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.

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.

Monetary policy: preventing asset bubbles, leaning against the wind?

This week, I’ve done a lot of reading, in the train and during my internship (I could write a book on what I wrote as well). As I came across many (I mean seriously a lot of) interesting papers, discussions, and other pieces, one thing especially caught my attention and this is what I’ll shortly write about. At least, I’ll try to keep it short. Keeping it short is not my strongest point (in writing that is, in words I find it so much easier to be short and concise).

Anyway, the results of the stress tests were published last Friday. I hope to write more on that next week, as I’m definitely curious about how the markets analysed the results during the weekend and how investors will respond to the failure of 7 banks during the stress test. My guess in earlier blogs was that publishing the results would not cause any stress nor any relief, simply because the scenarios tested were not strict enough. On the other hand, some banks appeared to have done some (mainly accounting) tricks and thereby made the results look much nicer. Slight chance that the markets take that to be something unimportant. The fact that banks performed those tricks is a very bad signal, but I could be wrong; perhaps the markets are relieved still (hmm right, like I’m ever wrong). We’ll know more tomorrow morning.

Now what I really would like to mention is the following.

This week, the IMF in a research bulletin discussed how monetary policy could and should be used to prevent increases in asset prices that are not sustainable (asset bubbles that is). A perfect example is the housing bubble that burst in the U.S. in the summer of 2007. Common thought –and the message of an important research paper by Ben (Bernanke)- before the financial crisis took off, was that tightening monetary policy is a too rude policy tool to avoid asset bubbles. Rather, the bubble should burst and it was supposed to be the role of monetary policy to clean up the mess afterwards, using a loose monetary policy to kick start the economy again.

Some months ago, I read a paper by three famous IMF-economists: Olivier Blanchard, Giovanni Dell’Ariccia and Paolo Mauro. In “Rethinking macroeconomic policy”, they wrote that we should learn from the current crisis and that we should use more direct policy tools to fix the problems at hand. As the Jan Tinbergen-rule goes: one target, one policy tool. So: monetary policy is used to target inflation. Fiscal policy is used to make redistributions and the automatic stabilisers of fiscal policy work countercyclical. A disregarded policy that can be used well to prevent asset bubbles is regulatory policy. And this sounds so simple (although I’m sure working out the exact details takes some more time), but collateral requirements, capital and liquidity charges, and stricter lending policies make banks hold more capital and prevent credit overexpansion or give banks some leverage such that they can overcome external shocks. An example is Spanish dynamical provisioning that builds buffers in good times that can be used in bad times, to put it bluntly.

For more details, I want to refer to the paper of Blanchard, Dell’Ariccia and Mauro, which is really clear, well written, and credible. For now, I’m just wondering why the IMF wrote that monetary policy should be used (carefully, but still) to attack asset bubbles. Why is it that they disregard in some way the paper I mentioned.

I mean, if other policy tools could ‘do the trick’; why bother using such a rough measure to try to achieve the same thing, while at the same time it could seriously undermine economic growth. To me, it is like bombing the house to kill the nasty fruit flies in the kitchen, because I think it are these fruit flies that cause the rotten peaches. (Likewise, asset bubbles are hard to identify.) Definitely I’ll regret bombing the house if it turns out that the peaches will become rotten also without the nasty fruit flies in the –now bombed- kitchen.