rapidly in response to years now of QE.
2. QE is "pumping cash into the stock market."
The truth is, little of this money finds its way into the stock
market. When the Fed implements QE, they are buying low-risk US
Treasuries and agency mortgages from the market, mostly from banks.
About 82% of the money the Fed has injected since QE started has
re-deposited with the Fed
as excess reserves. With the remaining 18%, banks have tended to
buy other fixed income assets of a slightly riskier nature-moving
out on the risk spectrum for a bank doesn't mean jumping into
equities, especially given the near-death experience that most of
them have just experienced.
Of course, not all of the US Treasury bonds (USTs) and
mortgage-backed securities (MBSs) injected into the economy were
purchased from banks. And some of the money does end up in
equities. But, really, not all that much. The other big holders of
USTs/MBSs who've been selling to the Fed for the most part have
fixed-income mandates too, and they are also unlikely to take the
cash from the Fed and cross over into equities with it.
So, the natural question is why-if the above is true-have equities
gone up so much in response to QE? The simple answer? Psychology
By taking an aggressive stand, the Fed signaled a positive message
to markets: "I've got this." The confidence that the Fed would do
everything it could to protect our economic downside stabilized
animal spirits. Then it slowly but surely enabled risk-taking to
re-engage. The fact that so many people believe that the Fed would
be "pumping money into the stock market," and because so many buy
into the "don't fight the Fed" aphorism (notwithstanding September
2007 to March 2009), the effect of the Fed's message was that much
In short, this largely psychological effect on markets-
one that I had initially underestimated
-bought time for household balance sheets to heal and is allowing
fundamentals to catch up somewhat with market prices.
3. QE will create runaway inflation.
"Yet" has become the favorite word of the inflationistas. As in,
"Oh, it'll come, just hasn't yet." And the magnitude of that
expected inflation has been dialed down from 'hyperinflation' to
But some continue to hang on. The most extreme inflationistas
insist that it is here now and the Fed is cooking the books. The
reality, of course, is the Fed has nothing to do with the
compilation of US inflation statistics,
which is done by
the Bureau of Labor Statistics
. Moreover, for those who are worried that all departments of
government are conspiring against the American people, you would
also have to believe the Massachusetts Institute of Technology is
in on it, too.
MIT runs the
Billion Price Project
, a means of testing, using broad-based Internet price sampling
techniques, the extent to which the government's measure of CPI
But, there really has been no inflation, even with rounds of QE and
interest rates stuck at zero. What we have learned in this crisis
has driven home the points that the lending and borrowing that
drive the money supply are more sensitive to risk appetite than
they are to the price of money.
Is it possible that this will end in a bout of inflation? Yes. But
the odds are lower than consensus had been thinking and they are
dropping fast, as inflation continues to be well anchored and
people come to understand better how the transmission mechanism of
monetary policy actually works.
4. QE is the reason we have high oil/gasoline
This very deeply held view is just as deeply mistaken. As the chart
below shows, post crisis/post QE, oil prices on average (red line)
have gyrated around $80 to 90 per barrel with no ascending trend.
The ascending trend came well before we knew what QE even was, in
the 2002-2007 period. And the most rapid phase of its rise took
place as the Fed was
rates from 2004-2006.
Paying high prices makes all of us angry, and it feels good to have
someone to lash out at, but, alas, reality disagrees.
What, then, caused the rise in the price of oil? In brief, the rise
of China after it joined the WTO in 2002 and investor allocations
to commodities as a "new asset class," with trend followers,
speculators, and prop desks front-running the pack.
Remember this was a period in which leverage was
building and speculative juices flowing full steam
In any event, it's pretty clear it was not a result of the Fed and
5. QE has debased the dollar.
Good luck convincing people this hasn't been the case. This is an
excellent example of repeating a falsehood until it becomes
accepted as true.
Again, roll tape…
This is the trade-weighted broad-dollar average. It, much like the
oil chart above, shows all the action took place
QE and the crisis. From 2002 to 2007, the Big Dollar, as currency
specialists like to call it, depreciated some 20%. And the fastest
depreciation came…that's right, when the Fed was raising policy
rates. Since the crisis oil has been roughly unchanged, with
gyrations suspiciously similar to those of oil.
Bottom line: Anyone alleging debasement is working from hearsay and
priors, not the scorecard. And there are some pretty high-profile
people still throwing around the 'debasement' word.
In fairness, the Fed did assume that their exceptional monetary
accommodation might result in some depreciation of the dollar. But
because the US is a closed economy (exports and imports make up a
relatively small share of GDP) the Fed felt-correctly in my
view-that it should be setting monetary conditions based on the
larger domestic economy. And if dollar depreciation were to ensue,
so the thinking went, it would at the margin be positive for US
growth, as long as the depreciation was orderly.
Why, then, did the dollar depreciate so much in the 2002-2007
period? For pretty much the same reasons that the price of oil went
higher: It was a period of risk-taking, leverage, and deepening
optimism regarding emerging markets. All three factors led to
dollar selling -- and that was well before QE ever made its first
appearance in the US.
In sum, much of the received wisdom surrounding the Fed and the
effects of its actions is misplaced. Through repetition and ex-ante
biases, deep misunderstandings have become engrained in market
Importantly however, the recent rise in the dollar and fall in
commodities suggest that these long-held misguided views are
becoming dislodged. There is plenty of risk ahead and the Fed's
task is far from easy or over. But the Fed, for the most part, is
ahead of the curve. Make sure you and your views don't get caught
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