Monday, September 17, 2012

Inspiration or Insanity? Fed action and Market Reaction


The big news of last week was the Federal Reserve's announcement of QE3, i.e.,  that it would buy $40 billion worth of bonds each month until the economy was back on its feet again. The fact that the commitment was open ended (unlike  QE2 and Operation Twist, the two prior big moves by the Fed during the last three years) and directly tied to stronger employment/economy was viewed as positive by the stock market, which jumped about 2% in the two days after.  I am sure that I am missing some significant piece of the puzzle, but as I watch the news coverage and market reaction, I am reminded of one of my favorite movies, "Groundhog Day".

While we can debate the intent behind the Fed move and whether it would succeed at awakening the economy, I would posit three points (all of which I am sure are debatable):
  1. The Fed does not set market interest rates: Much as I would like to buy into the notion that the Fed sets mortgage rates, corporate bond rates and treasury rates, the only interest rate that the Fed actually sets is the Fed Funds rate, the rate at which banks trade balances at the Federal reserve. In fact, if the Fed has as much power over interest rates as we think it has, the US would not have had double digit treasury bond rates in the 1970s.
  2. The Fed’s influence on market rates is greater at the short end than at the long end of the spectrum: It is true that the Fed can influence market interest rates through its actions on the Fed Funds rate, with interest rates falling (rising) on signals of a looser (tighter) monetary policy", but that fall or rise is greatest for short term rates. It is also true, in Operation Twist and continuing into QE3, the Fed is pumping billions into the bond market with the intent of keeping longer term rates low. The bottom line though is that influence does not equate control, and the bond market is far too large for even the Fed to turn the tide (if the tide is running against what the Fed would like to do).
  3. What the Fed wants to do and what it seeks to accomplish with that action seem at war with each other: If I understand what the Fed is doing, its intent is to keep interest rates low to induce higher real growth (and lower unemployment) in the economy. There is an inherent contradiction between the Fed's action and its objective. If the economy starts growing faster, market interest rates cannot and will not stay low, no matter what the Fed does. Thus, the only way the Fed can keep interest rates low for an extended period is if low interest rates do not translate into a stronger economy.   I would argue that the the Fed's earlier moves in this recession (QE1, QE2 and Operation Twist) make this point for me. Interest rates have stayed low, with mortgage rates and corporate bond rates at historical lows, but they have done so, because the economy has stagnated. 
To address the question of whether the Fed action is good for stock prices/values, I would list three “macro” variables that underlie the valuation of all equities:
  1. The risk free rate: The first corner of the triangle is of course the risk free rate, i.e, the rate you would earn as an investor on a guaranteed investment. Holding all else constant, a lower risk free rate should translate into higher equity values. 
  2. Equity risk premium: The second corner is the equity risk premium, which is the premium that investors demand for investing in stocks as compensation for exposure to macroeconomic risk, i.e., uncertainty about real economic growth and inflation. Holding all else constant, a lower equity risk premium should translate into higher equity values. 
  3. Real Growth: The third corner is real economic growth, with higher real growth, all else held constant, translating into higher equity values.
If you hold real growth and equity risk premiums fixed, and lower interest rate, the values of all financial assets should rise. But “holding all else constant” is easier said than done.  If the risk free rate is low because real growth is expected to be low and/or because investors are fleeing to safe harbors in the face of crisis, whatever you gain from having the lower risk free rate will be overwhelmed by the increase in the equity risk premium and the lower real growth. Thus, as I noted in an earlier post, a lower risk free rate does not always translate into higher equity values. The most charitable assessment I have of the market's optimistic reaction to the Fed’s action is that the market buys, at least for the moment, into the Fed’s juggling act: that they can keep interest rates low, without increasing macroeconomic risk, while spurring real growth in the economy. I think you could point to a more likely scenario where QE3 does not do much for real growth, while leading to more uncertainty about expected inflation (and higher equity risk premiums) and the net effect on stocks is negative.

Given high unemployment and an economy stuck in neutral, you may feel that the Fed had no choice. After all, doing something is better than doing nothing, right? That would be true, if QE3 were costless, but it does carry three costs:
  1. The inflation factor: The biggest cost of an expansionary monetary policy is the potential for inflation that comes with it. I know that the low inflation over the last few years has led some analysts to conclude that the inflation dragon has been slain forever.  However, history tells us that inflation is like a deadly virus, harmless as long as we can keep it trapped, but hard to control, once it escapes. Put differently, if the Fed has miscalculated and high inflation does return, the cure will be both long drawn out and extremely painful.
  2. Artificially "low" interest rates create winners and losers: If the Fed's bond buying is keeping interest rates at "artificially" low levels, not everyone wins. Among individuals, spenders are rewarded and savers are punished, a perverse consequence in a nation that already saves too little for the future. Among businesses, you reward those businesses that have to raise fresh capital, and especially those who are more dependent upon debt, and punish more mature and/or equity-focused businesses. Among sectors, you help out those that are more dependent upon debt-funded consumption (housing, durable goods) and do less for service businesses. Thus, keeping interest rates "abnormally" low may create bubbles in some sectors and encourage people to act in ways that are not good for the economy's long term health.
  3. Credibility effect: The powers of a central bank stem less from its capacity to print money (any central bank can do that) and more from its perceived independence and credibility, and I think the Fed has hurt itself on both counts. While I am willing to believe that the Fed acted without political considerations, any major action two months ahead of a presidential election will viewed through political lens, and it is natural for people to be suspicious. In addition, each time the Fed takes a shot at the "real growth" pinata and nothing happens, it damages it's credibility. Much as the market (and some economists) may welcome and justify QE3, but the ultimate test is in whether it will give a boost to real economic growth and if that does not occur, what's next? 
I was a skeptic on the efficacy of QE2 and Operation Twist and I remain unpersuaded on QE3. If the definition of insanity is that you keep trying to do the same thing over and over, expecting a different outcome, then we seem to be fast approaching that point with the Fed.



36 comments:

WhiteBelt said...

Dear Professor,
I'm a regular reader of your blog and really like this latest article due its more "macro" content which is a nice change from the usual equity focussed content (which I like too !)

I had 2 comments:
1)
Regarding your point (3) where you say - "If the economy starts growing faster, market interest rates cannot and will not stay low, no matter what the Fed does. " -
I dont really get the contradiction. If the economy does indeed start to grow faster, why would the FED want to keep the interest rates low anyway ? Wasnt the goal of low rates was to jump start the economy. If that goal is achieved, why would the FED want to keep the rates low? Sorry but didnt quite get the contradiction. Seems to be consistent with what the Fed is saying it wants to see.

2) If the inflation expectations increase, what I understand from you is that the equity risk premium should increase causing the equity prices to fall (as they are discounted by a higher number). However, intuitively, if there is inflation, shouldnt asset prices (including stock prices) increases due to additional supply of cash ? Where am I wrong in my understanding to resolve this apparent paradox.

Thanks for your time.

Regards
Ruchir Agarwal

The Contrarian Individual Investor said...

Dear Professor,

Is this merely a manipulation of interest rates or a move to stimulate the economy by stepping aside the banking system? Is the purchase of mortgage back securities directly targeted at stimulating construction and housing by increasing the demand for mortgage bonds?

profit.biz said...

This is really good information, thanks for updates, keep share such info always.

Commodity Intraday Tips India
MCX Tips India

Akhil Khanna said...

I totally agree with you that QE does not benefit the real economy in anyway but makes matters worse by increasing the prices of all products.
The taxpayer funded bailouts or QE for banks lead to lower standard of living for all the citizens of a country except for the direct beneficiaries of the bail outs. The poor people in any country live hand to mouth and do not contribute to tax revenues. The others who earn their living by small businesses or salaries pay taxes at a much higher rate than the rich individuals or big businesses. This is due to the loopholes in the taxation system which enable them to declare maximum profits in countries which have the least tax rates. So effectively in the long run the governments route the money collected as taxes from the middle class of people to the banks so that the bankers can enjoy enormous bonuses. We are in times of privatizing the profits and socializing losses for those who are well connected to the governments and the law makers.
http://www.marketoracle.co.uk/UserInfo-Akhil_Khanna.html

Aswath Damodaran said...

Whitebelt,
While I agree with you that the Fed may not care about keeping interest rates low, if the economy strengthens, the question then becomes about what the content of QE3 is. In other words, what exactly is the Fed promising to do? To keep interest rates low, if the economy does not strengthen? if so, what is the information in that promise since that would have happened anyway?
On the inflation front, if inflation goes up and becomes more volatile, there will be two effects. The first is that the riskfree rate will increase and the second is that the equity risk premium will go up. Thus, even if cash flows increase at the same rate as inflation, the value of equity will decrease.

Aswath Damodaran said...

Whitebelt,
While I agree with you that the Fed may not care about keeping interest rates low, if the economy strengthens, the question then becomes about what the content of QE3 is. In other words, what exactly is the Fed promising to do? To keep interest rates low, if the economy does not strengthen? if so, what is the information in that promise since that would have happened anyway?
On the inflation front, if inflation goes up and becomes more volatile, there will be two effects. The first is that the riskfree rate will increase and the second is that the equity risk premium will go up. Thus, even if cash flows increase at the same rate as inflation, the value of equity will decrease.

stock market said...

There is lot of articles on the web about this. But I like yours more, although i found one that’s more descriptive.

LimML said...

Sir,

If the FED pay $4,000 per month per person, that is 10 million employments it can create with the $40billion per month and we get 10 million people able to service their mortgages and help the consumption part of the economy. How about that?

WhiteBelt said...

Thanks Professor for your answer. The impact of inflation on stocks makes sense (risk free + eq. premium increase). However if I am not wrong, didnt the stock market indices soar in the inflationary scenarios in the Weimar republic, Zimbabwe etc (in nominal terms)?

Thanks

Anonymous said...

As leverage is reduced it will be difficult for growth to return regardless how much the Fed pumps in the bond market. The consumer has drastically changed their spending habits and lacks any bit of confidence. Should we start to talk stagflation at some point? I would love to hear your thoughts on this issue professor.

Thanks

Anonymous said...

What you in fact say is that FED actions can not have an effect on the real economy.

I think allmost all respected macro economist will disagree with you on that. It is well understood and broadly accepted that money does matter in the short run - but much less so in the long run.

I'm sorry to say that this is a field to blogged about by different professors.

Anonymous said...


"I'm sorry to say that this is a field to blogged about by different professors." Long Term Capital ring a bell. Those professors did really well.

Glad you are not a professor or least I hope not. QE1,2 has done nothing to help with growth and employment in the long run or short run. Consumers are reluctant to releverage their lives again with these low rates.

Loganthan said...
This comment has been removed by the author.
Loganthan said...

Professor
I am an avid student of yours and once again you have come up with a deeply analytical and yet simple to understand article.

While I understand your critique of the FED, what would your solution be?

Would you recommend any action at all and if so what would that be or are of the view that the ideal solution is to leave the economy to set itself right

capitalistic said...

The FED knows that the market sets real interest rates. What the FED wants to do, is punish risk averse investors by driving down bond yields. The FED wants to indirectly force sources of capital into long term investments, etc. The FED wants to create demand for capital. If/when demand for capital increases, the real rates will go up, thereby reversing the current deflationary environment.

Anonymous said...

Please value some middle market companies rather than high growth ones all the time?

tpweldon@uncc.edu said...

I think that the fed and economists have missed the most important point. We live in a time where the population pyramid is inverting or flat, and so retired people make up a large portion of the economy and wealth. Therefore, raising interest rates actually suppresses growth, since this fixed income sector is extremely dependent on interest income. In essence, this is the root cause of the twenty year malaise in Japan.

The fed seems not to consider whether the drastic changes in demographics over the past 100 years undermine the very foundations of classical theories. It seems that the fed is content to repeat the mistakes of Japan.

tpweldon@uncc.edu said...

oops Correction: lowering interest rates suppresses growth

Anonymous said...

To me, there are only two macro variables that determine the value of the current S&P500 companies:

(1) The ability of the companies to move the production of their businesses to areas where costs are low and the distribution of their products to where purchasing power of their customers is high.
(2) The purchasing power of Wall Street.

The fed action is aimed at maintaining the purchasing power of Wall Street. Present net margin of the S&P500 companies is 8.5%, a tidbit lower than its historical high of a year ago. Present Valuation of these companies is P/E=13.6, about $1 less than Wall Street paid for the same dollar earned a year ago. Hence, P/E is on the fall and needs stimulus as it needed for already more than 12.5 years.

Enabling Main Streets in the US and Europe to increase their purchasing power has mainly to do with the valuation of the collateral of their household Debts. During the past 15 years, purchasing power of Main Streets in Europe and the US rose by 25% at best. Some people may even argue that it is zero. The Value of the collateral of Main Street rose at least by 110% during those years, including the massive write-offs of the current years of mortgages. Main Street has no purchasing power to exchange that collateral for its present value, and the purchasing power of Wall Street is on the decline. That means more write-offs until the gap between 110% and 25% has been closed. It may take quite a while until the declining number of tax payers has absorbed that gap.

Anonymous said...

Maybe we should revisit the purpose of QE3. We assume that it is intended to boost growth, but is that true?

Can an argument be made that the real purpose of QE3 is to boost liquidity? Allowing the private (bank, corporate and households) and public sector to refinance their great debts. In that light it might be "sane".

What about growth?

This all seems a bit Japanese to me.

Shouldn't our analysis take into account that households are trying to de-leverage during a depression/recession (high unemployment & weak economy). This might be the real issue rather than interest rate levels.

Can the fed act in this arena?

If we accept the premise that private sector de-leveraging is a key factor that is impeding effectiveness of monetary policy, any real solution has to deal with some kind of bank restructuring and reform and large scale debt forgiveness/restructuring for households. However, this is outside of the Fed's mandate, so it can only help refinancing which doesn't actually reduce the level of private sector debt. So the QE3 insanity is actually sane, but won't solve the real issue.

Maybe the US needs a deepening of the depression and another financial crisis to get these policies on the table.

Loganthan said...

Maybe the Fed's goal is just to prop up the equity markets. Given rightly or wrongly that the equity markets are the most popular barometers of sentiment and the economy all that the Fed may want to do is to put a floor on the markets as any precipitous fall of the markets would lead to a downward spiral of sentiment and the economy. The Fed may be hoping that the economy may eventually correct itself in the form of higher growth once the excess in the system has been cleaned out and until that happens all that it may want to do is buoy up the equity markets.

JT said...

Professor,

Bernanke said that all recoveries after WWII have been driven by housing. Given that this new QE round is focused on MBS, wouldn't this help housing and so boost GDP growth directly? In this case then the ERP should come down while GDP growth starts to move upwards and the low rfr benefit is not overwhelmed helping equities in the medium/long term.

Vineet said...

I'm unable to understand the arguments that say QE would not help growth but would fuel inflation. How exactly would this happen, may I ask? Id the The first link, i.e., credit expansion whether through banking channel or debt capital markets does not work as transmission is broken, how can it translate to inflation?if it does work, it has to work by increasing aggregate demand first!!!

Risk is of concentrated flow of whatsoever limited broad money that is created into assets like crude oil can create price bubbles and here inflation. Reality suggests otherwise. Unless there is sufficient contango, holding physical commodities is costly. In backwardated markets, one can keep on buying futures, at expiry the front month contract is bound to come down. Of course one must take care not to index purchase price to a futures contract!

Vineet said...

Errata: I'm unable to understand the arguments that say QE would not help growth but would fuel inflation. How exactly would this happen, may I ask? If the link to economy, i.e., credit expansion (whether through banking channel or debt capital markets) does not work as transmission is broken, how can it translate into inflation? If it does work, it has to work by increasing aggregate demand first!!!

Risk is that concentrated flows of whatsoever limited broad money is created into assets like crude oil can create price bubbles and hence, inflation. Reality suggests otherwise. Unless there is sufficient contango, holding physical commodities is costly. Then again, funding of physical holdings can be penalized with very high capital requirements. In backwardated markets, one can keep on buying futures, at expiry the front month contract is bound to come down when it is rolled over. Of course actual users must take care not to index purchase price to a futures contract!

Anonymous said...

Excellent post (as any other on this blog), Keep them coming! Big thanks!

profit.biz said...

After the news of FDI investment in India, the stock market one again rise at very fast pace, government has also decided to increase the fuel price and limits of gas cylinders to stable the economy of the country.

MCX Tips
Commodity Tips

alternative investments said...

As Einstein said - the definition of insanity is doing something over and over again expecting it to be different. The FED and all central banks are pushing on the proverbial string.

Peter Thompson said...

Professor,

Following from my somewhat snarky comment above, I do have a couple of real questions:

1) Is it fair to say that QE at this point good have dangerous affects down the road? I read a bit that the money will eventually float into the real economy and create high inflation. The quote below is from an article found online touching on QE. If you see my post here and have time, I'd be curious what you think about this - any truth to that or is more a kind of hysteria? Peter


"Let's start with the Federal Reserve and the money supply. In response to the collapse of the housing bubble and most financial markets in 2008-2009, the Federal Reserve began printing like crazy. The monetary base more than doubled, and the M1 money supply at this point has risen a little over 60%. The reason we haven't seen rapid price inflation is that people are still squirreling away dollars because they're still very worried about the prospects for the economy. But that' not the end of the story. The Federal Reserve will keep printing – as everyone knows by now, Mr. Bernanke has pledged allegiance to the printing press and assured the markets that the printing isn't over and won't be over until the economy revives.

Sooner or later, the Federal Reserve will have created so much cash that many people – maybe most people – will be glutted with dollars, and buying anything will look good compared to holding on to more dollars. At that point, the urge to buy – whether it's capital goods or consumer goods or commodities – will revive the economy, and the recession will come to an end. That will reduce the level of caution people feel to something near normal. The result will be that all of the excess money that has been created since 2008 will come pouring out. For a little while it will look like happy days are here again – the economy will seem to be booming. But then the excess cash will set off hair-curling price inflation. And that's just the monetary side of the problem.

Yinghong said...

If boosting the stock market price and the real estate MBS is so important,then, why precipetate the asset bubble in the 2008 any way? Isn't it the FED's own doing to bring the real estate market down? Now you want it up since to stay at this level hurts too much? I agree with Prof. Damodaran, it is insanity!

Aswath Damodaran said...

Peter,
Not sure which prior comment was yours, but if it was snarky, no offense taken. I have a 17-year old daughter and you have seen "snarky" if you have not talked to her. I don't disagree with you, but if this is your optimistic scenario - an unsustainable, short term bubble, I would hate to see what your pessimistic scenario is.

Forex market said...

Wow!! i am very impressed with your lovely post.. I am so glad to left comment on this..This has been a so interesting read, would love to read more here….

Financial Directory said...

Now if QE 1 did not work and QE 2 did not work what makes anyone think QE 3 is going to work. Whats next QE 4.

stock market tips said...

It is a well executed post. I like the diagram most. It is a helpful informative post. Thanks for sharing this great information.

Stock tips said...

Good work…unique site and interesting too… keep it up…looking forward for more updates.

Free Antivirus Download said...

Market reaction is not stable and it is not possible. free antivirus download

Luchu Brawn said...

Forex Consultant Global Solutions provides cutting-edge technological solutions for enterprise and start-up FX & CFD brokerages