Van R. Hoisington and Lacy H. Hunt, in their third quarter review, suggest that the Federal Reserve will remain unsuccessful in their quest for higher growth by continuing Large Scale Asset Purchases (LSAP).
Fed’s economic forecasts repeatedly off the mark
The analysts contend that judging from the repeatedly over-optimistic economic projections made by the Fed, “they are misunderstanding the way their actions affect the economy.” According to the analysts, the Fed’s projection that real GDP could grow 2.7% in 2013 is likely to be off the mark by nearly 50%.
A key assumption the Fed makes is that higher stock prices could boost consumer spending, but this is at odds with econometric studies, which suggest that consumer spending does not correlate with a rise or fall in wealth. In fact the chart below shows that y-on-y growth in personal consumption expenditure has actually fallen (circled area) in the four quarters ended Q2. LSAP has therefore not achieved the objective of higher growth.
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Fed failed to consider the excessive debt
The authors point out that excessive debt blunts the impact of monetary policy on the economy. Studies prove that economic growth tapers off when total debt in the economy surpasses 260%-275% of GDP. In the U.S. economy, growth rates fell significantly after 2000 when indebtedness crossed 260% of GDP.
LSAP: A losing proposition
The authors contend that after five years of LSAP there has “been no measurable benefit.” According to one paper by renowned econometrician Robert E Hall, an expansion of reserves actually contracts the economy. Hall also said that LSAP adversely affects GDP targeting and forward guidance. The authors say “not only has the Fed not improved matters, they have actually made economic conditions worse with their experimentation.”
Fed unable to control the velocity of money
The velocity of money is the average frequency with which a unit of money is spent on new goods and services produced in an economy in a particular span of time. Velocity relates with the amount of economic activity associated with a given money supply. Nominal GDP = Money Stock (M) x Velocity of Money (V).
The authors claim that excessive debt levels in the economy, that approached the non-productive zone, eventually led V to crash in Q2 to its lowest level in six decades.
The authors point to economist Fisher’s argument that “declining velocity would be a symptom of extreme indebtedness just as much as weak aggregate demand.”
Other, unintended consequences of LSAP
Banks are unable to generate income from their traditional lending operations due to the sub-normal interest rates prevailing as a consequence of LSAP. They prefer to utilize their resources in risky but more profitable speculation in the financial or commodity markets. This kind of resource allocation therefore curtails the resources available to business, and therefore economic growth, via traditional lending.
The authors present evidence that this is indeed happening – the quarterly money multiplier reading in September 2013 of 3.1 is the lowest in the entire 100-year history of the Federal Reserve.
The economic growth outlook for the rest of 2013 is poor, and for 2014, is uncertain.
“The broadest measures of inflation, which are barely exceeding 1%, should weaken further. Since LSAP does not constitute macro-stimulus, its continuation is equally meaningless. Therefore, the decision of the Fed not to taper is inconsequential for the outlook for economic growth.”