Will QE Affect The Effect?

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When global central banks began to expand their balance sheets in an attempt to ward off the Great Recession of 2008-2009, their efforts were considered unprecedented. Never before had we seen this amount of money creation occur simultaneously on a global basis. At the time, planned central bank quantitative easings (printing money) were well defined in terms of time over which they would occur and magnitude of dollars/foreign currency involved in each QE iteration. That was then. Despite significant global government borrowing (US Federal debt alone has doubled since 2006) and global central banks that have printed over $11 trillion since 2008, the global economy is still growing quite slowly. In fact, global government borrowing of such magnitude over the last four years has now necessitated the need to increase taxes in many countries, the US is not alone. The US has sold this as a tax on the wealthy. But when looking at the reality of US Government budget and forward spending projections, there is absolutely no way the US Government can fund itself on its current spending and promises trajectory without very meaningful middle class tax increases to come. Shhh!!! The politicians just have not told anyone yet.

As a bit of a bookend to global central bank balance sheet expansions, we’ve now come 180 degrees from where we were in early 2009. No longer are central bank quantitative easings defined either in terms of time or magnitude as many a global central bank has recently promised unlimited money printing over an indefinite period of time. This is exactly what the US Federal Reserve has done four years into our current economic recovery. The election of Abe in Japan a month ago likewise cements the fact that the Bank of Japan will join in unlimited money printing. The Bank of England is also on the cusp of another round of money stimulus. And despite the recent appearance of calm in Europe, banking system recapitalization has not yet even begun and certainly promises to be quite the eye opener in terms of European Central Bank balance sheet expansion to come. The characterization of “unprecedented” has now been pushed to its academic definitional limit as it applies to global central bank actions four years after the Great Recession has apparently come to an end.

So just where have central banks been successful in their historically unprecedented monetary experiment if not in fomenting accelerating economic growth? First, the nominal level of interest rates rests at generational lows. By pushing interest rates to unseen depths, central banks have raised the net present value of alternative streams of cash flow. In other words, they have been successful at inflating certain asset prices that may not have risen to current heights in the absence of central bank actions. The US Fed has told us without flinching that they have been directly targeting stock and residential real estate prices. Why? The Federal Reserve believes in what has been termed the “wealth effect”. The thinking goes like this. If asset prices rise, consumers will feel more “wealthy” and will consume at a higher level than would otherwise have been the case. Additionally, consumers might even feel well off enough to borrow and spend if the value of their houses and portfolios rise, exactly as happened during the housing boom of the prior decade. The fact that consumption drives roughly two-thirds of US GDP has certainly not been lost in Fed thinking and actions.

Now that we have embarked on perhaps the final central bank journey of unlimited and indefinite money printing, will the US Fed and global central bank quantitative easing finally positively affect the “wealth effect”? So far, rising home prices for the last year and rising stock prices for the last four have not yet been the tonic for accelerating domestic consumption. Will boundless and limitless promises of money printing do the trick in getting US and global consumers to finally borrow and spend? Over the 2007 to early 2009 period, consumer net worth in the US contracted close to $12 trillion. If stock and home prices continue on their current price trajectory, all of this contraction in household net worth will have been recovered sometime this year. Households should be feeling great, correct?

Although the final outcome of this grand global central banking experiment remains to be seen, I doubt seriously the ability of central bankers to positively affect the so-called household wealth effect (and by implication consumption) by simply printing unlimited amounts of money to levitate residential real estate and equity prices. Why is this the case? Let’s have a look back at some data history I believe is quite important in contemplating this question. For not only does it have bearing on forward potential economic strength, but speaks to where stock and residential real estate prices may head for a time. The chart directly below looks at the US savings rate and the S&P 500 since 1980. The large rise in stock prices from 1980 to present is clear. Intuitively, we also know that over this same period residential real estate prices increased significantly, despite the downturn of the last half decade. Neither of these two phenomenon should be any surprise as the 1980 to present time frame mimics the coming of age and maturation of the baby boom generation - a generation that bought homes and started retirement plan savings en masse over this period.

Certainly what is striking in the relationship graph below is that over the 1980 to roughly 2006 period, the US savings rate declined from 12% to what was a record low near 1%. This occurred while stocks and residential real estate experienced a generational bull market. So let’s step back and think about the concept of a wealth effect – key to current central bank actions. Remember the Fed’s logic goes that if households “feel” wealthier based on rising stock and house prices, they will go out and spend/consume. But this line of reasoning seems to truncate without addressing the key economic question of “spend what?” If stock prices rise, will households sell them and use the proceeds to buy consumer goods? If housing prices advance smartly, will households sell their homes and rent, using the proceeds from the home sale to fund short term consumption? These questions are exactly why the relationship you see below is so important. Over the 1980 – mid-2000’s period, as household “wealth” increased via higher stock and residential real estate prices, it is absolutely clear that households “spent” their savings to consume at a higher level than would have been the case otherwise. We also know households borrowed to consume – remember HELOC loans?

spx 22 jan 2013 and us personal savings rate 1982 to 2012

What this historical relationship implies is that for the “wealth effect” to be a positive economic force in terms of spurring accelerated consumption, households must have something other than stocks or real estate assets to liquidate and use for consumption, exactly as they did from 1980-2006. They either need to spend their savings or borrow to consume. The key issue of the moment is that at least in the US, savings have not been rebuilt post the Great Recession. As of now, there are no increased savings to spend down while the Fed attempts to make households feel better via their efforts to levitate residential real estate and equity prices. The household savings rate today stands just shy of where it stood in January of 2008. I’d again ask the question “spend what”? In the post Great Recession environment, the largest growth in consumer credit has been in student loans, not in revolving or non-revolving credit balances. Households hurt by heavy debt balances, largely related to real estate in the prior cycle, have not embarked on a new borrowing cycle. From my vantage point, QE will not positively affect the “wealth effect” and translate into accelerating consumption and domestic GDP growth directly due to the lack of domestic savings and households still being gun shy in terms of leverage.

So where does this leave us? It still leaves us with global central bankers now committed to unlimited and indefinite money printing, but with an ongoing disconnect between the printing of money and actually getting that money into the real economies globally as has been the case since 2009. The money they “create” still needs to find a home. And now that we’ve moved into unlimited money printing mode, that means one big home. As a rule, central bankers can create additional liquidity, but they cannot control where or how that money will be put to use. Ideally, they would like to see banks increase lending with this unprecedented liquidity and theoretically get that money into the real economy, but bank lending has been very slow.

Almost as a process of default, that leaves the global financial and commodity markets as a potential repository for historic global central banker largesse. Over the past four years we have heard more than a number of commentators tell us that “the stock market is doing well so the economy must be doing well”. Unfortunately this has not proven to be the case as we continue with one of the most anemic economic recoveries on record when compared to the character of historic recoveries. Although we are certainly not there yet with equities (we are there with bonds), the danger is that this current round of truly extraordinary excess central banker liquidity creates further asset bubbles, very much as happened with the late 1990’s tech stock bubble and the clear bubble in mortgage lending in the middle of the last decade. By the Fed’s own admission, they missed “seeing” the last two asset bubbles they had a hand in creating. Now that we have moved into the endgame of global central bank monetary expansion, let’s hope central bankers globally have had their annual optometrist visit, no?

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About Brian Pretti CFA

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