Opinion

The Great Debate

Quantitative easing and the commodity markets

-The views expressed are the author’s own-

A warning by an International Energy Agency (IEA) analyst this week that quantitative easing (QE) risked inflating nominal commodity prices and derailing the recovery drew a withering response from Nobel Economics Laureate Paul Krugman, who labelled the unfortunate analyst the “worst economist in the world”.

According to New York Times columnist Krugman “Higher commodity prices will hurt the recovery only if they rise in real terms. And they’ll only rise in terms if QE succeeds in raising real demand. And this will happen only if, yes, QE2 is successful in helping economic recovery”.

Krugman’s criticism is unfair. There are clear links between QE and investor appetite for commodity derivatives and physical stocks (via the Federal Reserve’s “portfolio balance” effect), and from investors’ holdings of derivatives and physical inventories to cash prices (given the relatively inelastic supply and demand for raw materials in the short term).

In other words, there are financial as well as real economy links between QE and commodity prices. Commodities have some of the characteristics of financial assets as well as physical consumption materials. Via portfolio effects, QE could boost the relative (real) price of commodities even if it did not boost employment and output in the United States by very much.

It is a more open question whether commodity-driven inflation would hinder or promote a recovery in output and employment in the advanced industrial economies. It would reduce the real burden of inherited debts from the boom years. But it would harm savers, and it might harm manufacturers and households, depending on whether increased commodity prices were matched by rising non-commodity consumer prices and wages.

Markets make prisoner of the Fed

“Market participants should not direct policy,” Kansas City Fed President Thomas Hoenig warned listeners at a town hall meeting in Lincoln, Nebraska, back in August. Unfortunately that is precisely what is now happening.

Hoenig noted that Wall Street’s clamour for cheap money was not disinterested: “Of course the market wants zero rates to continue indefinitely … they are earning a guaranteed return on free money from the Fed by lending it back to the government through securities purchases.”

Now the same pressure groups want the Fed to launch a second round of asset purchases so they can sell U.S. Treasury bonds to the central bank (in effect back to the federal government) at inflated prices.

Weakened Fed mulls threats, promises

As any schoolteacher knows but the Federal Reserve will soon learn, threats and promises are the tools of the weak.

Trapped by interest rates that cannot sink below zero, the Fed, it is becoming clear, is not just preparing to engage in a massive new purchase of securities, or QE2, but is also considering a new communication policy it hopes will convince people that inflation, if not recovery, is just around the corner.

Investors expect a second round of ‘quantitative easing,’ or QE2, will take the form of increased purchases of Treasury debt aimed at keeping long-term rates low and encouraging consumers and businesses to go out and spend.

There is no such thing as inflation

In 1987, UK Prime Minister Margaret Thatcher whipped up a firestorm of criticism from her opponents on the left when she told a magazine reporter that “there is no such thing as society”, only individual men and women, and families.

The interpretation of those comments remains fiercely controversial. From the context it is not certain the prime minister was clear what she was trying to say.

But according to one interpretation the prime minister was encouraging her listeners to look beyond the impersonal aggregate of “society” to the individuals behind it.

The wrong sort of inflation

Chairman Ben Bernanke’s Fed is beset by demons of its own design.

Terrified by memories of the 1930s and Japan’s more recent experience in 1990s and 2000s, the academics who now dominate the Federal Open Market Committee display a hyperactive compulsion to tinker with monetary policy in a bid to solve all the problems besetting the U.S. economy.

But if inflation is always and everywhere a monetary phenomenon, as Milton Friedman argued, Fed policy has a smaller role in solving real-economy problems such as a gaping trade deficit, moribund housing market, sluggish growth and joblessness.

Expectations of another substantial round of quantitative easing (QE2) have gone too far for the Fed to pull back now. The Fed must press ahead or risk a massive, disorderly correction across all asset classes (bonds, equities, commodities and currencies).

QE2 to speed triumph of emerging markets

While “decoupled” is not the same as “immune”, look for growth and investment performance in emerging markets to be better than in the sclerotic developed world.

In the short term emerging markets will be free riders as the U.S. launches the second round of quantitative easing. A portion of the stimulus generated by “QE2″ will inevitably leak cross border, while the risks of the gambit will fall almost entirely on the U.S. and on dollar-denominated assets.

QE2 is designed to work in two ways: to stimulate investment by making it cheaper to borrow money and to lift consumption by boosting asset prices.

Fed is banking on phony wealth effect

The Federal Reserve is committed to enticing Americans into doing once again what worked out so badly in the last decade: spending the phony paper gains engineered by overly loose monetary policy.

That, at least, is the very strong impression given by a speech by Brian Sack, the markets chief of the New York Federal Reserve, a man whose job it will be to implement the second round of large-scale quantitative easing coming after the elections in November.

A round of speeches from key Fed officials has given the clear view that, faced with deteriorating conditions and trapped by the lower bound of zero in its monetary policy, the Fed is preparing to once again buy up large amounts of Treasuries, perhaps even more than the government is issuing on an ongoing basis, in an attempt to drive down market interest rates and stimulate the economy.

Central banks face crisis of confidence

Central banks around the world are facing the worst crisis of confidence since the 1930s, as investors, households and firms question their commitment and ability to deliver price stability.

Whether it is inflation or deflation, outsiders question whether the major central banks will be able to regulate prices in the next few years.

TOO HOT ….
Bank of England Chief Economist Spencer Dale last week lashed out at what he branded “dangerous talk” the Bank had gone soft on inflation and was choosing to ignore price increases persistently above the target.

The Knightian dog ate my recovery

Remember when business and economic leaders droned on about “100-year storms,” 2008′s get-out-of-jail free card for people who missed the housing bubble?

This was the whole idea that there was no way that people could be held accountable for the crisis because the notion of there being a problem with continual double-digit house price growth and sky-high leverage was just so darned unlikely.

Well, it looks like we have the 2010 version of how the dog ate their homework again and this time it is called “Knightian uncertainty.”

Fed can’t fix broken economy, politics

The Federal Reserve’s decision to move to a kind of quantitative neutrality is a tacit admission that it, or rather that the United States, is in a political bind that makes a bold response to a deteriorating economy difficult.

Despite reams of evidence that conditions are worsening — much of it cited in the statement the Fed made as it left rates on hold — the U.S. central bank made only a token gesture; announcing that as mortgage-related debt it holds on its balance sheet comes to term and is repaid it will replace it  with new, mostly long-term, Treasuries.

That keeps its quantitative easing policy essentially static, a strategy dubbed “quantitative neutrality” by Northern Trust economist Asha Bangalore.

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