Behind the curve: The US Fed’s exit from QE

The US Federal Reserve will decide if they will start reducing the pace of open market bond purchases under the quantitative easing programme (taper). This is the last meet under the chairmanship of Ben Bernanke. So they may well leave the exit to the new FOMC (the open market committee of the Fed) under Janet Yellen. The interesting thing is that the market has been expecting QE tapering for some time now, but the Fed has deferred it for fears about the weak labour market. Unemployment rate in the US has fallen sharply – and more so than the Fed expected. However much of the gain in the unemployment rate has come through the fall in the Labour Force Participation Rate rather than the pace of new job creation.

[As an aside if you don’t look for a job you are not counted as unemployed even if you are out of work. Thus if you are discouraged after seeking work for months and failing, you will just drop out of the reckoning of the labour force itself. The unemployment rate is the ratio of the number of unemployed to the number of those in the labour force.]

Today, Barry Ritholtz writes in Bloomberg on this idea – which has been promoted for several months by David Rosenberg. Rosie’s view is that with the fall in the employment rate, there is likely to be a spike in wage inflation and therefore general inflation in the US. Read this article in the Business Insider also.

The Fed believes that if the employment situation improves, the LFPR will increase as more people return to looking for jobs. Thus the lower unemployment rate may just be masking the weak underlying situation. However there is additional research to support an alternate thesis. Michael Shedlock (Mish) has been at it in depth here. Mish takes off on a Fed research paper in his analysis.

Mish’s work shows that much of the fall in the LFPR has been in the 55+ age group as older workers retire. This is structural in an ageing labour force. These people won’t rejoin the workforce if labour market conditions improve. It seriously calls into question the Fed’s decision mid-year not to reduce the pace of QE.

It is very possible that we see a big spike in inflation in the US in the next few quarters. The Fed may well be struggling to contain inflation through rate increases soon. But increasing interest rates when there has been so much primary money supplied to the system is itself fraught with risk. Back in 2011, John Hussman pointed out that there is a stable relationship between the short term interest rate and the amount of base money per unit of GDP (see also Hussman’s update later in 2011 here). Since the latest QE programme started after Hussman’s chart was made, I re-created it using the St. Louis Fed’s FRED database:


The vertical axis here is the Base Money/GDP ratio while the horizontal axis is the 3-month treasury bill rate. Back in 2011 Hussman pointed out that the BASE/GDP ratio had hit 16 cents, much larger than the peak seen in Japan of 12, which is the country most famous for central bank balance sheet expansion. Now the ratio has gone over 18 (to be exact 18.7). If the Fed were to being normalizing interest rates, it faces a huge “sterilization exercise” by which it must eliminate most of this excess base money through open market sales.

Otherwise just consider even raising rates to 1%. When the 3-month T Bill yielded 1%, the Base Money / GDP ratio was close to 6 cents. That is one-third of the current number. If the base money remains what it is today, nominal GDP must triple. In short order there is no way for the US to triple real GDP, so prices have to treble. This is a near hyper-inflation scenario. There appears to be no easy way out.

To summarize:

1. The fall in the US unemployment rate appears to be driven by a fall in the labour force participation rate

2. There is evidence that this is because of the baby boomer generation retiring, and thus likely to be structural

3. This means that as growth continues, there is likely to be increased competition for the rest of the labour force leading to rising wages

4. Rising wage inflation will lead to generalized inflation

5. The Fed will be behind the curve and will have to increase interest rates sooner than it had anticipated

6. At higher interest rates the amount of base money will lead to a sharp rise in inflation unless the Fed begins large scale open market sale of securities

7. This will be messy

Is there a way out?

One option the Fed is looking at is to absorb cash through reverse repos. In a reverse repo, the Fed sells securities for short term to the market and absorbs money leading to a fall in base money. This month they started experimenting reverse repos, so this is going through the Fed as a possible exit strategy. Alternately they could incentivize banks to hold excess reserves by paying a higher rate of interest on reserves. I am not sure if this is enough.

Whether through large scale OMO sales or reverse repos we are probably on the cusp of uncharted monetary waters again.

PS For any American who stumbles onto this post, please forgive the English spellings for programme and labour!

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