Tuesday, October 26, 2010

QE2 is not only unnecessary but foolish (cont.)

As next week's FOMC meeting approaches and estimates of the size of Fed asset purchases range from $1 trillion to many trillion, I want to reiterate my view that another round of quantitative easing—regardless of size—is unnecessary and foolish.

QE2 would only be justified and warranted if deflation were a serious risk and/or the economy were displaying obvious signs of a liquidity shortage or liquidity crisis. Neither is the case today, and I offer the following as evidence:


The most recent measures of inflation are all positive. Over the most recent 12 months, the core CPI is up 0.8%; the CPI is up 1.3%; the PCE deflator is up 1.5%; and the PCE core deflator is up 1.4%. Over shorter time intervals none show any significant deceleration. (In any event, the CPI is the last place you would expect to find evidence of rising inflation.) The Producer Price Index is rising at a rate clearly above zero. Producer prices represent inflation pressures in the early stages of the inflation "pipeline." The PPI crude index is up 20% in the past year, while the PPI intermediate index is up almost 6% in the past year. As prices rise beginning at the early stages of production, they eventually get passed on to consumers. For example, we've recently heard from General Mills that they plan to raise cereal prices, which is in part a response to the 50% increase in wheat prices over the past four months. Price hikes such as this, and others announced by Starbucks, MacDonald's, Kimberley Clark and Goodyear, will almost certainly find their way into the CPI. (HT: Larry Kudlow)


Gold and non-energy industrial commodity prices are in a headlong dash to higher price levels. We haven't seen such widespread and powerful inflation at the commodity level since the inflationary 1970s. To think that prices of a broad range of industrial commodities can double or triple without having any positive or significant contribution to the general price level is beyond foolish. Gold is the most monetary of all commodities, and it typically leads. Gold is telling us that we haven't seen the end of the current rally in commodity prices.


The dollar is declining against almost all currencies, and is at or close to its all-time lows, both in nominal and real terms. When the dollar loses its purchasing power against gold, most commodities, and most currencies, that is about as close as you can get to a guarantee that it will lose its value against just about everything, on average, and that is the most fundamental definition of inflation that I know. The dollar is weak because the Fed is pumping out more dollars than the world wants; another QE2 will only make the dollar weaker by creating still more unwanted dollars. It is inconceivable that the dollar can fall further without at some point triggering higher prices throughout the economy.


All measures of money are growing at significantly positive rates. Over the past 6 months, M1 is up at a 10.4% annualized rate; M2 is up at a 6.5% annualized rate; MZM is up at a 7.3% annualized rate; and currency in circulation is up at a 6.6% annualized rate. The nominal increase in M2 since the onset of the financial crisis in Sep. '08 is a whopping $945 billion; currency in circulation has surged by $128 billion; and required reserves for U.S. banks have expanded by over 50%. This adds up to solid evidence that some portion of the $1 trillion that the FOMC has pumped into the banking system is being used to create new deposits and loans.

As evidence that there is no liquidity crisis, I offer my previous post which details the dramatic improvement in swap and credit spreads. Swap spreads are so low, in fact, that they virtually rule out even the hint of a concern about the health of our financial markets. As evidence that not only are deflationary expectations nonexistent but that inflation expectations are now rising, I offer my earlier post on how TIPS and Treasuries are priced to rising inflation.

The Fed has been very vocal on the subject of QE2, and that probably means that they are preparing the ground for a QE2 announcement which is almost universally expected to come next week. But the Fed governors are not unanimously behind QE2. Fed Governor Hoenig yesterday said that more quantitative easing would be a "dangerous gamble." Fed Governor Fisher last week said that the "Fed is not committed to further asset purchases," and that the "debate on possible easing may not be completed in November."

There is no need for any QE2, and certainly no need for trillions more of asset purchases. Therefore, I think there is a strong case to be made for a QE2 announcement next week that "disappoints." Why couldn't the Fed announce a token QE2 (e.g., a hundred billion in installments) to reinforce the fact that they are committed to avoiding deflation, but also unwilling to provoke too much inflation? While such an announcement would seem likely to result in an equity selloff, I would view it as very good news from a long-term perspective, and thus an excellent buying opportunity. If the Fed does the right thing, that can never be bad. Downplaying the risk of deflation and the need for a massive QE2 would also send a strong message of badly-needed optimism.

UPDATE: Art Laffer, in a letter to clients today, points out that the Bernanke Fed has suffered an unprecedented level of dissension. "Of the 32 FOMC policy decisions under Greenspan's watch, there were three that received a dissenting vote ... under Bernanke's stewardship, 19 of 42 FOMC policy decisions have faced a dissenting vote, with 21 total votes against." Moreover, quite a few of the FOMC Governors and regional Fed Presidents have questioned the benefit of, actively criticized, or pointed out potential negative consequences of further quantitative easing: Fisher, Hoenig, Kocherlakota, Lacker, Plosser, Warsh, and even the perennially dovish Yellen. In short, there is good reason to suspect that the FOMC decision next week may fall short of market expectations. The market may view that as bearish for the economy, but I would view it as ultimately bullish. Too much monetary ease is not something we need or should be hoping for at this juncture.

13 comments:

John said...

Scott,

Your points are well made. However, the Fed has a mandate given it by law to promote 'full employment' as well as price stability. The Fed is a political 'creature of Congress' as Alan Greenspan has said. We have nearly double digit unemployment. The political reality is that the Fed MUST address that issue.

I have said I do not know if it is necessary or not...but I have great respect for your position...I just think that (maybe unfortunatly) the reality is that politics will decide this. Not economics.

Scott Grannis said...

John: the Fed's full employment mandate is a perennial source of problems, since it is not clear how changes in monetary policy can create jobs. Bad monetary policy can certainly destroy jobs, that we know, since every post-war recession has been caused by a severe tightening of monetary policy. But to create jobs by lowering interest rates on Treasuries or by buying various and sundry assets? That is not obvious at all. Jobs and prosperity are created by the private sector, by risk-takers, and by hard work.

If printing money could create jobs, Argentina would have the biggest economy in the world.

But you are right that the Fed feels under political pressure to do something. That's very unfortunate, but it doesn't justify their actions for one second.

The stronger the political case for QE2, the stronger the case for higher inflation. Very unfortunate.

W.E. Heasley said...

Lacker of the Richmond Federal Reserve is arguing against additional QE but he is not a voting member of the FMOC this year.

JDTapp said...

Higher NGDP growth should be the goal. Given all of these asset prices are factoring in expected massive Fed purchases they will definitely fall if the Fed "disappoints." But I almost agree with you at this point.
I'd rather the Fed overshoot and have to correct later rather than miss the mark as it has since 2008 and in allowing inflation expectations to fall over the course of this year. The Fed needs to put the (Krugman's) "liquidity trap" notion out of its misery once and for all.

Family Man said...

Scott,

Re: real USD value. Calculating USDJPY rate in real terms (CPI in US vs CPI in Japan) the USD to get to previous lows should reach ca 75, so 8% lower then now. I don't know that value for a USD index, but it for sure would be lower.

Bubba1 said...

I am a newer small business owner of a restaurant/pub. More importantly to me, I am in the real estate business as I bought this highly visible property on which the restaurant sits, and where the immediate area recently had a local announcement that makes the property even more valuable, at a major discount from a bank REO with no financing.The reason I got such a good deal was because of being able to negotiate with cash. The property's current worth is in the 1 million range.

With rates as low as they are most investors would agree it to be a palpaple strategy to pull some credit out. How much do you think the banks are willing to lend on a loan to value ratio?? Zero. They won't touch me even though my "new" business has been cash flow positive from month one.

In addition to this, I have a primary house worth over 5ooK with no mortgage. The banks won't touch me for even a 100k mortgage. Why? My business is too "new". As one banker said, "You can have 3 million in liquid assets, it still won't matter because your new self employment is considered too risky".

These are the same people that just a few years ago were lending 110% L to V with no doc. My point is obvious. Like Scott has said, the Fed can lower to zero, if the banks aren't lending what does it matter.

I have a solid balance sheet with an outstanding credit history, where a bank could lend %20 L to V. A low risk loan by many calculations.

One other point switching topics. My food, liquor, beer and other costs have done nothing but gone up in the eight months of running this restaurant/pub. Deflation??

Charles said...

The best approach for the fed would be - as you say - to put mechanisms in place to do QE and to make it absolutely clear as to what would trigger these actions and what would shut them down.

My concern is that the fed will not tighten when inflation targets hit 2% with unemployment at 17%. Nor will they tighten at 3%. Or 4%.

This is the issue with NGDP targeting or price level targeting. The political pressures go in one direction only.

As you document, there is no deflation. The European crisis last spring caused a sudden rush to the dollar and a temporary easing of inflationary pressures. There are two factors that continue to delay the flow of commodity price increases into the core CPI. The first is asset deflation and the second is the horrific job market, which is the direct result of job-killing government policies.

marmico said...

the horrific job market, which is the direct result of job-killing government policies.

What are ya, a conservative teapot? As John points out the Fed has a dual mandate and Grannis is silent on the duality.

As you are no doubt aware Charles, while Bush43 was in office private sector payrolls declined. Eight years and 675000 private job losses. That tidbit of data is just stunning. You could look it up.

Grannis' opinion on QE2 is just that. An opinion. Who cares? I don't. But I noticed that he has now graduated to name dropping. LOL

Greenspan was an autocrat. Bernanke is collegial. Something about Greenspan's missing doctoral dissertation.

Family Man said...

Scott,

Mkt is already telling your story on FED under/no QE2 delivery.
HYG is stable while gov bonds falling, mining sector in EU topping.
Different assets price action predicts this for some time.
Thanks for perfect hint.

Scott Grannis said...

FM: What a pleasant surprise! I didn't expect to be proven right so quickly.

Scott Grannis said...

FM: Re dollar/yen. According to my calculations and estimates, dollar/yen would have to fall to something less than 70 to be as weak as it was in 1995. The real dollar I'm referring to is the one the Fed puts out. (Real Broad Dollar Index)

Smoky Mountain Hiker said...

Scott - first off, you have an oustanding blog - thank you!

I was wondering if there was anyway that you could produce a chart that compares industrial commodity prices and gold to that of the CPI - going back to 1970?

I would love to see the relationship between the three measurements to see what's in store for us - mainly, how severe inflation will be and how far out into the future we can expect it.

Maybe this analysis doesn't make sense, so I'll leave that judgement up to you.

Jeff

Scott Grannis said...

Smoky: Thanks. As for your request, it is not very easy to respond. Gold and commodity prices rose significantly more than inflation in the 1970s, and the same is true today. But the situation back then was compounded by Nixon's decision to take the dollar off the gold standard. That resulted in a dollar collapse that rocked the world and destroyed confidence in the dollar, thus boosting inflation. We have not had a similar dollar shock today, fortunately, and that leads me to hope/expect that inflation will not be as severe in coming years as it was in the 1970s.