What Has QE Wrought? – John Mauldin

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although you can find people who will argue either side of any of those and another dozen questions. And make a lot of sense in doing so.

We are running the economy on an untested set of academic theories. Maybe they are right, although I do not think so. I am wary of actions that grossly distort market behavior, because a small group of people (central bankers) want 330 million (or maybe even billions) of people to change their self-interested actions, and offer us incentives to do so.

There has been almost total academic and bureaucratic capture of the Federal Reserve. When the Fed was established, bankers ran it (an approach that has its own set of issues), but now the process is driven by academics who mostly adhere to a group-think view of how economics works.

Look at the following chart from an article in this week’s Wall Street Journal entitled “Fed Governors Increasingly Have Academic Backgrounds.”

Quoting from the article:

The report flags the fact that the only current governor with direct regulatory experience isSarah Bloom Raskin, who previously supervised banks as Maryland Commissioner of Financial Regulation. And she’s likely on her way out after having been nominated to a position at the Treasury. Fed governor Jerome Powell has held a wide portfolio of jobs: lawyer, investor, private business and a stint at the Treasury under George H.W. Bush dealing with financial institutions. Fed governor Daniel Tarullo, after a series of government jobs, came to the Fed from Georgetown University Law Center, where he taught on banking issues.

The report categorizes governors going back to the founding of the Federal Reserve a century ago, and finds that the domination of the board by academics goes back some way. It’s only until one rolls the clock back to the 1960s do those with governmental banking oversight profiles make a strong showing.

While the report doesn’t analyze the current leaders of the regional Fed banks – they lead the institutions where most of the actual bank oversight takes place, even as it’s controlled from Washington – those officials are also by and large academic economists. Only Boston’s Eric Rosengren and Kansas City’s Esther George have extensive direct experience in bank supervision. Meanwhile, Dallas Fed boss Richard Fisher has an extensive and successful background as an investor, while Atlanta Fed chief Dennis Lockhart was a long-time banker who also spent time in academia.

And what are they telling us about the future they have planned? It is going to turn out extremely well, they say. As a group they are forecasting economic Nirvana by at the end of 2016: a 3% GDP growth rate, 2% inflation, and a 5.5% unemployment rate. What would you expect the Fed funds rate to be in such a world? Might you assume that you would at least get some inflation premia?

Think again. They are forecasting a median Fed funds rate for 2016 of 1.75%, which is a 0.25% negative risk-free return!

I have highlighted in the past how truly abysmal the models are that the Fed uses to forecast economic conditions. It is almost statistically impossible, as numerous researchers have documented, to do as badly as Federal Reserve economic forecasts have done, although the Office of Management and Budget and other congressional forecasters give them a run for their money. The latter have the partial excuse of being economists employed by politicians. The Fed has no such excuse. Their models are just plain bad.

I truly hope these people are right. I really do. But eight years without a recession in an environment where interest rates have been aggressively repressed for all that time? What distortions are we creating? What shocks await as we adjust? Will this test of a theory end without tears? We have no choice but to wait and find out. And invest our portfolios for the uncertainty into which we are headed.

Which brings us back full circle to Woody. After highlighting the distortions in the shadow banking and financial systems of the world, he notes other research, such as that of Bill White, which I have written about at some length. White was at the BIS and posted a paper at the Dallas Federal Reserve that is an important critique of Fed policy. We should pay attention, because he is one of the academics who actually forecast the credit crisis of 2007-10 prior to its happening.

Let’s jump to Woody’s conclusion (emphasis mine):

The purpose of this PROFILE has been to examine some of the unintended consequences of the ultra?easy monetary policy we have experienced both here in the US and overseas since 2008. We have seen at least a dozen ways in which today’s long period of very easy money and very low yields has distorted the workings of the financial system. This will cause unintended consequences in the near future as QE is ended, and as the funds rate is driven back up from near zero.

Many of these will be adverse consequences. The best note on which to end this paper is to restate what we have stressed repeatedly during recent years — as have many central bankers worldwide: Much too much has been asked of monetary policy in dealing with a very serious macroeconomic breakdown. Via the Tinbergen “controllability theorem” that we often cite, it is not that monetary policy does not help; it clearly does. Rather it is that no matter how “easy” monetary policy has been, it will never suffice to generate a normal recovery on its own. We emphasize that this is a theorem, not merely an opinion. Proper fiscal and regulatory policies are needed to complement the central bank’s efforts.

Had all three of these policy knobs on the dashboard been jointly optimized, as is required in the Tinbergen?Arrow?Kurz theory, there would have been no need for monetary policy to have been ULTRA?easy. The Funds rate could have bottomed at 2%, and much less QE would have been required. As a result, many of the future “risks” we have detailed would not exist.

This last point has been perhaps the most central theme of our 2013 PROFILE essays: What matters is optimal macroeconomic policy and controllability. Accordingly, the market’s obsession with the only game in town (monetary policy) is badly misplaced. What scholars such as William White and Jeremy Stein have done is to warn us that, aside from not serving to generate meaningful recoveries, ultra?easy monetary policy has created myriad new risks of the kind we have described. Historians will one day assess ex post whether this unprecedented monetary policy gamble was successful on a “net” basis.

What Will the Stock Market Do?

Finally, a brief note that I got from Ron Surz, setting out what stock market returns might be in 2014. I offer his words and chart and then a comment:

Now that this great 2013 is coming to an end, everyone is wondering what will follow in 2014. There is a formula that can help us couch our outlook. It goes like this:

Return = Dividend + (1 + Earnings Growth) X (1 + P/E expansion/contraction) – 1

The following table uses this formula to peek into 2014. The cell highlighted in yellow – earnings growth of 6% and an ending P/E of 15 – is the average long-term situation. In other words, if 2014 is “average,” we’ll see a 16% loss. But what if it’s not average? The purple cells highlight a band around the average and indicate a performance range between a 13% gain and an 18% loss.

Earnings Growth

End P/E






























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