MacroScope

In QE3 waltz, Fed again steps toward easing

May 17, 2012

On again, off again. That’s been the story with prospects for another round of monetary stimulus from the Federal Reserve. Expectations for a third installment of quantitative easing, the much-debated QE3, had ebbed with improving economic data in the first quarter – but are now flowing anew.

Following a weak employment report for last month, the latest hint that more bond buys could be in the offing came from minutes of the central bank’s April meeting, which saw the Fed leave rates near zero and repeat that it would likely hold them there until at least late 2014. Policymakers appeared to be taking an increasingly dim view of economic prospects given an array of looming threats to growth, even if none are particularly new.

According to the minutes:

Participants identified several downside risks to the projected pace of economic expansion, including the fiscal and financial strains in the euro area and the possibility of an abrupt fiscal consolidation in the United States.

To Millan Mulraine at TD Securities, the more negative tone suggested a modestly greater inclination to lean in the direction of easing. In particular, Mulraine singles out this sentence in the minutes:

Several members indicated that additional monetary policy accommodation could be necessary if the economic recovery lost momentum or the downside risks to the forecast became great enough.

Writes Mulraine:

Interestingly, while the former condition was also considered to be a threshold for more stimulus, the wording of the second condition suggests that the line in the sand for action may be the need to mitigate the contagion risks from Europe, and may no longer require the realization of the downside risk as a trigger for action. That is, the Fed may be willing to take further action to insulate the economy from the risks if the probability of a disorderly outcome in Europe increases sufficiently. We see this as somewhat more dovish.

For now, markets will have to keep on dancin’.

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Last week, the Brits reached the same conclusion I did a year ago: that we’ve reached the point of diminishing returns with QE. The pain from QE-motivated inflation is as damaging as the benefit from stocks rising (wealth effect?)

Hence: There should not be a QE3.

What happens when Operation Twist ends in June 2012? Will Ben launch QE3 during this year’s Jackson Hole conference? I sincerely hope not.

In this country, the central bank (The Federal Reserve) has a dual mandate (since 1978):

full employment
stable prices (read as low inflation)

That’s a short list. Conspicuously absent from that list is a mandate to:

-encourage speculation,
-drive the stock market higher,
-punish investors reliant upon income or that are otherwise unwilling to place a large portion of their life savings in the Vegas-like machine that is the US stock market,
- foment international unrest from a drop in value of the US dollar.

It is true that QE1 played a very significant role in stopping an economic collapse in 2009, and that it spurred another sugar-rush unsustainable stock market rally (is that what prosperity is?). But there was no free lunch. QE1 managed to reverse the deflationary forces taking hold of the economy, but it also significantly debased the value of the US dollar. This in turn meant the most significant export of the United States became inflation.

QE2 took over where QE1 left off:

-another risk-on unsustainable purely speculative stock market rally,
-high quality bonds lost value again (penalizing those that were defensive and conservative),
-interest rates rose on consumer loans and mortgages,
-food and fuel inflation spiked in the US and globally. In no small part, QE2 helped induce the “Arab Spring”.

Launching QE3 might provide yet another sugar-rush stock market rally (though probably smaller). But whatever the perceived gain might be, it would be counter-balanced by the detrimental effects of heightened food and fuel inflation, and higher interest rates courtesy of foreign buyers of US Treasury bonds balking at our printing press efforts. Surely the point of diminishing returns was reached with QE2.

Conventional monetary policy tools seem to have worked in rectifying previous recessions. A case could potentially be made to launch QE3 if it were obvious we were in a classic business cycle recession and that one more dose of monetary steroids might cure the ailment (not merely mask the symptoms). But it is clear we were not (2007-2009) and are not now in a business cycle recession. Rather, we have been and are in a much more challenging type of recession: a balance sheet recession. The best that can be hoped from monetary policy tools in a balance sheet recession is they act as an expensive snooze button. The systemic economic issues don’t go away. They merely wait to be addressed. But the cost of the most recent monetary policy tools (QE1 & QE2) are such that they’ve added to the systemic problem by increasing our public debt. It turns out you can’t solve a debt problem with more debt.

Let’s briefly look at what joint myopic monetary and fiscal policy intrusion has delivered over the past 12 years:

A recession in year 2000. 18 years of overspending and irresponsible myopic fiscal policy was beginning to take a toll. Arguably, we should have taken our medicine then. But no. Monetary and fiscal steroids were the prescription. The S&P500 lost 47% as demand collapsed. The Fed dropped short term rates to 1% in response. The US Congress & White House gave us unfunded tax cuts for a decade and introduced a massive new unfunded healthcare liability (medicare part D). The result was predictable: an artificial bubble in risk and leveraged assets (the stock market, the housing market). A colossal mis-allocation of resources and waste of several years. The problem was made larger and delayed for someone else to deal with (kick the can).

A recession recurred in 2008-2009 when the eventual housing and stock market bubble burst. The S&P500 lost 57%. This time it took 0% interest rates, QE1, QE2, $ Trillions in US bailouts and Keynesian fiscal policy stimulus (spending beyond our means), and a stream of sovereign bailouts in Europe that remains unresolved. The snooze button again.

Another US recession will likely begin in mid 2012 (June?). Early 2012 sees the S&P500 all the way back up to where it was 12 – 13 years ago. Worse, there is a very good chance stock markets will fall through the March 2009 lows. Why shouldn’t they ? Are the economic prospects that much better than they were 4 years ago?
There should not be a QE3 or any other monetary policy intrusion. Our three decade debt binge needs to be worked off. This position necessarily means the US and most world economies will head into the worst recession since the 1930s. But more monetary policy tricks will only add to the problem.

The last time we saw a balance sheet recession was the 1930s. We know what came next: WWII. Let us try to avoid the same mistakes. Ben, avoiding WWIII may not be part of the Fed’s mandate. But it should be.

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