Hussman Weekly Market Comment: Superstition Ain't the Way

“The problem with QE is that it works in practice but it doesn’t work in theory.” 

- Ben Bernanke, Outgoing Federal Reserve Chairman, January 16, 2014 

"When you believe in things that you don't understand, then you suffer. Superstition ain't the way." 

- Stevie Wonder, Superstition, 1972 

Bernanke clearly meant it as a joke, but it is also an unfortunate statement on recent monetary policy. It's poetic that Stevie Wonder recorded Superstition in 1972, just before the stock market fell by half. A few weeks ago, William Dudley made the same point as Bernanke – even the Fed doesn’t quite understand how quantitative easing works. What FOMC officials are really saying is that aside from a very predictable effect on short-maturity interest rates, there is no mechanistic link between the monetary base and any other variables – financial or economic – that they are trying to control. There is a sense that creating more monetary base helps stocks advance, and that this contributes to economic confidence. What’s missing is a transmission mechanism that operates through identifiable banking and economic channels – other than promoting a speculative reach-for-yield and the psychological exuberance that accompanies a bull market. 

The fact is that Treasury bond yields are above where they were when QE2 was initiated in 2010, and year-over-year growth in non-farm payrolls, civilian employment, real GDP and real final sales have at best done little but hover at the thresholds that have historically bordered expansion and recession. Good economic policy acts to ease constraints that are binding, and monetary policy can clearly be useful in that regard – particularly during liquidity crises when depositors are rushing for cash. At present, however, quantitative easing acts by massively loosening a constraint that is not binding at all, drowning the economy with idle bank reserves that aren’t even desired. That’s going to have negative consequences. 

The chart below shows the ratio of bank reserves to the M1 money supply. We are increasingly moving away from a “fractional reserve” banking system, as the relationship between reserve creation and lending has collapsed. Idle bank reserves now exceed the amount of demand deposits in the U.S. banking system by more than two-to-one, and exceed 25% of all deposits in the U.S. banking system. Keep in mind that these reserves don't "go into" the stock market (every buyer of stocks is matched by a seller who gets the cash). Rather, these reserves may change owners, but stay in the banking system in aggregate, depressing short-term interest rates, and resulting in a pool of zero-interest deposits that change hands from one uncomfortable holder to another.