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Key points in this Outlook:
Quantitative easing (QE) and fiscal stimulus are becoming less effective. Why is that? The reason is the same as the reason that antibiotics, overused in an attempt to cure infections including common colds, are becoming less and less effective with more intensive use: endogeneity.
Endogeneity is a property of endogenous systems—be they biological, sociological, or economic—where changes have an internal cause or origin. Biological endogeneity, helpful for understanding economic endogeneity, refers, in one popular and widely discussed case, to the enzymes that evolve to protect bacteria against being attacked by antibiotics. The Centers for Disease Control and Prevention has recently decried the excessive use of antibiotics to deal with common colds. Such use deadens their effectiveness in combatting more serious illnesses such as pneumonia. After repeated treatments, the cold bacteria, with the antibiotic-resistant gene, survive and thrive. A population of bacteria emerges that cannot be killed by antibiotics. Newer antibiotics might work for a time, but only until the bacteria evolve with new enzymes that destroy the newer antibiotics. Medical science ends up in a race to develop new antibiotics at an accelerated pace, running faster and faster just to stay in place, like Alice in Wonderland in the Red Queen’s race.
How do such anti-immune dynamics apply to economic systems? First consider monetary policy in normal times. The Federal Reserve follows a rule, usually the Taylor Rule, that ties the Fed’s target interest rate (the federal funds rate) to the difference between actual and target inflation and growth rates. Some versions replace the growth rate target with a target rate of unemployment. Given the rule, changes in the federal funds rate, the Fed’s instrument of monetary policy, are expected to be tied to the changes in growth and inflation relative to their target values. Households and firms that are best prepared for changes in the Fed’s policy adjustments—those best at predicting growth and inflation—will, given rational expectation, already have responded to the Fed’s actions that are predictably driven by the Taylor Rule. Therefore, the actions themselves produce a less discern-ible impact on growth and inflation.
Repeated rounds of Fed responses to nontarget levels of goal variables make it easier for more and more households and firms to accurately anticipate the Fed’s behavior. Fed policy changes come to be endogenous, having an internal causal origin, and produce a less discernible impact on the economy. The Fed’s antibiotic—changes in the federal funds rate—is rendered powerless by the anticipatory adaptation to such changes by the households and firms it is trying to impact.
Such endogeneity and the lack of responsiveness to policy-driven rate cuts that it implies eventually forced the Fed to push the federal funds rate to zero in late 2008, when the economy continued to collapse even as the rate was cut rapidly from 2 percent in September down to virtually zero in December 2008. As recently as September 2007, the federal funds rate had been far higher, at 5.25 percent. (See figure 1.) In 2010, the Fed turned to QE that tied its purchases of Treasury securities and mortgage-backed securities to the inflation rate, the unemployment rate, and de facto to changes in the level of stock prices.
As households and firms adapted to this policy, a regime that came to be called “the Bernanke put” because the Fed was so predictable in its support of financial markets, QE became less and less effective in boosting the economy. Successive rounds of QE continued to boost stock prices because zero interest rates kept forcing investors seeking income from investments to keep taking more risks. As QE persisted and zero interest rates were described by the Fed as likely to stay at zero “for a considerable period,” income-hungry investors kept buying more risky investments such as junk bonds and dividend-paying stocks.
Repeated, increasingly larger rounds of QE (see figure 2) became less effective at boosting the economy over time until, by May 2013, Fed Chairman Bernanke hinted that QE might be gradually phased out. Tapering obsessed markets all throughout summer 2013. Having adapted to the prospect of rising QE, markets responded negatively to tapering hints until the threat of it was temporarily, as it turned out, withdrawn in September 2013. By December 2013, tapering had been so widely discussed and QE so widely accepted as ineffective that the initiation of actual tapering produced little, if any, discernible impact either on markets or on the economy. QE had become endogenized and therefore nearly powerless, an impotent ecobiotic. In its place, the promise of sustained low interest rates for an ever-expanding period—until the unemployment rate drops to 7 percent, then to 6.5 percent, and more recently to 6 percent or lower—is also becoming endogenized and therefore less effective as an economic stimulant.
The Power of Surprises
Of course the concept being described here is an operational counterpart to the concept of rational expectations. That concept, introduced in the 1970s by, among others, Robert Lucas and Thomas Sargent, postulates that only surprise (unexpected) policy changes produce any impact on real economic indicators such as the pace of growth or the unemployment rate.
Endogenous measures are those that are fully anticipated because they are predictable responses to deviations from actual target values of inflation, growth, or some other policy objective. On the other hand, policy surprises are exogenous, determined outside the ecosystem. As such, they are not anticipated (endogenized) and so they can have real effects on output or unemployment.
The September 2008 Lehman Brothers collapse and the immediately ensuing full-blown financial crisis were truly massive exogenous shocks. These shocks produced large negative impacts on growth and employment. (See figures 3 and 4.) The Lehman shock was actually a policy change in so far as it resulted from a decision by the Department of the Treasury and the Fed to not rescue Lehman as they had rescued Bear Stearns just six months earlier in March 2008. The massive policy responses to the late 2008 financial crisis—such as the Troubled Asset Relief Program, cutting the federal funds rate to zero, and eventual QE—exceeded the expectations of households and firms and therefore helped stabilize the economy. They had an exogenous component. By March 2009, markets had begun to recover. Subsequent measures such as QE produced diminishing returns on markets, growth, and employment as they became endogenized by markets. The ever-enlarging rounds of QE2 during 2010–12 boosted markets, but not the economy.
While anticipated, the initiation and subsequent enlargement of QE3 in September 2012, to a pace of $85 billion per month in Fed purchases of Treasury and mortgage-backed securities, signaled to investors that more risk taking (buying stocks, junk bonds, and emerging-market assets) would be required to earn higher returns. As rent-seeking behavior was anticipated by more and more investors, prices of stocks and junk bonds kept rising during 2013. The same was true for house prices, another popular household asset favored by investors at low interest rates and low prices.
The endogenization of the Fed’s support for risk taking carries with it a paradox. As repeated rounds of stock and junk-bond buying boost prices and the wealth of their owners, spending rises and the economy improves. Then, as investors begin to anticipate self-sustaining growth and observe a falling rate of unemployment, the prospect of further Fed encouragement of risk taking atrophies. This change was reinforced when the Fed began tapering asset purchases in December 2013. Paradoxically, better economic news may well produce lower stock prices in 2014, just as worse economic news boosted stock prices in 2013. Both apparent paradoxes result from eco-endogeneity, which ties the search for returns on risky assets to predictable Fed efforts to boost a persistently weak economy.
The policy endogeneity problem also arose with the repeated rounds of fiscal stimulus that began in January 2009, which were repeated on a virtually annual basis until early 2013. These fiscal stimulus measures turned into fiscal drag after the tax increases of January 2013 and the “sequester” of spending begun in March 2013.
It is interesting to note that the sharp 2013 reversal of US fiscal policy from boost to drag probably contributed to slower growth during the first half of 2013. But by the second half, the economy grew faster, partly in response to continued firm signals of support from the Fed and partly in response to the wealth increases that had resulted from the search-for-yield boosted stock, junk-bond, and property prices.
The Fed’s Dilemma
Endogeneity and the diminishing effectiveness of countercyclical monetary and fiscal policy measures is more pronounced after large exogenous shocks such as the 2008 financial crisis. This is because the size of the negative shock forces repeated rounds of monetary and fiscal stimulus that, as they are endogenized by households and firms, have progressively less impact on their behavior. The only thing that “works” is the pressure from zero returns on owners of low-risk, low-return assets to acquire riskier assets that will provide more income. The rise in the price of those assets produces the wealth effect that in turn stimulates spending. Unfortunately, higher stock and house prices leave such riskier assets vulnerable to price drops if investors’ still-tepid appetite for risk vanishes in the face of exogenous bad news like emerging-market crises such as Argentina’s January 25 currency devaluation and rising fears over China’s financial sector.
Eventually, even the positive impact of zero interest rates on stock prices atrophies as asset prices are stretched beyond normal levels and the economy is boosted by positive wealth effects. The market comes to expect a withdrawal of Fed efforts aimed at boosting risk taking. The Fed—some Federal Open Market Committee (FOMC) members have already said so—may risk creating a bubble if such efforts are seen to boost stock prices above “fair value.” Better economic news and endogeneity signals a reversal of Fed support for markets. Asset allocators then may even sell stocks and buy bonds in the face of economic strength, which portends less Fed support for markets. Commentators marvel at the paradox of a better economy that emerges alongside weaker stock prices and lower interest rates (higher bond prices) as asset allocators switch out of stocks and into bonds.
The emerging 2014 endogeneity-driven paradox of a better economy coupled with a weaker stock market will confront the Janet Yellen–Stanley Fischer Fed with difficult choices. Under one scenario, the Fed continues to moderate QE as stock prices fall in the face of a stronger economy. In this case, the Taylor Rule holds and employment and inflation closer to target levels signal a need for less stimulus. Under an alternative scenario, the Fed reboosts QE in response to falling stock prices, pushing those prices into bubble territory. The risk of higher inflation—so troubling to FOMC hawks—intensifies, and if inflation actually does rise, the Fed confronts a need to tighten.
The first scenario—where the Taylor Rule combined with lower unemployment and the risk of higher, stable inflation—drives the Fed to reduce QE faster or hint at an earlier increase in the federal funds rate, and may be emerging in the first quarter of 2014. Should this scenario continue to play out, risky assets—especially emerging-market stocks, currencies, and bonds—will weaken further. Stock prices in advanced economies may fall as well, as investors move from stocks back into high-grade bonds. This shift would be intensified by continued falling inflation.
The second scenario, where rapidly falling US stock prices frighten the Fed (wealth losses, weaker spending, and an economy relapse), would elevate market volatility. A drop in house prices would compound the Fed’s fear of recession. The drop in stock prices in scenario two is interrupted once the Fed determines that the pace of implied wealth loss jeopardizes growth and risks further negative inflation and outright recession. If it boosts the stock market, the eventual Fed ease—reverse tapering and a longer-term pledge of zero rates—would signal the birth of the Yellen-Fischer put.
It is too soon to tell which scenario will play out, but under either, stock prices will probably fall during the first half of this year. What happens after that is up to the Yellen-Fischer Fed.
1. See Centers for Disease Control and Prevention, Antibiotic Resistance Threats in the United States, 2013 (US Department of Health and Human Services), www.cdc.gov /drugresistance/threat-report-2013/pdf/ar-threats-2013-508.pdf.
2. See Robert E. Lucas, “Expectations and the Neutrality of Money,” Journal of Economic Theory 4 (1972): 103–24; Thomas J. Sargent, “Estimation of Dynamic Labor Demand Schedules under Rational Expectations,” Journal of Political Economy 86, no. 6 (1978): 1009–44; and Thomas J. Sargent, “Rational Expectations, Econometric Exogeneity, and Consumption,” Journal of Political Economy 86, no. 4 (1978): 673–700.
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