Daamien
04-16-2011, 04:50 PM
Quantitative easing is a term for when central banks conduct unconventional open market operations to stimulate the economy by increase the monetary supply when changing interest rates is no longer effective. The central bank, in the case of the United States the Federal Reserve, buys mid-to-long term government securities in the secondary market from banks using newly created electronic money. Therefore, it does not directly "monetize" the government debt, but rather lowers interest rates on debt as the newly created dollars flow increase aggregate demand and therefore the price for government securities. Bank reserves are therefore freed up and the net effect also hypothetically includes increased lending, stabilizing the economy which is based on consumer and homeowner debt.
However, there are unforeseen consequences to increasing the monetary supply, namely that money does not necessarily flow towards the intended areas of the economy. Rather than increasing home prices and wages, the inflated dollars have found their way into commodities and equities. Instead of re-inflating an asset bubble in housing and consumer lending, the Federal Reserve has inflated prices hard assets such as precious metals, food, and fuel.
The current $600 billion round of the Federal Reserve's quantitative easing, nicknamed QE2, is scheduled to end on June 30, 2011. Therefore, there is a looming uncertainty over the markets on what Fed policy will be pursued after June 30, 2011:
• Will the Federal Reserve end quantitative easing measures due to inflationary pressures?
• Will the Federal Reserve also move to increase interest rates?
• Will the Federal Reserve push the pedal to the metal and instantly embark on QE3?
• Will the Federal Reserve take a nuanced approach by combining different options?
Abruptly ending quantitative easing in June and/or moving fast to increasing interest rates would cause a harsh temporary collapse in the overall economy and deflate commodity and equity bubbles. Furthermore, higher interest rates would hasten a crisis in government borrowing as interest payments necessary to service the debt would balloon. The burden of higher interest payments on the deficit could potentially cause a death-spiral in treasuries where the government would rely on additional lending which itself would require additional interest to pay off current interest. The only way to avoid this scenario which would result in a US sovereign debt collapse would be if Congress made massive cuts to spending and/or dramatically increased taxes to control the deficit which we have seen is an unreliable expectation. The Federal Reserve, being staffed with accommodating Keynesian inflationists, is hardly likely to pursue this painful policy of taking away the punch bowl, even though it could be best for long-term fundamental economic stability and growth.
Increasing quantitative easing through QE3, 4, 5… ad infinitum would have diminishing returns on growing the economy leading to stagflation and would potentially result in hyperinflation as the dollar’s purchasing power is sacrificed to the point where it becomes an unreliable means of exchange. The Federal Reserve has pursued this politically convenient policy thus far and has tried to downplay resulting inflation. However, we are potentially reaching a breaking point where the economy’s expectations for more cheap money is becoming a reliance on more quantitative easing like a drug addict with the potential for overdose.
So, how does the Federal Reserve both maintain stable yields on government debt while avoiding a hyperinflationary environment? In short, it really can’t. However, the Federal Reserve governors and Ben Bernanke thinking that they are smarter than entire markets are likely to try through a combination of contradicting policies. The Federal Reserve will likely pursue some form of QE3, but it will be marketed differently to the public and likely modified to also include more purchasing of consumer debt and mortgage debt to directly influence housing prices and lending. This more targeted approach to quantitative easing will be accompanied by offsetting nominal increases in interest rates through gradually raising the Federal Funds Rate in an attempt to stave off inflation in the rest of the economy. It will appear to the public as if the Federal Reserve were concerned about inflation via interest rate hikes, but the net effect would be a gradually increasing monetary supply with the augmented quantitative easing. However, this policy clearly doesn’t have an end-game, as the Federal Reserve will be unable to unload government, mortgage, or consumer debt without significant consequences. These tactics will simply further delay problems while the Federal Reserve hopes for a robust economic recovery in vain.
What does this mean for investing? Well, if the Federal Reserve does pursue a mixed policy, then it may not be a wise idea to short government debt. Furthermore, shorting the US Dollar would also not have quite the same returns as if interest rates were kept around 0%. US Equities and commodities will likely take a short-term hit, but the biggest loser will be US corporate debt, as they won’t benefit from interest rate changes or the more focused quantitative easing.
In the end Americans and the federal government need to wean ourselves off cheap money and reckless borrowing if we want to return to a fundamentally sound economy. We need to reduce the burden of government and focus on making the United States an attractive place to do business and work in the globalized economy. This means a greater focus on real manufacturing and quality jobs-focused education. If we fail to take steps to embrace austerity and hard work they will be forced upon us regardless through harmful crises. Let’s act now before it is too late.
However, there are unforeseen consequences to increasing the monetary supply, namely that money does not necessarily flow towards the intended areas of the economy. Rather than increasing home prices and wages, the inflated dollars have found their way into commodities and equities. Instead of re-inflating an asset bubble in housing and consumer lending, the Federal Reserve has inflated prices hard assets such as precious metals, food, and fuel.
The current $600 billion round of the Federal Reserve's quantitative easing, nicknamed QE2, is scheduled to end on June 30, 2011. Therefore, there is a looming uncertainty over the markets on what Fed policy will be pursued after June 30, 2011:
• Will the Federal Reserve end quantitative easing measures due to inflationary pressures?
• Will the Federal Reserve also move to increase interest rates?
• Will the Federal Reserve push the pedal to the metal and instantly embark on QE3?
• Will the Federal Reserve take a nuanced approach by combining different options?
Abruptly ending quantitative easing in June and/or moving fast to increasing interest rates would cause a harsh temporary collapse in the overall economy and deflate commodity and equity bubbles. Furthermore, higher interest rates would hasten a crisis in government borrowing as interest payments necessary to service the debt would balloon. The burden of higher interest payments on the deficit could potentially cause a death-spiral in treasuries where the government would rely on additional lending which itself would require additional interest to pay off current interest. The only way to avoid this scenario which would result in a US sovereign debt collapse would be if Congress made massive cuts to spending and/or dramatically increased taxes to control the deficit which we have seen is an unreliable expectation. The Federal Reserve, being staffed with accommodating Keynesian inflationists, is hardly likely to pursue this painful policy of taking away the punch bowl, even though it could be best for long-term fundamental economic stability and growth.
Increasing quantitative easing through QE3, 4, 5… ad infinitum would have diminishing returns on growing the economy leading to stagflation and would potentially result in hyperinflation as the dollar’s purchasing power is sacrificed to the point where it becomes an unreliable means of exchange. The Federal Reserve has pursued this politically convenient policy thus far and has tried to downplay resulting inflation. However, we are potentially reaching a breaking point where the economy’s expectations for more cheap money is becoming a reliance on more quantitative easing like a drug addict with the potential for overdose.
So, how does the Federal Reserve both maintain stable yields on government debt while avoiding a hyperinflationary environment? In short, it really can’t. However, the Federal Reserve governors and Ben Bernanke thinking that they are smarter than entire markets are likely to try through a combination of contradicting policies. The Federal Reserve will likely pursue some form of QE3, but it will be marketed differently to the public and likely modified to also include more purchasing of consumer debt and mortgage debt to directly influence housing prices and lending. This more targeted approach to quantitative easing will be accompanied by offsetting nominal increases in interest rates through gradually raising the Federal Funds Rate in an attempt to stave off inflation in the rest of the economy. It will appear to the public as if the Federal Reserve were concerned about inflation via interest rate hikes, but the net effect would be a gradually increasing monetary supply with the augmented quantitative easing. However, this policy clearly doesn’t have an end-game, as the Federal Reserve will be unable to unload government, mortgage, or consumer debt without significant consequences. These tactics will simply further delay problems while the Federal Reserve hopes for a robust economic recovery in vain.
What does this mean for investing? Well, if the Federal Reserve does pursue a mixed policy, then it may not be a wise idea to short government debt. Furthermore, shorting the US Dollar would also not have quite the same returns as if interest rates were kept around 0%. US Equities and commodities will likely take a short-term hit, but the biggest loser will be US corporate debt, as they won’t benefit from interest rate changes or the more focused quantitative easing.
In the end Americans and the federal government need to wean ourselves off cheap money and reckless borrowing if we want to return to a fundamentally sound economy. We need to reduce the burden of government and focus on making the United States an attractive place to do business and work in the globalized economy. This means a greater focus on real manufacturing and quality jobs-focused education. If we fail to take steps to embrace austerity and hard work they will be forced upon us regardless through harmful crises. Let’s act now before it is too late.