In starting a second round of quantitative easing (QE2), the Fed is gambling on a program that has little potential upside and a substantial amount of risk. In the first round (QE1) the Fed bought $1.7 trillion of mortgage and Treasury bonds (beginning in March 2009) and dropped short-term rates to between zero and 0.25%. It was also preceded or accompanied by massive fiscal intervention in the form of TARP, the stimulus plan, cash-for-clunkers, homebuyer tax credits, tax cuts, mortgage modifications and extended unemployment insurance. For all of their efforts the authorities did help prevent a global financial collapse, but achieved only an extremely sluggish economic recovery that was almost completely dependent on an inventory turnaround and government transfer payments. Now, even this halting recovery is showing signs of petering out with debilitating Japanese-style deflation an increasing threat. Without further help the current economic expansion is unsustainable.
We believe that QE2 will have minimal direct effect on boosting the economy and that Bernanke knows it. This seems obvious upon reading his op-ed article in today’s Washington Post, in which he states that this approach eased financial conditions in the past, and specifically mentions that stock prices rose in anticipation of the recent action. In fact he mentions higher stock prices twice in the same paragraph, as if to indicate the real reason for implementing QE2. In his own words, Bernanke says, “higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”
To be sure, the Chairman also states that lower mortgage rates will make housing more affordable and that lower corporate bond rates will encourage investment. However, according to the Fed, the planned Treasury purchases are almost all in the two-to-10 year range. We note that the two-year rate is already at 0.37% and the 10-year at 2.62%. If these historically low levels can’t spur spending, we doubt that another 20 or 30 basis points will make much difference. Corporations base their capital spending decisions on overall demand for their products and services far more than on the level of interest rates, and, in any event, are already sitting on piles of cash that they aren’t using. And don’t forget that mortgage rates are already at record lows. That virtually leaves mainly stock prices as the Fed’s real target for QE2, and Bernanke is saying that bluntly in today’s column.
We doubt that the stock market will get the boost that Bernanke and the “street” widely expect. The market reacted coolly following the FOMC announcement on Wednesday, but burst upward today on the Chairman’s unprecedented column. After all, when the Fed explicitly announces its intentions of jolting the stock market—-a thought previously expressed only by conspiracy theorists—-investors take notice. The bulls point out that stocks rose substantially during QE1, and believe that they will do so again under QE2. However, the market is in a far different position today than it was in March 2009, when QE1 began. At that time the market had declined by a whopping 57%, the S&P 500 sold at only 11 times trendline reported earnings and bears outnumbered bulls by 45% to 32%. In contrast, the market has climbed 83% since then and sells at an elevated 18.8 times smoothed reported earnings, while bulls outnumber bears by almost 2-to-1. At that time fear of a global financial collapse was rampant while now optimism is widespread as is apparent from watching the cheerleader mentality on financial TV today.
In addition to the limited upside, QE2 carries a substantial amount of risk. It has already led to a plunging dollar and far higher commodity prices on anticipation alone. Actual implementation will exacerbate these trends with potentially serious side effects. This raises costs for many American companies that buy significant amounts of commodities including energy, food and cotton. These companies would very much like to pass these increased costs along to consumers, but feel constrained by lack of demand as a result of high unemployment, limited wage increases, weakness in housing and tight credit. Already, a few companies have blamed 3rd quarter disappointments in revenues or earnings on rising commodity prices, and this tendency could snowball in coming quarters. Furthermore, to the extent that consumers have to pay higher prices for some necessities they will have no choice but to cut back on discretionary expenditures and big ticket items.
In addition, lower U.S. interest rates and a declining dollar will cause capital to flow to emerging nations, increasing the value of their currencies and hurting their economies. A number of emerging nations are taking measures to protect their exports and limit imports, possibly leading to a global trade conflict that results in less overall trade and declining economies.
Given the limited upside and potentially serious risks, why is the Fed taking this unconventional gamble? If conditions are as rosy as the stock market seems to imply, what is so dire about the economy and financial conditions that the Fed feels it necessary to take such a bold and unconventional step? Although the overall situation is exceedingly complex, the answer to this question is relatively simple. The Fed has a mandate to maintain full employment and low inflation. As it has repeatedly stated through its FOMC meeting statements and numerous speeches by Fed members, a majority of the Fed believes that the economy is growing below “stall speed” with another recession possible. It also believes that without another boost, either from monetary or fiscal policy, unemployment will remain stubbornly high, preventing a sustainable economic recovery with outright deflation a distinct threat. Bernanke also knows that the Fed has already used all of its conventional monetary weapons and that concern about increased budget deficits has all but ruled out any further help from fiscal policy. He also believes that the Fed is now the only game in town and cannot just sit there and do nothing while the economy fizzles.
As Chairmen of the Fed he also has to pretend that all of this will work and that if it doesn’t he has even more weapons to trot out. However, the last paragraph of his op-ed column shows that he knows the desperation of the measures he is undertaking. In a statement that can only be interpreted as a plea for help he says, “The Federal reserve cannot solve all the economy’s problems on is own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector”. Given the current political standoff such help is not likely. It is also likely, therefore that the strong market rally is based on false assumptions, as were the runs to the tops of early 2000 and late 2007.