Friday, September 14, 2012

QE3: The Fed Gambles With Our Economy

In order to boost job growth, Ben Bernanke, the Chairman of the Federal Reserve, announced the other day the start of a third round of quantitative easing - QE3. It is creating money out of thin air. This from Q&O:

The Fed will increase its holdings by an estimated $85 billion per month in securities, about half of which will be long-term Treasury bonds, and the remaining $40 billion or more will be agency mortgage-backed securities. The agency paper will be purchased with new cash, while the long-term Treasuries will be acquired in exchange for short-term Treasury paper, as a continuation of Operation Twist.

There is no ultimate target amount or end date specified for this round of easing. Essentially, the Fed will buy or exchange $1 trillion in securities per year, until chairman Bernanke says to stop. It is completely open-ended. Additionally, the Fed expects to keep interest rates at or near 0% until sometime in 2015.

Let’s be clear about what this announcement means: The Fed will print $500 billion per year in new money, and inject it into the economy by buying agency paper (Freddie Mac, Fannie Mae, et al.), while also flooding the market with $500 billion of short-term paper in exchange for long bonds. That new money is not based on any realistic estimate of economic growth, or economic requirement to expand the money supply. It is pure, Keynesian monetary stimulus.

This is the fed trying to use monetary policy to solve problems that are not "monetary" in origin under the Obama economy. Credit isn't sluggish because interest rates - today at historic lows - aren't low enough. Being able to borrow more money does nothing for overleveraged consumers trying to shed their debt. The fed action does nothing to assuage the concerns of businesses regarding new taxes and regulations. The fed action will do nothing to bring down the price of energy. Actually, as to the price of energy and other commodities, these will skyrocket as the Fed's balance sheet grows to $4 trillion and the dollar is devalued.

Whatever minimal benefit the fed action will have on our economy, its potential downsides are far more significant. The first and most obvious is that this will eventually cause run away inflation. Zombie at PJM has a good primer on this - Quantitative Easing, Wiemar Edition. And as Gerri Willis wrote at Fox Business:

Now, the federal government promises a blank check, printing unlimited money to pull us out of the ditch. How will they ever unwind all this stimulus? Who will pay? What will be the unintended and inevitable consequences?

Economist John Taylor recently wrote that sky-high inflation will be the ultimate result of the federal government’s moves, before today’s action.

And, almost undoubtedly, he sure seems right.

Two, this act of the fed threatens the bond market

Thierry Apoteker, chief economist at TAC Financial, . . . tells CNBC that a QE3 program could turn into a disaster for bonds.

"If you have fiscal policy that is loose and monetary policy that is loose, and commodity prices rising, then you have the recipe for a very lethal cocktail on the bond market," Apoteker says.

The bond market is crucial to our economy, as it is what allows every level of our local, state and federal government, not to mention businesses, to borrow money from the public.

Lastly, as Zero Hedge points out, this is the fed firing the last bullet in their gun. Moreover, by announcing it as an open-ended program, the Fed loses the ability to impact the markets in response to a future crisis. That is a terrifying proposition.

The economy is stagnant - neither getting worse or better at the moment. Its ills and the solutions thereto are all in the political realm. Trying to use monetary policy - with all its potential downsides - to solve the political problems of the Obama economy is just wrongheaded in the extreme. One wonders whether it is not time to reconsider the independence of the Fed and its ability to act unilaterally.

Update: Well, that didn't take long. In response to QE3, ratings firm Egan-Jones has downgraded its rating of U.S. government debt:

In its downgrade, the firm said that issuing more currency and depressing interest rates through purchasing mortgage-backed securities does little to raise the U.S.'s real gross domestic product, but reduces the value of the dollar.

In turn, this increases the cost of commodities, which will pressure the profitability of businesses and increase the costs of consumers thereby reducing consumer purchasing power, the firm said.

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