Federal Reserve - Speeches by Dallas President Richard W. Fisher

Remarks before the Asia Society Hong Kong Center
Hong Kong April 4, 2014

Adieu Quantitative Easing

To encourage economic recovery from the debacle of the financial crisis of 2007–09, the FOMC cut interest rates to near zero. The Fed introduced an array of special lending facilities during the most panicked stage of the crisis. These credit and liquidity programs were largely self-liquidating as market functioning improved. But still being “zero bound,” we embarked upon a program of massively expanding the Fed’s balance sheet, referred to internally as “large-scale asset purchases” and popularly known as quantitative easing (QE). By buying copious quantities of longer-term U.S. Treasury bonds and mortgage-backed securities (MBS), our balance sheet has grown from slightly under $900 billion prior to the crisis to $4.3 trillion at present.

When the Fed buys a Treasury note or bond or an MBS, we pay for it, putting money out into the economy with the expectation that the money will be used by banks and other creditors and investors to finance job-creating investment, the purchase of homes and other expansive economic activity.

Thus far, much of the money we have pushed out into the economy has been stored away rather than expended to the desired degree. For example, we have seen a huge buildup in the reserves of the depository institutions of the United States. Less than a fifth of commercial credit in the highly developed U.S. capital markets is extended through depository institutions. Yet depository institutions alone have accumulated a total of $2.57 trillion in excess reserves—money that is sitting on the sidelines rather than being loaned out into the economy. That’s up from a norm of around $2 billion before the crisis.

The Fed’s large-scale asset purchases dramatically and more broadly impacted credit markets. The U.S. credit markets are awash in liquidity.

As of March 14, our par holdings of fixed-rate MBS exceeded 30 percent of the outstanding stock of those securities. Through these purchases, we have driven down mortgage rates and helped rekindle the U.S. housing market.

We now own just shy of 24 percent of the stock of Treasury coupon securities. Having concentrated our purchases of Treasuries further out on the yield curve, and done so in size, we have driven nominal interest rates across the credit spectrum to lows not seen in over a half century.

This has allowed U.S. businesses to restructure their balance sheets, manage their earnings per share through share buybacks financed with bargain-basement debt issuance, bolster stock prices through enhanced dividend payouts and position themselves for financing growth once they see the whites of the eyes of greater certainty about their economic future. By driving nominal interest rates to half-century lows, we have also reduced the hurdle rate by which future cash flows of publicly traded businesses are discounted. Thus, through financial engineering, we have helped bolster a roaring bull market for equities: The indexes for stocks have nearly tripled from the lows reached in March 2009.

Alongside these signs of rebound have been some developments that give rise to caution. I have spoken of these in recent speeches, echoing concerns I have raised in FOMC discussions:

    The price-to-earnings (PE) ratio of stocks is among the highest decile of reported values since 1881. Bob Shiller’s inflation-adjusted PE ratio reached 26 this week as the Standard & Poor’s 500 hit yet another record high. For context, the measure hit 30 before Black Tuesday in 1929 and reached an all-time high of 44 before the dot-com implosion at the end of 1999.[1]
    Since bottoming out five years ago, the market capitalization of the U.S. stock market as a percentage of the country’s economic output has more than doubled to 145 percent—the highest reading since the record was set in March 2000.
    Margin debt has been setting historic highs for several months running and, according to data released by the New York Stock Exchange on Monday, now stands at $466 billion.[2]
    Junk-bond yields have declined below 5.5 percent, nearing record lows.[3]
    Covenant-lite lending is becoming more widespread. In my Federal Reserve District, 96 percent of which is the booming economy of Texas, bankers are reporting that money center banks are lending on terms that are increasingly imprudent.

The former funds manager in me sees these as yellow lights. The central banker in me is reminded of the mandate to safeguard financial stability. As I said recently in a speech in Mexico, we must watch these developments carefully lest we become responsible for raising the ghost of irrational exuberance.

It is clear to me that we have a liquidity pool that is more than sufficiently deep and wide enough nationwide to finance job-creating capital expansion and reduce labor market “slack.” But that will happen only if and when our fiscal authorities—the Congress and the president—are able to muster the courage to craft tax, spending and regulatory incentives for job-creating enterprises to mobilize liquidity for expansion and payroll growth.

Thus far, inflation has yet to raise its ugly head, and inflation expectations as measured by consumer surveys and market-traded instruments have remained stolid. However, with each passing day, constantly adding massive amounts to the monetary base will inevitably present a significant challenge to the FOMC, which must ultimately manage this high-power money so that it does not become fuel for sustained inflation above the committee’s 2 percent target once it is activated and flows into the economy.

Thus, I was more than supportive of the collective decision of the FOMC to begin cutting back on our rate of accumulation of assets beginning in December. Over the course of our recent meetings, we have cut back from accumulating $85 billion per month in Treasuries and MBS to a present rate of $55 billion per month. This is still somewhat promiscuous. Even with the taper, the recent decline of mortgage supply has driven our absorption of the MBS market to 85 percent of fixed-rate MBS issuance. The fall in net MBS supply is outpacing the taper.

At the current reduction in the run rate of accumulation, the exercise known as QE3 will terminate in October (when I project we will hold more than 40 percent of the MBS market and almost a fourth of outstanding Treasuries). We will then be back to managing monetary policy through the more traditional tool of the overnight lending rate that anchors the yield curve.

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