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.
