QE3 - An Exercise in Futility
On February 2, 2011, Bloomberg News anchor Andrea Catherwood asked Marc Faber, publisher of the Gloom, Boom & Doom Report, regarding what appears an abating European debt crisis, “Are we kidding ourselves to think it is over?” Marc Faber replied, “With monetary policy, you can postpone the time of crisis for quite some time. You can create a lot of inflation and hide the debt problem through inflation, but eventually it will come back.”
Later, when asked about the prospects of a long-term U.S. economic recovery, he said the U.S. is experiencing a “crack-up boom that is driven by ultra expansion in monetary policies” that is “not sustainable” and will be followed by a “setback”.
Federal Reserve Chairman Ben Bernanke, on March 1, 2011, testified during the first of the Fed’s two-day semiannual monetary policy report that the goals of QE2 are 1) to stabilize inflation at a long-run normal rate of about 2%, and 2) to see a sustainable recovery in jobs; and that over the next few months the Fed will be able to make a judgment as to whether the economy has enough momentum to move ahead on its own, and thus be able to ascertain the necessity of additional support from monetary policy.
In order to grasp the magnitude of the Fed’s upcoming decision on quantitative easing, we need to take a look back at where we have come from. Meredith Whitney, CEO Meredith Whitney Advisory Group LLC, said in a May 5, 2010, Bloomberg interview, “Sixty-five percent of all jobs created in the last 15 years were driven by small businesses enabled by massive growth in consumer credit. All (that) consumer credit was enabled by the securitization market, which is closed.”
Over the 15-year period between 1993 and 2008, 26 million jobs were created. We can extrapolate, then, from Whitney’s data that about 17 million jobs were created as a result of securitization-enabled credit expansion. Since February 2009, the U.S. economy has lost a net 2 million jobs. So unless the economy is in a position to produce real output in a way that supports the remaining 15 million jobs – reflected by an additional minimum 125,000 jobs per month and an unemployment rate headed toward 5~6%, absent QE injections – then we should expect further net job losses over the next few years. So if the Fed’s deliberation horizon on additional monetary-policy support is just “over the next few months”, then we should position ourselves for QE3.
Judging by the way Chairman Bernanke “turned on a dime” in the summer of 2010 when in June the Fed halted purchases of mortgage-backed securities and Treasury notes (QE1) on an improved economic outlook only to launch QE2 the following August on disappointing economic performance, then, based on established behavior and a bleak outlook for the second half of 2011, QE3 could be launched around August, which is shortly after the June conclusion of the Fed’s $600-billion long-bond purchase plan.
The Federal Reserve Banks are the world’s single-largest holder of Treasury securities at $1.29 trillion. Other domestic investors account for about $3.28 trillion; and foreign investors hold about $4.43 trillion. In light of an already bloated Fed balance sheet; rising oil, wheat and other commodity prices blamed on the inflationary effects of easy money; and worldwide political and economic destabilization incited by rising food prices, if the Fed determined U.S. economic growth is not sustainable without monetary support, would policymakers pursue quantitative easing despite the negative consequences? You bet.
As for addressing inflation, the Chairman believes the Fed has the tools to withdraw liquidity at any time, but I’d like us to take a look at some of the Fed policy tools one by one to consider their efficacy in taming inflation induced by rising commodity prices:
Fed-Funds Target Rate: The Fed can raise the Fed-funds target rate as a means of slowing economic activity, but commodity prices are based on global demand, not just U.S. demand. Commodity prices can remain high, as we are seeing, even in a weak economic environment. Notwithstanding, every quarter-point rise in the target rate on $9+ trillion in outstanding government debt adds $23 billion to the deficit, which would not only harm U.S. interests, but would spark a political firestorm;
Discount Rate: The Fed can raise the rate at which depository institutions borrow from the Fed as a way of slowing circulation, but again, when the time comes for me to fill up my car to get to work, how much the Fed charges Bank of America for a loan does not factor into my decision to buy gasoline; neither would it mean much to OPEC;
Reserve Requirements: The Fed can raise the reserve requirement as a means of draining liquidity, but people still need to buy clothing, much of which is made of cotton. The cost of securing cotton permeates throughout the apparel market – from the product maker to the retailer to the consumer – regardless of Fed monetary policy;
Interest on Excess Reserves (IOER): By increasing the interest rate paid on reserves, banks will be unwilling to supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at Federal Reserve Banks. Paying a higher IOER rate will restrict the circulation of money, but would have a negligible effect on the price of globally consumed commodities, such as wheat;
Term deposits: Similar to certificates of deposit, the Federal Reserve auctions the opportunity for banks to set aside fixed quantities of reserves at rates not to exceed the interest rate paid on reserves held at the Federal Reserve Banks. By buying term deposits, banks benefit by locking in longer-term interest earnings on excess reserves for a fixed period, and the Fed benefits by having those excess bank reserves taken out of circulation. But this has very little to do with the international consumption of corn.
So, it well appears Fed policy tools are powerless to restrain the inflationary effects of rising commodity prices. Still, with one policy tool and lending program after another, the Fed has firmly established itself as “THE” lender of last resort, filling in the gap torn open by an enormous withdrawal of liquidity. But as alluded to by Marc Faber, in the absence of sound economic growth, it’s just a matter of time before the Fed finds itself unable to continue propping up the economy with QE pillars of paper-(dollar)-mache now replacing the crumbled columns of 15-year credit expansion; or to stave off oncoming waves of consumer price increases (the likely “setback”) propelled by rising commodity prices (the Fed’s Achilles’ heal) driven by the rising supply of U.S. dollars via easy-money Fed policy, namely, quantitative easing – waves which are pounding away at the QE paper-mache pillars. “What goes around comes around.” Hence, QE3 would simply be an exercise in futility.
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