Quantitative is the story of a triangular relation: the Federal Reserve, Wall Street and Congress. Its short life is punctuated with several well-known maxims on the Street: Greenspan put, helicopter Ben and tapering -- each instructive of a particular moment in the on-going relationship between the Federal Reserve and Wall Street. All of these originate in the belief that monetary policy is the instrument of choice to steer the economy to achieve full employment.
Milton Friedman is the putative father of quantitative easing. In a famous speech, entitled: "Deflation: Making Sure 'It' Doesn't Happen Here", delivered on November 21, 2002, Ben Bernanke* stated that if all else failed, the Federal Reserve would have to resort to Milton Friedman's "helicopter drop" to prop up the economy. It would take the form of a central bank's financed budget deficit. Previously, Alan Greenspan** had injected large amounts of liquidity to halt the stock market fall of October 1987. The policy was a success and later termed the "Greenspan put", in reference to the put option -- a financial instrument which gives the owner of a financial asset the right, but not the obligation, to sell it at a given price by a predetermined date to a specified party.
Ben Bernanke applied the same strategy after the subprime crisis. The stock market quickly rallied and within a year the economy recovered and unemployment receded. Monetarists celebrated this success, ignoring that the 10 percent deficit in the federal budget in the two years following the crisis had a lot to do with the recovery. Congress is the third actor in this tragedy. It is conspicuously absent after 2010. In a New York Times interview in November 2015, Ben Bernanke, refusing to be blamed for the extended period of low interest rates causing an asset price bubble, said to the journalist: "Go complain to Congress because the fiscal policy turned very contractionary, which meant the Fed had to bear the entire burden of creating a recovery". He continued: "If fiscal policy had been more balanced, then we could've had the same recovery with higher interest rates. But because fiscal policy was contractionary, and Congress said essentially, 'The Fed will take care of it,' then the Fed could use the only tool it had."
Be this as it may, in June 2013, Bernanke thought it was time to end the quantitative easing policy which by then had been branded "unconventional monetary policy". The Fed fund rate was down to 0.125% and the Federal Reserve's balance sheet had been multiplied by a factor of 3. He thus informed the Senate that the time for "tapering" the market liquidity had come. The choice of an unusual term to announce a change in the monetary policy did nothing to reassure the market. Stocks went into a tail spin forcing him to backtrack. It was left to Janet Yellen***, to raise the Fed fund rate by a quarter percent in December 2016. The increase was to be followed by more rate hikes in 2016.
Meanwhile, China's economy continued to give signs of weakness with a growth rate below 7% in 2015, far from the double digit rates the market had been used to. Then, unexpectedly, in only a few days, the value of the yuan dropped by 2.6% in March 2016, giving capital markets over the world the jitters. Immediately, Janet Yellen announced that the 2016 rate hikes would be put on hold. The declaration calmed the markets. For a few days, many wondered whether the world economy was not about to experience a major shock, something akin to what happened in 1929. This was unlikely. The world's largest central banks, the Federal Reserve, the European Central Bank, the People's Bank of China, the Bank of England and the Bank of Japan, still had enough credibility and ammunition to prevent it. They may be able to control the next one but not the one after that, whenever it happens -- in a few months or in a few years, at the most.
Unable to raise rates for fear of a crisis, but knowing low or negative interest rates had become ineffective, if not dangerous with the creation of a financial bubble, the Federal Reserve is faced with an inconvenient truth: quantitative easing is a strategy without an exit. The end game is a worldwide depression. So, what can we do? "Keep smiling", ordered the officer to Johann Moritz, "keep smiling, smiling"" (C. Virgil Gheorghiu -- The 25th hour)
*Chairman of the Federal Reserve Board (2006-2014)
**Chairman of the Federal Reserve Board (1987-2006)
***Chairwoman of the Federal Reserve Board (2014 to present)