QE2 could boost growth, but it will not

Below, I will spend some time explaining how the programme that the Fed will announce in a few hours could boost the U.S. economy, and why it will not do this.

With already more than two months since the Fed started talking about a new programme of money-printing (the economics word for it is quantitative easing, 2nd version, also: QE2), the list of opponents to QE2 is growing larger, and the list includes ever more renowed names. Examples: Volcker, Greenspan, Stiglitz, PIMCO's Gross, etc. All of them warn for medium- to long-term inflation dangers that will be a huge cost of the quantitative easing programme, whereas benefits are minor - that is, if they are there.

Nevertheless, the Fed will announce its QE2 programme today. Probably with monthly asset purchases of $100 billion, after each injection of cash reconsidering its next step dependent on the economy's progress. The Fed is hardly paying attention to the warnings, so it seems. Or actually, most members of the FOMC are 'not hearing evil, not seeing evil'. But yet, the Fed has never been so divided over what to do next. How come? The upcoming package of QE is unprecedented; there is no evidence of the effects of such programmes. All that Boom-Boom Bernanke is now seeing is that the Fed's dual mandate is out of sight. At least, when you look at the numbers superficially (more on that later). One mandate, an annual inflation rate between 1.7 and 2% is being missed. The other mandate, achieving close to full employment, is even further out of sight with a current unemployment rate of 9.6%, with risks of rising further as the government's austerity programme probably kicks in by 2011. Hence, the two targets are not being reached.

But there's more to this dual mandate. First of all, they are intertwined. The historically high current output gap that partly exists because firms are not hiring (thus, low employment), so capacity is not being used. This causes deflationary pressures. Get employment up, and inflation rises. Secondly, it is doubtfull that unemployment is cyclical and can be reduced by loose monetary policy (that is why it seems that the second target is being missed, but actually the mandate concerns cyclical employment as there is always some structural unemployment). As the U.S. economy is somewhat recovering, many people do not have the skills required by the sectors that are recovering, as they have been trained to work in sectors that are now declining. Looser monetary policy will do nothing to change this. Rather, retraining of workers, more flexible labour markets and changed legislation are needed. This argument has been advanced some speeches by Dallas Fed president Richard Fisher, who strongly opposes QE2.

So is the achievement of the dual mandate in the Fed's reach? Probably not, given current conditions.

However, the logic of Bernanke is the following (he, obviously, does think QE2 will help - somehwat): asset purchases lower interest rates, lower the cost of borrowing and create a wealth effect as firms and households see their balance sheets improve due to rising asset prices, whereas lower borrowing costs induce them to borrow more; hence, to spend more. This will create a domestic-demand-driven positive growth cycle. Companies will start to hire again once they see consumer spending restored.

But there are some crucial steps that need to be taken for this QE2 programme to succeed, which makes the plan weak. Some problems related to QE2:

• Interest rates are already very low. Even if the real interest rates get pushed down even lower, why would this now all of a sudden induce the consumer and business owner to start borrowing?
• Financial institutions are reluctant to lend. The normal transmission channel of monetary policy is broken. Lowering interest rates further does not automatically get credit in the economy up.
• As banks do not lend, they sit on a lot of cash that needs to go somewhere, so they invest it in higher-yielding (hence: riskier) assets. These high-risk yields get depressed as well, as can be seen already today, because of these capital flows into emerging market (EM) stocks and equities. This could lead to risks being significantly mispriced again, which was one of the causes of the recent crisis.
• It takes time to recover from a debt crisis. Consumers and firms took a blow as they saw their balance sheets destroyed. They are now reluctant to spend, and are seeking to deleverage. They just want to get rid of the debts! They do not want to invest; they want to save.
• Bernanke assumes that lower borrowing costs can get consumers/firms to borrow more (due to the substitution effect). However, lower borrowing costs imply lower returns from savings. Therefore, consumers/firms need to save even more to achieve the same return from their savings. It might well be that this income effect outweighs the substitution effect, by a lot. This is a big point. If it is true (I think it is), interest rates need to go up, not down, to get people to safe less.
• Following from the previous argument: As long as interest rates remain low, wealth gets shifted from consumers that save to financial institutions that borrow, whereas the consumers should be the ones to carry the recovery. Now they get deprived of returns to savings, whereas financial institutions that are actually doing pretty badly get to continue their operations. Higher interest rates would get less-efficient firms and financial institutions out of business. Keep borrowing costs low, and overall economic productivity stays low.
• Lastly, if the so-called 'wealth effect' is to take place, consumers/firms would have to genuinely believe in the restoration of their balance sheets from the increase in asset prices. If they think that higher asset prices are caused by the money-printing instead of asset prices rising from demand-supply forces, they will not start to borrow more againts their assets. In other words: if they think their houses etc. do not truly become worth more, they will also not lend against higher house prices, because they will foresee a new burst of the asset bubble.

And in the end, if these problems persist, and the Fed does not quickly undo the injection of money into the economy, inflation will be upon us.

This is a long list of negative effects and problems related to QE2. Monetary easing cannot lift the economy out of the doldrums. It is far too uncertain that QE2 will do any good, because of the hurdles discussed above, while the unintended consequences are possible enormous.

QE2 distracts people from the true problem, which is the unsustainable level of debts in 'advanced economies'. This problem should be recognised and attacked. However, given that the Fed proceeds with its nonsense QE2 programma, I hope the markets can get fooled. If not, QE2 will have no effect and the next (debt) crisis will be seriously damaging.

Demand and supply forces? How the Fed tries to fool us.

These are truly very interesting times to be an economist, or an intern that is supposed to keep track of basically everything that is going on today on the financial markets. Let alone in politics. Besides interesting, it is funny as well.

The famous quote goes: you can fool some of the people all of the time, and all people some of the time, but you cannot fool all of the people all of the time.

Personally, I really like the sarcasm of this quote by Abraham Lincoln, but that's not the point I want to make.

One of the people that can be fooled all of the time is Trichet. Or does he seriously believe that in is in the US' best interest to have a strong dollar, while everything the US are doing leads me to conclude that they rather want a weak dollar?

And then there are people that try to fool all of the people, all of the time. Or they are trying to fool themselves, all of the time. Choose either one you want.

Take DeLong. I did not agree with his articles stating that US Congress should spend more, even when Obama signed the huge fiscal stimulus bill in 2009, but that was more on philosophical grounds. In a current article of him at Project Syndicate (Economics for Parrots), he argues that economics is all about supply and demand. If there is a shortfall in demand, prices will drop. A shortfall in supply? Prices will rise. Current prices for government bonds are rising, so he concludes that it must be true that there is a shortage in supply of government bonds. Thus, the government should issue more debt. This is also what people are saying when they claim that the government should engage in further fiscal stimulus, since interest rates have never been this low.

However, an utmost important fact that DeLong (and others) are ignoring, is that the Fed is intervening heavily in the market for government bonds. It is the Fed that is exerting such enormous pressure on the Treasury market, that prices remain high (and interest rates low). (Additionally there is the uncertainty about the economic outlook that leads people to look for a safe haven.) If it is the Fed itself that is creating the superfluous demand, then one cannot conclude that for demand and supply factors, there is a shortage of supply of government bonds.

The Fed is thereby also trying to fool all of the people, all of the time. They wish to keep nominal interest rates low, while striving for higher inflation. They will likely aim for inflation somewhat above the current target of 2% by creating a price target. This is a paradox. If people believe both that nominal rates will remain depressed, but that inflation will rise during the coming years, nominal rates must go up. And probably more than just by the rate of expected inflation, because the risk premium that investors demand also rises on the fear of higher inflation than expected. Overall, the Fed will probably get more inflation than it wished for.

Except, of course, when it can fool all of the people, all of the time.

Note to "Bad news is good news"

No matter how strongly I believe that further quantitative easing will not help the U.S. economy move forwards, this does not mean the Fed will not engage in QE2, unfortunately. I believe they have gone down a road and now cannot turn back, because:

• Markets have priced in a large amount of possible further easing. Announcing no or only little QE2 will shock the markets, but in the wrong direction (stocks, gold and commodities will decline);
• The first round of QE helped (although back then loose monetary policy served the completely different purpose of providing liquidity to a system in need of liquidity);
• With fiscal policy offering little help, the Fed must do (rather: try to do) something (it's in their mandate);
• Future disadvantages to QE2 are far away, and very much unknown (unknown also are the benefits, but hey...), and;
• Bernanke is in favour of QE2, and so are most Fed members (and Krugman)

With this in mind, I think it is just much more likely the Fed will announce on 2-3 November a shocking package of purchases of government bonds and private assets.

Bad news is good news

The title of one of my previous blogs was 'No news is good news' and it mentioned the market's reaction to what was actually nothing new. The blog dates 20 September: just after the Fed's remarks that the economy showed no substantial signs of improvement and they would wait and see what would happen with economic growth in the coming months. Market sentiment was positive, although there was in fact nothing to be positive about: the outlook was just as bleak as before.

Today, the outlook is just as bleak, if not worse. However, the Fed is seriously contemplating QE2. Good for the stock markets and commodities and for these markets, a substantial amount of the by-markets-desired-$1trillion-at-least-of-QE2 has been discounted in market prices. A poor nonfarm payroll number last Friday made markets more confident that the Fed will give them 'their money' and subsequently, stock markets rallied. Hence, for the markets, "bad news is good news".

However, in a speech of Dallas Fed president Fisher, Fisher hinted at markets being overly confident about Fed starting a second round of quantitative easing. Payrolls are not expanding, because businesses as unwilling to hire as they experience too much uncertainty regarding future taxes and regulation, but they are aware of the fact that some day in the future, taxes will have to be raised to finance the huge government debt. In this environment, the Fed cannot do anything to bring down unemployment. If anything, they only contribute to more uncertainty and thus higher unemployment. So far for one goal of their dual mandate. More on inflation next time.

Moreover, liquidity is abundant and more liquidity is not needed. It helped in 2008 when the financial system was experiencing a lack of liquidity and the Fed had to step in to address this market failure. But now, only a very small amount of businesses find they are credit constraint, and probably the Fed cannot overcome this. They have done whatever they have to do. Now it's time for the Fed to get their hands off of it and let Congress, now matter how divided they are there, do its job.

FAQs part II

In my last blog I posed some questions for which we still don’t have a (more) definitive answer, except perhaps for the first question. With the Fed taking steps to quantitative easing 2.0 (albeit baby steps, since for now it has announced only to maintain the size of its balance sheet, and not let is shrink – indicated by the FOMC’s public statement last Tuesday), the markets are certainly not responding enthusiastic. More accurately: the past week has been a very hectic week for the financial markets. Worries about the recovery in the U.S. spread to more concerns about mainly the periphery of Europe. German export-led growth for now pulls the Eurozone ahead, but how long will that last? Quarterly growth was well above expected, but if countries importing German goods see their economies weaken, German growth will be unable to sustain itself. The ECB has indicated it will slowly move to exit strategies. Although problems in the periphery are still very concerning and dependence of banks in Portugal, Spain and Greece on ECB financing is increasing steadily.

The Fed, on the other hand, is much more willing to support the economy with an even looser monetary policy. Analysts and commentators alike are very pessimistic about the effectiveness of further quantitative easing. If it has not worked in the past, why would it work next time? Is there so much more the Fed can do? Well, actually, yes. But that is just in theory. Central banks worldwide are constrained by the whims of the market. Should a sudden worry for hyperinflation pop up, better beware! If central bankers do not respond quickly taking the money out of the system within a week or so, double-digit inflation may be the result.

But for now, the Fed is walking a very thin line between high inflation and deflation. Core inflation in the U.S. (excluding food and energy prices) is already in negative territory and should economic activity not pick up, negative annual core inflation is not unlikely. Of course, for a large part this is driven by the still declining housing prices. Nevertheless, deflation is a dangerous phenomenon and Ben Bernanke will do everything in its power to prevent it, but he has not indicated directly what he will do should the economy get even worse. If such measures are taken (the measures the Fed could possibly take are in an earlier blog of mine), however, the market will interpret this as a sign that the economy is doing really, really, really, really terrible. No need to explain here what that means. But on the other hand, when signs of the economy weaken, and the Fed does not respond, the markets will also react negatively.

My overall conclusion therefore is: whatever monetary policy does, it will not improve the matter much (the matter being the U.S. economy), and it is fiscal policy that should get things going again. But please not in the way fiscal policy has been used in previous U.S. fiscal stimulus packages. Let’s look at China; they really set a good example.

More on that later.

The Federal Reserve and blood pressure

Yesterday I wrote on the U.S. economy and the Fed that will have to act someway or the other to at least try to avoid Japanese deflation scenarios. So as I promised, today you could have read the options available to the Fed. Not in my blog, but on the front page of the Wall Street Journal. Surprise!

First of all a word on my new colleagues: they are really great (they must be reading this sooner or later, so if I wanted to say something bad about them, I couldn’t anyway, for my own sake). The first day of my internship at iCC has past and I have to say that I look forward working there and doing the research for my master thesis (and for iCC, as the report is also in their interest), but more on this some other time.

Anyway, I don’t want to disappoint you already after my third blog (this will scare away the few loyal followers) so I will write here what I promised to write; let me quickly summarise what the article said (and which is, of course, exactly what I was going to write J).

So hang on: here is what the Fed could (COULD, not should) do:

1. Ideally, the Fed would strengthen its promise of keeping the fed funds rate low for an extended period of time, in order to encourage investors to borrow and take risks. Forecasts already expect the rate to stay close to zero well into 2011, so if this is not encouraging enough, what is? An yes, there is the problem of credibility. Because once investors borrowed, why not increase the rate?

2. A road the Fed could take is to push short-term rates to zero, but they are very reluctant to do so as it would disrupt the money market.

3. An attractive thing to do would be to use cash received from mortgage-backed securities or underlying loans that are paid off to invest in new mortgage-backed securities. At least, it seems to be an attractive option as it signals the Fed’s attempt to stimulate growth and so avoid deflation. A likely course of action, but the estimated impact is small, as mortgage rates are already very low so further stimulation is unnecessary.

4. Lastly, a very aggressive option would be to repurchase U.S. government bonds or mortgage-backed securities, to push down the long-term interest rate. The only problem here is that also this effect is likely to be small; the Fed would then have an even smaller portfolio to pour money from into the economy. The damage would be huge if the plan would backfire and inflation expectations rise.

So this was the theoretical part. Basically, the hands of the Fed are tightened and there are drawbacks to every option it has. Pumping money into the economy to get people to spend can stimulate growth, but whatever the Fed does, it comes at the cost of further increasing budget deficit and so it further constrains fiscal policy. What is really needed are tools to get employment up, fight falling wages and prices, but this is not the job of the Fed.

Currently the Fed is debating internally about what to do, and I think that is the best they can do; let them sit there and debate, because loosening monetary policy even more will do more harm than good. Let the U.S. government solve out how to fight unemployment and get spending and investment up.

To close with, I want to warn you. Research performed at the University of Chicago shows that loneliness can raise blood pressure. Such a relief: this holds only for those aged above 50. Don’t think: ‘time to start making friends before I’m that old’! First of all: 50 is not that old, I plan on becoming 110. Second, it’s not the amount of friends you have that determine how lonely you feel, but rather how long you can wait before someone write/calls you and how long you can stand to be alone (i.e. feelings of loneliness). Obviously perhaps, but nice that this gets confirmed by research.

The U.S. economy and the Fed

As a skip tonight’s news broadcast (just came back from a board meeting) and still have some time before I hit the bed but it’s too late to engage in some physical activity like my favourite dance game with the Wii, let me share with you my view on the U.S. economy. (That’s having your priorities straight.)

My curiosity on this topic was triggered by Paul Krugman’s blog on the Feckless Fed (btw. feckless means something like not fit to assume responsibility or being generally incompetent – nice word huh?). Paul Krugman is obviously pessimistic on the U.S. economy (rightly so), but moreover he is sceptical on how the U.S. Federal Reserve responds to the situation in the U.S., e.g. high unemployment rates, a huge government debt, too costly reform of the health system and already slow growth.

The first question that came to my mind was how it can be that the IMF in the world economic outlook predicts a growth rate for the U.S. of 3.3% in 2010 and 2.9% in 2011, while the prospects look so bleak. Of course, the states are recovering from the nadir and restoring from such a low does not require much. On the other hand, the fundamentals are really flawed and not much have been done to restore the financial system. The only good news in the last few weeks came from rallying stock indices and releases of macro-economic figures that were not too bad. However, these good figures and the following rallies again stem from increasing imbalances; too high borrowing from emerging economies and future generations. All in all, can we really believe these positive growth projections? I think we should be much more careful than taking these figures at face value.

The second question that came to my mind was when the Fed will make its move to avoid Japanese-style deflation and what move this will be. Paul Krugman’s worries about deflation are not completely ungrounded (and if they were, I wouldn’t dare to say so) and the Fed too has to confess that deflation in the near future is not completely unlikely to occur. So far, they have not taken any concrete action to do so. Even worse, the last statement of the Federal Open Market Committee suggests that economic prospects and the labour market start to improve gradually, but where does this recovery come from? There is only modest income growth and the housing market is still locked due to high unemployment. Okay, business spending is increasing, but confidence is decreasing, and many banks have not yet recognised their losses on commercial mortgage backed securities. The Eurozone economy does also not contribute positively to U.S. growth. These are the reasons for deflation not being completely unlikely.

If the Fed does not recognise this, surely they will not do anything to avoid deflation. If they would recognise it, what can they do? I range the options from hardly credible to somewhat more credible:

1. 1. ...

2. 2. ...

But this you can read tomorrow! J Sleep tight.