Does the latest Federal Reserve stimulus or QE2 carry the seeds of its own failure?

Well this is definitely the morning after the night before! I wrote yesterday in my initial thoughts to the Fed.’s move that markets would take a while to digest the news and that it would be wise to see a further breakdown in exactly what maturity of bonds the Federal Reserve was going to purchase. The reason for this was that when it announced the policy of QE-lite where it aimed to maintain the size of its balance sheet it announced one thing and then something different about an hour later to the consternation of the US long bond (30 year Treasuries) price which gyrated like a spinning top or perhaps like soldiers in the rhyme about the Grand Old Duke of York.

I quoted from the statement in my update of last night but for flow in this article I will repeat my explanation of what it is.

Explanation of what has happened

The FOMC has decided to announce a flow of asset purchases and continue with its existing programme of QE-lite. Accordingly it will buy around US $110 billion of US government debt per month if you combine the two in what will now be called QE2.

There was a debate as to the maturity of the debt which will be purchased. The FOMC has confused itself on this issue in the past but it has indicated that it will buy in the 5 to 6 year maturity as an average. This might seem very technical but for those who hold say the 30 year benchmark this does matter because it implies either none of these or very few will be purchased by the Fed and maybe fewer ten-years than the market had factored in. So we could see falls in their prices with the 30 year likely to fall by more.

You could argue that this is US $600 billion or US $900 billion so markets may be confused for a while as this is digested.

I will add one more technicality to the debate as you may well see it quoted and wonder what is being talked about. Up until now the Federal Reserve has a limit called System Open Market Account or SOMA which restricts it to purchases of only 35% of any particular Treasury Bond issue. As it is about to buy more and intends to buy in specific maturities it soon would have gone through this limit. Put another way you can consider this as an example of the size of the purchases being considered when you add them to the Fed.’s existing holdings.

To provide operational flexibility and to ensure that it is able to purchase the most attractive securities on a relative-value basis, the Desk is temporarily relaxing the 35 percent per-issue limit on SOMA holdings under which it has been operating. However, SOMA holdings of an individual security will be allowed to rise above the 35 percent threshold only in modest increments.

If you want my opinion the Fed. has borrowed the Bank of England’s definition of the word temporary as I believe this move will be permanent. After all as they only intend to buy more bonds, how exactly can they reverse it? In case you are wondering as to why they are doing this in such an obtuse fashion they are frightened of headlines like “Fed moves towards debt monetisation”. In a world of Orwell-speak the truth is always one of the early casualties.

Comment: An implication for the policy of QE-lite and hence QE2

After further consideration it has occurred to me that there are implications for the policy of QE-lite here. In simple terms it was an attempt to maintain the size of the Fed.’s balance sheet at around US $2.3 trillion dollars as otherwise as Mortgage Backed Securities expired it would shrink. So it set out to buy US government debt (Treasury Bonds) with the funds received from the maturities. The amounts would vary depending on the maturity spectrum but somewhere of the order of US $300 billion was expected over the following year.

This policy was announced on August 10th and yet on November 3rd less than 3 months later it has been replaced by something much larger. Is that not an admission of failure? I know that it is continuing but as a part  of a much larger scheme. Now let us stop and consider what has happened in the US economy since August the 10th. Initially we saw signs of a slowdown but since then many economic variables have improved in what supporters of QE-lite might have argued were signs of success. And yet the biggest supporters (the FOMC) have felt the need to in effect replace it with something much larger. I discuss this later in more detail as I feel that Quantitative Easing in these times may carry the seeds of its own failure but for now I wish to point out that the fact that what is called QE2 is now on its way down the slipway it means that QE1 and QE-lite have failed to achieve much. Does that mean that we should expect what will no doubt be called QE3 in say 6 months time well quite possibly as after all the FOMC statement did say.

The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

I do remember a manager who in the English Premier League was subject to the terrace chant “You don’t know what you’re doing” somewhat unfairly if you look at his overall record. However if you re-read that sentence it does not seem quite so unfair here.

Market Response

I left us some benchmarks to return to.

The Dow Jones Industrial Average closed at 11,188 which was up 64 points. As to whether this welcomed a likely Republican swing or was just getting ready for the FOMC statement it is hard to say. In terms of government bond yields then the ten-year yields 2.57% and the thirty-year yields some 3.91%. Moving onto currencies then the trade-weighted US dollar index stands at 76.68. Another possible benchmark is the gold price which has a front month futures price of US $1354.

I further suggested that initially “You could argue that this is US $600 billion or US $900 billion so markets may be confused for a while as this is digested.” This appeared to happen in equity markets as the Dow Jones moved up only 26 points to 11,215 after gyrating up and down. Overnight and this morning as the news has been digested we have seen strong rallies in equity markets with the Japanese Nikkei 225 equity index rising by 198 points to 9358 and the UK Ftse 100 is up 100 points or so as I type this. The impact on US government bonds followed the predicted pattern purchases by the Fed with 5 year yields falling by 0.06% to 1.1%, ten years edging 0.01% higher to 2.58%%, whilst thirty-year yields surged by 0.15% to 4.06%. The US dollar index has fallen to 75.87 or 1%. Gold initially fell but since than has rallied strongly and is currently up some ten dollars at US $1364.

So at this point Ben Bernanke might be reasonably happy with equity and other asset prices rising and the US dollar’s exchange rate falling. I would like to add a further element to this. As this move was fairly well predicted then much of the move it induces is likely to have happened before the meeting and I feel that recent equity and asset price rises and dollar exchange rate falls were caused by expectations of what the Federal Reserve would do. Quantifying this however is virtually impossible and is one of the problems facing theoretical economics.

Will the good ship QE2 be a self-fulfilling failure?
I ask this because it is a thought which has been growing in my mind. If we start from the beginning we have economic dislocation mostly caused by the ending of a financial bubble which built up in the middle of the last decade and exploded in 2008 with severe economic implications. Once the interest rate weapon had been fully used the Federal Reserve and others has replied with what it calls Large Scale Asset Purchases or QE.

If we look at what it is supposed to achieve it directly boosts narrower measures of the money supply which is supposed to lead on into wider measures of the money supply such as M2 and M3 in the US. This via boosts in bank lending and eased credit is supposed to boost the economy.

The problem is that the very same credit crisis or bubble has made wider measures of the money supply very unresponsive to the narrower ones. For example right now the problems of “foreclosuregate” in the United States are likely to be influencing how much US banks are willing to lend and there is little Ben Bernanke’s bazooka can do about that. I fear that we are doomed in this scenario to be like a dog chasing its tail.

This is not to say that there are no economic effects at all as there are likely to be wealth effects from asset prices which may well rise or to be more specific already have risen but these are weak.There will be consumption effects from higher bankers bonuses and salaries as this sector benefits from this. But once the economy recovers can you see the problem? As soon as it does and normal behaviour begins then narrow money will influence broader measures and bank lending then my analogy is of a brick on the end of a piece of elastic which has been stretched.

It is then in danger of whacking us on the head and we will measure it with inflation. Put another way as I do not expect Ben Bernanke to change course I expect we will see the good ship QE3 sailing down the slipway over the next 6 months or so. Looking further ahead when he retires and goes on the lecture circuit many of the listeners may well be humming Elton John’s “Sorry seems to be the hardest word.”

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6 thoughts on “Does the latest Federal Reserve stimulus or QE2 carry the seeds of its own failure?

  1. In one of his many recent speeches Ben Bernanke told us to look at his National Economic Indicators as the basis for the Fed’s actions. What strikes me is that corporate profits are only just beneath their peaks in 2006 and this contrasts with 9.6% civilian unemployment rate with extremely low wage costs and hours worked in the labour force.Real wages must be shot through. How does creating artificial liquidity loosen corporate reserves toward investment and job creation? I just dont get it unless this is all about driving the exchange rates down to boost manufacturing….I agree that the maturity targets probably indicate and exit strategy based on “no exit” ie hold securities to maturity so as to avoid capital losses on the Fed’s balance sheet?

  2. In an article here: http://economistsview.typepad.com/economistsview/2010/11/bernanke-what-the-fed-did-and-why.html

    Bernanke is saying that the initial QE didn’t boost the broader wider money supply.

    That’s right.

    Further to this:

    http://blogs.ft.com/economistsforum/2010/11/lord-skidelskys-speech-on-the-uks-spending-review/

    Also BIS report on private sector deleveraging during economic crises:
    http://www.bis.org/publ/qtrpdf/r_qt1009e.pdf

    “Financial crises tend to be followed by a protracted period of debt reduction in the nonfinancial private sector. We find that a period of debt reduction followed 17 out of 20 systemic banking crises that were preceded by surges in credit. Debt/GDP ratios fell by an average of 38 percentage points, returning to approximately the levels seen before
    the increase. If history is any guide, we should expect to see a much more significant reduction in private sector debt, particularly of households, than has so far taken place after the recent crisis. The costs of this process in forgone output are difficult to pin down, but there are reasons to believe that they need not be high provided that the
    banking sector problems that led to the crisis are fixed.”

    Additionally, and as the budget report of June 2010 showed debt in the financial sector has shown the marked increase in the last quarter of a century or so.

  3. I have a question about the relationship between different measures of money, and the effects of QE on these. It looks like QE in the States has so far doubled the monetary base MB, increased M1 by ~20% and M2 by ~10%. My question is about creating broader money, i.e. M3 and others from this increased base. Am I right in thinking that reserve requirements are an outdated mechanism for controlling banks’ lending? and that these days it is equity/assets, rather than reserves/liabilities, that are the real constraint on lending? What I am getting at is, do you think that narrow money really will have a large (i.e. multiplied, hyperinflationary) effect on broad money? As I’ve confessed before, I am no economist, so perhaps I am missing something crucial here.

    PS. Shireblogger: I think that when you say “unless this is all about driving the exchange rates down to boost manufacturing”, this may be a large part of the Fed’s unstated (and unmandated) aim – although, since they are supposed to foster sustainable growth and maximum employment in the US, you could argue that this is what they are trying to achieve. This is not in the short-term interests of anyone of course.

    PPS. I would like to point out that I am not a cheerleader for QE2 – I am just trying to understand the Fed’s motives (and playing devil’s advocate!).

    • Hi Graeme

      Many countries have abandoned the system of using reserve assets as a way of controlling bank lending. For those that still have it then it is not usually particularly relevant. There are many ways of multiplying credit that have developed in recent years such as the shadow banking system. So the picture is very complex and one of the reasons I argue for genuine reform. Frankly if we saw the end of fractional reserve banking as is proposed by the MP Douglas Carswell it may do some good but would probably be subverted.

      As to the links between narrow and broad money which is the crux of your question. Let me try to explain. Although they are all labelled as money supply as you move along the curve and go from narrow monetary base to wide moneatry base to m2 to m3 you are moving from measuring money supply to measuring money demand. As an example you could expand the narrow money supply by printing more notes if you wanted and it would also expand the wider measures but it is a smaller percentage of them. They depend as much on demand as bank lending only exists if somebody wants the loan. Currently we have a problem and I have highlighted it where banks are being allowed to raise the price of credit and reduce the demand for it. It would appear in the case of mortgages they are also using credit criteria but of course that is for usually cheaper credit…..Also individuals appear to be wanting to pay down debt at this time.

      So the wider measures of the money supply have struggled. However in normal times these would hopefully recover and we would suudenly have a boost to wider money supply measures. I do not argue that this would lead to hyper-inflation but as the size of the sums of money being pumped into the economy increase so does the risk. My contention is that we are likely to get inflation and even a modest run of it is damaging. My analogy of a brick with the elastic getting ever taughter and then being released conveys the possible whipsaw event.

      We would then be relying on the same crew who appear impotent in the face of the current crisis to deal with the inflation, I don’t know about you but that prospect troubles me.

      • Thanks for your reply – it’s a little clearer to me now. I agree with your point about confidence and demand for credit, and not just supply, being important for broad money growth. The solvency of the financial system is the key though, no? (and this, in turn, depends on asset prices) I still have a gut feeling that we will have a second deflationary bust, because the political environment is turning sour towards bailouts and global cooperation. You are right that the Fed does not appear to have covered itself in glory, but I cannot decide whether to ascribe this to incompetence or low cunning.

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