Thursday, August 25, 2011

Why Bernanke's Jackson Hole speech won't announce QE3

Fed Chairman Bernanke is due to speak tomorrow at the Fed's annual Jackson Hole conference. There has been lots of ink spilled about what he is likely to say, with many observers expecting him to either announce, or lay the foundation for, another round of Quantitative Easing or some other measure(s) designed to increase monetary stimulus of the economy. I think this would be a mistake.

The economy doesn't need more monetary stimulus, because what stimulus it has already received has done little to stimulate growth but more to stimulate inflation. Moreover, monetary stimulus is a very ineffective—if not useless—tool to stimulate economic growth. You can't manufacture jobs by printing money or making money artificially cheap; all you are likely to get is more speculation, more inflation, and possibly even a weaker economy in the end. Most importantly, however, there is no indication that the economy is starved for liquidity, as there has been prior to the first two rounds of quantitative easing.

As this first chart shows, the inflation-adjusted value of the dollar against a broad basket of currencies today is as low as it's ever been. This is prima facie evidence that dollars are in abundant supply relative to the demand for dollars. Supplying more dollars to the world by buying more Treasuries or by reducing the interest rate paid on bank reserves would only weaken the dollar further, and eventually that can only stimulate inflation. Note that the first two QE programs were begun at a time when the dollar had risen in value during times of financial stress, which is a good indications that dollars at the time were in short supply. There is a legitimate reason for easing monetary policy when the dollar faces conditions of scarcity. That's not the case today.

Gold has dropped almost 8% from its recent high, but in real terms and over many decades, it is still at very high levels, as this second chart shows. (Note also that gold's current uptrend began in 2001, only days after the Fed announced the first in what would prove to be a long and protracted series of eases.) The world is willing to pay a huge premium for gold for a variety of reasons, one of which is undoubtedly the great uncertainty that has been created already by the Fed's unprecedented efforts to provide monetary stimulus. More stimulus will only validate the gold market's fears, thus increasing uncertainty and speculation, and reducing the likelihood that the world's scarce resources will be directed to productive activities.

The Fed's easing efforts are traditionally confined to the front and middle part of the yield curve, because it can directly control short-term interest rates. Therefore, it is necessary to look at the various segments of the yield curve to see how the bond market is reacting to changes in Fed policy. This third chart compares the slope of the Treasury curve from 10 to 30 years with the inflation expectations embedded in the difference between nominal and real yields in the front part of the curve. These two tend to track each other, but not always. Regardless, comparing today's message with the message that prevailed in late August of last year, it is clear that inflation expectations have risen and the long end of the curve has steepened. Both of these developments are like flashing red lights that caution the Fed against further easing moves.

One of the Fed's primary justifications for quantitative easing has been to avoid the risk of deflation. As this fourth chart shows, inflation was indeed quite low at the time it instituted QE1 and QE2, but that is certainly not the case today. By all measures, inflation has moved higher in the past year. According to the PCE Core deflator, which is supposedly the Fed's preferred measure, inflation over the past 6 months was an annualized 2.1%, which is just above the Fed's 1-2% target range.

If anything is seriously wrong in the world that needs fixing, it is the problem of sovereign debt in the Eurozone, as this fifth chart suggests. Eurozone swap spreads are trading at very elevated levels, signaling that there is significant systemic risk in Europe, a high degree of perceived counterparty risk (further suggesting that the viability of the banking system is at stake), and the risk of a meaningful slowdown or Eurozone recession. In contrast, U.S. swap spreads are still at relatively benign levels. The problem is in Europe, not the U.S.

Bernanke should not risk the Fed's credibility tomorrow by proposing another round of monetary easing. The facts don't justify it, and the market is not particularly welcoming it either. Further easing would only damage the dollar and risk higher inflation. It's time that the Fed tried a little "tough love" instead of lower interest rates. They should let the world know that while they are concerned about all the world's problems, they don't feel that any further action on their part is justified. What's needed most at this time is less uncertainty and a stronger, not a weaker, dollar.


McKibbinUSA said...

Hi Scott, you said that "gold has dropped almost 8% from its recent high, but in real terms and over many decades, it is still at very high levels." Actually, the value of gold has not changed much since the late 1940's as gold purchased the same amount of crude oil then as today. Hence, gold values are not "high" per se. Rather, the value of the dollar is down -- way down -- about 95% since the late 1940's. Said another way, gold has held its value, the dollar has not. Moreover, the value of the dollar may even be artificially hight when one considers how many dollars are committed to reserve currency treasuries worldwide. If the dollar were to lose its reserve status globally, the value of the dollar would likely plummet another 95% overnight.

Sensible people need to accept that dollars are near worthless without the monetary gymastics of the Federal Reserve. Better to move aggressively out of dollar denominated investments, into investments that revalue transparently in global markets. Real property, commodities, and certified skills are the best way to combat the looming collapse of the US dollar, which is imminent...

Benjamin Cole said...

The Fed needs to get agressive--instead, we are being Japanned.

There is a growing group of conservative, Friedmanites calling for nominal GDP targeting. The Fed announces nominal GDP targets, and prints money to hit those targets. See Scott Sumner, David Beckworth, Marcus Nunes. See Friedman's advice to Japan in the 1990s.

Waiting for markets to liquify and clear and for wages to fall enough to bring up employment--well you can wait 20 years, and still have markets and wages going down, as in Japan. The monetary do-nothing policy is simply not advisable, and it can lead to perma-deflation-recession.

Inflation? Where? The Chicken Inflation Littles have been squawking about inflation for years, and the only asset they can point to is gold.

What about real estate? Natural gas? Unit labor costs? Eggs? Cotton?

Of course, there is inflation in some commodities--China and India are growing, and 2.5 billion consumers.

The worst thin we can do now is fight inflation, even as global demand pushes up demand for commodities.

Some people are ascetics, believe in asceticism--you have to suffer for some higher moral good.

Monetary ascetics believe we should all suffer to preserve the value of the dollar. We should suffer for years, decades, even generations if that preserves the value of the dollar. Preserving the value of the dollar is a moral code.

The value of the yen is great--but Japan is in the toilet, falling behind China and S Korea.
The do-nothing tight-money school does not offer valuable advice once we get to zero bound or very low interest rates.

Times change--sticking to shibboleths is not helpful.

John said...

"If anything is seriously wrong in the world that needs fixing, it is the problem of sovereign debt".

If Europe is such an economic basket case, then why is the Euro worth so much more than the US dollar?

TradingStrategyLetter - Weekly Summary said...

Chinese are big buyers of the Euro diversifying themselves out of the US dollar.

Scott Grannis said...

Saying that the euro is worth so much more than the dollar could be akin to damning with faint praise. The dollar is at its lowest level ever, and falling. Both the euro and the dollar has fallen hugely against gold.