Via Peter Tchir of TF Market Advisors,
The “Transmission Mechanism” Is Broken.
As the Fed debates what form of QE to launch on the world and whatever new communication strategies they are going to employ, maybe they should sit back and figure out why their policies seem to be doing so little.
The Fed is clearly trying to stimulate the economy. As much as I disagree with many of their policies, I do believe their intentions were to boost the economy and not just help banks make easy money. In spite of their intentions, they have failed and I think it is because they are clinging to two flawed assumptions.
The Wealth Effect
The Fed seems to have an unwavering belief in the wealth effect. They believe that if they can just increase stock prices, people will feel better and spend more. This may have been the case at one time, but there are several reasons why it isn’t working. The most obvious flaw (which has been reported on www.zerohedge.com) is that the wealth is now far too concentrated to benefit the economy as a whole. Relatively few people own most of the shares. The benefit of an increasing stock market just goes to too few people. We are just off record highs of food stamp recipients, but the number is shocking. Somewhere around 45 million people are getting food stamps. It doesn’t take a PhD in economics to figure out that people using food stamps to survive are unlikely to get too excited about stocks being up 15% or even 30%.
So the poor don’t care about the wealth effect.
What about the middle class? Maybe in 2000 people would have been impressed by the wealth effect and spent more, but things have changed. The middle class is worried about their homes. They are not comfortable that they have much equity (if any) in their homes and that has created risk aversion that will outweigh any wealth effect. But the wealth effect is further eroded since much of the “savings” and stock investments are held in IRA’s. The middle class remains concerned not only about their jobs, but also about what they will be forced to pay for in the future. Even those people lucky enough to have defined benefit plans are concerned that those pensions and benefits will be cut back. The likelihood of receiving significant support from governments in the future (state, local, or federal) is being questioned. So the gains in IRA are offset by fears that other promises will be broken. The wealth effect may allow the middle class to consume at a reasonable level, but there are too many other concerns for this wealth effect to have much of an impact.
What about the rich? Certainly at the extreme end, going from 100 million to 110 million probably doesn’t do much for your ability or willingness to consume. Even at a lower wealth level, the change may not be enough to offset future earnings concerns – especially if you work on Wall Street. The “rich” have a lot of their wealth in restricted shares of their companies. That value will have increased, but the willingness to spend money based on an increased valuation of restricted shares is greatly diminished. Enron was treated as an isolated case, but since 2007, people are being much more careful treating “restricted shares or options” as true savings.
Then there is the psychology of the rich. Many of the rich got rich because they were smart or hard working or figure out what someone needed. They made money because they found opportunities and took advantage of those opportunities. They are smart enough to see that this “wealth effect” is being created by artificial stimulus and not real true demand. The Fed is creating demand for “risk assets” but not for products. The rich will find ways to accumulate and sell “risk assets” because that is where the Fed has been able to stimulate demand. That doesn’t generate longer term growth for the economy, but why would the rich spend money to build factories or create new products when the actual demand for products hasn’t changed? They won’t. The fact that the rich know QE just creates demand for risk assets is one of the biggest (and least discussed) reasons for the failure of QE programs to generate growth in the real economy.
At least the Fed does seem to be trying to target housing now. They must realize that attempting to generate “wealth effect” growth via the stock market is hopeless.
Low Rates for Banks means Low Rates for Banks’ Customers
Somehow the Fed believes that providing low cost funds for banks will translate into low cost funds for the clients of the banks. It just isn’t happening. Liquidity remains a key concern of banks. They are willing to sacrifice margin for liquidity and perceived safety. Why lend to a consumer when you can buy corporate bonds or treasuries. Those have much greater liquidity and require much less effort to accumulate a large portfolio then making loans a few hundred thousand dollars at a time.
The Fed has not only underestimated how much value the banks place on liquidity, they have encouraged it, as capital rules benefit banks with more liquid assets. Lending to small companies and individuals requires lots of work (costs) and results in relatively illiquid assets. The banks are placing a high value on liquidity and are extremely cost conscious, so the cheap money they get is not making it down to the lower levels of the economy. Microsoft, on the other hand, can add to their cash stash with one quick call to the syndicate desk at any big bank.
Not only have the regulations encouraged banks to concentrate on liquid assets, the Fed has given them extra reasons to focus on the lowest risk products. By becoming a bid of last resort (as far as I know there have been no details on the prices paid by the Fed for its POMO purchases) the Fed was able to help banks generate easy profits (notice how almost no bank lost money on any day when QE2 was active). Banks focused on the assets where they know there is always a bid, and not exactly the most price sensitive bid. Operation twist has failed to help get cheap mortgages into the average consumer, but it did manage to teach banks that they should continue to stick to assets where there was easy money to be made and where positions could be closed quickly.
These extremely cheap loans were like free money. Somehow the Fed thought bankers would stand in line, take the cheap money and then do something constructive for the economy with it. Instead, the banks take the free money and then do what any intelligent human being would do, they go to the back of the line to get more free money.
When a theory doesn’t work, it is often because the assumptions are flawed. The Fed should be going back and figuring out how to address the failure of the stock market wealth effect and of the bottleneck of the banks. Maybe the Fed should just make mortgage loans directly to individuals? Probably a stupid idea, but at least it would impact homes which is where the wealth effect would really be felt across the board, and it would ensure the cheap money was making it to the people the Fed wants to see getting cheap money.