In John Hussman’s view, equity markets still aren’t really appreciating the 100% certainty of Greek default because bailouts have been so fully ingrained in the investor mentality.
Undoubtedly, one of the main factors prompting a benign response to what is now virtually certain recession and virtually certain Greek default is the hope that the Fed will launch some new monetary intervention. While Wall Street appears to view the present weakness as a replay of 2010, it is strikingly clear that the evidence tells a different story, with a broad ensemble of data implying near-certainty of oncoming recession (see An Imminent Downturn ).
While we have to allow for the possibility of a knee-jerk speculative response in the event of further Fed intervention, it is also much clearer now than it was in 2010 that quantitative easing does not work, and that even its marginal effects have reached the point of diminishing returns. To a large extent, the only basis for further Fed action here is superstition in the absence of either fact or theory.
Ultimately, effective policy acts to relieve some constraint on the economy that is actually binding. Effective policy has some “transmission mechanism,” where changes in the policy target can be expected to translate into decisions that improve the allocation of resources and the level of activity in the economy. Effective policy is also preferably grounded in historical evidence that supports its effectiveness, or at the very least does not contradict the action. At present, the policy menu advocated by Ben Bernanke has none of these advantages.
Consider, for example, a further round of quantitative easing through purchases of Treasury securities. With $1.6 trillion of excess reserves already sitting idle in the U.S. banking system, it is inconceivable that the U.S. faces any binding constraint that would be eased by the creation of more reserves (which is what QE does). With the 10-year Treasury yield already below 2%, it is also inconceivable that the U.S. faces any binding constraint that would be eased by further depressing that yield. Moreover, from an investment standpoint, it is difficult to envision a situation where long-term Treasuries purchased at current prices will not result in a loss for the Fed at some future date when the position is unwound – even a 0.25% increase in the 10-year Treasury yield presently would wipe out a full year of interest earnings. So the Fed would take a loss on newly purchased bonds even if it unwound them at a 3% Treasury yield four years from now. A failure to eventually unwind the position would be predictably inflationary. As for Bernanke’s baseless view that higher stock market values trigger a “wealth effect” and a “virtuous circle” of spending and income, it is well-established in decades of economic data that each 1% change in stock market value is associated with a transitory increase of only 0.03-0.05% in GDP.
At best, a further round of QE would create an even larger pool of zero-interest assets that somebody would have to hold. That could prompt some of the same reaching-for-yield that we saw during QE2, misallocating resources, distorting markets, but ultimately producing no durable effect. So yes, by embarking on QE3, the Fed could try to engineer a brief burst of speculation in financial assets and commodities, and could put some additional downward pressure on the U.S. dollar on the foreign exchange markets. But to what real end other than the total loss of the Fed’s remaining credibility?
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