Tuesday, August 9, 2011

Why we don't need a QE3

Today the FOMC is meeting, and because the world's equity markets suffered a near-meltdown yesterday, all eyes are on the Fed. Will they come to the rescue with another round of quantitative easing? I sure hope not.

With the benefit of hindsight, Quantitative Easing, as practiced by the Fed in late 2008 and from Oct. '10 through Mar. '11, was justified since at the time it helped satisfy the world's intense demand for highly liquid, dollar-based safety. A failure to satisfy a surge in the demand for dollars would have been deflationary, since it would have resulted in a shortage of dollars. The need for more dollar-based liquidity can be seen in certain market-based indicators prior to each round of quantitative easing.


The above chart is arguably the best measure of the value of the dollar relative to our trading partners, since it adjusts the dollar's nominal value for changes in relative inflation. As it shows, the dollar rose prior to the onset of each round of Quantitative Easing, signaling that the world's demand for dollars was exceeding the Fed's willingness to supply dollars. Following each round of QE, the dollar's value fell, which in turn suggests that the Fed ended up over-supplying dollars to the world. Unfortunately, the dollar is now at its lowest level ever. There is no sign now of any shortage of dollars or unsatisfied demand for dollar liquidity. Just the opposite: the world is awash in dollars. More dollars would only depress its value further, resulting in rising inflation.


This chart shows the market's forward-looking inflation expectations, and is derived from the yields on 5-yr TIPS and 5-yr Treasuries. First, recall that 1997 was the year that S.E. Asian currencies plunged against the dollar. Huge devaluations created an intense demand for dollars at the time, but the Fed ignored this and remained in a tightening mode through early 2001. Inflation expectations plunged as a growing scarcity of dollars led to a very strong dollar in early 2002 and eventually to the U.S. economy's flirtation with deflation in 2002-2003. Second, note that QE1 and QE2 both came at a time when inflation expectations were falling, a sign that the Fed needed to respond to an emerging scarcity of dollars. Today, however, inflation expectations are rising, and that argues strongly against another round of quantitative easing.


This next chart just makes the point again. Not only were sensitive market-based indicators signaling the need for quantitative easing, core inflation measure were also. The core CPI suffered some significant declines in the months preceding the onset of each round of quantitative easing. Currently, however, most measures of inflation are rising, and that argues strongly against another round of quantitative easing.

There is a common thread to most of the world's economic and financial problems these days, and that is excessive government intervention in markets and excessive government spending financed by debt. Decades of policies designed to make housing more affordable gave us the housing bubble, and policies and government subsidies geared to make it easier for people to get mortgages gave us the subprime mortgage crisis. Together, they almost brought down the global banking system. Generous government pensions and early retirement have bankrupted Greece, and our own social security and medicare systems are critically under-funded thanks to politicians' inability to resist the urge to increase benefits without regard for costs or the discipline of free-market price mechanisms.

It's time for policymakers to take a deep breath, step back, and let markets sort things out for a change. No matter how smart they may be, technocrats can't match the collective wisdom of free markets. Please, no more quantitative easing, no more extensions of unemployment benefits, no more taxes, no more regulations, no more mandates, no more stimulus. Victor Davis Hanson explains this more eloquently than I can:

We are witnessing a widespread crisis of faith in our progressive guardians of the last 30 years. ... We are living in one of the most unstable — and exciting — periods in recent memory, as much of the received wisdom of the last 30 years is being turned upside down. In large part the present reset age arises because our political and cultural leaders exercised influence that by any rational standard they had never earned.

If the Fed screws up enough courage to take a pass on QE3 today, I for one will breath a huge sigh of relief.

UPDATE: Following its meeting, the FOMC's statement noted that the economy had weakened considerably, but refrained from announcing another quantitative easing program. Instead, the statement said that it likely would keep short-term interest rates "at exceptionally low levels ... at least through mid-2013." Markets are reacting with apparent disappointment (yields down and equity prices down, both reflecting weaker growth expectations), but it's not unusual for the market's initial reaction to a monetary disappointment to be wrong. The market was hoping for additional easing, and so is disappointed by the lack of a QE3. In my view, no additional easing is good news for the dollar, and that in turn is likely to prove good for the economy.

15 comments:

TradingStrategyLetter - Weekly Summary said...

Should the shell game masterminding continue - and the US loses it's prized and privledged reserve currency status - look for the DJIA to open at long term support at 1,000!

Dr William J McKibbin said...

I have been advocating for monetary expansion for several years -- however, as I sit here right now, I see new opportunities emerging economically for the US that are compelling -- the truth is that a QE3 would take months to ramp up, and would be "too little, too late" to repair the damage already done to the Federal Reserve and US government's credibility -- what is needed now is neither austerity nor default per se, but rather, the US Treasury should restore order by immediately releasing a supplemental form of currency in the form of "red" US Treasury Gold Certificates, and "blue" US Treasury Silver Certificates -- these new currencies would be released by the US Treasury rather than the US Federal Reserve -- the "green" US Federal Reserve Notes would continue to be legal tender in the US, and those who are paid entitlements, pensions, or salaries by the US government would continue to be paid in "green" Federal Reserve Notes -- moreover, all sales, employment, and services contracts promulgated and denominated in US dollars would continue to be enforceable as written in US Federal Reserve Notes -- however, equities (which are transparent) would be instantly marked-to-market (by the buyers and the market) in the new US Treasury Gold and Silver Certificates, which would be circulated electronically internationally -- these new "red" and "blue" US Treasury Certificates would also be tradable internationally against other gold and silver backed currencies that are likely to emerge in the near term -- if the US does not take such action to create a new gold and silver backed currency issued by the US Treasury, then the US will be left out of the new and emerging world order that will be based on various gold and silver backed currencies that are now being formulated by global banking leaders -- we live in interesting times -- those with high quality dividend and rent-paying equities, as well as certifiable skills, will do well -- those who own nothing of value or lack world-class skills are destined for hard times -- well, this is my view at least based on what I am seeing in the markets -- the US cannot go back to the past at this point -- it's simply too late for a QE3 as our nation endures an emerging monetary depression...

Benjamin said...

"With the benefit of hindsight, Quantitative Easing, as practiced by the Fed in late 2008 and from Oct. '10 through Mar. '11, was justified since at the time it helped satisfy the world's intense demand for highly liquid, dollar-based safety. A failure to satisfy a surge in the demand for dollars would have been deflationary, since it would have resulted in a shortage of dollars."--Scott Grannis.

Okay. And now you are against QE3?

I must say I am bewildered at my conservative friends, and their extremely acute concerns about inflation--they are obsessing over minute rates of inflation while our economy struggles.

We will see headline deflation in coming months, and core will drop below 1 percent.

Now is not the time to worry about inflation or Soviet bombers.

Times change.

Benjamin said...
This comment has been removed by the author.
Benjamin said...

BTW.

According to the BLS, the CPI-All Urban Consumers was at 225.722 in June 2011. It stood at 219.964 on July 2008.

Let's get scared. That is a 2.62 percent increase in just three years.

Really this is less than one percent a year, well under any reasonable target. One might even say inflation is dead.

Why are my right-wing friends so hysterical about inflation?

TradingStrategyLetter - Weekly Summary said...

The Fed is petrified of any tick up in interest rates.(see recent Fed statement). It now looks like we have moved into a 'fixed' interest rate environment and are starting to look like Argentina in the 70's and 80's. Higher inflation rates will quickly move rates higher. This is classic catch 22 stuff. With loads of debt the second worse scenario is indeed a deflationary environment. The worst scenario almost always (especially in this case) is an inflationary environment.

Benjamin said...

You can cry Argentina, but you are only one ocean off--cry Japan instead.

Inflation is dead. Real estate is dead. Equities are dead. People give money to the US government for nothing.

I have just described Japan.

TradingStrategyLetter - Weekly Summary said...

A move to reflate and/or recklessly relate will not be recieved well abroad and probably the eventual loss of reserve currency status. At minimum it sends a horrible message to the emerging juristictions.
Should that tragically happen have plenty of dry goods and ammunition!
I got a bad feeling this ain't gonna end nice either way!

Christian S. Herzeca, Esq. said...

if i were a bank ceo and you told me that i could count on (not just expect) <.25% deposits for the next two years, i would be stunned (in a nice way)...

TradingStrategyLetter - Weekly Summary said...

...only if you were too big to fail!

The Roller said...

You cannot remedy an insolvent debt problem with more debt, or restructured debt.

You can only remedy a debt insolvency with more income. There is no other way.

There is only one policy to address our national debt, and that single policy is to create a fiscal context for 'Growth' that our monetay policy can align behind to support.

So, when policy makers start talking about 'austerity' as a policy to address excess debt, or to justify an increase or restructuring of borrowing, I know that the policy has no chance of working. Austerity is the default condition caused by the failure to create a context for Growth.

The big take away from the down grade now is that the likelihood of a near term tax increase to address the down grade just went up. The market response where odds of a near term tax incrase go up, is to sell off equities and buy bonds.


The biggest maleducated elitist idiot in all of this appears to be our President.

Until somebody in Europe, China or the US starts to talk about growth, this will get uglier and uglier.

The Roller said...

The best thing that happened with today's bounce is our President did not speak.

William said...

Just a brilliant analysis of the economic situation! Looks like the Federal Reserve gets it.

William

Scott Grannis said...

Christian: excellent comment, and it is no surprise that bank stocks surged today. Anyone with access to money at close to the Fed funds rate is going to enjoy a bonanza until, of course, the Fed has to tighten to counteract rising inflation.

TradingStrategyLetter - Weekly Summary said...

Of course the 'bank stocks will surge' when you guantee that the tax payer will provide you with free inventory for two more years! How long will this abuse continue?