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The point of no return for quantitative easing is getting closer
Ivan Martchev

Did Ben Bernanke and Haruhiko Kuroda discuss helicopter money?

On Nov. 21, 2002, Federal Reserve Board Governor Ben Bernanke gave his infamous "helicopter" speech titled, "Deflation: Making Sure "It" Doesn't Happen Here," before the National Economics Club in Washington, D.C. The speech raised eyebrows. The most notable part has been quoted often:

"What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

In that speech, Bernanke referred in passing to economist Milton Friedman's phrase "helicopter drop" about excessive money creation. Now, as a former Fed chairman, Bernanke surely regrets the parts of this speech that gave him the nickname "Helicopter Ben," but it resurfaced as he met with Bank of Japan Chairman Haruhiko Kuroda earlier this month in Tokyo. This informal meeting was seen as a sign that Japanese authorities were considering even more extreme monetarist measures, and the yen dropped while the Nikkei 225 benchmark index jumped.

The past year hasn't been a pleasant experience for Japanese stock market investors as the yen USDJPY, -0.65%   strengthened from 125 all the way to 100 against the dollar as many of the famous Japanese exporters derive the majority of their earnings from abroad. In that regard, the correlation of the Nikkei 225 Index NIK, -1.13%   and the USDJPY exchange rate is very high.

Bernanke's visit to Tokyo makes this comment on Japan from his 2002 "helicopter" speech even more prescient today: "I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan's overall economic problems."

Given that the Japanese have run a QE program since 2013 that is three times more aggressive than the Fed's QE program (relative to the size of GDP), and officials have still not gotten the results they were looking for is rather telling. Sure, the yen originally weakened from 80 all the way to 125 (last year) and the Nikkei surged, but why has the currency been strengthening so much of late? (See my May 31, 2013 MarketWatch article, "Repercussions from the yen surge.")

Etsuro Honda, one of the most trusted advisers to Japan's prime minister, noted that Bernanke at an earlier meeting in April, had mentioned the option of "perpetual bonds." Under this scenario the government would issue non-marketable perpetual bonds with no maturity date and the Bank of Japan would buy them. This is practically helicopter money, as it is direct monetization of government debt by the central bank. While the details of the latest meeting are still not known, the currency markets certainly acted like they heard the sound of helicopters landing in Tokyo.

Monetizing Japanese government debt, as the government simply cannot manage to repay it, is where this all seems to be moving. It may be simply too late for Japan. I have no doubt that the strengthening cycle of the yen over the past year is temporary from a longer-term perspective as it is primarily driven by a short squeeze due to the yen's popularity in institutional carry trades. But from a longer-term perspective, such as five years, the yen's prospects aren't good if the plan is to run the printing presses until Japan runs out of trees and drop those freshly-printed bank notes from helicopters. Under such a "helicopter" scenario, who knows how much the yen will fall?

Until it becomes clear what new and innovative ways the Japanese authorities will choose to monetize their way out of the present economic mess, the yen will probably coast near present levels. The talk of more monetarist measures in Japan, particularly given what is going on in Europe and China, only means one thing: the U.S. Dollar Index is headed to fresh multiyear highs above 100.

The U.S. Dollar Index DXY, -0.28%   is down marginally in 2016 since the four rate hikes originally expected in 2016 are no longer expected. But given the relative performance of other currencies in the index and their monetary policy developments, I expect the U.S. Dollar Index will be higher by year's end.

Is there a limit to quantitative easing?

The short answer is "yes," but the trouble is we don't know where that line in the sand is situated. Total assets of central bank balance sheets at the moment are $17.2 trillion. It is rather scary when one starts to round trillions, as every decimal point is $100 billion. Before the Great Financial Crisis started in 2007, total central bank assets were $6.4 trillion, according to Yardeni Research.

Most market observers think the Fed came up with the idea of impregnating their balance sheet, but that is incorrect. In 1998 the Bank of Japan embarked on the first real QE operation in the modern era, which can be seen in the first upward zigzags in the blue line here. The Federal Reserve unofficially started QE in late 2008 by taking in all kinds of illiquid debt instruments, the markets for which had vanished at the time. Officially, QE operations in the U.S. Treasury and mortgage markets began in early 2009.

What I am worried about is that central bankers may get cocky, as so far their monetarist maneuvers have not broken the financial system. While quantitative easing isn't necessarily real debt monetization and outright printing in the U.S. as the Fed swaps one interest-bearing asset Treasurys) for another (excess reserves), it is that interest on excess reserves has purposefully always been above the fed fund rate that stops them from producing hyperinflation. This higher rate stops excess reserves from entering the fed funds market and in effect stops the credit multiplier of the fractional reserve banking system.

In essence, the U.S. version of QE was the most profitable carry trade in the world where the Fed paid 0.25% (the interest rate on excess reserves for most of QE's tenure, rising to 0.50% on Dec. 17, 2015) to buy assets that had yields of 2% or higher, in effect remitting the difference to the Treasury.

Monetary economists at the Fed seem to think that they know how to unwind its balance sheet (see "The Federal Reserve's Balance Sheet and Earnings: A primer and projections").What I am worried about is that what was discussed in Tokyo this month is very different than the controlled QE in the U.S. and is more along the lines of what Ben Bernanke told Etsuro Honda in April.

It feels to me that the line in the sand — the QE "point of no return" — is getting nearer and nearer.

Ivan Martchev is an investment specialist with institutional money manager Navellier and Associates . The opinions expressed are his own. Navellier and Associates holds no positions in any investments mentioned in this article. This is neither a recommendation to buy nor sell the securities mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the above mentioned securities. Investing in non-U.S. securities including ADRs involves significant risks, such as fluctuation of exchange rates, that may have adverse effects on the value of the security. Securities of some foreign companies may be less liquid and prices more volatile. Information regarding securities of non-U.S. issuers may be limited.

 

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