Wednesday, June 26, 2013

Gold continues to realign with commodities

The realignment of gold with other commodity prices is one of the more significant events occurring in global financial markets today, so I have updated the chart (above) I introduced last April.

Last April I also noted the strong gains that equities were starting to register against gold, so the above charts are worth repeating, along with these excerpts from that post:

Over the time period of the second chart above, there have been only two episodes in which stocks strongly outperformed gold over a sustained period: the first, from around 1950 to around 1965, and the second, from late 1982 through 2000. In the first period, real GDP grew at an annualized rate of 4.5%, which is substantially more than the the 3.1% long-term average growth rate of the U.S. economy. In the second period, real GDP grew at an annualized rate of 3.7%, well above average. Real GDP growth was below average in the periods during which stocks fell relative to gold, the worst being from 2000 through 2012, when real GDP growth was an annualized 1.6%.
The upturn in stocks is thus a preliminary indicator that the economic fundamentals may be shifting in favor of equities, and that, in turn, would suggest that the long-term outlook for the economy is improving. Probably not immediately, but some time in the next few years we could see some genuine improvement in the economic fundamentals. Markets are always forward looking, and this indicator (the ratio of stocks to gold) could be one of the most forward-looking of all. Let's hope so.

Tuesday, June 25, 2013

More signs of strength in the housing market

The news keeps getting better for the U.S. housing market. Prices are up, construction is up, and new home sales are up. These are significant changes on the margin that are likely to have positive ripple effects throughout the economy.

Both measures of housing prices show a 12% gain over the past year. Higher mortgage rates are likely to temper—but not derail—further price increases. Higher mortgage interest rates are a logical response to stronger demand for housing.

On an inflation-adjusted basis, prices have bounced off their lows of early 2012. This marks almost four years of price consolidation after three years of catastrophic declines. There is every reason to believe that we have seen the worst, and that the future for housing looks bright.

The supply of homes for sales is at very low levels, after being very high for most of the past seven years. There is no longer a glut of homes for sale; the market is now faced with a relative shortage of homes for sale, although there are signs that the inventory of homes for sale is rising. Rising prices are restoring equity to millions of homeowners that had been "underwater."

May new home sales beat expectations (476K vs. 460K), and are up 75% from their lows. That's in line with the 90% increase in housing starts since the 2009 lows. It's reasonable to expect further gains, since construction is still very low from an historical perspective. 

Putting higher interest rates in perspective

As I detailed last week, the dramatic rise in nominal and real yields since the end of April marks a big change in the market's expectations for the future of the U.S. economy. Two months ago, the market believed the economy would be so weak that the Fed would be unable to raise short-term interest rates for the next two years. Today, the market expects the economy to be doing well enough to allow the Fed to raise short-term rates to about 1% two years from now. As a result, interest rates all across the yield curve have jumped, and it's all because the market has gained confidence in the economy's ability to grow. It's hard to see how this can be interpreted as a negative for the equity market, or for the housing market, since even after the expected rate increases occur—if indeed they do—interest rates would still be relatively low from an historical perspective.


The chart above shows the Treasury yield curve as it stood at the end of last April, as it stands today, and as the market expects it to be in two years. 5-yr Treasury yields were 0.7% two months ago, and are now expected to climb to 2.7% over the next two years. 10-yr Treasury yields were 1.7% and are now expected to be 3.3% in two years. These are significant changes, but they are hardly life-threatening from the economy's perspective.

As the chart above shows, a 3.3% yield on 10-yr Treasuries would still qualify as an extraordinarily low yield from an historical perspective. 

As the chart above suggests, the current -0.2% real yield on 5-yr TIPS is only now approaching levels that might be consistent with the economy growing by a tepid 2% per year for the next several years—at about the same rate that it has grown over the past several years. What stands out in this chart is just how low real yields had fallen two months ago. The bond market was exceptionally bearish on the economy's prospects last April, and now it is much less pessimistic. But it is still far from being optimistic.

Today's interest rates, which embody expectations of higher interest rates to come, are not likely to pose a threat to the U.S. economy. They have presented a problem, however, for investors who thought that interest rates would remain close to zero for a very long time. 

The jump in Treasury yields has boosted mortgage rates by almost a full point, as seen in the chart above. Does this threaten the housing market? I doubt it. In the entire history of the U.S. mortgage market, rates have only been lower than they are today for the preceding year. Prior to 2012, rates have never been lower than they are today. 

Today's release of the Conference Board's measure of consumer confidence marked a new high for the current recovery. This is consistent with the action in the bond market: people are feeling a bit more comfortable now about the future prospects for the U.S. economy. 

UPDATE: According to ICI, taxable bond funds this month have experienced their biggest net outflow in over four years. Big things are indeed happening; the bearish case for the economy—which calls for very low interest rates for as far as the eye can see—has been dealt a serious blow.

Thursday, June 20, 2013

Putting today's market action in perspective

Here are some different perspectives on today's decline in equity prices:

Drudge: "Dow Dives Deep," "Year's biggest selloff," "Fed fear."

Bloomberg: "S&P 500 Posts Biggest Drop Since November 2011 on Fed."

Here's how I see it:

Yep, it's pretty scary. The recent selloff is so huge you need a magnifying glass to see it.

It's important to keep things in perspective.

The bond market is unwinding its doom and gloom fears

The most important message to be found in today's bond market action (i.e., sharply rising real and nominal yields on Treasuries) is that the Fed's purchases of Treasuries did not artificially distort the Treasury market. Yields were low because the market expected the economy to be very weak for a long time—not because the Fed's purchases made them low. I commented at length on this about a month ago; here's an excerpt:

It's my impression that most market participants have been persuaded by the flow argument: namely, that the Fed's massive QE3 purchases have artificially depressed market interest rates. After all, that's been the Fed's stated intention: to buy lots of bonds in order to depress interest rates and thereby stimulate borrowing and economic activity. This line of reasoning says that the fact that 10-yr Treasury yields averaged an exceptionally low 1.75% over the past year has nothing to do with the market's view of inflation or economic growth; Treasury yields have in fact become meaningless inputs to valuation models and offer no insight into market and economic fundamentals, other than as a distorting influence. 
I've argued to the contrary on many occasions over the years. I believe that interest rates are determined by the market's willingness to hold the existing stock of bonds, especially since Fed purchases on the margin represent only a small fraction of the existing stock. I think the Fed can only influence yields to the extent that the market's view of the economy is similar to the Fed's. If both expect the economy to be very weak, yields will be low, and prices will behave as if Fed purchases of bonds to stimulate the economy are in fact achieving their stated objective. But if the market thinks the economy is improving and/or inflation is rising, then no amount of Fed purchases will be able to keep yields from rising. That's the situation today, and it's been unfolding (in fits and starts) almost from the day QE3 began.

And so it is that despite the Fed's purchases of $45 billion of Treasury notes and bonds every month, and $40 billion of MBS every month, 10-yr Treasury yields have jumped some 80 bps and MBS yields have jumped almost 100 bps:

What has changed since the beginning of last month that has caused Treasury yields to soar? Only one thing: the market has come to believe that indeed—as the FOMC's recent statement suggested—the outlook for the economy has improved a bit. The Fed has been telling us for a very long time that it would eventually stop buying bonds, but until recently the market just didn't believe it would ever come to that; the market thought the economy would be mired in a slump for as far as the eye could see. The "new normal" economy was going to last forever. Now, however, the market is beginning to see some light at the end of the "new normal" tunnel: things might be getting better. And of course, if the economy does improve, then the Fed will not only taper and then stop its QE purchases, but it will sooner or later begin to push short-term interest rates up. Even if the Fed waits until next year to raise short-term interest rates, which seems likely, the market can now believe that short-term interest rates will rise, and so today the market is adjusting to what it believes will happen in the next several years.

If the market thinks the economy is improving and/or inflation is rising, then no amount of Fed purchases will be able to keep yields from rising. That is what today's market action is all about.

So it makes sense for Treasury and TIPS prices to be plunging/yields to be rising, because the market now believes that interest rates will be higher in the future than it thought until recently. And it makes sense for inflation expectations (as measured by the spread between TIPS and Treasury yields) to be declining, because the Fed is now less likely to make a big inflationary mistake.

It also makes sense for gold prices to be plunging, since the market now realizes that the Fed is not going to be doing QE forever, which in turn implies that the risk of runaway inflation and dollar debasement is much less than previously feared. As I mentioned last April, gold had reached incredibly high levels on the back of speculative fever and concerns over too much Fed easing. Gold is now well on its way to re-linking with other commodity prices, with a likely price target of $900-1000/oz. Commodity prices in general appear to be under a little selling pressure, but gold is the bigger story since its rise, in retrospect, was extraordinarily overdone. 

It makes sense for credit spreads to be relatively low and largely unaffected by the turmoil in the Treasury market, because the outlook for the economy has improved somewhat. What's bad for Treasuries is not necessarily bad for the economy. Indeed, the prospects for economic growth can be a powerful influence on Treasury yields. Weaker-than-expected growth usually results in lower yields, which stronger-than-expected growth usually results in higher yields. (Higher Treasury yields can be bad for the economy, but only if the Fed is actively tightening in order to slow the economy, as happened in the late 1990s.)

Equity prices have suffered a bit, but that's not so unusual given the enormous changes underway in the bond market. As the chart of the S&P 500 (above) shows, the recent decline in equity prices is still in the nature of a minor correction. It wouldn't make sense for the equity market to collapse just because the outlook for the economy has improved, would it? Higher Treasury yields are not going to bring down the economy; higher yields are the natural result of improved expectations for growth. Growth does not sow the seeds of its own destruction. The Fed is many years away from tightening by enough to threaten growth.

The Vix index has jumped, and that too is not unusual because the market is undergoing a big reassessment of its assumptions and its outlook. But as the charts above show, this rise in fear, uncertainty, and doubt is still relatively minor when viewed from a long-term historical perspective. And that makes sense, because today the market is not worrying about a major deterioration in the outlook, but rather a modest improvement in the outlook. This is not the stuff of doom and gloom; it is the unwinding of doom-and-gloom fears. That's a big difference. 

If this analysis is correct, then the decline in equity prices has only increased the attractiveness of equities. All things considered, it's good news that the outlook for the economy has improved somewhat, and that the Fed is planning to accelerate—however modestly—its plans for unwinding its Quantitative Easing efforts. 

Monday, June 17, 2013

Households' financial health continues to improve

U.S. households continue to bolster their financial health. Financial burdens are down to 30-year lows, and credit card delinquency rates are at all-time lows. These are some impressive and dynamic adjustments that have been achieved in just 4-5 years, and they set the stage for a return to stronger economic growth in the future.

Households' financial burdens (monthly payments as a percent of disposable income) as of March 2013, are at their lowest levels in over 30 years, according to calculations by the Federal Reserve.

Credit card delinquency rates (shown on a quarterly basis for all banks in the first of the above charts, and on a monthly basis for American Express (revolving), Bank of America, Capital One, Chase, Citibank, and Discover, in the second chart. Delinquency rates based on all available data are as low as they have ever been, and are likely to continue to decline. Good news all around, especially for bank profits. I note that an index of financial sector stocks (XLF) has more than tripled since March, 2009. 

Friday, June 14, 2013

Industrial production lackluster

May industrial production figures show only lackluster growth, and are consistent with the modest-to-moderate economic growth we have seen for the past several years. What the economy is lacking is an improvement in business confidence, and that is not likely to come unless and until we see reforms that reduce regulatory burdens (especially those associated with Obamacare) and corporate income taxes. I think we will see movement in this direction before the end of the year, but for now things look pretty dull and unexciting.

U.S. industrial production has generally fared much better than Eurozone industrial production over the past decade or so. In fact, Eurozone production hasn't experienced any net increase for the past 13 years (since May 2000). Germany stands out as a relative powerhouse, but production there has been stagnant on balance since mid-2011, mostly as a result of the onset of the PIIGS sovereign debt crisis. It is encouraging to see that German production has enjoyed a sizable pickup in recent months, as this may be a leading indicator of a more widespread improvement in the Eurozone economy after more than two years of declining output. U.S. industrial production growth has been lackluster, rising only 1.6% in the past year.

Abstracting from utility output, which has been roughly flat for the past seven years, manufacturing production was up a bit in May but up only 1.7% over the past year.

Production of business equipment has been doing a little better, posting 3.2% growth in the past year, but growing at only a 1.8% annualized rate in the past six months.

Thursday, June 13, 2013

Fears of tapering are misplaced

Recent economic data continue to show no sign of any emerging weakness or unusual strength in the U.S. economy. The economy is likely continuing to grow at about a 2% pace, which is the average pace of the current business cycle expansion. Despite any notable changes in the health of the economy, the market has rather suddenly been gripped by fear that a tapering of the Fed's Quantitative Easing program—not a reversal, just a slower pace of asset purchases—puts the economy at risk. This fear is based on the assumption that the recovery has been primarily driven by QE, an assumption I think is unfounded. I see no logical connection between the Fed's purchases—which amount to swapping T-bill substitutes for notes and bonds—and the creation of new jobs. As I argued months ago, the Fed is not "printing money."

If there is any connection between QE and economic growth, it is that both are unprecedented: we've never seen the Fed purchase assets of such magnitude, and we've never seen such a slow-growing economy after such a deep recession. Indeed, it might make more sense to believe that QE has actually retarded the economy's growth—and that therefore a tapering of QE might actually boost growth—rather than to worry that a slow-growing economy might get even slower if the Fed begins to taper its purchases of notes and bonds.

Some brief notes on today's data releases:

Weekly claims for unemployment continue their downtrend. This suggests the labor market is getting more resilient by the day, as employers have done just about all the cost-cutting they need to.

Relative to the size of the workforce, layoffs have rarely been lower than they are today.

The number of people receiving unemployment insurance is down almost 21% in the past year. This continues to be one of the biggest changes on the margin in the U.S. economy, and it is a positive, since it increases the incentives for people to find and accept employment.

May retail sales were stronger than expected (+0.6% vs. +0.4%). To date there is no sign that the expiration of the payroll tax holiday (which caused withholding taxes to increase beginning in January) has had any significant impact on consumer spending. Real retail sales are up about 3.3% in the past year, and in the past six months they are up at 2.7% annualized pace.

The main problem with the economy has been a failure to thrive. Unemployment remains quite high, and the economy is operating at much less than its capacity. As the chart above suggests, retail sales are a little more than 10% below where they otherwise could have been if this had been a normal recovery. This, combined with the fact that inflation remains relatively low, is hardly evidence that the Fed has artificially pumped up the economy with QE.

Wednesday, June 12, 2013

Federal finances continue to improve

Federal tax receipts are growing strongly while spending is stagnant, thanks to a deadlocked Congress, a growing tax base, and higher tax rates. The federal deficit as a % of GDP has fallen almost by half in the past 3 1/2 years. This dramatic improvement is likely under-appreciated and almost totally unexpected. At the very least this removes a good deal of uncertainty about the future, at the same time as it removes the need for further tax hikes and increases the odds that tax rates might be lowered in the future.

Federal spending has changed very little in the past four years. In the 12 months ended May 2013, spending actually declined 1.1%. 

Federal tax revenues have been rising steadily for the past several years, and have surged at a 17% annual rate in the six months ended May 2013. Several factors were responsible: jobs and incomes are growing, the payroll tax holiday expired at the end of last year, income was shifted forward at the end of last year as people attempted to avoid an anticipated increase in tax rates, tax rates on top income earners increased, and a stronger stock market generated more capital gains. Federal revenues over the past 12 months reached a new all-time high of $2.7 trillion.

The federal deficit in the past six months was $870 billion, down from a high of $1.47 trillion in CY 2009. Relative to GDP, the federal deficit has dropped almost by half, from a high of 10.5% to now only 5.5%. Almost all of the nominal reduction in the deficit has come from increased revenues (since spending has been flat), which in turn is mostly due to ongoing economic growth, and partly due to higher tax rates. Relative to GDP, 3 percentage points of the 5 percentage point reduction in the deficit have come from the decline in the relative size of government spending, while 2 percentage points have come from the rise in tax revenues.

If current trends continue, the budget could end up balanced within 5-6 years.


Note to Keynesians: The massive increase in the deficit that occurred from late 2008 through 2009 was supposed to "jolt" the economy back to life, but instead we got the weakest recovery in history. If anything helped get the recovery started, it was the Fed's first Quantitative Easing program, which supplied the cash and cash equivalents that were so desperately needed in a world that had become suddenly very risk-averse. Similarly, the huge decline in the deficit that began in 2010 would have choked most Keynesian models, leading to a painful contraction of economic activity that never occurred. Massive fiscal stimulus was followed by excruciating fiscal contraction, yet the economy grew at a fairly steady and unimpressive pace of about 2% throughout—with surprisingly little variation, as the chart above shows.

This recovery has been a perfect laboratory test of the predictive powers of Keynesian economic models, and they have failed utterly. It's time to throw Keynesian economics into the dustbin of history.

Tuesday, June 11, 2013

Soaring real yields are good news

The biggest change on the margin in the financial markets continues to be the rise in real yields, so this update to my earlier post is both timely and important. Higher real yields reflect not only an improving outlook for growth but also a decline in inflation expectations, and that is a sanguine combination.

Real yields on 5-yr TIPS (see chart above) have soared almost 110 bps since the end of March, to their highest level in more than 18 months.

Ditto for real yields on 10-yr TIPS, which are up 100 bps from their December lows.

As the chart above shows, both real and nominal yields are up on the margin, but real yields have increased by more than nominal yields, thus reflecting a moderate decline in inflation expectations. Inflation expectations are still within a "normal" range, however, and do not reflect any serious risk of deflation.

As I've argued before, government-guaranteed real yields that are available for purchase in the TIPS market can tell us a lot about the market's expectations for real economic growth. As the chart above suggests, the negative real yields on TIPS that we saw earlier this likely reflected market fears of very slow GDP growth. Investors were willing to lock in a negative real yield on TIPS because they feared that the real yields on alternative investments would be even worse, the by-product of collapsing real growth. Real yields are now moving back up towards levels that are more consistent with economic growth of 1-2% per year in the years to come. So this is not a market that has suddenly become optimistic; it is a market that has become less pessimistic. That's not unreasonable at all, given the modest to moderate growth signals we see from other indicators.

The recent decline in the price of gold is also consistent with the message of TIPS. Gold had reached exceptionally high levels not too long ago, arguably driven by fears that the Fed's QE policy might lead to a serious increase in inflation, as well as by fears that the economic outlook was fraught with risk stemming from huge increases in government debt in most developed economies. We now see that the U.S. federal deficit has declined significantly, and TIPS are telling us that inflation risk has also declined, and that the Fed is now likely to reverse QE sooner than expected, thus reducing the likelihood of failure. As I've suggested in a prior post, it looks like gold prices are now coming back down to a level more consistent with other commodity prices. That spot commodity prices are still quite elevated relative to where they've been in the past few decades arguably confirms that the outlook for global growth is far from precarious, so there is no sign here that a Fed reversal of QE poses any serious threat to growth.

As the above chart shows, every recession in the past 50 has been preceded by a significant rise in real yields (the result of concerted Fed tightening), but the current rise in real yields still leaves real yields at very low levels. A true Fed tightening involves not only very high real yields (on the order of 4% or more) but also an inversion of the yield curve. Neither of those conditions exist today. The yield curve is still quite steep, and that implies that monetary policy is still expected to be accommodative for the next several years at least.

The recent jump in nominal and real yields does not threaten the health of the economy. Rather, higher yields reflect a market that is adopting a healthier expectation for growth in coming years. Higher rates normally accompany a healthier economy; they only rarely weaken an economy. This is all very good news.

Friday, June 7, 2013

Why the modest growth in jobs means an end to QE

The May employment report shed no new light on the state of the labor market. For the past two years, and for the past six months, the private sector has been adding jobs at about a 2% annual pace. Consideriing the huge job losses that came with the Great Recession, that adds up to the slowest recovery in the jobs market in modern times, and it's the source of lots of angst and hand-wringing. Things could be a lot better, but at least jobs are growing. There is no boom or double-dip recession out there, and neither appear likely for the foreseeable future. It's simply modest-to-moderate growth.

But as I've been asserting for a long time, avoiding recession is all that matters when the yield on cash is zero. If the labor market continues to grow at the pace of the past two years, investors who avoid cash are likely to do better than those who hold cash, because the yield on non-cash assets is much higher. Zero-interest cash only pays off if the economy suffers a disruption that reduces cash flow, increases default risk, and/or impairs profits (since any of those is likely to depress the prices of risk assets). As time passes and the economy continues to grow, the cumulative outperformance of non-cash assets will increase the world's temptation to reduce cash holdings, and that will eventually show up as higher prices for risk assets.

The Fed will eventually succeed in reflating the economy, but not by "printing money." Reflation requires convincing the world that holding lots of cash (and relatively safe assets like short-term Treasuries) doesn't make sense. To date, the Fed has been working hard to supply bank reserves to the world in order to satisfy what has proved to be an extraordinary demand for cash and cash equivalents. As the demand for cash declines, the Fed should be able to reverse its Quantitative Easing with no adverse consequences, because it will be trading higher-yielding assets (e.g., notes and bonds) for the cash the public has tired of holding. The key to reversing QE is thus a declining demand for money, and we are seeing the early signs of that in the recent rise in real yields on TIPS and nominal yields on Treasuries (see chart above). Rising yields on relatively safe assets such as 5-yr T-notes and 5-yr TIPS are the flip side of falling prices (i.e., falling demand). Put another way, rising real yields on TIPS are a sign of increased confidence in future economic growth (or decreased pessimism). Increased confidence in the future comes hand in hand with reduced demand for cash and cash equivalents.

But back to the labor market. As the chart above shows, the economy continues to add jobs. Since the low in early 2010, the private sector has created between 6.7 and 6.9 million new jobs, according to the government's two employment surveys. There is no sign that this growth is ebbing or accelerating.

Overall jobs growth has been a bit slower than the growth of private sector jobs, because the public sector has been shedding jobs for the past four years. This is actually a healthy development, since the private sector is generally more efficient than the public sector, and since the public sector had grown like topsy over the past decade or so. A shrinking public sector frees up resources for the more productive private sector, so over time that should boost growth somewhat. We probably haven't seen the end of this shrinkage either.

Private sector jobs growth has been averaging just over 2% a year for more the past two years. This is almost exactly the same pace as jobs growth in the mid-2000s. In a sense, it's business as usual.

The most unusual thing about this recovery is the very slow growth of the labor force over the past four years. Instead of growing about 1% per year (in line with growth in the population), labor force growth has been extremely weak, and has posted only 0.4% growth in the past year. Demographics (e.g., the aging and retirement of baby boomers) can explain some of this slowdown, but it's likely that the large increase in transfer payments since 2008 (e.g., food stamps, social security disability, emergency unemployment benefits) has played a role as well. When compassionate government doles out money to assuage the victims of a recession, it inadvertently acts to retard the recovery because it reduces the incentives to get back to work. It's also likely that the big increase in regulatory burdens in recent years (e.g., Dodd-Frank, Obamacare, EPA rules) has created disincentives for businesses to expand, thus limiting job opportunities and leaving many would-be workers discouraged. Higher marginal tax rates haven't helped either, since they are a disincentive to work and invest. The economy is growing at 2% despite all these headwinds.

Does the Fed really think that buying $85 billion worth or Treasuries and MBS each month and paying for them with bank reserves will change this relatively slow-growth picture? How exactly will more bank reserves lead to more job creation? It's not obvious to me.

As the chart above shows, there is no evidence that the Fed's Quantitative Easing efforts have resulted in any unusual amount of money growth. The M2 measure of the money supply, arguably the best, has grown only slightly faster than 6% per year since the Great Recession. That growth is easily explained by strong money demand: the vast majority of the growth in M2 in the past 4-5 years has come from an increase in bank savings deposits. At the same time, virtually all of the Fed's $2.3 trillion worth of purchases of Treasuries and MBS have gone to support increased currency in circulation and excess reserves. Banks now hold $1.9 trillion of excess reserves at the Fed; they are presumably happy to do so because reserves pay interest and are thus effectively a substitute for T-bills. Banks are still quite risk averse as is the public, since households continue to deleverage. Hardly any of the flood of new bank reserves has been used by banks to increase lending and expand the money supply. Currency in circulation is up more than $0.34 trillion since Q3/08, largely because people all over the world want to hold more dollars under the mattress, so to speak.

This can't go on indefinitely. At some point attitudes toward risk will change, and the demand for safe assets and cash will decline. Bank lending will increase. Money supply growth will increase. Nominal GDP growth will increase. The prices of risk assets will rise further. All of these will be signs that the Fed should begin to reverse QE. As mentioned above, there are already tentative signs of this, and one more non-recessionary jobs report such as today's only makes it more likely that this process is getting underway. I'm reminded of my post last March:

... the biggest risk we all face as a result of the Fed's unprecedented experiment in quantitative easing is the return of confidence and the decline of risk aversion. If there comes a time when banks no longer want to hold trillions of dollars worth of excess bank reserves for whatever reason (e.g., the interest rate the Fed is paying is no longer attractive, or the banks feel comfortable using their reserves to ramp up lending, or the public no longer wants to keep many of trillions of dollars in bank savings deposits), that is when things will get "interesting."

I suspect that the Fed has been engaged in a bit of false advertising, claiming that it is buying billions of Treasuries and MBS in order to lower interest rates and thereby goose the economy. The dirty secret is that monetary policy can't create or stimulate growth, it can only facilitate growth. As I discussed the other day, interest rates are now higher than they were when QE3 started late last year. Paradoxically, rising interest rates are the clearest sign that QE has achieved its real purpose. In reality, all the Fed is doing is satisfying the world's demand for safe assets: exchanging bank reserves for notes and bonds. There's nothing wrong with that, and if they hadn't done this we'd be in a world of hurt—there would have been a shortage of safe money and that could have led to deflation and worse. The Fed has satisfied the world's demand for safe assets, but there is no evidence at all that the Fed's actions have translated into more jobs or faster growth. The economy has been growing all along the old-fashioned way: by adjusting to new realities, by working harder and more efficiently, and by investing more, in spite of all the obstacles. Economic growth and new jobs are not created by adding bank reserves to bank balance sheets.

The issue right now is when the Fed will begin to "taper" its QE program, and whether this will hurt the economy or not. The Fed has suggested that the unemployment rate needs to fall much further before they start to unwind QE, but we're not likely to see a 6.5% unemployment rate anytime soon if current trends continue—it could take another year.

Meanwhile, there seems to be growing unease among FOMC members with the obvious progress the economy is making. It's risky to keep the monetary pedal to the metal year after year when the economy has already demonstrated the ability to create jobs at the same pace as it did in the mid-2000s.

I think this explains why the Fed is trying now to accelerate its transition to an unwinding of QE, well in advance of the economy hitting the targets the Fed had previously proposed. It's a tacit admission that the purpose of QE wasn't really to create more jobs, it was to satisfy the world's demand for safety in uncertain times. Now that the economy has demonstrated the ability to grow for the past four years, and now that the public's demand for safe assets is beginning to decline (witness also the big drop in gold prices in recent months), QE is no longer necessary. Godspeed. It will not be missed. Higher interest rates do not necessarily pose a threat to growth, they are a natural result of growth.