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.