And Now, It's Time For Something Completely Different: "Quantitative Tightening"

By Peter H. Lester, Sr.

During the Great Recession, the Federal Reserve took unprecedented steps to stabilize the economy.

Historians and researchers will no doubt discuss for years the factors that led to the financial meltdown. And, no doubt, critics of central planning and command economics will wonder why the “central planners” did not anticipate the crisis.  Those same critics will most likely condemn the steps the Federal Reserve took as too invasive.

Having said this, many believe Ben Bernanke was uniquely qualified to lead the Federal Reserve through the financial crisis. Earlier in his career, Mr. Bernanke studied and wrote a great deal about the Fed’s potential role in avoiding a period of deflation.  This was one observation economists from the monetarist school of thought (namely Milton Friedman) made as they looked back on the 1930s. They have proffered that monetary policy during that period was too constrictive.

Out of these presuppositions came Quantitative Easing (QE).

Quantitative Easing starts with the Federal Reserve making large purchases of securities. Due to our fiat monetary system, the Federal Reserve was able to make these purchases by expanding the money supply.  The European Central Bank, Bank of Japan and many other central banks followed.

QE was intended to lower interest rates which they hoped would lead to economic expansion in the housing sector, or, at a minimum, stabilize home prices. It was hoped that QE would also encourage capital investments by corporations. Both of these would encourage higher stock prices which would elevate consumer confidence and spending.  When spending increased, corporate profits would improve and unemployment would drop elevating personal incomes.

In retrospect, many of these goals were met: the unemployment rate is at 3.8%, consumer confidence is high and the stock market indexes are setting records.  However, it did not occur without a few stumbles

• Initially, monetary velocity slowed to a crawl and lending was slow to increase 
• Companies and individuals alike, hoarded cash
• Economists may have under estimated just how over-extended households had become
• Consumer spending, according to the Federal Reserve, has yet to pierce the pre-housing crisis long-run average
• Pre-Recession, household debt as a share of disposable personal income topped  out at 115%. It now hovers at 86% (as reported by New York Fed/BEA/Haver Analytics) – that is Aggregate Debt of $13.29 trillion compared to disposable incomes of $15.46 trillion.
• Stock prices have increased over 300% (as of October,2018) from the market’s low in 2009.
• While household incomes have risen, there are concerns about the quality of new jobs.

Since August of 2007, the Federal Reserve’s balance sheet has “grown in size and changed in composition”, growing from $869 billion to over $2 Trillion.¹

So the question is – as the Federal Reserve begins to reduce its balance sheet and enters a phase of “Quantitative Tightening” (QT), what will the impact be on the economy? Will asset prices deflate?

Many investors have benefited from the low interest rate environment.  US corporations have taken advantage of the low rates to sell nearly $10 Trillion in corporate debt, over a third of which was used to repurchase shares.  Private equity firms have also become highly leveraged. Interestingly, for various reasons (whether driven by valuations, regulations, reporting requirements of Sarbanes-Oxley, etc.), many companies have gone private, leaving rank-and-file investors chasing fewer investment offerings on the various exchanges.

It very well could be that the harbinger for the next financial crisis might come from the debt markets:

-          Increasing defaults on consumer loans, and home loans
-          Downgrading of both corporate and government debt
 

¹ Board of Governors of The Federal Reserve System, updated August 28, 2018.