Thursday, September 13, 2012 - QE to Infinity and Beyond

QE to Infinity and Beyond

-by Sinclair Noe

DOW + 206 = 13,539
SPX + 23 = 1459
NAS + 41 = 3155
10 YR YLD -.01 = 1.76%
OIL - .24 = 98.07
GOLD + 35.80 = 1768.20
SILV + 1.37 = 34.78
PLAT + 36.00 = 1690.00

I told you what I thought the Fed would do and today they did it. That doesn't make me a genius, because the Fed has been telegraphing today's action for about a month. The Federal Reserve wrapped up their Federal Open Market Committee meeting and announced a big new plan to stimulate the economy. The Fed said that it would expand its holdings of mortgage-backed securities and potentially take other steps to encourage borrowing and financial risk-taking. Perhaps more significant than those details was the basic change in its approach, for the first time pledging to act until the economy improves rather than creating programs with fixed endpoints; this is open ended quantitative easing; QE to infinity and beyond.

In its measures, the Fed said it would add $23 billion of mortgage bonds to its portfolio by the end of September, a pace of $40 billion in purchases per month. It would then announce a new target at the end of this month, and every subsequent month, until the outlook for the labor market improves “substantially” and so long as inflation remains in check. The statement did not further explain either standard.

The scale of the new QE is actually smaller than the Fed’s previous rounds of asset purchases. The Fed’s most recent expansion of its portfolio added about $75 billion in securities each month. QE1 was even larger. So, what the Fed really did was a smaller QE and they talked it up to make it seem bigger.

The Fed also said it would continue Operation Twist through the end of the year; this is the program it announced in June to exchange short-term securities for longer-term securities, taking the total volume of purchases to roughly $85 billion a month.

The Fed thinks the housing market still needs help, and that lower rates on mortgage loans could provide significant benefits for the broader economy. The committee said in its statement that the new actions “should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.” Of course, rates have been low for quite a while; the problem has been getting a loan, especially on negative equity.

The Fed’s statement made clear, however, that it would continue to stimulate the economy even as the recovery strengthens, and they'll just worry about inflation later. In the Fed's statement they said: “A highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.”

Then, Fed head Ben Bernanke held a news conference and he explained that he doesn't know what the end-line looks like but we'll know it when we get there; Bernanke said: “We are looking for ongoing, sustained improvement in the labor market. It is not a specific number we have in mind, but what we have seen the last six months, that isn’t it.”

The FOMC also committed to ZIRP, or a zero interest rate policy, into 2015. They also said they would take other measures as necessary, including purchasing other kinds of assets; again we don't know what other kinds of assets but I guess we'll know it when we've bought it.

In a separate statement, the Fed said its senior officials now expected the economy to expand between 1.7 percent and 2 percent this year, down from their June projection of growth between 1.9 percent and 2.4 percent. The officials continued to predict that the unemployment rate would not fall below 8 percent.

The Fed's decision to go open-ended big on QE reflected not only an increased concern about the health of the economy, but an increased determination to respond; this was disturbing on several levels. The official inflation levels have been well below target for a long time and the official unemployment levels have been way too high for a long time, and instead of being big and bold, the Fed policy was late and lackadaisical. And now they finally got around to action, they've run out of tools in their toolbox. What exactly is the follow-up for open-ended QE?

Today, the Fed acknowledged that its approach until now has been flawed. The Fed also acknowledged its limits; Bernanke claimed: “Monetary policy, particularly in the current circumstances, cannot cure all economic ills.”

While it is true the Fed can't cure all economic ills, Bernanke is too modest. Fed policy has been a spectacular success … at protecting the banking system at all costs. Let's look at how the QE works. To buy bonds, the Fed essentially creates money from nothing, paying for its purchases by crediting the accounts of banks from which it buys the bonds. That's a clue as to how it works -- as money piles up in their Fed accounts, earning the paltry quarter-of-a-percentage point in interest that the Fed pays, banks may be keener to lend to companies and people. If companies use that money to buy equipment, and households use it to buy homes and cars, the economy gets a jump.

Of course, the banks may be very happy to take a paltry quarter percent for doing nothing on very high volumes; that's the very definition of easy money. Or they might make low interest long term loans to responsible home buyers and businesses, but that entails more work and more of a chance of something going wrong; plus the only reason a business would want to go in debt to buy equipment is if they have demand, if they have a customer ready to buy what they could make. Or the banks might take the money and go to London and gamble recklessly, and if they win a few rounds in the casino, the bank exec take home huge bonuses. So, it shouldn't surprise you that the financial stocks were big winners today.

And if all this QE sounds like so much trickle-down idiotic economics, where the Fed pumps money directly into the banks and just click their heels and snap the fingers and pray the banks lend – well, Bernanke addressed that; he said: “this is a Main Street policy, because what we're about here is trying to get jobs going. We're trying to create more employment. We're trying to meet our maximum employment mandate, so that's the objective. Our tools involve -- I mean, the tools we have involve affecting financial asset prices, and that's -- those are the tools of monetary policy. There are a number of different channels -- mortgage rates, I mentioned other interest rates, corporate bond rates, but also the prices of various assets, like, for example, the prices of homes. To the extent that home prices begin to rise, consumers will feel wealthier, they'll feel more -- more disposed to spend. If house prices are rising, people may be more willing to buy homes because they think that they'll, you know, make a better return on that purchase. So house prices is one vehicle.

 

“Stock prices -- many people own stocks directly or indirectly. The issue here is whether or not improving asset prices generally will make people more willing to spend. One of the main concerns that firms have is there's not enough demand. There are not enough people coming and demanding their products. And if people feel that their financial situation is better because their 401(k) looks better or for whatever reason -- their house is worth more -- they're more willing to go out and spend, and that's going to provide the demand that firms need in order to be willing  to hire and to invest.”

What Bernanke failed to say or perhaps realize, is that demand comes from jobs. Maybe, it's unfair to blame Bernanke for all the problems; he has no hammer and he's trying to use a chisel and a handsaw to pound nails. Or maybe Bernanke is just peeing on your leg and telling us it's raining, because that's how the trickle-down theory in practice.

Oh, here is something fun. Gold prices moved higher on the notion that the Fed's actions will somehow debase the paper currency, and that such debasement will be long lasting and open-ended, and look at that, gold is sneaking back to the old highs. Exactly like I told you.