Did the Fed catastrophically mis-time QE2?

February 28, 2011

USAThe sternest criticism of QE2 is the way it pumped up asset prices like commodities in recent months without making much of an impact on U.S. economic growth. Rising fuel and food costs have weighed on inflation everywhere from emerging markets to the UK. But this criticism might step up a gear if Middle East tensions lead to a spike in oil prices and the Fed tries to protect growth using a similarly blunt tool as QE2.

The political crisis in the Middle East has been the game-changer for the global economic outlook in the past couple of weeks.  In just five days WTI oil (U.S. crude) jumped $10, and Brent (European oil) surged to within touching distance of $120 per barrel. This showed us what fear is like: since the 1970’s each recession has been preceded by an oil price shock. You don’t need much more evidence than this to see the extremely close relationship between oil and growth especially in the U.S., the largest consumer of crude in the world.

The West is extremely sensitive to the Middle East. The region is undergoing a period of transition and what the new post-crisis Middle East will look like or how it will function has yet to be figured out, so investors are left to contemplate the worst case scenario in a vacuum of uncertainty. Right now the worst case would be if protests and public uprisings in North Africa spill over to the Middle East, specifically to Saudi Arabia – the most powerful nation in the region, an ally of the West and home to the world’s largest oil reserves.

In this case we could see oil well over $200 per barrel sending economists scrambling to reduce their forecasts for U.S. growth. Far from considering an exit plan the Federal Reserve would probably start planning QE3. After all, if it pumped the economy full of dollars during a blip in global growth last year then surely it should do so when the U.S. faces a real threat of recession?

The answer seems like a no-brainer – but not quite. QE2’s critics have pointed out two flaws to the current stimulus plan. Firstly, although the Fed pledged to bring down unemployment with its second stimulus plan the jobless rate still remains uncomfortably high at 9 percent, and arguably only started to moderate after the announcement that President Barack Obama would extend the Bush-era tax cuts in December. Secondly, even before Middle East tensions arose the Fed’s $600bn stimulus programme was blamed for artificially pumping up global commodity prices, with most of the liquidity flowing into the financial markets rather than the U.S. economy.

This is evident in the price action of commodities. WTI crude has been on an upward trajectory since August when Ben Bernanke first touted the prospect of QE2. Back then it was trading at $75 per barrel and finished 2010 nearly $20 higher. While the spike to $100 isn’t bad for the U.S. economy by itself, it’s the rate of change that causes the biggest impact on headline inflation rates. The $25 increase in 7 months could just be the start, especially if we see an escalation in tensions in the Middle East.

Unlike Europe where oil consumption has been falling, in America it has been growing since the 1970’s, so a supply shock, or price spike, would weigh on headline inflation and has the potential to have a devastating impact on growth. As more of peoples’ pay checks get used up on gas and other commodity prices, the more it depresses core inflation as consumer confidence gets hit slowing spending and thus economic growth.

St. Louis Fed President James Bullard said “never say never to QE3” in a speech recently, but while the Fed’s first instinct might be to plan for more quantitative easing as a reaction to an oil supply shock, it should think again. That course of action would just bring even more criticism of the Fed’s macro-economic policies to its door, and it could be blamed for aggravating oil prices at the same time as geopolitical tensions are hotting up. The Fed would find it difficult to argue its way out of that one.

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