QE2 is going to go down as one of the worst monetary policy initiatives in the history of the modern Federal Reserve era. On almost any metric applied, QE2 ends up not only falling well short of its proposed goals, but actually turns certain metrics like GDP growth negative compared with the prior quarter, and heading in the wrong direction.
Costs Eat into Corporate Profits = No Hiring
Analysts all over Wall Street are starting to revise their 2nd quarter GDP forecasts down, and some like Goldman Sachs have made several downward revisions as higher input costs due to a weak dollar are creating an additional burden on businesses and consumers and thus slowing economic growth.
A weak dollar (Fig. 1) to a point can help exports, but an extremely weak dollar which in combination with QE2 liquidity juicing up commodities even further, turns out to be a net negative on the economy, and risks sending the economy into another recession.
The reason for this is if businesses are having to eat higher input costs, and start to have lower margins, guess what? They start cutting costs again, and that means either stagnant employment practices or workforce cuts in the future. This would start sending the employment figures in the opposite direction, and negate much of the recent progress made over the last year.
Increase Cost of Living = Consumer Pullback
These higher commodity prices negatively affect consumers as well because they have to apply more of their income to food and energy needs, which means they have less discretionary income to spend for entertainment, retail shopping, vacations, traveling, and discretionary consumption which infuses the economy and creates jobs in the overall economy.
And since the US is largely a consuming nation, if the consumer pulls back, then businesses are going to pull back as well. This linkage of events does not bode well for employment growth, and this shows how rising input costs not only hurt one of the fed`s mandates for price stability, but can also have a negative impact on their other mandate which is to increase employment.
Increase Consumer Debt…& Defaults
There is another angle we saw back in2008 with these same level of gas prices. Namely, consumers were feeling pinched by the jump in costs for food and energy (see charts below), so they started filling out credit card applications, and charging up their credit cards in order to pay for the additional costs to their weekly and monthly budgets for food and energy. In short, the higher costs for these items resulted in more debt for consumers.
This means that the recent gains of consumers paying off their debts, and having more money to spend at retailers over the past year will start to reverse as consumers pay a higher percentage of their monthly budget in finance costs. The real damage starts to add up as consumers start to default on their credit cards as the high food and energy costs continue to be financed on credit cards until the consumer hits the breaking point, and just defaults.
We saw a lot of this in 2008, and this is where we are heading again unless commodity prices start to come down in a rapid fashion. There are a large group of consumers whose monthly budget doesn`t allow for a 30% increase in gasoline prices at the pump, or a 10% rise in food costs at the grocery store. So they just pile up debt until they max out their credit cards.
Dominos to Credit Card Issuers
These increases in credit card defaults hurt businesses like banks and credit card firms as they have to write off more accounts, and thus their margins start to get squeezed. This means additional contractionary effects as they respond by cutting costs, and you can readily see how this starts to become a vicious deflationary cycle.
Deflation by High Commodity Prices
This is why high commodity prices are actually deflationary in the long run. Something the fed should think about the next time they embark on a dollar weakening campaign, whether intended or not QE2 has been a dollar weakening campaign.
And for those of you who still do not understand the chain of events, and how the Federal Reserve is responsible in large part for higher commodity prices here is the chain of events.
- The Fed undertakes QE2 Initiative – States goal to raise asset prices
- Assets trade as a group: Equities, Silver, Gold, Oil, Gas, Corn, Soybeans
- The US Dollar is used as a carry trade with such low fed funds rate (0-.25%)
- The Fed encourages investors to take more risk: Go out of safe assets like bonds, and go into riskier assets like commodities and stocks.
- When traders take on more risk, they use more leverage-This means shorting the dollar, as part of the carry trade like a funding bank, to use these additional funds (leverage) to invest in risk assets like Gold,