QE’s Fanboys and Fearmongers Fan Economic Perversity

By Dan Kervick

The government released a disappointing August jobs report today. And unfortunately, the hype and misinformation surrounding the Fed’s quantitative easing program has created a perverse situation in the capital markets which may contribute to sustaining that job market stagnation for some time.

For several months now, we have seen the establishment of an entrenched pattern in which investors routinely respond to a bad jobs reports with bullish behavior and respond to a good jobs reports with bearish behavior. Bad jobs news is treated as good news for investors; good jobs news is treated as bad news for investors. Why in the world would they respond in this way? Because in a classic case of the madness of crowds driven by misinformation and disinformation, the markets have convinced themselves that the fate of the world now depends on whether or not the Fed will choose either to continue or “taper” its quantitative easing program in the near term.

The negative economic consequences of such an entrenched pattern should be obvious: We now have a clumsy capital market that is systemically programmed to step on its own feet. If investors are buying, that should stimulate investment and hiring. The result will be an uptick in the employment picture presented in the succeeding jobs report. And that uptick will then be treated as bad news, and a reason to pull back on the buying! So good jobs news is treated by the markets as a reason to counteract its own earlier bullishness and worsen the prospects for the jobless. Clearly this isn’t the way we want our economy to work.  Good news about jobs should be treated as … good news! … which will help drive a virtuous cycle and a self-sustaining recovery.

Let’s review:

First, today’s job report was rightly received as disappointing by most reporters and analysts.  The Wall Street Journal’s Phil Izzo sums it up well:

The U.S. unemployment rate dropped 0.1 percentage point to 7.3% in August and a broader measure of unemployment fell to 13.7% from 14%, but the declines came from the wrong reasons.

The drop in the main unemployment rate was driven almost totally by negative factors. The number of people employed fell by about 115,000. The only reason the rate declined is that the overall labor force dropped by a larger 312,000, a possible sign of discouraged long-term jobless dropping out.

The labor force participation rate, which is the percent of the population either working or looking to work, took a tumble to 63.2% — its lowest level since 1978.

So how did investors respond to the bad report? Well they think it’s great news! So they bought more stocks and bonds and pushed up their prices:

Investors had been eagerly awaiting the jobs report, as it is the last major piece of economic data leading up to the Fed’s next meeting in less than two weeks.

U.S. stock futures ticked higher after the release of the report, a sign that investors think that the economy is still to fragile to support the Fed’s plan to begin winding down its stimulus support for the economy as early as this month.

Bond prices rose and Treasury yields fell sharply following the jobs report, with the 10-year yield dipping to 2.88% from nearly 3%. (Bond prices and yields move in opposite directions.) Investors may be betting that the Fed will continue to buy $85 billion in bonds a month as opposed to tapering these purchases.

And I think we can safely predict that if their had been a good jobs report, investors would have turned sour and panicked about a Fed “Septaper.” They would have rushed to sell rather than buy.

Note that the Federal Reserve’s quantitative easing program has two dimensions. On the one hand there are the direct, primary effects due to the Fed’s participation in the markets for Treasury securities and mortgage-backed securities. As would be the case if any large buyer entered those markets and consistently spent many tens of billions each month, the result of such participation is to raise bond prices and push down yields. The later iterations of QE have focused on long term securities, and so long-term interest rates have fallen.

So much for the primary effects. But then there are all of the secondary effects of quantitative easing based not on the primary impact, but on market perceptions of what quantitative easing is, and how it does or doesn’t work. There is no science to these effects, since they all depend on the crazy psychological vicissitudes of whatever investors think is real, not what is real. But once a pattern of perceptions is established, it tends to be self sustaining, because investors come to expect that other investors will act in consistent ways in response to certain kinds of news, and they conform their own behavior to those expectations. The result can be that Fed actions, and perceptions of Fed actions, can take on the role of a mere signal that is wholly unrelated to the primary effects of those actions.

As I wrote in an earlier post, there now seem to be a not-insignificant number of people who believe:

1. The Fed has been “keeping the economy afloat” by its asset purchases which “pour money into the economy.”

and

2. The future volume of Fed asset purchases depends inversely on its perception of the health of the private sector economy.

The second claim is no doubt true at this point, but the first is based on misinformation. The actual nature of QE was clarified, yet again, by Warren Mosler in this recent interview with Stephanie Kelton. When the Fed buys Treasury securities from private sector financial institutions, the effect is to shift funds from those institutions’ securities accounts at the Fed to their dollar accounts. It’s the Big Bank equivalent of moving money from savings to checking. Also, if the Fed buys agency securities, part of the result is to drain interest income from the private sector as cash flows that once went to the private sector holders of the securities are now absorbed by the Fed. QE is an open market trade between two parties in which one kind of financial asset is swapped for another kind of financial asset of roughly equal value, but with differing yields and maturities. The swap does not “pour money into the economy”.

The Fed’s QE program has both enthusiastic fanboys and pessimistic fearmongers. But what both the fanboys and the fearmongers seem to agree on is the idea that QE pumps money into the economy, and as a result is inflationary and highly stimulatory. The fanboys crave these supposedly inflationary and economy-juicing outcomes. The fearmongers dread them, and recommend bunkering yourself behind gold and other non-dollar-denominated assets to prepare for the coming Armageddon of bubbles and hyperinflation. Unfortunately, there is widespread confusion about all of this. (Note Kelton’s anecdote about her airplane conversation with an experienced investor who foolishly put his money into overpriced gold because he mistakenly believed QE pumps oodles of inflationary dollars into the economy.)

The Fed hasn’t itself done that much to boost the QE hype, and they have been reasonably clear about what primary effects they are trying to achieve. But pundits have a responsibility to educate themselves, because their misinformation and distorted pictures about the role of Fed asset purchases are creating a bad situation in the markets, and stiffer headwinds for the nation’s jobless.

Perhaps a first step in unwinding the perverse market pattern would be for people to accept that the fate of galaxies does not hinge on whether or not the Fed tapers later this month, or the month after that, or the month after that.  Much more depends on whether Congress and the President reverse their misguided program of fiscal contraction and sequestration, because deficit expansion does pump financial assets into the economy.

Cross-posted from Rugged Egalitarianism

Follow @DanMKervick

29 responses to “QE’s Fanboys and Fearmongers Fan Economic Perversity

  1. “a possible sign of discouraged long-term jobless dropping out”

    Or a possible sign of baby boomers leaving the workforce as they retire.

    The employment picture is very unclear, except that it is not good. But the decline of the % of working age population that is in the workforce is not necessarily a negative. When it was rising, it was widely perceived as negative, and it was said that a single income could no longer support a family. If people can afford to retire, and do so, they shift from being savers to being dissavers, which should help.

    Are there numbers on monthly retirements? Perhaps new applications for Social Security retirement benefits would be a good proxy?

    • GJ, you may be right about baby boomers , but speaking as someone who could retire but hasn’t because I need the income, the effect could also work to discourage younger workers as boomers hold onto their jobs for dear life. A comparison of percent of SS applicants to SS eligible workers both in “normal” times and today might clarify the point.

      • That’s a different, also useful measure. What I was thinking is that maybe there is a demographic effect that is reducing the participation rate, rather than or in addition to an economic effect. Conversely, maybe there were demographic and cultural effects (as well as economic) on the participation rate that launched it in the 1970’s on its way to historic peacetime highs: baby boomers entering the workforce, women’s liberation, people waiting longer before getting married and/or having children. Maybe also increased willingness to use day care in order to have two incomes while their children were young.

  2. I have the impression that even in more nearly normal times, with Fed funds rate above zero, good jobs reports tend, all other things equal, to depress asset prices, or at least temporarily brake their appreciation, because of the perception that falling unemployment will compel the Fed to rate interest rates to restrain the risk of accelerating inflation. That this happens whether in the ZLB/QE regime or the more nearly “normal” monetary policy regime suggests that the problem may not be QE per se, but the mentality underlying NAIRU and the way that monetary policy is given all the burden of both restraining inflation and supporting maximal employment — which you point to at your conclusion.

    If fiscal policy were used to restrain inflation, perhaps with automatic tax hikes to restrain demand when inflation accelerated in the context of low unemployment, I don’t think you would see the same reactions from the markets, particularly if the tax hikes were relatively neutral with respect to the kinds of income produced by various asset classes.

    • Yes, even in normal times the market reacts to anticipated Fed actions, and the Fed is trying to be counter-cyclical. “Don’t fight the Fed” is conventional wisdom. But reactions to day-to-day news items are often short-lived, and in the end the market reacts to fundamentals, to earnings and earnings expectations.

      It’s true that Fed tightening precedes recession, but so also does fiscal tightening and slowing or reversal of earnings growth. They all correlate to the business cycle, so causality is hard to discern, absent some theory to explain it all.

      • Seems right. I can’t remember this kind of chronic obsession with Fed policy. Seems to me that in the past it was all about whether Greenspan would raise or lower interest rates by 25 basis points.

        • I think the chronic obsession is driven by the perception that the current policy is unsustainable, and therefore must change soon, or must lead to disaster. 25 basis points don’t inspire the same urgency. But long before Greenspan there were analysts reading the Fed’s tea leaves, watching for every comma inserted in the published remarks, looking for the change from “modest” to “relatively modest” expectations that would trigger catastrophic action. I think there must be people at the Fed who amuse themselves by making small, meaningless changes to the language of the statement, just to see how the market will react.

          • Yeah, that would be fun. You could craft statements like:

            “This month’s employment increases are not entirely to be discounted”

            “Growth for the previous quarter fell somewhat short of the target range viewed as robust”

  3. C’mon–this is the Plunge Protection Team at work. They can jerk the market around anytime they need to buttress Wall St. psychopaths.

  4. One of the most excellently written accounting of the QEmania. And especially to be commended for showing how distortionary monetary policy can be. The idea that fiscal stimulus interferes more in the marketplace than monetary fiddling is crazy.

    Couple questions. First, the Fed has hinted if not pleaded that Congress apply fiscal measures to boost employment instead of relying on the Fed to feebly kick at with the one goofy trick they have left in their arsenal. Is there any possibility that the revenues now coming to the Fed from these agency securities in any way push the treasury cash flow/debt ceiling showdown a bit further out on the calendar? Just brainstorming how Fed/Treasury revenues/outflows can be shifted/monkeyed with similar to what multinational corporations engage in to goose balance sheets/incomes/taxes to max advantage. Nothing “stimulative” is going to result from the upcoming clown show over the debt ceiling.

    And does anybody have a good explanation where these vast sums of money pushing stock prices up is coming from? Where’s it flowing “from”? I suppose it’s from agencies’ cash holdings the price gains have at least greater potential to stimulate greater economic activity than where they were prior. I don’t know where it’s come from, so I’m kind of uneasy. Is it funded by debts issued by the big banks? Is there another “shadow economy” developing where private exchanges are trading off-balance-sheet that we need to worry about?

    • There’s a constant inflow of funds to the market from pension plans and 401(k) contributions, as well as IRAs. Lately, too, there have been large outflows from bond funds owned by such investors, who are shifting to stock funds. Also, many companies are buying their own shares, since they have nothing better to do with the cash accumulating on their balance sheets.

      As for the debt ceiling, I think Sec’y Lew just said Treasury has been using all the accounting tricks they can think of for some months now to extend the time until the ceiling takes effect. The money from the Fed helps, but the only time I’ve seen it mentioned it sounds as if that is an annual accounting, not monthly or continuous.

      • Thanks. I just don’t know enough where to look for good numbers on this so I’ve got gut feelings but little else to go by. With the Fed a major purchaser of these bond funds through QE, would those monies be sitting in excess reserves or indeed, is it backing newly generated deposits/loans resulting in stock purchases? Private bond holders may be selling to go into stock, but who buys them? The money they bought them with had to come from somewhere too. And pension funds, IRA’s are either already invested or sitting in cash–it stands to reason new monies coursing into these funds would associate with new or rising personal incomes, which it sounds like we just aren’t seeing so much of either.

        I did see reports that insured bank deposits are down. But that’s fairly recently, and it’s hard for me to grasp the decline, which wasn’t large as a percentage, was sufficient to fund all this volume of higher priced stock trades.

        Maybe it’s not so mysterious after all–maybe I’ve an exaggerated image of the volume of what’s being traded related to what are really just so-far paper gains in these portfolios–which to me appears ginormous relative to where it was 2008.

        • There must be a regular press release or something of mutual fund inflows and outflows. I only see a number when it is “big news” or unusual, or helps to make a point about investing.

          “With the Fed a major purchaser of these bond funds through QE, would those monies be sitting in excess reserves or indeed, is it backing newly generated deposits/loans resulting in stock purchases?”

          I think you’re confusing two things here. When the Fed purchases a security, someone in the private sector exchanges a security for a bank balance. In the settlement process, the Fed credits the reserve account of that guy’s bank. So reserves go up, and they stay up. If the guy uses his bank balance to buy another bond, or a stock, or a car, it only shifts the bank balance from his account to the seller’s account, and shifts the reserves from his bank to the seller’s bank. If he leaves his money in the bank, reserves again remain unchanged. The Fed created reserves and deposits, both. The new reserves do “sit in reserves”, there is no other place they can go. (Not exactly, banks could exchange them for vault cash, but reserves cannot be transformed into loans or deposits.) The new deposit could be used to buy stocks, tending to raise the price of stocks, but that does not affect the aggregate level of bank reserves, it only moves them from bank to bank.

          “And pension funds, IRA’s are either already invested or sitting in cash–it stands to reason new monies coursing into these funds would associate with new or rising personal incomes”

          No, not at all. Personal incomes could be falling, and still some % of income will be added to the pension fund or IRA or 401(k) each month. There are outflows from these funds, too, as they pay benefits, but on balance the money in them is increasing each month, even if incomes are falling.

          It is surely possible for them to shrink, which could happen if some people tap their balances more than other people add to them – or if they sustain losses in their investments – but for now I think they are pretty much rising continuously.

          “I did see reports that insured bank deposits are down.”

          There could be two things happening: people taking cash out of the bank, and holding cash instead of a bank deposit, or money shifting from insured accounts to uninsured accounts. The former would result in a drop of total bank deposits, the latter no change in total deposits, but a drop in insured deposits. Businesses are accumulating cash, so maybe their deposits are mostly uninsured? Inequality is increasing, so maybe money moves from the 99%’s accounts that are insured to the 1%’s accounts that are too large to be insured? It’s not a result of increased stock prices. For every buyer there is a seller, and the transaction only moves money from one person’s account to another’s, it doesn’t change aggregate bank deposits.

    • Demythify,

      I quite agree that monetary policy is distortionary. In went into the point in some detail in an article on Mike Norman’s site just recently:

      http://mikenormaneconomics.blogspot.co.uk/2013/09/guest-post-ralph-musgrave.html

  5. Has that article from the Fed already been linked to?
    http://www.newyorkfed.org/research/staff_reports/sr380.pdf
    I think it explains really well how QE works and why banks suddenly hold so much reserves.

    • I have that article. Yes, as they sum up in the final paragraph: the Fed’s post-crisis liquidity facilities (and subsequent to the article, the asset-purchasing programs) created a lot of reserves, and apart from small fluctuations reserves don’t leave the system when banks increase lending.

  6. Dan, this comment is peripheral to your primary theme, but is a criticism of the WSJ article.

    You quoted WSJ:

    The drop in the main unemployment rate was driven almost totally by negative factors. The number of people employed fell by about 115,000. The only reason the rate declined is that the overall labor force dropped by a larger 312,000, a possible sign of discouraged long-term jobless dropping out.

    The most important point about the market reaction to numbers such as these is that they are not significant. The measurement error uncertainty in the Household Survey numbers each month are of the order of +/- 400,000. See item 1: http://www.bls.gov/news.release/empsit.faq.htm

    The discussions about the meaning of monthly employment changes and labor force changes less than 400,000 have no significance.

    Since measurement error decreases as the square-root of the sample size for random errors, using a four-month moving average (4x larger sample) would reduce the uncertainty to +/-200,000, if all errors are random and none are systematic for the survey process. I do not know if anyone has tried to identify if there are any systematic process errors.

    So moving averages of several months could reduce the uncertainty but at the expense of forgoing any pretense that the data provides any month-to-month information.

    The nonfarms payroll data, on the other hand, does provide meaningful month-to-month information. The establishment Survey has a measurement error uncertainty of the order of +/-100,000.

    However, differences much less than 100,000 between expectations and the actual number have no significance whatsoever. Today the consensus expectation for private payrolls was 18,000 higher than the 162,000 actual. There is no statistically significant difference.

    The Wall Street Journal is trying to”make a living” on trivia of no consequence.

    • The quote from the WSJ is one paragraph only. The rest is my comment.

      WSJ:

      “The drop in the main unemployment rate was driven almost totally by negative factors. The number of people employed fell by about 115,000. The only reason the rate declined is that the overall labor force dropped by a larger 312,000, a possible sign of discouraged long-term jobless dropping out.”

    • Thanks John. Useful information.

  7. Thinking on this a bit further, and it hit me how this combination of factors will encourage our political leaders to respond perversely as well. Congress is incapable of managing its own lunatic fringe coalition, let alone the nuances that spell disaster in these numbers.
    And Obama doesn’t have the leadership skills to convince the American people the job numbers are terrible even though on the surface they look ok. That these Wall Street gains are ephemeral, or that they’re based on the market’s failure to price stock rationally. And that the declining treasury deficit is very, very damaging to all of us, and not signals the economy is “turning around”. He can’t convince the average voter that good news is fundamentally bad – not when his opposition has painted him as the anti-business, “food stamp” president – the America hating, socialist, class-warrior harboring a secret agenda of government takeover to turn citizens into slaves of the state. He can’t lead the charge–he’s poison. If he so much as hints that these supposed “positive” indicators are really negative, and the opposition will harden. If he proposes an employment tax cut, for example, guaranteed his own party won’t follow and opponents on the right will flip like a switch to the pro-tax position.

  8. pundiots

  9. Dan:
    Can you explain why Wall Street Journal’s Phil Izzo article uses?
    “……The labor force participation rate, which is the percent of the population either working or looking to work, took a tumble to 63.2% — its lowest level since 1978.”

    While some economist like Paul Krugman uses “Civilian Employment-to-Population Ratio (EMRATIO)” which has 58.6% ratio as of Aug 2013 when bloging about the dire employment situation that US faces?
    http://krugman.blogs.nytimes.com/2013/08/31/bankers-workers-obama-and-summers/?_r=0

    • I think part of the reason is that the author chooses the one that makes his point the best. There’s a hint in Krugman’s blog: ” (It looks a bit better if you adjust for an aging population, but not much)”

      They tell two slightly different things about the economy. The labor force participation rate is the % of those who might reasonably be expected to be working (16 to 65 yo) and EMRATIO is the entire population. The participation rate reflects some cultural factors as well as economic, and EMRATIO is a stricter measure of how big the pie is compared to how many are sharing it.

      • Can it also be that EMRATIO excludes those employed in the military while the labor force participation rate includes both civilian and military employees?

        • It certainly could be. Has there been a military buildup since 2008? If so, using EMRATIO would also tend to support Krugman’s point.

  10. “Markets can remain irrational a lot longer than you and I can remain solvent.” – JM Keynes

  11. I don’t want to seem cynical, but, what reasons should the great unwashed masses have to be concerned about how the markets interpret financial and economic data?

    The stock, bond and mutual funds ( the market )

    The top 1% of America own 50% of all the stocks, bonds and mutual funds, whereas the bottom 50% own 0.5%.
    The remainder is almost entirely owned by the top 10%.


    All Big Banks now competing to be next Goldman Bubble Machine


    Markets Are Manipulated

    In America, at least, the vast majority are already dealt out of the economic picture.

  12. “Much more depends on whether Congress and the President reverse their misguided program of fiscal contraction and sequestration, because deficit expansion does pump financial assets into the economy.”

    We can just create the mechanism to circumvent the blockage at the bank level and the government level. The central bank could directly pump financial assets (reserves) into the economy in the form of transfers directly to people, while monitoring inflation. These reserves could be reclassified as equity instead of liabilities and they would represent new net financial assets.

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