Quantum Pranx


QE2: The Ship is leaving the Dock

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by Jeff Harding
Posted originally October 5th, 2010


YOU CAN ALWAYS TELL WHEN SOMETHING IS UP WHEN THE FED PRESIDENTS ARE MAKING NEWS. For the past several days we’ve heard Bernanke, Bullard (St. Louis), and now Evans (Chicago) talk about quantitative easing. The NY Fed’s President William Dudley and Brian Sack Exec. VP in charge of carrying out FOMC decisions, have made major speeches about it. You have to understand that the Fed always has a purpose in its communications with the public, and rarely do its interlocutors stray from the official script.

The gist of each of these communiques has been that the Fed will soon, perhaps by the November 2 meeting, start massive additional purchases of Treasurys in order to create inflation. They wish to create inflation because they are clearly worried about “deflation.”[1] According to a recent report by Goldman Sach’s Jan Hatzius, as reported in todays Zero Hedge by fellow reporter Tyler Durden, GS believes that the Fed will buy at least $500 million of medium-term Treasury’s, probably $1 trillion, and “possibly much more.”

The Fed hierarchy believes that price inflation is necessary to enable them to carry out their mandate: maintain stable prices and full employment. They will attempt to stimulate the economy by massive quantitative easing (QE), a process by which the Fed monetizes the debt of the federal government. This is one of the ways the Fed can expand money supply. Price inflation, they believe, will create economic activity by reducing the debt burden on borrowers, maintain asset values, improve credit, and create additional income from consumers. And, importantly, they believe it will prevent price deflation.

Today I went through 30 pages of reports including the official texts of Messrs. Dudley’s and Sack’s speeches, whom I believe to be the most important players at the Fed next to Ben Bernanke.

What is infuriating to me is that they still do not have a clue why i) the boom-bust cycle occurred, ii) why the monetary and fiscal remedies have failed, and iii) what will happen when they print massive amounts of money in QE ($1 trillion plus).

President Dudley according to my review of his lengthy speech,  is the ultimate post-Keynesian, neoclassical, econometrician Monetarist tinkerer. He states that the Fed can set goals for the economy with some precision and carry them out. I believe that much of this kind of talk is “communique” from the Fed that is meant to make financial actors believe that the Fed is in control of the situation. He says:

As the central bank, we and we alone can control inflation—if not precisely in the short run, then over the medium term. By clarifying our intentions, we can reduce the risk of further disinflation.

And, in reference to the Fed’s exit strategy, he said:

[T]he Federal Reserve has the tools to control financial conditions and credit creation even with an expanded balance sheet.

In fact they are far from being in control and Dudley’s speech is both fascinating and frightening at the same time. One could raise the questions: If they were in charge of things, i) why did they let the crisis happen, and ii) why haven’t they revived the economy two years after October 2008?

I’m going to take you through Mr. Dudley’s speech and point out to you why we are in so much trouble. First we need to examine his, and I assume the Federal Reserve’s, view of QE. Dudley says:

I am very mindful of concerns here and abroad that balance sheet expansion could be interpreted as a policy of monetizing the federal debt. However, I regard this view to be fundamentally mistaken. It misses the point of what would be motivating the Federal Reserve. The FOMC would only engage in large-scale asset purchases in order to push the economy more rapidly toward the dual mandate goals of full employment and price stability. Once these goals were accomplished, there would be no basis for further purchases regardless of the government’s fiscal position because additional purchases would not be consistent with this mandate.

This is an astounding statement from an economist so prominent as Mr. Dudley. He is saying that debt monetization isn’t really debt monetization when they do it for good reasons. He says they wouldn’t do it for bad reasons, such as if the economy was fine but the government was still running massive deficits. He notes that those reasons don’t fit into their mandate. But since I am certain that the government will continue to run massive deficits, would not the result be higher interest rates, putting a halt to the inflationary boom they create with QE? Perhaps he should have read Mr. Bernanke’s speech on Monday:

In the short run, “concerns and uncertainty about exploding future deficits could make households, businesses, and investors more cautious about spending, capital investment, and hiring,” he said in remarks prepared for a meeting of the Rhode Island Public Expenditure Council.

“In the longer term, a rising level of government debt relative to national income is likely to put upward pressure on interest rates and thus inhibit capital formation, productivity, and economic growth,” Mr. Bernanke said.

In reviewing this and other statements by Mr. Dudley, I believe we will have the desired inflation they wish for, but it will not be mild.

Most disturbing to me is that Mr. Dudley’s explanation of the boom and the bust fail to mention anything about the role of the Fed in the cycle. He discusses the conventional wisdom explanations such as the run up in housing prices, the decline in mortgage standards, the rise of CDOs, and the spending financed by home equity loans. Nowhere does he mention the real causes of the boom: lowering the Fed Funds rate to 1%, thus exploding the money supply, or the role of the federal government and GSEs in guaranteeing the mortgage market’s abandonment of common sense underwriting standards.

To his and the NY Fed’s credit he fully acknowledges the problems that exist in the economy, including the credit crunch, the decline in real estate values as collateral for loans, deleveraging in all sectors of the economy, increased savings by consumers, lack of loan demand by businesses and consumers, and the reality that there may be a “sea change” in consumer spending-savings patterns.

Then Mr. Dudley gets to his point: we need price inflation to prevent price deflation. He explains the need for more price inflation than we are currently experiencing (1.5% per the PCE deflator):

[A] decline in inflation expectations that drives up the real interest rate and thereby increases the real cost of credit cannot be offset by simply lowering the federal funds rate. Thus, in a very direct sense, a fall in inflation expectations when the target interest rate is at the zero bound represents a de facto tightening of monetary policy and of financial conditions. Such a tightening would clearly be highly undesirable at a moment when unemployment is too high, inflation is too low and the economy has only moderate forward momentum.

And why are falling price inflation expectations important?

As the central bank, we and we alone can control inflation—if not precisely in the short run, then over the medium term. By clarifying our intentions, we can reduce the risk of further disinflation—or even an outright debt-deflation spiral that would make it still more difficult to accomplish the necessary balance-sheet adjustments.

Deflation is the core of the Fed’s anxiety. By creating price inflation debt can be paid off cheaply. Who are the big debtors right now? The consumer and the federal government (actually all governments). If we experience price deflation, money will be more valuable, debtors will have a greater burden, creditors will benefit, but the upside is that goods will be cheaper.

But, Mr. Dudley is, of course, on the side of debtors, not creditors. He believes that by careful purchases of Treasurys, perhaps at least $500 billion, they can effect a reduction of long-term interest rates from 50 to 75 basis points. They will target maturities from 2 to 10 years, average 5 years, and thus reduce the holding period price inflation risk premia for such debt. This would reduce interest rates or at least prevent a further decline.

The benefits of such renewed price inflation:

Even in today’s challenging circumstances, lower long-term rates would support the economy through a number of channels. Lower long-term rates would support the value of assets, including houses and equities and household net worth. Lower long-term rates would make housing more affordable and support consumption by enabling households to refinance their mortgages at lower rates. This would increase the amount of income left over for other spending. Of course, this channel can be made more powerful to the extent that further progress can be made in efficient mortgage debt restructurings that allow households with negative equity in their homes to take advantage of the drop in mortgage rates. In addition, lower long-term rates would reduce the cost of capital for businesses, thereby fostering higher levels of capital spending for any given economic outlook.

This is of course is an economic chimera. What he fails to see is that by benefiting debtors, he reduces the incomes of creditors. Thus there is really no net gain when you think it through. The price inflated dollars used to pay back  creditors are now worth less than when the debt obligation was originally created, so in effect, this policy just transfers money from creditors to debtors. But then the federal government is a debtor. In essence, they are trying to avoid the consequences of the housing boom and bust by creating a new inflationary boom.

There are further depressing mistakes he makes about the economy. Such as the idea that with capacity utilization low, it might be hard to start price inflation. Of course, that just isn’t true. During the stagflation of the 1970s we had high price inflation and low capacity utilization. These little ideas are the reason we are still having big problems.

The important question is: how much? Mr. Dudley and Mr. Sacks refer to research that supports their contention that $500 million of new QE will result in a long-term interest rate reduction of 50 basis points. Goldman Sachs believes that will be the minimum number. I don’t really know, but half a billion now sounds right to me. The key to the intensity of their efforts will be the unemployment numbers. Lately they appear to be bottoming out and new jobless claims are on the decline. I believe that a lagging manufacturing sector will spillover into the general economy and keep a lid on employment, perhaps even decreasing it further. If the data coming in from the EU and other buyer of US goods continue to soften, then a slowdown will hit the multinationals as well.

If unemployment does increase or fail to trend down, then you could see the QE2 exploding well beyond $1 trillion. This, despite Mr. Dudley’s protestations, would monetize more debt which would lead to higher inflation than the Fed ever intended. This of course is difficult to predict because you have to tell me what the Fed and the government would do in the future. As Mr. Dudley said:

In making our assessments about next steps, we need to be a bit humble about our capacity to forecast how market participants would respond to our actions. We do not control their behavior nor have much historical experience that we can draw on to easily assess how they are likely to behave. Even viewpoints that turned out to be incorrect could persist for a long time and generate adverse consequences. It is not enough for us to be right in theory. We also have to be convincing in practice and in explaining why concerns we think are misplaced are indeed unwarranted.

He has no idea how right he is. I am still convinced the Fed has no idea what it is doing.


1. In order to not confuse my readers, I need to be more precise in how I define inflation and deflation. My definitions are different from the Fed’s. The Fed and most economists say inflation is a general rise of prices and deflation is the opposite, a decline in prices. In Austrian theory, inflation is an increase in money supply and deflation is a decrease in money supply. Thus inflation and deflation are monetary phenomenon. One of the results of inflation is rising prices. Other impacts are a distortion of the entrepreneurial process which leads to our typical boom-bust business cycles. I will refer to the Fed’s usage as “price inflation” or “price deflation.”

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