FOMC: QE2 Is Working

The latest Fed minutes are out and they contain some good commentary and some bizarre commentary.  Of particular interest is their commentary regarding QE and their claim that it is helping to keep rates lower than they otherwise would be:

“Interest rates at intermediate and longer maturities rose substantially over the intermeeting period, while credit spreads were roughly unchanged and equity prices rose moderately. Participants pointed to a number of factors that appeared to have contributed to the significant backup in yields, including an apparent downward reassessment by investors of the likely ultimate size of the Federal Reserve’s asset-purchase program, economic data that were seen as suggesting an improved economic outlook, and the announcement of a package of fiscal measures that was expected to bolster economic growth and increase the deficit over coming quarters. It was noted that the backup in rates may have been amplified by year-end positioning, as well as by some reported mortgage-related hedging flows. A number of participants indicated that, because the backup in rates appeared to importantly reflect changes in investors’ expectations about the size of Federal Reserve asset purchases, the backup was consistent with purchases helping to keep longer-term yields lower than would otherwise be the case.”

I’ve covered all of this in vivid detail in the past (see here & here), but these comments appear to imply that the Fed program is having a positive impact on the economy and interest rates.  They claim rates are lower than they otherwise would be.  This is impossible to prove of course.  All we know is that rates on the long end have surged.  In the case of a 30 year mortgage rates have jumped 80 bps in just the last few months.  It’s practically impossible to make the case that this is helping homeowners and debtors.  Of course, the Fed doesn’t truly control the long end so QE was destined to fail before it even began.  The program was flawed from inception.  It’s abundantly clear that the Fed has not been able to keep interest rates low which would entice borrowing and theoretically create a wealth effect in other markets (although Robert Shiller has already provided sound evidence that there is no such thing as a wealth effect from the equity market).

Where QE does appear to have a real impact is by spreading myth.  The psychological impact of QE should not be downplayed. It has clearly contributed to inflation fears and helped to bid up other assets.  What QE has not done is generated a fundamental reason for the economy to recover.  It clearly has failed in keeping interest rates lower.  It has not reduced the dollar.  It has not generated a borrowing boom.  It has not even increased CPI despite all the fears over money printing (though input costs are rising).  Operationally, QE is merely an asset swap and so it has no real fundamental impact on anything (or marginal at best).

The myths surrounding QE have likely helped to generate higher input costs via commodities markets and contribute to higher prices in equity markets.  Without real fundamental change QE is akin to telling the public that they should go spend money because they will receive a tax cut only to inform them several months down the line that they will not be receiving the tax cut.  This psychological impact can change behaviour in the near-term, however, without real fundamental follow-thru there is no reason to believe that the impact is sustainable.  Thus far, there is almost no evidence that QE is having any real fundamental impact.  But I am sure that won’t stop monetarists from claiming that monetary policy is succeeding (even though the August ISM, mere days after the Jackson Hole speech, clearly proved that double dip was off the table and that QE2 was never really necessary to begin with).  The residual effect of the Bernanke Put will likely be more damaging than many believe, but don’t expect the FOMC members to discuss the psychological impacts of their policies – they prefer to discuss mythical price changes which can never actually be proven.

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