Just a quick announcement. Anyone who has visited the site lately likely noticed that I have not been posting as much. Between my family, job, and studying for the CFA I have been really busy. However, I love writing and it helps me think clearly so I plan on continuing to write as much as possible. In addition, we have a few great writers who have been contributing on a regular basis to the site so there is always around 10 new posts a week.
Now back to some of my own unique content. Everyone is talking about QEII and I have some strong feelings on the topic. First for anyone unfamiliar with the term here is a great explanation from NPR:
A big bank — Bank of America, say — has $50 billion in government bonds. They’d sell those bonds if anyone would pay enough for them, but nobody is willing to pay that much. So the bank just holds on to them.
Michael Mauboussin: Here’s what active managers can do
The debate over active versus passive management continues as trends show the ongoing shift from active into passive funds. Q2 2020 hedge fund letters, conferences and more At the Morningstar Investment Conference, Michael Mauboussin of Counterpoint Global argued that the rise of index funds has made it more difficult to be an active manager. Drawing Read More
With quantitative easing, the Fed comes along and says, “Hey, Bank of America, we’ll buy those bonds for a little more than anyone else is willing to pay.” Bank of America says, “OK, great, send us the money.”
This is where the Fed gets to use central-bank magic. They pay for that $50 billion purchase in new money. They just invent it. That’s what the Fed — but nobody else — gets to do.
So now Bank of America has $50 billion they need to do something with. The Fed is hoping that Bank of America will decide to lend that $50 billion to companies and people to invest or spend. That stimulates the whole economy.
I hope that explains it for people who are not so familiar with the term.
I believe that Bernanke thinks the economy is weak and thinks that some type of stimulus in needed. During the height of the financial crisis in late 2008 to early 2009 both monetary and fiscal policy were used to help the economy recover. Bernanke as head of the Fed and Presidents Bush and Obama worked together to stabilize the economy.
I think Bernanke is doing this because he knows there is no will in Congress to pass another stimulus package and therefore all monetary policy will be constrained. This is confirmed by recent comments by Obama that he supports QEII.
According to the FT Obama stated yesterday:
“We can’t continue in a situation in which some countries are maintaining massive surpluses and other countries are maintaining massive deficits,” he said. Referring to the Federal Reserve, Mr Obama added that it was in nobody’s interests for the US to “end up being stuck with no growth or very limited growth”.
Bernanke probably is throwing a hail mary hoping that fiscal policy will help in the absence of any monetary policy. But the banks are already well capitalized and not lending so I do not see how buying treasuries from the bank to give them more cash will help.
So what does Bernanke intend to accomplish?
I have three possible thoughts.
Devaluation of the dollar:
Bill Gross recently stated that QEII might cause the dollar to decline by 20%. A weak dollar is good for exports as the goods are cheaper for foreigners to purchase. This would fit in with President Obama’s repeated declarations, that he wants to double exports. So it is not surpising as stated above that President Obama supports QEII.
However, devaluing the dollar is not a magical solution that solves all the problems. It could easily lead to trade wars which will be disasterous. Already several of the world’s largest economies including China, Russia, Brazil and Germany are furious over the Fed’s actions. Despite the fact that China is blatantly hypocritical since they artificially maintaining a weak currency, we must take into account retaliatory actions by nations like China and even countries in the Euro Zone.
Inflate Asset Prices:
With the Fed’s purchase of massive amounts of treasuries it will likely lower yields on bonds. Bond yields are already dangerously low and although I would not call it a bubble, I would not buy any medium or long term bonds at this moment. Bernanke knows if bond yields fall other asset classes including the stock market and the housing market could rise in value. A rise in housing prices would obviously solve many economic problems and help banks with bad loans prosper again.
However, mortgage rates are already near record lows for over a year and housing demand is weak. This is because no matter how low prices gets people cannot afford homes if they are in debt and underemployed or unemployed. Reducing unemployment is the key here (which obviously is very difficult) but lower interest rates will not help at all here.
In terms of stocks; an increase in the stock market does help increase confidence. If people see their 401Ks rising in value they are more likely to purchase goods which will lead to an increase in consumer spending which (for better or worst) is very important to our economy. In addition, businesses will have a lower cost of capital because they can issue stock at higher prices (and debt at lower prices). Many companies have been taking advantage of low interest rates to issues debt, and I suspect if stock prices increase companies will start raising more capital through issuing additional shares.
However, here too Bernanke must be careful. An inflated stock market that is based on speculation and low interest rates can create a stock market bubble. Stock market returns in the long run are based on earnings and not low interest rates. Bernanke might be creating a stock market bubble which could just as easily crash as it rose. In addition, the market might get scared of all the possible negatives that come along with QEII and it could lead to a market decline. Bottom line is that Bernanke is taking a huge gamble if he is trying to inflate the stock market.
This is very similar to the previous point but I am trying to focus on a slightly different aspect here. Bernanke has famously been nicknamed “Helicopter Bernanke”. He has promised to do everything possible to prevent deflation (why deflation is considered a four letter word to central bankers is beyond the scope of this article). In 2002 Bernanke stated: “The U.S. government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at no cost.” He referred to a statement made by Milton Friedman about using a “helicopter drop” of money into the economy to fight deflation.
Bernanke knows the Fed is the last resort to prevent deflation so he is likely doing everything he can to induce inflation. However, this policy is extremely dangerous as it could lead to hyper inflation as we saw in the early 1980s since once inflation gets out of control it is very hard to stop it.
I think this is a non-partisan issue. Almost every great mind who has taken an opinion on the matter thinks that QEII is a distaster.
This list includes:
Michael Burry (made famous by Michael Lewis’s, The Big Short) : said Federal Reserve Chairman Ben S. Bernanke is trying to use “poison as the cure” by pumping more cash into the economy to spur growth www.businessweek.com
Martin Feldstein is worried about the effects of more Fed asset purchases. “The Federal Reserve’s proposed policy of quantitative easing is a dangerous gamble with only a small potential upside benefit and substantial risks of creating asset bubbles that could destabilise the global economy.
John Hussman in his Weekly Market Comment wrote: We will continue this cycle until we catch on. The problem isn’t only that the Fed is treating the symptoms instead of the disease. Rather, by irresponsibly promoting reckless speculation, misallocation of capital, moral hazard (careless lending without repercussions), and illusory “wealth effects,” the Fed has become the disease.
Jim Rogers: “Dr. Bernanke unfortunately does not understand economics, he does not understand currencies, he does not understand finance,” he said Thursday, according to Bloomberg. “His whole intellectual career has been based on the study of printing money.
Niall Ferguson thinks QE2 will not only stimulate the US economy, but rather capital flows will be felt all over the world and would be likely to manifest themselves in emerging economies and rising prices for commodities.
Even Kevin Warsh who is a member of the Board of Governors of the Federal Reserve wrote an op-ed in WSJ that expressed reservations about QEII.
Disclosure: I am short long term treasuries.