How the Fed Could Save the Economy and Destroy the Currency
How the Fed Could Save the Economy and Destroy the Currency
Is the glass half full? The Federal Reserve has committed to buying $600 billion worth of Treasury bonds between now and June, and it wants to purchase up to $900 billion in debt by the end of September 2011.1 This second round of quantitative easing has been dubbed QE2. Basically, this effort would pump cash into the banking system to promote lending and some inflation, and it has the potential to help stocks, the housing market, consumer spending and employment. Let us all be reminded that the basic premise of the Fed lowering interest rates or in this case QE2 is that lower rates of interest leading to increased money supply in the economy will spur investors to invest, banks to loan, and businesses to hire workers and invest in their businesses, which presto creates positive economic activity.
Or is it half empty? Various economists, financial analysts, and business leaders are extremely worried about the impact of this tactic. They fear it may create another stock market bubble like the dot com bubble via an inflated equities market motivated by speculation and low interest rates instead of real earnings by growing businesses. Likewise, others see a commodities bubble that could burst dramatically in the years ahead much like the current housing market.
QE2 has already earned some prominent detractors. Bond market guru Bill Gross of PIMCO just called it "a Ponzi scheme" that will end the 30-year bull market in bonds (an event he has actually forecast for some time). Jim Rogers, the Quantum Fund co-founder who astutely called the worldwide bull market in commodities in 1999, recently labeled QE2 "petrol on the fire" of the commodities market and told an Oxford University audience that Fed chair Ben Bernanke "does not understand economics ... all he understands is printing money."2, 3
Will this help stocks & housing? The Fed's bond-buying program implies lower long-term interest rates, lower bond yields and a weaker dollar. In an environment with lower bond yields and paltry savings rates, investors are predisposed to enter asset classes such as real estate, stocks, commodities, venture capital or other equity type investments that offer higher returns then bonds (of course the risks are also higher too). If the stock and housing markets improve, that will certainly aid consumer confidence which, in turn, should aid consumer spending and thus uplift the economy.
Of course on Main Street, there are two speed bumps on the way to that rosy domestic destination. A lack of customers and/or demand (especially in the housing market) and unemployment; as those that have been laid-off, are working for less income, or are afraid of being laid-off do not make good consumers. Additionally, even with mortgage rates at all-time lows, loan requirements today are far tougher than in the past 5 years for those that seek to purchase a new or existing home. Thus the Fed's strategy may have a tough time navigating these economic obstacles.
Why are other nations arguing against it? QE2 could invite a global trade war. A weak greenback means a big advantage for U.S. exports. Our products will be cheaper in other nations thanks to the increase in the money supply holding down the value of the dollar. Correspondingly, imported goods will cost us more and we will buy less of them. That's terrible news for nations such as Brazil, Canada, China, Germany, Russia, Japan, France, Great Britain and Hong Kong, all of whom are counting on stable currency exchange rates and particularly forexported goodsto aid in their economic recoveries.
"It's the wrong way to prevent or solve problems by adding more liquidity. Excessive, permanent money creation in my opinion is an indirect manipulation of an exchange rate." -Germany's Economy Minister, Rainer Bruederle.4
If U.S. interest rates are too low for too long, investors may try the emerging markets and/or the commodities markets seeking higher returns. So the commodities markets and the emerging markets could get even hotter as they become flooded with cheaper US dollars looking for higher investment returns.
"I agree that there's suggestion that aggressive quantitative easing in the United States would create devaluation pressure on the US currency." - Canada's Finance Minister, Jim Flaherty.5
If that happens, it would also imply higher prices for oil, crops and raw materials in the United States, which would look like inflation at the grocery store or the gas-pump to Main Street and long-term hamper our economy. Of course, many financial analystsand economists think the commodities markets will keep advancing with or without influences like QE2 because there is simply too much global demand and not enough available supply.
Is this the "Hail Mary" play? I think James Grant of Grant's Interest Rate Observer, considered one of the most astute and independent thinkers on macroeconomic and monetary analysis, may have best summed up "the risks" the Fed is undertaking by moving forward with QE2.
"The intended consequences of this intervention include lower interest rates, higher stock prices, a perkier Consumer Price Index and more hiring. The unintended consequences remain to be seen. A partial list of unwanted possibilities includes an overvalued stock market (followed by a crash), a collapsing dollar, an unscripted surge in consumer prices (followed by higher interest rates), a populist revolt against zero-percent savings rates and wall-to-wall European tourists on the sidewalks of Manhattan.
As for interest rates, they are already low enough to coax another cycle of imprudent lending and borrowing. It gives one pause that the Fed, with all its massed brain power, failed to anticipate even a little of the troubles of 2007-09".
With interest rates at nearly 0% and one round of bond-buying already in the history books, the Fed doesn't have many options left to jump-start the economy. Here's to its latest move giving the recovery more traction (the proverbial shot in the arm) and not becoming a shot in the foot.
Citations
1 - money.cnn.com/2010/11/03/news/economy/fed_decision/index.htm [11/3/10]
2 - blogs.wsj.com/marketbeat/2010/10/27/pimcos-bill-gross-qe2-is-a-ponzi-scheme/ [10/27/10]
3 - bloomberg.com/news/2010-11-04/bernanke-doesn-t-understand-economics-investor-jim-rogers-tells-oxford.html [11/4/10]
4 - bloomberg.com/news/2010-10-23/germany-says-u-s-federal-reserve-heading-wrong-way-with-monetary-easing.html [10/23/10]
5 - businessweek.com/news/2010-10-25/g-20-to-avoid-competitive-devaluation-of-currencies.html [10/25/10]
6 - nytimes.com/2010/11/14/opinion/14grant.html?pagewanted=2&_r=2 [11/13/10]
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