Quantitative Easing

ECB joins the money printing party and launches QE lite

euro

Vivek Kaul

The European Central Bank (ECB) led by Mario Draghi has decided to cut its main lending rate to 0.05% from the current 0.15%. It has also decided to cut the deposit rate to –0.2%.
European banks need to maintain a certain portion of their deposits with the ECB as a reserve. This is a regulatory requirement. But banks maintain excess reserves with the ECB, over and above the regulatory requirement. This is because they do not see enough profitable lending opportunities.
As of July 2014, the banks needed to maintain reserves of € 104.43 billion with the ECB. Banks had excess reserves of € 109.85 billion over and above these reserves. The ECB was paying a negative interest rate of –0.1% on these reserves. Now it will pay them –0.2% on these reserves. This means that banks will have to pay the ECB for maintaining reserves with it, instead of being paid for it.
These rate cuts have taken the financial markets by surprise. When the ECB had last cut interest rates in June earlier this year, it had indicated that would go no further than what it had at that point of time. Nevertheless it has.
So what has prompted this ECB decision? In August 2014, inflation in the euro zone (countries which use euro as their currency) dropped to a fresh five year low 0.3%. In fact, in several countries prices have been falling. From March to July 2014, prices fell by –1.5% in Belgium, –0.4% in France, –1.6% in Italy and –1% in Spain.
In an environment of falling prices, people tend to postpone their purchases in the hope of getting a better deal in the future. This, in turn, impacts business revenues and economic growth. Falling business and economic growth leads to an increase in unemployment. And this has an impact on purchasing power of people.
Those unemployed are not in a position to purchase beyond the most basic goods and services. And those currently employed also face the fear of being unemployed and postpone their purchases. The rate of unemployment in the euro zone stood at 11.5% in July 2014. This has improved marginally from July 2013, when it was at 11.9%. The highest unemployment was recorded in Greece (27.2 % in May 2014) and Spain (24.5 %).
Hence, the ECB has cut interest rates in the hope that at lower interest rates, people will borrow and banks will lend. Once this happens, people will borrow and spend money, and that will lead to some economic growth. But is that likely the case?
The numbers clearly prove otherwise. In June 2014, the ECB decided for the first time that it would charge banks for maintaining excess reserves with it. In April 2014, the excess reserves of banks with the ECB had stood at € 91.6 billion. The hope was that banks would withdraw their excess reserves from the ECB and lend that money. The excess reserves have since increased to € 109.85 billion. What does this tell us? Banks would rather maintain excess reserves with the ECB and pay money for doing the same, rather than lend that money.
The ECB had cut the interest rate on excess deposits to 0% in July 2012. Hence, the negative interest rate on excess deposits has been around two years, without having had much impact. In fact, the loans made to companies operating in the euro zone is currently shrinking at 2.3%.
Also, banks always have the option of maintaining their excess reserves in their own vaults than depositing it with the ECB. They can always exercise that option and still not lend. Interestingly, in July 2012, the central bank of Denmark had taken interest rates into the negative territory. The lending by Danish banks fell after this move.
The Draghi led ECB has also decided to crank up its printing press and buy bonds, though it refused to give out the scale of the operation. The ECB plan, like has been the case with other Western central banks, is to print money and pump that money into the financial system by buying bonds. This method of operating has been named “quantitative easing” by the experts. The Federal Reserve of United States, the Bank of England and the Bank of Japan have operated in this way in the past.
The hope as always is to ensure that with so much money floating around in the financial system, banks will be forced to lend and this, in turn, will rekindle economic growth.
The ECB has plans of printing money and buying covered bonds issued by banks as well as asset backed securities(ABS). Covered bonds are long-term bonds which are “secured,” or “covered,” by some specific assets of the bank like home loans or mortgages. The ABS are essentially bonds which have been created by “securitizing” loans of various kinds.
The size of the ABS market in Europe is too small, feel experts, for these purchases to have much of an impact. Nick Kounis, an economist at ABN Amro told the Economist that “the likely size of possible purchases would be €100 billion to €
150 billion.” This is too small to make any difference. Bonds covered by home loans and worth buying could amount to another € 500 billion.
Further, the buying of ABS is unlikely to begin at once. As Ambrose Evans-Pritchard of The Telegraph put it on his blog “Buying may not begin in earnest until early next year since the ABS market is not ready.”
All this makes Evans-Pritchard conclude that “this would be a form of “QE lite” but it would be trivial compared with the huge operations of the Bank of Japan and the US Federal Reserve, together worth €120bn a month at their peak.”
If the ECB has to launch a serious form of quantitative easing it needs to be buying government bonds. But any such move is likely to be opposed by the Bundesbank, the German central bank. As the Economist put it “such an intervention would be bitterly opposed by the Bundesbank on the grounds that it would redistribute fiscal risks among the 18 member states that belong to the euro.”

The article was published on www.FirstBiz.com on Sep 5, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

'The Federal Reserve Learnt the Lessons Of The Great Depression'

Prof Randall Kroszner..

R Jagannathan and Vivek Kaul

Randall S Kroszner served as a Governor of the Federal Reserve System from March 2006 until January 2009. During his time as a member of the Federal Reserve Board, he chaired the committee on Supervision and Regulation of Banking Institutions and the committee on Consumer and Community Affairs. Kroszner was a member of the President’s Council of Economic Advisers (CEA) from 2001 to 2003. Currently he is the Norman R Bobins Professor of Economics at the University of Chicago Booth School of Business. He is an expert on international financial crises and the Great Depression. He was recently in India for the opening of The University of Chicago Center in Delhi. In this interview Kroszner tells Forbes India on how the Federal Reserve managed to avoid another Great Depression in 2008 and why it had to let the investment bank Lehman Brothers go bankrupt.

You were a governor at the Federal Reserve between 2006 and early 2009. That must have been a very tough and an exciting time…
Three easy years…(laughs). I am joking.
Can you give us some flavour of how those years were?
It was an incredibly challenging time because the markets were moving so rapidly. The economy was also moving rapidly downward. So we had to take important decisions in real time. We would often get into situations where we would try to survive until Friday and then try to do the resolution by Sunday, before the Asian markets opened. So we had a lot of board meetings late on Fridays, Saturdays and Sundays. And it was a time where having an economic framework was very useful because when you have to make decisions in real time, you need to have a framework to understand what the priorities are.
You and Ben Bernanke are scholars of the Great Depression. How did that help?
A number of us were quite familiar with the economic history. Three out of the five of us on the board had written papers on the Great Depression. And we were all pretty much influenced by Milton Friedman and Anna Scwartz’s magisterial A Monetary History of the United States. Their study squarely put the blame on the inaction of the Federal Reserve, turning a depression into the Great Depression. Those were very important lessons for us and gave us both an economic and historical framework for looking into the kind of price distress we were having at that point of time, so that we could act quickly and boldly to prevent a repeat of the Great Depression.
Did you all really believe that if the fiscal side and the monetary hadn’t acted as they did in 2008, you were really seeing a repeat of the Great Depression?
There was a certainly a risk of that because clearly there was a lot of turmoil in the financial markets. There was a potential for failure of many financial institutions, if the Fed did nothing and did not provide liquidity to the market and some institutions. It was by no means a certainty. Even if the probability was low, it’s a risk that I and other members of the Federal Reserve board were reluctant to take.
In the meetings at the Fed before September 2008 what was the atmosphere like? Did Chairman Bernanke and other governors have a clue of what was to come?
If you see the verbatim transcripts of 2008 many of us including myself were very concerned about the fragility of the market and the economy. We undertook some very bold action in terms of a very rapid interest rate cut. This was at a time when the European central banks were raising interest rates because oil prices were rising throughout 2008. But our forecast was that demand was likely to go down significantly and that the rise in oil prices was just a temporary price shift not suggesting an underlying increase in inflation. And that is why we had interest rates very low during that time period while other central banks were raising interest rates.
Being the Chair of the committee on Supervision and Regulation of Banking Institutionsyou must have been in the room when a decision to let Lehman Brothers go bust would have been made. What was the atmosphere like?
So, there was no meeting where a go/no go was made. It was a series of processes. Remember we were dealing with independent investment banks having significant funding troubles and having great concerns about their ability to survive. And so we were exploring whether there could be merger partners for organisations like Merrill Lynch and Lehman Brothers. Bank of America decided to buy Merrill Lynch. There were others who were looking at Lehman Brothers and we thought that we would be finding a merger partner. But it then emerged over that weekend[the weekend of September 13-14, 2008] that a merger partner was not available for Lehman Brothers. The market had known that they were in trouble for a while. And Lehman Brothers had not been willing to merge with a number of other institutions that had proposed merger over the summer. Hence, it was in an effectively weak capital position. Its business model was imploding and so, the Fed was not able to do a capital infusion.
Why was that the case?
The Fed can only lend against good collateral to a solvent organisation. It was very difficult to make an assessment at that time. There was a merger partner avaialble for Merrill Lynch and Bank of America could provide capital infusion and support. Morgan Stanley and Goldman Sachs had sufficient capital and sufficiently functional business models, that we felt comfortable granting them bank charters on an emergency basis. But Lehman Brothers did not have that wherewithal.
But two days later Federal Reserve stepped into rescue AIG. How do you explain that?
Well remember that the Fed could lend against good collateral. The problematic part of AIG was the financial products subsidiary of the holding company. But AIG had other operations in many states and in many countries that were not associated with the challenges that were there in the financial products division. And also AIG had sufficient collateral to be able to post against the loan.
You are also a scholar of the Great Depression. What were the mistakes made during the Great Depression that haven’t been made during the period of what is now called the Great Recession?
As you know a number of us including Bernanke, myself and one of the other governors, were students of the Great Depression and had done work on it. Milton Friedman and Anna Scwartz’s in their magisterial book on the monetary history of the United States had said that depression of the late twenties and early thirties was turned into the Great Depression precisely because the Fed did not act. The Fed stood by as the money supply collapsed, and as deflation came in. The prices fell by a third, GDP fell by 30%, and unemployment went up to 20%, and there was no action.
And that was the lesson?
Yes. That was a very important lesson for those of us who had studied the Great Depression, to make sure that we did not make that mistake of inaction because the central bank can prevent deflation. Broadly, we certainly learned the lessons of the Great Depression at the Fed, to make sure that we didn’t make the same mistakes. We didn’t just sit ideally and allow the price level to fall significantly and allow the GDP to contract. Honestly, we were able to avoid a significant to recession. It is really something very different from what happened in the 1930s.
You also managed to avoid a deflation…
Deflation can be very destructive as we saw in the thirties. Even a mild deflation can be very problematic as we have seen over the last fifteen years in Japan. It was the strong commitment on the part those of us who studied the 1930s as supposed to the others, to make sure to not allow a state of inaction, where a central bank did not act as the lender of the last resort, which is actually what it was created to do. Further, central banks around the world have to be vigilant against the threat of deflation.
International financial crises is an area of your expertise. Why are economists unable to spot bubbles. Your colleague and Nobel laureate Eugene Fama has even gone to the extent of saying that “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”
It is easy ex-post to say that aha that price did not make any sense or it was clear that price would be coming down. But when in you are real time it is very difficult to be able to tell whether there is some sort of dislocation of the market or a fundamental change. We had the same challenge after the Asian, Russian and the Latin American crisis in the 1990s. The World Bank, IMF and many economists looked for indicators, so called red flags, which you could look at and tell when the economy is is getting overheated. They tried to figure out which are the indicators that can tell us that credit growth is too fast, or that there is a “bubble” in a particular sector. Despite a lot of work by a lot of very smart people on the policy side and the academic side, we really haven’t come up with a simple set of indicators or any indicator where you can have confidence and say just look at x, y and z, and you know that there is some sort of dislocation here, that is going to be reversed.
In a recent interview you said that the Fed’s approach to communication has changed through the years. Could you elaborate on that?
The communication has become more complete and more transparent and also the words have changed over time. They are sometimes called forward guidance. They are sometimes called open mouth operations because its talking about what kind of purchases and sales that the open market operations are going to do. In my last meeting at the Federal Open Market Committee(FOMC) we brought interest rates to approximately zero and said that we would keep them there for an extended period of time. That gradually changed into a particular date, and Fed would describe dates like 2014/2015. That changed to a description of 6.5% unemployment threshold. And most recently the Fed has said that it would not be focusing on a particular unemployment threshold.
What is the aim here?
I think all of the statements are trying to get at the same thing. It’s different words in different circumstances, around the same idea about the desire of the Fed to provide liquidity support to monetary accommodation to make sure that the economy fully recovers before it decides to take the punchbowl away. In these uncharted waters, giving a little bit more guidance about what the Federal Reserve thinks about policy making and how is it going to react to data is helpful because the past behaviour may not be that useful because we haven’t had these kinds of circumstances before.
In a recent interview when you were asked that when do you think the time will come when the Federal Reserve will start to raise interest rates, you had replied “I do think it will come sometime in my lifetime”. Does that mean the era of low interest rates in the US is here to stay? That was a bit of flip comment. I hope you understand that it was not meant seriously. We have had low interest rates for five to six years now. There is a hope that the economy will be strong enough sometime in 2015, and rates will be able to go up. You can see from most recent FOMC documents all of the FOMC members believe that the interest rates will be higher by the end of 2015 than they are now. And that sounds to me as reasonable.
A lot of gold bulls have been thinking that some point gold should have some role in money making. Do you see gold ever having any kind of role in monetary policy in future?
It’s narrow to pull this in any particular commodity because then the value of the currency will rise and fall depending on the vagaries of the particular market. So, like a flood in a mine in South Africa will have a big impact. And that is like putting too many eggs into one basket. The least you would want is a broader commodity based basket that would be well diversified and would be able to withstand these kind of shocks. So certainly thinking about alternative benchmarks for units of account are worthwhile to do. But I wouldn’t want to put all of my eggs in one particular commodity basket, particularly a market like gold which is a very small one. Small shocks like a flood in a mine in South Africa could have a big impact on money supply. Hence, it doesn’t seem like a very stable system.
The near zero interest rates and the QEs have had a bigger impact on the assets markets than the credit markets and the real economy. Would you say it is building up some problem?
It is important that the Fed is aware about this and is looking into this. Jeremy Stein one of the governors of the Fed has been at the forefront trying to think about what indicators to look at, indicators that might raise red flags. Jeremy as well as his staff are thinking very carefully about that. Monitoring this very very closely is very important and I know that the Fed is. To be able to predict which markets will have a dislocation, it is impossible to do that. No one has that kind of foresight. But I do think there is much more focus on that today than there was in the past.
In another five six months it will be six years since the Lehman Brothers went bust. How long do you think the easy money policies will continue?
As Chairman of the Federal Reserve, Ben Bernanke had said, whatever it takes, a corollary of that is as long as it takes. We have had a slow recovery than anyone had hoped for and that has been true not only in the US but many other countries as well. Some countries like India and some emerging markets that had done very well in the late 2000s have seen a significant fall in growth more recently. As the FOMC and Janet Yellen have said they are now on a path of tapering. It is very important to draw the distinction between tapering and tightening. The Fed had made a commitment to buy $85 billion worth of additional assets every month and that added nearly $1 trillion to the balance sheet every year. And with tapering now it is going to reduce the pace of that increase. So, it is not a tightening it just reducing the pace of additional accommodation. The additional accommodation is likely to wind down by the fourth quarter of this year and then depending on economic conditions, around six to nine months after that, the Fed might actually begin the process of tightening. But this is sort of a very gentle lengthy process. This is not a sudden shift of policy.

The interview originally appeared in the Forbes India magazine dated Jun 27, 2014

 

Sensex reclaims 21k: Why yen carry trade will ensure ‘easy money’ continues

1000-yen-natsume-sosekiVivek Kaul
The Federal Reserve of United States, the American central bank, plans to go slow on money printing starting this month i.e. January 2014. Until the last month the Federal Reserve printed $85 billion every month. It pumped this money into the financial system by buying government bonds and mortgage backed securities.
The idea was to ensure that there is enough money going around in the financial system and, thus, help keep long term interest rates low. This would hopefully encourage people to borrow and spend and, thus, help the American economy to start growing again.
The risk was that all the money being printed would lead to inflation. While the money printing hasn’t led to consumer price inflation, it has led to a rapid rise in the stock market as well as real estate prices in the United States. This is primarily because people (which includes investors) could borrow at very low interest rates and invest that money in stocks as well as buy homes.
“Since the turnaround began on March 9th, 2009, the S&P-500 index has chalked up gains of +175%, – ranking it as the fourth longest bull market of all-time. In cash terms, the US-stock market has generated $13.5-trillion in paper wealth,” writes Gary Dorsch, Editor, Global Money Trends, in his recent column.
The 20 City S&P/ Case- Shiller Home Price Index, the leading measure of U.S. home prices,rose by 13.6% in October 2013, in comparison to a year earlier. This is the highest gain in prices since February 2006, when prices had risen by 13.9% in comparison to the year earlier. Real estate prices in the United States, as measured by the 20 City S&P/Case- Shiller Home Price Index had peaked in April 2006.
So the markets in the United States as well as other parts of the world have done very well over the last few years as the Federal Reserve of United States has printed truck loads of money. The interesting thing is that even with the Federal Reserve deciding to go slow on money printing, the markets haven’t fallen.
It is worth pointing out here that when the Federal Reserve Chairman Ben Bernanke had first talked about going slow on money printing (or tapering as he called it) in May-June 2013, financial markets (stock, bond and foreign exchange) had reacted very badly to the news.
But when the Federal Reserve has actually gone ahead with “tapering” and decided to print $75 billion per month (instead of the earlier $85 billion) the markets haven’t reacted violently at all. Why is that the case?
One reason is the fact that the Federal Reserve has managed to communicate to the investors that tapering isn’t really tightening. What that means is that even though the Federal Reserve will go slow on money printing and not print as many dollars as it was in the past, it will ensure that short term interest rates will continue to remain low. As Jon Hilsenrath writes in the Wall Street Journal “Most notably, the Fed’s message is sinking in that a wind down of the program won’t mean it’s in a hurry to raise short-term interest rates.”
This means at some level the dollar carry trade can continue. Hence, big institutional investors can continue to borrow in dollars at low interest rates and invest that money in different financial markets all over the world.
It needs to be pointed out that whether the Federal Reserve decides to further cut down on money printing depends on the overall state of the American economy. One particular number that the Federal Reserve likes to look at is the number of jobs created every month. In December 2013, the US economy saw a net increase of 74,000 jobs. As Andre Damon writes onwww.globalresearch.ca “The US economy generated a net increase of only 74,000 jobs in December, about one third the number predicted by economists and less than half the amount needed to keep pace with population growth. The increase in non-farm payrolls was the lowest since January 1, 2011, when the economy added 69,000 jobs. Friday’s number followed two months in which payrolls grew by 200,000 or more, leading to claims that the economy was shifting into high gear.” This implies that it will be difficult for the Federal Reserve to cut down from the $75 billion that it is currently printing in a month. Hence, it is unlikely that the Federal Reserve will stop money printing any time soon.
What has further energised the financial markets is the fact that the Bank of Japan, the Japanese central bank, is also printing money big time. As Dorsch writes “The Bank of Japan(BoJ) has taken a page out of the Fed’s quantitative easing playbook, – but multiplied by 3-times. The BoJ is buying ¥7.5-trillion of government bonds (JGB’s) per month, and intervening directly in the equity market, by purchasing ¥1 trillion of exchange-traded funds linked to the Nikkei-225 each year. The BoJ aims to inject $1.4-trillion into the Tokyo money markets by April ‘15, equal to a third of the size of Japan’s $5-trillion economy.”
The Federal Reserve until last month was printing $85 billion every month. This works out to a around $1.02 trillion every year. The amount of money being printed by the Bank of Japan is more than that. What this means is that interest rates in Japan will remain low. This will encourage the yen carry trade, where an investor can borrow in yen and invest the money in different financial markets around the world.
What will also help is the fact as the Japanese central bank keeps printing money, the yen will depreciate against the dollar and thus spruce up returns. In the last one year the yen has gone from around 89 to a dollar to almost 103-104 to the dollar currently. “With liquidity injections of ¥7-trillion per month, Tokyo has engineered the yen’s -18% devaluation against the US$, -23% against the Euro, -15% against the Korean won, and a -12% slide against the Chinese yuan,” writes Dorsch.
How does this help yen carry trade? Let us understand this through an example. Let’s say an investor borrows 100 million yen and converts them into dollars. Currently one dollar is worth around 104 yen.
Hence, 100 million yen can be converted into around $961,538 (100 million yen/104). This money is invested in financial markets around the world and let’s say at the end of one year has grown by around 8% and is now worth $1.04 million. One dollar by then let us assume is worth 110 yen.
When $1.04 million is converted into yen, the investor gets 114 million yen. This means a return of 14%. Hence, the depreciating yen adds to the overall return for anyone who borrows in dollars.
It also means that financial markets around the world will see foreign investors continuing to bring in more money. India should also benefit from the same over the next one year. Given this, the BSE Sensex should continue to go up till December 2014. CLSA expects the Sensex to touch 23,500 by December 2014. Deutsche Bank Markets Research expects the Sensex to do even better and touch 24,000 by the end of this year. It does not matter that the real economy will continue to be in doldrums.
 
The article originally appeared on www.firstpost.com on January 13, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)
 
 

Why the Federal Reserve will be back to full money printing soon

helicash Vivek Kaul 
The Federal Reserve of United States led by Chairman Ben Bernanke has decided to start tapering or go slow on its money printing operations in the days to come.
Currently the Fed prints $85 billion every month. Of this $40 billion are used to buy mortgage backed securities and $45 billion are used to buy American government bonds. Come January and the Fed will ‘taper’ these purchases by $5 billion each. It will buy mortgage backed securities worth $35 billion and $40 billion worth American government bonds, every month. The American central bank hopes to end money printing to buy bonds by sometime late next year.
The Federal Reserve started its third round of money printing(technically referred to as Quantitative Easing(QE)- 3) in September 2012. The idea, as before, was to print money and pump it into the financial system, by buying bonds. This would ensure that there would be enough money going around in the financial system, thus keeping interest rates low and encouraging people to borrow and spend money.
This spending would help businesses and in turn lead to economic growth. With businesses doing well, they would recruit more and thus the job market would improve. Higher spending would also hopefully lead to some inflation. And some inflation would ensure that people buy things now rather than postpone their consumption.
Unlike the previous rounds of money printing, the Federal Reserve had kept QE 3 more open ended. As the Federal Open Market Comittee(FOMC) of the Fed had said in a statement issued on September 13, 2012 “ If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”
Now what did this mean in simple English? Neil Irwin translates the above statement in The Alchemists – Inside the Secret World of Central Bankers “We’ll keep pushing money into the system until the job market really starts to improve or inflation starts to become a problem. And we will act on whatever scale we need until we achieve that goal. We’re not going to take the foot off the gas, that is, until some time after the car has reached cruising speed. Markets had been eagerly speculating about the possibility of QE3. Instead, they got something bigger: QE infinity.”
In a statement issued on December 13, 2012, it further clarified that it was targeting an unemployment level of 6.5%, in a period of one to two years. And the hint was that once the level is achieved, the Federal Reserve would start going slow on money printing.
The unemployment rate for November 2013 came in at 7% as employers added nearly 203,000 workers during the course of the month. This is the lowest the unemployment level has been for a while, after achieving a high of 10% in October 2009. The Federal Reserve’s forecast for 2014 is that the rate of unemployment would be anywhere between 6.3 to 6.6%. Given this, it was about time that the Federal Reserve started to go slow on money printing.
History has shown us that continued money printing over a period of time inevitably leads to high inflation and the destruction of the financial system. Hence, going slow on money printing “seems” like a sensible thing to do. But there are several twists in the tail.
The unemployment rate of 7% in November 2013, does not take into account Americans who have dropped out of the workforce, because they could not find a job for a substantial period of time. It also does not take into account people who are working part time even though they have the education and experience to work full time.
Once these factors are taken into account the rate of unemployment shoots up to 13.2%. The labour participation ratio has been shrinking since the start of the finanical crisis. In 2007, 66% of Americans had a job or were looking for one. The number has since shrunk to around 63%. To cut a long story short, all is not well on the employment front.
What about inflation? The measure of inflation that the Federal Reserve likes to look at is the core personal consumption expenditure (CPE). The CPE has been constantly falling since the beginning of 2013. At the beginning of the year it stood at 2%. Since then the number has constantly been falling and for October 2013 stood at 1.11%, having fallen from 1.22% a month earlier. This is well below the Federal Reserve’s target level of 2%. In 2014, the Federal Reserve expects this to be around 1.4-1.6%. And only in 2015 does the Fed expect it touch the target of 2%.
The point is that the Federal Reserve hasn’t been able to create inflation even after all the money that it has printed over the last few years, to keep interest rates low. A possible explanation for this could be the fact that the disposable income has been falling leading to a section of people spending less, and hence, lower inflation. As Gary Dorsch, editor of Global Money Trends newsletter points out in his latest newsletter “For Middle America, real disposable income has declined. The Median household income fell to $51,404 in Feb ‘13, or -5.6% lower than in June ‘09, the month the recovery technically began. The average income of the poorest 20% of households fell -8% to levels last seen in the Reagan era.”
Given this, instead of the inflation going up, it has been falling. The benign inflation might very well be on its way to become a dangerous deflation, feels CLSA strategist Russell Napier.
Deflation is the opposite of inflation, a scenario where prices of goods and services start to fall. And since prices are falling, people postpone their consumption in the hope of getting a better deal at a lower price. This has a huge impact on businesses and hence, the broader economy, with economic growth slowing down.
Deflation also kills stock markets. As Napier wrote in a recent note “Inflation has fallen to 1.1% in the USA and 0.7% in the Eurozone and we are now perilously close to deflation…Investors are cheering the direct impact of QE on their equity valuations, but ignoring its failure to produce sufficient nominal-GDP growth to reduce debt…When US inflation fell below 1% in 1998, 2001-02 and 2008-09, equity investors saw major losses. If a similar deflation shock hits us now, those losses will be exacerbated, since the available monetary responses are much more limited than they were in the past…We are on the eve of a deflationary shock which will likely reduce equity valuations from very high to very low levels.”
Albert Edwards of Societe Generale in a research note dated December 11, 2013, provides further information on why all is not well with the US economy. As he writes “So far, S&P 500 companies have issued negative guidance 103 times and positive guidance only 9 times. The resulting 11.4 negative to positive guidance ratio is the most negative on record by a wide margin. The highest N/P ratio prior to this quarter was Q1 2001, at 6.8…The margin cycle is turning down, profit forecasts over the next few weeks will be eviscerated. To me, this is consistent with recession.”
What these numbers tell us is that all is not well with the American economy. Over the last few years it has become very clear that the only tool that central banks have had to tackle low growth is to print more money.
Given this, it is more than likely that the Federal Reserve will go back to printing as much as it is currently doing or even more, in the days to come. The FOMC has kept this option open. As it said in a statement “However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchase.”
In simple English, what this means is that if the need be we will go back to doing what we were. As The Economist magazine puts it “It is entirely possible that the tapering decision will prove premature. The Fed terminated two previous rounds of QE, only to restart them when the economy faltered and deflation fears flared. The FOMC’s forecasts have repeatedly proved too optimistic. Two years ago it thought GDP would grow 3.2% in 2013; a year ago, that had dropped to 2.6%, and it now looks to come in around 2.2%..”
We haven’t seen the end of the era of easy money as yet. There is more to come.
The article originally appeared on www.firstpost.com on December 19, 2013.
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

How money printing has made the rich richer

helicash
Vivek Kaul
 
Raghuram Rajan before he became the governor of the Reserve Bank of India, wrote a book called Fault Lines. This was one of the first books that offered reasons for the financial crisis and that went beyond the greed of Wall Street.
One of the reasons that Rajan discussed in great detail was income inequality. He argued that this was one of the major reasons behind the financial crisis.
The top 1% of the households accounted for only 7.9% of total American wealth in 1976. This would grow to 23.5% of the income by 2007. This was because the incomes of those in the top echelons was growing at a much faster rate.
The rate of growth of income for the period for those in the top 1% was at 4.4% per year. The remaining 99% grew at 0.6% per year. What is even more interesting is the fact that the difference is even more pronounced in the 1990s and the first decade of the twenty first century.
The incomes of those in the top echelons grew at a much faster rate since the 1990s. Between 1993 and 2000, when the dotcom bull run happened and when Bill Clinton was the President of the United States, the income of the top 1% grew at the rate of 10.3% per year, and for the remaining 99%, it grew at 2.7% per year.
Between 2002 and 2007, when George Bush Jr was the President, the income for the top 1% grew at the rate of 10.1% per year. For the remaining it grew at a minuscule 1.3% per year. In fact, the wealthiest 0.1% of the population accounted for 2.6% of American wealth in 1976. This had gone up to 12.3% in 2007.
But it was not only the CEOs and the super rich who were getting richer. Even those below them were doing quite well for themselves. In 1976, the top 10% of households earned around 33% of the national income, by 2007 this had reached 50% of the national income.
In fact in 1992, before the dotcom bull run started, the top 10% earned around 41% of the national income, by the time it ended, the number was at 47% of the national income. When George Bush took over as President the number was at 45% and by the end of his term in early 2008, it had galloped to 50%.
The rich were getting richer in America. One reason for this was the fact that those at the upper echelons of organisations were making more money than ever before. At a more basic level there was also a huge increase in “college premium”. This meant that people who had a college degree earned much more than those who had stopped studying at the high school level. 
The advent of technology had made a lot of low level jobs redundant. Earlier secretaries used to be required to type letters and responses, or to communicate within the various offices and branches of the firm. With the advent of computers and internet, people did their own typing. And that in turn meant lower pays at lower levels.
The solution to this increasing inequality of income to some extent was more and better education. But that is something that would take serious implementation and at the same time results wouldn’t have come overnight. They would take time.
Hence, the American politicians looked elsewhere to deal with this increasing inequality. There solution was to ensure that loans were easily available to people. Rajan explains this in Fault Lines. As he writes “Politicians have therefore looked for other ways to improve the lives of their voters. Since the early 1980s, the most seductive answer has been easier credit. In some ways, it is the path of least resistance…Politicians love to have banks expand housing credit, for all credit achieves many goals at the same time. It pushes up house prices, making households feel wealthier, and allows them to finance more consumption. It creates more profits and jobs in the financial sector as well as in real estate brokerage and housing construction. And everything is safe – as safe as houses – at least for a while.”
This availability of easy money led to a big real estate bubble, which finally morphed itself into the global financial crisis which has been on since late 2008. In the aftermath of the crisis economic growth slowed down. Central banks around the world, led by the Federal Reserve of United States, the American central bank, started to print money.
The idea was to flood the system with money, keep interest rates low and encourage people to borrow, to get the economy up and running again. But that did not happen or at least did not happen at the pace that central banks expected it to.
Low interest rates led to financial firms borrowing and investing money all over the world driving up various financial markets to all time high levels, including the American stock markets. As Gary Dorsch, an investment newsletter, writes in his latest newsletter dated December 4, 2013, “The US-stock market rally is now 57-months old, and over this time period, the S&P-500 index has climbed a “wall of worry,” rising +170% from its March 9th, 2009 low, and hitting an all-time high, above the 1,800-level.”
The idea was that once the stock market started to go up, the wealth effect would come into play i.e. people would feel rich and they would go shop. But as it turned out, the retail investors have stayed away from the market for a large part of the last four and half years and have only now started to come back to the market. As Dorsch puts it “But only this year, did it begin to earn the grudging respect of smaller retail investors. They’ve plowed $175-billion into equity funds so far this year, after withdrawing $750-billion in the previous six years.”
Meanwhile the rich got richer. As Dorsch  wrote in a newsletter dated October 3, 2013, “Over the past 1-½ years, the Fed has increased the…money supply by +10% to an all-time high of $12-trillion. In turn, traders have bid-up the combined value of NYSE and Nasdaq listed stocks to a record $22-trillion. That’s great news for the Richest-10% of Americans that own 80% of the shares on the stock exchanges.”
He also adds in his latest newsletter that “US-equity values have increased $14-trillion over the past 57-months. Across the Fortune-500 companies, the average chief executives pockets 204-times as much as that of their rank-and-file workers, that’s disparity is up +20% since 2009. Perversely, the compensation of the S&P-500 chieftains is often linked to the ruthless slashing of jobs and wages in order to increase the companies’ profitability. In theory, that boosts stock prices, and CEO’s collect about 90% of their compensation through the exercise of stock options.”
And this has meant that the rich have got richer, while the average income of the middle class and the poor has been falling, as jobs are being slashed. “For Middle America, real disposable income has declined. The Median household income fell to $51,404 in Feb ‘13, or -5.6% lower than in June ‘09, the month the recovery technically began. The average income of the poorest 20% of households fell -8% to levels last seen in the Reagan era,” writes Dorsch.
Due to this nearly more than 100 million Americans are receiving one or another form of welfare from the government. “According to the latest data from the Census Bureau, the US has already passed the tipping point and is officially a welfare society. Today, more Americans are receiving some form of means tested welfare than those that have full-time jobs. No, that’s not a misprint. At the end of 2011, the last year for which data are available, some 108.6-million Americans received one or more form of welfare. Meanwhile, there were just 101.7-million people with full-time jobs, including both the private and government sectors.The danger is the US has already developed a culture of dependency. No one votes to cut his own welfare benefits,” writes Dorsch.
And this is clearly not a healthy sign. The irony is that the American politicians helped by the Federal Reserve created a real estate bubble to address income inequality. Once that bubble blew up, they started printing money. And that in turn has led to more inequality. The solution has aggravated the problem.
The article originally appeared on www.firstpost.com on December 6, 2013 
(Vivek Kaul is a writer. He tweets @kaul_vivek)