Wednesday, June 22, 2011


Today the FOMC announced the end of its incremental quantitative easing efforts. The Fed won't undertake a QE3, but it will keep in place—for now—the extra $1.6 trillion of reserves that it has supplied to the banking system via its purchases of Treasury and agency debt. There will be no tightening of monetary policy, and there will be no further easing: monetary policy will remain plenty easy as it is.

The market reacted to the news with what amounts to a yawn, which is good. 10-yr Treasury yields were unchanged on the day, after having declined some 60 bps since February; stocks fell marginally today, and are down only about 5% from their recent highs. The decline in Treasury yields and stock prices reflects a market that has soured on the economy's growth prospects, but not a market that is fearful that a Fed on hold—with interest rates close to zero—poses any significant threat.

The contrast between the two charts above underscores a reality that is not widely understood or appreciated. The Fed has injected a massive amount of bank reserves into the financial system, but this has not resulted in any unusual growth in the broad M2 money supply. The extra reserves have not been used by the banking system to make new loans, because banks have instead preferred to hold those extra reserves in order to bolster their balance sheets. Without any meaningful increase in the amount of money sloshing around the financial system, there is no meaningful risk that inflation will soar to frightening levels.

In short, although the numbers are theoretically terrifying ($1.5 trillion of extra bank reserves could potentially result in a doubling of the M2 money supply and a huge increase in inflation), the reality is that nothing much has happened.

That's not to say that nothing unseemly will happen, of course. It's quite troubling that the dollar is just about as weak as it has ever been, and $1500 gold is makes a powerful statement to the effect that the world is seriously worried about the future of the dollar.

But despite all the lingering bad news, it's reassuring to know that there is no shortage of important measures of economic health that are in good shape or materially improving. Corporate profits are very strong; the economy has created over 2 million private sector jobs since the recession low; swap spreads are very low; the implied volatility of equity options is only moderately elevated; the yield curve is very steep (thus ruling out any monetary policy threat to growth); commodity prices are very strong (thus ruling out any material slowdown in global demand); the US Congress is debating how much to cut spending, rather than how much to increase spending; oil prices are down one-third from their 2008 recession-provoking highs; exports are growing at strong double-digit rates; the number of people collecting unemployment insurance has dropped by 5 million since early 2010; federal revenues are growing at a 10% annual rate; households' net worth has risen by over $9 trillion in the past two years; and the level of swap and credit spreads shows no signs of being artificially depressed (thus virtually ruling out excessive optimism or Fed-induced asset price distortions).

When you put the latest concerns about the potential fallout from a Greek default (which is virtually assured and has been known and expected for months) against the backdrop of these positive and powerful fundamentals, the world doesn't look like a very scary place.


Benjamin Cole said...

I like to read this...but. Every time I read a "business is good" story, it is related to the trade-enhancing exchange rate of the US dollar.

Dr. Perry today as a story that Brazilians are boosting Miami real estate, armed with reals.

With QE2 gone, will the dollar appreciate?

Manufacturing and exports are one of the few strong points in the US economy, and maybe foreign capital flows into real estate.

I agree that banks have money to lend. Hedge funds are stuffed full. Private equity guys have nowhere to invest. Venture capitalists are wondering how to deploy their money.

Some say the Fed should stop paying interest on reserves. I am for that.

puffer said...

Scott -

What do you think the odds are that a Greek default spreads to other debt ridden countries such as Ireland, Portugal, Spain, Italy? Could we see a domino effect?

Scott Grannis said...

That's anybody's guess, of course. But I note that there has been a whole lot of speculation in this regard. If this is a serious risk, it is not going to come as a surprise to the market. Risk-averse people and institutions have had plenty of time to protect themselves against a Greek contagion effect. Meanwhile, assume a radical 50% haircut on PIGS debt as a result of a default, and the losses would be roughly $400 billion, which is only a small fraction of Eurozone GDP. The PIGS debt tail is not likely to seriously wag the global GDP dog.

Public Library said...

Some suggest QE2 actually went to foreign banks to shore up their balance sheets hence the lack of monetary growth in the US.

It is foolish to think the amount and diversity of governmental action around the globe will not have major ramifications down the road...

OzWarren said...

Could you please confirm statistic that households' net worth has risen by $9 TRILLION over past 2 years.

Scott Grannis said...

That is correct, and the data comes from the Federal Reserve. See a chart here:

TradingStrategyLetter - Weekly Summary said...

Inflate or die!

Jeff said...

OK, things look good. All your charts agree.

But then why is everyone still so scared? And what happens when all those excess reserves enter the system? At some point with the economy improving, those 'excess' reserves will no longer be needed as excess and will enter the system with a multiplier effect. Would M2 really double? What happens then?

Oh, maybe that's why everyone is so scared.