What is the significance of QE2? I would argue that it is not the $600 billion of additional treasuries the Fed has committed to buying. After all, this quantity is less than 1/2 the size of QE1, and many people would argue that action had little real effect on the economy. The significance lies in the signal being sent. The true significance of the move lies in the signal the Fed is making: they are committed to taking action to prevent a deflationary outcome, and their responses will not be limited by traditional measures. It reminds me a little bit of my friend in middle school who wanted a reputation of being “crazy” so that bullies wouldn’t pick on him: he would smash his hand into lockers and generally inflict a great deal of pain on himself and pretty soon sure enough people said he was crazy and was liable to do anything. And you know what, the bullies left him alone!
Animal Spirits and Perception of Value
Say what you will about Keynes, his idea of animal spirits has merit. The question is – does quantitative easing really threaten the value of the currency? If the answer is yes, then money velocity in the US will increase as the desire to hold the currency decreases. However, even if the answer is no, but the perception is yes, than the same thing will happen. Astute market participants observe that the bottom line in this crisis has been the real estate market, and that this dynamic will keep the velocity of money down. They cite the hoarding of cash by banks, big business and the continued accumulation of foreign exchange reserves by export countries. Just as in 2006 it was hard to imagine housing prices going down, it is now equally hard to imagine them going up in a sustainable manner. However, this dynamic of hoarding can turn on a dime. As soon as general perception of risk shifts to a currency risk, real money holders will quickly transfer into real assets. As one of those real assets, real estate could rally in nominal terms, erasing the balance sheet losses for banks, which would then further increase the velocity of money.
Does the Fed intend for a weaker dollar? Looking at official rhetoric, there has been an increased targeting of export surplus countries as a tax on global growth and the source of global imbalances. While the Federal Reserve won’t come right out and say that the dollar is too strong compared to the Yuan, their actions speak louder than words. If the Chinese want to insist on a devalued Yuan, the Federal Reserve seems to be saying they can just as easily insist on more and more accommodative policy.
Back to the Future
Let’s take a trip back in time. The date is July, 2008 - crude oil is $140 and rising. CPI is 5.6%, and everybody is worried about inflation.
Figure 1: CPI – 2005 through July 2008 averaged nearly 4% and seemed to be accelerating. Data: BLS
How soon we forget. In July, 2008 there were voices out there arguing for deflation – but how credible were they? At the time, they didn’t seem very credible, and yet everyone remembers the outcome of the second half of 2008. Now we have moved into an opposite position – it seems like we’ll never get out of recession and deflation appears to grip the land. The sad truth is that humans are often limited in our ability to imagine the future by what we see in the present. Right now, all we see is deflation and recession and so that is all we can imagine in the future. But just as crisis and deflationary forces shook our consciousness in 2008, now a different kind of crisis and inflationary crisis may shake our consciousness now.
Precursors to change – Fed minutes and silver/gold ratio
In July 2008, there was no way to predict the financial maelstrom that was about to hit. Or was there? Perhaps there were a couple of clues that the landscape was about to shift. First, the Fed language in the June 2008 meeting had been quite hawkish, which was surprising given that economic fundamentals appeared to be weakening:
“The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.
Recent information indicates that overall economic activity continues to expand, partly reflecting some firming in household spending. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and the rise in energy prices are likely to weigh on economic growth over the next few quarters.
The Committee expects inflation to moderate later this year and next year. However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high.
The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time. Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.”
In spite of deteriorating economic fundamentals, the FOMC kept their rates at 2% and prominently mentioned the upside risks of inflation and inflationary expectations. I would argue that the analogous statement in the current environment is the last FOMC meeting, where the participants stressed the risks of deflation and announced a 0 billion dollar bond purchase.
The second marker is the silver/gold ratio. In 2008, it led the markets lower by more than a month. The silver/gold ratio started to collapse in early August of 2008, while the fireworks in the stock market didn’t come until the end of September and early October.
Figure 2: Silver/Gold ratio had its largest fall between August and October, well before the stock market fell.
This time around, the silver/gold ratio has led to the upside, accelerating its breakout after the Fed meeting last week:
Figure 3: Silver/Gold ratio started higher two weeks before stock indexes in August, 2010. Since the latest FOMC meeting, the ratio has accelerated to the upside.
What is the Fed Saying?
Sometimes the truth is just as simple as it appears. In this case, the Fed has announced that it wants more inflation for the first time in its 100 year history. For those of us who believe that the Fed is not powerless, this should be a notable occasion. In this case, all of the negative economic data, bank balance sheets, sovereign credit risks, lack of consumer demand, etc. are the trees, and the Fed’s intention to create inflation is the trees. Although this experiment will almost surely end badly, for now we have to accept the Fed at its words and assume that inflation is the most likely scenario.