The Trapdoors at the Fed’s Exit

The ongoing weakness of America’s economy – where deleveraging in the private and public sectors continues apace – has led to stubbornly high unemployment and sub-par growth. The effects of fiscal austerity – a sharp rise in taxes and a sharp fall in government spending since the beginning of the year – are undermining economic performance even more.

Indeed, recent data have effectively silenced hints by some Federal Reserve officials that the Fed should begin exiting from its current third (and indefinite) round of quantitative easing (QE3). Given slow growth, high unemployment (which has fallen only because discouraged workers are leaving the labor force), and inflation well below the Fed’s target, this is no time to start constraining liquidity.

The problem is that the Fed’s liquidity injections are not creating credit for the real economy, but rather boosting leverage and risk-taking in financial markets. The issuance of risky junk bonds under loose covenants and with excessively low interest rates is increasing; the stock market is reaching new highs, despite the growth slowdown; and money is flowing to high-yielding emerging markets.

Even the periphery of the eurozone is benefiting from the wall of liquidity unleashed by the Fed, the Bank of Japan, and other major central banks. With interest rates on government bonds in the US, Japan, the United Kingdom, Germany, and Switzerland at ridiculously low levels, investors are on a global quest for yield.

It may be too soon to say that many risky assets have reached bubble levels, and that leverage and risk-taking in financial markets is becoming excessive. But the reality is that credit and asset/equity bubbles are likely to form in the next two years, owing to loose US monetary policy. The Fed has signaled that QE3 will continue until the labor market has improved sufficiently (likely in early 2014), with the interest rate at 0% until unemployment has fallen at least to 6.5% (most likely no earlier than the beginning of 2015).

Even when the Fed starts to raise interest rates (some time in 2015), it will proceed slowly. In the previous tightening cycle, which began in 2004, it took the Fed two years to normalize the policy rate. This time, the unemployment rate and household and government debt are much higher. Rapid normalization – like that undertaken in the space of a year in 1994 – would crash asset markets and risk leading to a hard economic landing.

But if financial markets are already frothy now, consider how frothy they will be in 2015, when the Fed starts tightening, and in 2017 (if not later), when the Fed finishes tightening? Last time, interest rates were too low for too long (2001-2004), and the subsequent rate normalization was too slow, inflating huge bubbles in credit, housing, and equity markets.

We know how that movie ended, and we may be poised for a sequel. The weak real economy and job market, together with high debt ratios, suggest the need to exit monetary stimulus slowly. But a slow exit risks creating a credit and asset bubble as large as the previous one, if not larger. Pursuing real economic stability, it seems, may lead again to financial instability.

Some at the Fed – Chairman Ben Bernanke and Vice Chair Janet Yellen – argue that policymakers can pursue both goals: the Fed will raise interest rates slowly to provide economic stability (strong income and employment growth and low inflation) while preventing financial instability (credit and asset bubbles stemming from high liquidity and low interest rates) by using macro-prudential supervision and regulation of the financial system. In other words, the Fed will use regulatory instruments to control credit growth, risk-taking, and leverage.

But another Fed faction – led by Governors Jeremy Stein and Daniel Tarullo – argues that macro-prudential tools are untested, and that limiting leverage in one part of the financial market simply drives liquidity elsewhere. Indeed, the Fed regulates only banks, so liquidity and leverage will migrate to the shadow banking system if banks are regulated more tightly. As a result, only the Fed’s interest-rate instrument, Stein and Tarullo argue, can get into all of the financial system’s cracks.

But if the Fed has only one effective instrument – interest rates – its two goals of economic and financial stability cannot be pursued simultaneously. Either the Fed pursues the first goal by keeping rates low for longer and normalizing them very slowly, in which case a huge credit and asset bubble would emerge in due course; or the Fed focuses on preventing financial instability and increases the policy rate much faster than weak growth and high unemployment would otherwise warrant, thereby halting an already-sluggish recovery.

The exit from the Fed’s QE and zero-interest-rate policies will be treacherous: Exiting too fast will crash the real economy, while exiting too slowly will first create a huge bubble and then crash the financial system. If the exit cannot be navigated successfully, a dovish Fed is more likely to blow bubbles.

This piece is cross-posted from Project Syndicate with permission.

20 Responses to "The Trapdoors at the Fed’s Exit"

  1. Deon Opperman   April 29, 2013 at 10:42 am

    As Shakespeare had Macbeth put it: " I am in blood
    Stepped in so far that, should I wade no more,
    Returning were as tedious as go o'er."

    • jack straw   May 21, 2013 at 7:58 am

      yeah, well…as Lady Astor said "that's a fine beaver." this is the most worthless tripe i've ever read…vis a vis the USA of course. the Fed would need to STOP the asset purchases first before it DOES anything…this guy is a total dope if he doesn't understand that. and THAT WILL BE ANNOUNCED as well….which should be very interesting indeed. "one must phrase these things carefully as well." second the principal base is soaring by leaps and bounds in the USA…so sure, yields are at or near zero…but if my asset size suddenly swells to ten million "i can live on 1 percent." high yield Dr Doom says? not if i'm lending into an environment of TRILLIONS. i do agree…it must be successful however. payment structures, trading platforms…SECURE trading platforms, information flow…all of this would have to be managed and managed EXPERTLY in order to pull trades of this size and magnitude off. clearly though the New Normal is Apple at 600 and Google at a 1000 a share. we have to deal with "the new math" now.

  2. David Wishart   April 29, 2013 at 3:42 pm

    This presumes that quantitative easing is actually doing anything to help the employment situation in the US. If households and non-finance sector businesses are unwilling to take on credit, then the benefits of QE of lower interest payments for government and existing debtors is exceeded by the costs of lower interest income to households. Since the private sector has on net more assets than it does liabilities, the reduction of interest rates is a transfer of income from the private sector to government. Since a sovereign currency issuer doesn't face a solvency constraint, the overall effect is to weaken the private sector for no benefit. Monetary policy can only encourage more private sector debt, which won't be borrowed in a debt deflationary slump. I'd say the best policy at this point is to stop QE and increase new bond issues by government deficit spending through the use of payroll tax cuts to slowly drain excess reserves, allowing rates to slowly migrate upwards. In other words, less monetary accommodation could actually improve the employment picture rather than worsen it.

    • Glen   May 5, 2013 at 1:22 pm

      QE is allowing the fiscal changes that you speak of to not happen. The Fed can not make the changes, but by QE it postpones congress from having to act. Remove QE and the markets will force congress to do what you speak of. The markets should have been aloud to force fiscal changes prior to the Fed stepping in. 4 years of pain why?

  3. wastewater1   April 30, 2013 at 3:16 am


    Listen, this Jew hater Obama of Israel and these late term 8 month and even after born abortions he encourages…you really wonder what our future looks like…hold onto your hats cause you have seen noth'n yet unless we hold this joker and Hillary in house arrest in suspicion of breach of faith, treason for leaving our brave patriots behind at the "Benghazi Massacre" – wake up!

    Open the Doors to Our White House Now!

    • Serge lewithin   April 30, 2013 at 5:23 am

      Re wastewater 1 10p

      Dissent is not the same hate. I remember correctly, Abraham Lincoln, commenting on hate condemned it, because it exits from the Bill of Rights which puts hate outside the realm of law.

      • S. Marshall   April 30, 2013 at 9:18 am

        When do facts become hate? Just curious. Am I missing something here?

    • Mike   May 7, 2013 at 5:24 pm

      Man what a venue to preach hate and other abstracts! Get thee to a church.

    • mary   May 16, 2013 at 10:41 pm

      "………. Aaaaand moving forward." Lol

  4. Bobbi   April 30, 2013 at 1:30 pm

    hee hee hee….in case we forget how many true wackos we have in this world, we have wastewater to remind us.

    Sorry some of the posts on this very important article are just lame nonsense. I did read and do appreciate the Trapdoors analysis Mr. Roubini. Please ignore the nonsense which follows.

  5. Tom   April 30, 2013 at 1:34 pm

    It seems to me still very early, but what we're really talking about here is how this cycle ends. You might not see much evidence of it, but we're actually in a growth and credit expansion cycle, albeit a tepid one. There's still some spotty de-leveraging underway in parts of the US private and public sectors, but overall the real sectors are increasing leverage, especially the corporate sector. Junk bond issues are an excellent example of that.

    It's possible we could see some acceleration of growth and inflation in 2014, after this year's austerity is in the past. But I wouldn't hold your breath. We seem just as likely to be heading for a Japan-ish scenario of prolonged low growth and low inflation.

    The really crucial thing to watch is the spread between short-term interest rates and the rate of inflation. For now that spread is large and the US is able to monetize its deficits with little consequence. Nouriel is writing about the dangers of a scenario in which inflation starts to rise, which would force the Fed to decide between allowing inflation (and/or asset bubbles) to run rampant, or crushing inflation and growth with rate increases. I think there is so much leveraged duration on public and private balance sheets that even a modest increase in rates would quickly bring on recession. But I see another scenario in which inflation comes down closer to interest rates, similar to Japan. We may be in for another, much less appealing Great Moderation.

    • jack straw   May 25, 2013 at 3:13 pm

      sorry for my outburst above but there is scant data in the article…more "Article of Faith" really. i do agree if we're using a template to "divine the future" this is the right one. "we are Japan…but a little better." in other words Japan unsuccessful reflated their bubble economy back in 90's and have been battling deflation ever since…this is an historical FACT. whether "this time they went too far" will be seen come Tuesday vis a vis the JGB's…and it will be empirical, data momentous and policy related…in short "more than Wall Street can handle"…but certainly enough for them to take advantage of. insofar as this relates to the USA…the historical record is also clear: Ben Bernanke is a student of the Japanese and Great Depression "asset fails." And he had a solution in waiting…namely QE…which since the economy hadn't in fact already deflated he believed that there was time to execute on the plan…which he did…and did repeatedly…to dramatic effect. Equities are at RECORD highs (something Japan has never been able to achieve), real estate is at RECORD highs (something Japan has failed to achieve as well), commodities are rolling over WITHOUT need for an "uber dollar" (something Japan was unable to achieve)…growth albeit slow to anemic has been "allowed to proceed"…the jury is still out on the deficit but it appears revenues are soaring as well meaning the "interest rate monster" has been contained…gold and silver are rolling over. frankly i can't think of a better outcome other than an 80's like "economic boom" and what it takes to get there. obviously we have a huge Federal Government so they've been the prime beneficiary of the recovery…that is a substantial part of the US economy (via transfer payments, military spending, technology transfers, rule of law, a build up to more policy successes?) and so far it is the private sector that is lagging…quite dramatically actually. this is a start…something to "build a base off of" so to speak. i think unemployment can be ended tomorrow if the President were to request and be granted a draft by Congress. how it would be structured would interesting…but no longer would you be dealing with youth unemployment…put some structure in young people's lives…four year commitment sounds good to me. it's better than what we have right now of course. no one is requesting it of course…it should be bi partisan actually…we'll see if the Tea Party itself can make part of its "Platform to move beyond the 2 party system." i do agree however a Japanese "realization" is in the offing here…these bubbles can't grow to the moon…a healthy if not unhealthy correction is in order. We shall see…

  6. benleet   April 30, 2013 at 6:42 pm

    Roubini, Hockett and Alpert authored a paper, The Way Forward, Oct. 2011, advocating government sponsored job creation. Where is that recommendation now? Quote: "First, as Pillar 1, a substantial five-to-seven year public investment program that repairs the nation’s crumbling public infrastructure and, in so doing, (a) puts people back to work and (b) lays the foundation for a more efficient and cost-effective national economy. We also emphasize the substantial element of “self-financing” that such a program would enjoy, by virtue of (a) massive currently idle and hence low-priced capacity, (b) significant multiplier effects and (c) historically low government-borrowing costs." Over 5 years they promoted a $1.2 trillion program. All the factors, a, b, and c, are still relevant. The other 2 pillars of the program are also still relevant.

  7. Dan   April 30, 2013 at 8:44 pm

    come on Roubini – a sharp drop in government spending. Can we please refrain from using exaggerated adjectives.

    • jack straw   May 25, 2013 at 3:16 pm

      "sharp drop in Government hiring" it is then. "now throw another trillion are way too…" ridiculous repeat of an already failed policy. one hit wonder…move along.

  8. Tilak Ratnayake FCMA   May 1, 2013 at 3:21 am

    What I like in Rubni analysis is that he talks straight with lot of relevant this case what happens beyond the present when the rates go up is relevant.

  9. BWilds   May 14, 2013 at 6:35 am

    I have totally misjudged how far Bernanke would go in attempting to re-inflate this economy. In our modern world money flows everywhere, borders no longer exist. More reform must come from governments and less from central banks. Current policies are not the answer, Bernanke should be more honest about the problems. More on the subject below,