Good Friday Morning! Welcome to the 300th edition of this newsletter. When I started writing them in 2016, I never anticipated I’d still be writing them now. I initially created them to put myself on a deadline to force myself to write. Deadlines can move your brain to think critically and develop thoughts. I appreciate all of you for being on this ride. I don’t have an audience of thousands, but I have a dedicated reader base, and I’m grateful for all of you and the feedback you send.
This week, I will cover a topic that has occupied parts of my brain since I was in college in 2008: the Federal Reserve and Quantitative Easing. It’s an important topic, perhaps the most important of the last 25 years, and it doesn’t get the attention it deserves—links to follow.
Where you can find me this week
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[7/15/2022] An illegal immigrant rapes a child, and Democrats try to talk abortion – Conservative Institute
QE Forever and Decision Time on Inflation
The Great Financial Crisis of 2007-2008 was much longer than we remember. The NBER backdated the start of that recession to Q4 2007, and they said we were in a recession on December 1, 2008. To call this a late call is an understatement; by that time, Bear Stearns and Lehman Brothers had already liquidated, unemployment had skyrocketed, Congress had passed TARP, George W. Bush was trying to knock out some unpopular policies to help out the incoming Obama White House, and the Obama administration was debating its bailout programs.
If you bought into the stock market the day the NBER declared a recession, you’d have bought near the bottom of the market. It’s impossible to call a bottom, but that was a pretty accurate prediction for the GFC. The end of that recession is dated June 2009, but the NBER didn’t declare that until September 20, 2010 (which caused a minor uproar on the right because they believed the NBER was trying to boost Democrats’ chances heading into the 2010 midterms).
So, we spent almost three full years in either an undeclared or declared recession, and we never knew when it started or ended in the moment. The NBER says that the recession lasted 18 months, officially. But as a day-to-day news event, it lasted much longer. We spent time debating whether we were in a recession and then whether or not it was over for nearly three years.
Two things essentially saved the global economy during that time: the Troubled Assets Relief Program (TARP) passed by Congress and QE1 by the Federal Reserve. I’ll save TARP for another day because we’ll focus on the Federal Reserve today.
Quantitative Easing is an attempt by the Federal Reserve to increase “liquidity” in markets. If you remember, the Great Financial Crisis caused a massive credit crunch. Because so many homes defaulted (and debtors went under, in general), banks became highly reticent to loan out any money for any reason. The US is a credit-based system. Economic growth is near impossible when people and businesses can’t buy on credit because banks refuse to give money to anyone for any reason.
The Fed announced QE1 on Nov. 25, 2008. Fed Chairman Ben Bernanke announced an aggressive attack on the financial crisis of 2008. The Fed began buying $500 billion in mortgage-backed securities and $100 billion in other debt. QE supported the housing market that the subprime mortgage crisis had devastated.
Fannie Mae and Freddie Mac guaranteed the securities. They are two agencies established by the government to boost the housing market. Historically, Fannie Mae has bought mortgages from large retail banks while Freddie Mac bought them from smaller thrift ones.
In December 2008, the Fed cut the fed funds rate to near zero and the discount rate to 0.5%. The Fed even began paying interest to banks for their reserve requirements. At that point, all of the Fed’s most important expansionary monetary policy tools had reached their limits. As a result, quantitative easing became the central bank’s primary tool to stop the crisis.
By March 2009, the Fed’s portfolio of securities had reached a record $1.75 trillion. The central bank continued to expand QE1 to fight the worsening recession. That month, it announced it would buy $750 billion more in mortgage-backed securities, $100 billion in Fannie and Freddie debt, and $300 billion of longer-term Treasurys over the next six months.
By June 2010, the Fed’s portfolio had expanded to an alarming $2.1 trillion. Bernanke halted further purchases since the economy had improved.
TARP was the bailout that cleared much of the bad debt off the books. Quantitative Easing (QE1) was an attempt to jumpstart the economy by injecting it with straight cash. Or a better metaphor is by Ben Hunt of Epsilon Theory:
That situation – the worst Depression since the 1930s, where everyone is losing their job and no one is willing to invest any money in anything, and everyone is afraid that the entire financial system is about to collapse – is exactly what Ben Bernanke and the Fed faced in early 2009. I think that the emergency action they took then, what became known as QE1, is totally fine. More than fine. Honestly, I think that QE1 saved the world. I think that QE1 was exactly why central banks were invented in the first place – to provide emergency liquidity in incredible quantities when everyone else is too scared to do it. It’s like that scene in Pulp Fiction when John Travolta plunges the syringe of adrenaline straight into Uma Thurman’s heart. The Fed is Travolta, Thurman’s heart is the global economy, and the adrenaline is QE1.
To the Fed’s credit, it worked. And if this were the end of the story, that’d be it. Policymakers saved the economic system from utter ruin, and we go into a future where everything gets centered around rebuilding. But that’s not where things ended because Quantitative Easing never ended.
As Ben Hunt writes, the adrenaline shot never stopped: “No, the problem wasn’t QE1. The problem was QE2 and QE3 and QE-infinity. The problem was turning a $2 trillion balance sheet with the completion of QE1 into a $9 trillion balance sheet today! The problem was turning a one-time straight-in-the-heart shot of adrenaline into a permanent intravenous mainline of adrenaline.”
The economic recovery under the Obama administration was slow. Painfully slow. The official unemployment rate peaked at 10% in October of 2009 (it was much higher than this). We would not see unemployment drop back to pre-GFC levels until 2016 (see FRED data).
The Federal Reserve, looking at this, restarted the Quantitative Easing machine. First, they declared QE2, then QE3 after markets had a taper tantrum, and then shifted to no time horizon for when it would end. There was a brief moment under Trump when they tried removing the adrenaline shot in 2018. Markets immediately plunged, and I’m confident Trump told the Federal Reserve to stop. And so, the emergency QE money machine continued until the Fed declared an end to it to tackle inflation in November 2021.
And we didn’t get an official end to QE until the Federal Reserve started raising rates and unwinding its balance sheet — which didn’t occur until June 2022. For 13 years, the Federal Reserve has pumped a constant flow of emergency liquidity into the market system. When the COVID-19 pandemic hit, they injected even more — a massive amount, sending their balance sheet over $9 trillion.
What’s changed? Inflation.
But everyone knew inflation was a threat — the Federal Reserve explicitly wanted inflation during the GFC. Here’s how that works:
QE1 led to the second problem. The Fed now had a record-high level of potentially dangerous assets on its balance sheet. Some experts became concerned that the Fed had absorbed the subprime mortgage crisis. They worried that the massive amount of toxic loans might cripple it like they did the banks.
But the Fed has an unlimited ability to create cash to cover any toxic debt. It was able to sit on the debt until the housing market had recovered. At that point, those “bad” loans became good. They had enough collateral to support them.
That, of course, led to the third problem with quantitative easing. At some point, it could create inflation or even hyperinflation. The more dollars the Fed creates, the less valuable existing dollars are. Over time, this lowers the value of all dollars, which then buys less. The result is inflation.
But the Fed was trying to create mild inflation. That’s because it was counteracting deflation in housing, wherein prices had plummeted 30% from their peak in 2006. The Fed was dealing with the immediate crisis. It wasn’t worried about inflation. Why? Because inflation doesn’t occur until the economy is thriving. That’s a problem the Fed would have welcomed. At that time, the assets on the Fed’s books would have increased in value, as well. The Fed would have no problem selling them. Selling assets would also reduce the money supply and cool off any inflation.
That’s why QE1 was a success. It lowered interest rates by almost a full percentage point. Rates fell from 5.21% in April 2010 to 3.98% in November 2011 for a 30-year fixed interest mortgage.
These low rates kept the housing market on life support. They also pushed investors into alternatives. Unfortunately, sometimes this included runs on oil and gold, shooting prices sky-high, but record-low interest rates provided the lubrication needed to get the American economic engine cranking again.
But the mild, needed inflation during the GFC became the generational inflation monster we have now. The liquidity crunch of the GFC made it impossible for anyone to get anything on credit. During the COVID-19 pandemic, Congress and the Fed flooded the economy with raw cash. Congress pumped trillions in handouts to help everyone survive, and the Federal Reserve pumped another $2 trillion via QE into the markets.
The recession for this lasted only about two months, with recovery occurring rapidly. The problem was that supply chains got entirely jacked up from the lockdowns. The sheer amount of cash the Fed and Congress pumped into the system caused an immediate spike in demand. Everyone wanted to buy everything. Inflation immediately jumped because money was sloshing around everywhere.
Thats’ why we saw bizarre things like the “stonks only go up!” crowd or the massive influx of cash into crypto. When money is free, and everywhere, you can pump into the riskiest of assets. It didn’t matter what you picked from March 2020 to November 2021. You made a killing in risky investments.
Now we’re in the current moment, with inflation at generational highs and the Federal Reserve trying to trigger a recession to stop runaway inflation. Raising interest rates decreases the money supply, causing deflation. We have more than a decade of built-up adrenaline shot into the system, more than $9 trillion. Fixing inflation requires draining that back out, and that will be painful.
Ben Hunt lays out the scenarios here, and I think he’s correct:
Roughly speaking, we need a wealth destruction event that’s equivalent to the 2008-2009 Great Financial Crisis just to get the ratio of wealth to GDP back to pre-pandemic levels.
If you sincerely want to eliminate inflationary pressure and expectations, that is.
If you don’t want to eliminate inflationary pressure and expectations, or rather, if the political consequences of the wealth destruction required to eliminate inflationary pressure and expectations are too unbearable, then you can instead simply mandate the effects of inflation away through wage/price controls and related policies (effective nationalization of large swaths of economic activity, for example). But those are your choices. Neither is attractive. At least with the former – wealth destruction to get at the heart of what creates inflation – you can recover and grow your way back to a more equitable and more vibrant society. The latter, though – wage/price controls and outright nationalization or pseudo-nationalization of entire economic sectors – man, you never recover from that.
To fix inflation, you have to drain wealth out of the system. Raising interest rates means causing deflation, which causes the power of the dollar to go up. At the same time, the value of everything else plummets. We’re seeing that partially now, with commodities across all sectors starting to plunge from their inflationary highs.
A form of deflation is starting to set in, but Ben Hunt makes the point: how much of this will get allowed politically? When Paul Volker set out to hammer inflation, he ignored the economic pain and let Reagan unleash supply-side policies to provide an off-ramp. Biden will do no such thing here. People will be instructed to suffer patriotically by this White House.
If the Federal Reserve reverses course to ease the pain and re-introduces quantitative easing, it will increase inflation. We have not fixed inflation yet, so expanding the money supply will increase inflation. QE cannot return until inflation gets resolved.
Here’s the other variable: raising interest rates attacks demand and decreases credit. Remember, we’re a credit-based economy, and the Federal Reserve is trying to slow that side of the economy. But doing that does nothing to fix supply chains. It doesn’t end the war in Ukraine. It improves no other external events that could negatively impact the US economy (like another pandemic or hurricane in the Gulf of Mexico). All of those events could increase inflation.
Where does this all end?
I don’t know. I tend to keep CNBC on in the background during a workday. I hear all these investors and analysts comparing our moment to things like the dot-com bubble collapse or Paul Volker in the 1980s. Those comparisons make sense because these people tend to be of a certain telegenetic age where they only know the parts of history they’ve lived through. They’re ignoring the reality that QE is over. QE defined everything for nearly 25 years (if you count Greenspan’s low-interest rate policies, which led to the housing bubble crisis).
Maybe the Federal Reserve will bring QE back. But there are genuine issues with that plan. And if they stick out their plan to end inflation, the pain will only increase. As a warning: the latest jobs report was red hot, as was the newest CPI report at 9.1% annualized. Markets are starting to price in a 100 bps rate hike, double what they were doing just a few months ago.
The Fed is panicking. And who can blame them? They don’t know where this will end, and planning for all the variables is impossible.
Sobering up is difficult. But there’s little choice right now.
Links of the week
Hollow Men, Hollow Markets, Hollow World – Ben Hunt, Epsilon Theory
Republicans Are Favored to Win the Senate – Sean Trende, RealClearPolitics
Biden Admin Urges Pharmacists to Fill Prescriptions for Drugs That Can Be Used in Abortions: New federal health guidelines cite possible antidiscrimination violation if patient is refused drugs used for medication abortion and other medical conditions – WSJ
China’s economy shrinks 2.6% during virus shutdowns – Associated Press
A Berkeley professor’s Senate testimony didn’t go how the left thinks it did – Megan McArdle, Washington Post
Good for Dutch farmers for fighting back against a gov’t bowing to enviro-radicals – Michael Shellenberger, NYPost
My Democratic abuelos raised me. Here’s why I’m now a Republican running for Congress: My abuelos were staunch Democrats. They believed in the values of hard work, family and self-determination. But the Democratic Party has left those values that are so important to our community. – Alexis Martinez Johnson, USA Today
I Am Not a Latinx Taco: Beyond the idiocy and laughter over the Latinx taco, Jill Biden’s comment reflects a huge underlying problem: Democrats think Hispanics are stupid – Vanessa Vallejo, El American
The Rise of Hispanic Religious Republicans – George Neumayr, The American Spectator
Twitter Thread(s) of the week
Satire of the week
Juul Labs Pivots to Making Cigarettes – Reductress
U.K. holds 245th annual July 4 hearings – Duffel Blog
Thanks for reading!