For the third time in a little more than 10 years Wall Street has embraced a dubious narrative to drive the market higher in the face of crumbling fundamentals. In early 2000 the conventional wisdom discarded over a hundred years of valuation history in denying that the market was in a bubble driven by speculation in internet-related stocks. In late 2007 investors again drove the market to a peak, insisting that the subprime mortgage problem was just too insignificant to impact either the economy or the market. And if anything did go wrong, the good old Fed was there to ensure that the worst outcome would be a so-called “soft landing”. In both cases the economy went into a recession and the market dropped more than 50%.
Now, once again the economy is struggling, and investors are depending on the Fed’s impending announcement of QE2 to bail them out, driving up the market in anticipation of the news. That the economy is deteriorating is obvious. If not, QE2 would not even be under discussion. The problem, though, is that after TARP, the stimulus plan, Fed purchases of $1.7 trillion in mortgages and Treasuries, near-zero interest rates, cash for clunkers, homebuyer tax credits, mortgage remodifications and unemployment insurance extensions, there is little more that the Fed can do that they haven’t already done. The Board has used all of its conventional tools and some not so conventional, and now is in the position of entering into a great experiment with unknown outcomes and possible unintended consequences. The truth is that the Fed cannot use monetary policy to force companies, banks and consumers to take credit that they do not want.
The problem was well presented in an August op-ed column in the Wall Street Journal by Alan Blinder, a former Fed vice-chairman and colleague of Ben Bernanke at Princeton. The article, called “The Fed is Running Out of Ammo”, outlined three options for the Fed—-expanding the Fed’s sheet further, changing the “extended period” language in the Fed’s statement or lowering the interest rate on bank reserves. He then demonstrated that each of these options had negative political consequences, economic drawbacks or limited effectiveness. He concluded by saying that if the economy didn’t pick up, it would be time to use even this “weak ammunition”, although he obviously didn’t think it would be of much help.
Blinder is a main-stream economist, and we doubt that his views differ much from the majority of the FOMC. They must know that they are about to implement a policy that has never been tried before on this scale and that the outcome is extremely uncertain. However, with the White House and Congress in gridlock, the Fed knows that they are the only game in town. What they are hoping to do is increase the Fed’s balance sheet, induce the banks to extend a lot more credit, lower long-term interest rates, spark spending by consumers and business and raise the inflation rate, which they regard as too low. In doing this they are also devaluing the dollar and raising commodity prices, at least in dollar terms.
We have serious doubts as to whether this works. The 10-year interest rate has already declined to 2.5% from 4% in April, a period during which the economy weakened. If the rate drops a bit more there is little reason to believe that the economy would be helped. In addition we note that most of the dollars created by QE1 ended up as excess reserves in the banking system, and did not result in any increase in credit availability or money supply as the money multiplier declined. The same is likely to happen with QE2. The effects on the real economy are also likely to be limited. Mortgage rates are already at historic lows, and QE2 won’t stop impending foreclosures or pare down bloated housing inventories. Similarly, QE2 won’t increase consumer spending as households are only in the early stage of deleveraging. In fact, to the extent that QE2 raises commodity prices, food and energy prices will rise, making the plight of the consumer even worse than it is now. Moreover, lower long-rates probably won’t increase capital spending, which depends more on the economic outlook than on interest rates.
Whether intentional or not, QE2 is also an effective tool in devaluing the dollar, an outcome that we suspect the Fed wouldn’t mind, since, other things being equal, it increases U.S. exports. As we pointed out last week, this would exacerbate the currency war that has already started. Most nations do not want to see their currencies rise and would likely take action to devalue, institute or raise tariffs, implement quotas or take steps to control capital inflows. The result would be major decline in world trade, resulting in a slowdown of economic growth or outright recession—exactly the opposite of what the Fed is trying to achieve.
In sum, we think the chances of QE2 succeeding are slim, and that the stock market is off on a flight of fantasy similar to 2000 and 2007. The economic problems we face today took a long time to build and will not be solved anytime soon as there are really no good options. The market is building up expectations that cannot be met and the expected Fed announcement after the November 3rd meeting may not have much impact as it has already been discounted. What has not been discounted is the potential failure of QE2 to solve our problems, leaving economic policy makers with even fewer options than before.