We’ve decided to initiate an ongoing series of short notes that address a single point. We have long been of the view that QE has no longer any significant impact on the economy and therefore no central bank (CB) will embark on more. We note that QE has major (economic) impacts on markets but this translates into little impact on the economy. We have written extensively on this before. We will summarize why QE will have no impact on the economy and present our view why in fact QE will come.
The only real tool CBs have to stimulate the economy is their control of interest rates. Lower rates encourage borrowing and spending leading to economic growth. Control at the front end of the yield curve was broken when the zero bound was reached (ZIRP – do a search on this site). QEs (note that the FED definition of QE includes the requirements that interest rates be at zero) in various forms were then used to lower rates across the curve. Later ones addressed the long (30-year) bond to lower mortgage rates with an insignificant effect on the housing market.
In short, QE has reached its limit in being able to affect the real economy which is why we have argued that the Fed in particular will not engage in more of it. The reason for this we have detailed in other posts: the consumer who is responsible for 70% of GDP in the US has reached a debt ceiling. He has no capacity left for borrowing more. Moreover as we have described, this condition (high debt among all players in the economy) will lead to reduced growth and lower GDP for decades.
For support of these points see Bloomberg yesterday – Banks Use $1.77 Trillion to Double Treasury Purchases:
- There’s all sorts of good long-term developments that are occurring on household balance sheets, but you sense the Fed would like them to be not quite as thrifty and instead put a little more money to work
- It’s a function of inherently weak demand for loans and that relates to inherently weak demand in the economy, … Consumers, households, businesses: they’re paying down debt, they’re saving money, they’re not borrowing. They don’t have an appetite.
- Household purchases, which account for about 70 percent of GDP, grew at the slowest pace in a year, according to the commerce department’s report on GDP.
The Europeans, however, are using monetization, of which QE is one form, to purchase the sovereign debt of peripheral countries whose yields are out of control. The latest plan by the ECB to cap interest rates is described by Ambrose Evans-Pritchard in Germany backs Draghi bond plan against Bundesbank. If Mario Draghi gets his way, this will result in massive open-ended purchases of Italian and Spanish debt initially and several more countries ultimately. This of course will require a massive printing of euros, dropping its value, possibly precipitously.
The Fed will likely have to respond in kind to maintain a currency alignment that is not destructive to US export industries. This falls into the area of currency wars that Jim Rickards has lately been pounding the table about to promote his new book on the subject (Reserve Bank of Australia Under Pressure, ABC News, How China Is Driving Federal Reserve Policy). His argument is the Fed will have to entertain some form of QE such as GDP targeting in some kind of an open-ended policy, in an effort to combat the Chinese yuan.
The market has largely priced in (we recently saw an 80% figure: BofA: QE3 is 80% priced into the markets) QE3. A clear signal from the Fed that there will be no QE will cause a sharp equity correction. This would not sit well with a weak economy in front of presidential elections. On the other hand, to announce QE3 would have the appearance that the Fed had abandoned its neutrality to support Obama. Look for more equivocating similar to what has come out of the last few FOMC meetings, to come out of the Jackson Hole conference this weekend.
Ultimately the fed will probably have to intervene from the currency market rather perspective rather than the job market perspective (we have shown how QE has had little or no effect on the unemployment numbers). However the latest FOMC minutes show a growing view that more may be necessary and relatively soon (Zero Hedge: FOMC Minutes Indicate No Shift In Fed’s Views, Even As Many Members See More Easing Likely Warranted):
Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.
This sentiment has been slowly but steadily growing over a number of FOMC meetings.
Momentum is moving in the direction of massive ECB bond purchases and monetization. Germany may yet block the initiative but the signals are becoming if anything, more mixed. The Finns may prove to be the source of any effective block to the strategy. They are a small player but have taken very hard positions all along and recently stated effectively ‘no more money’. We think the ECB at this point may prevail and the result will be called QE in some eurozone parlance.
Pundits keep saying Bernanke needs an economic event such as a really bad non-farm payroll number, to justify a new QE program. We think the Fed should know that they really have no leverage left over unemployment despite this being one of their mandates. However, the increasing sentiment towards some form of stimulus intervention suggests they think they still have a card or two left to play. They may try to drag it out hoping for signs of a real recovery. Eventually they will have to decide which side of the fence appears to have the greener grass (less risk or pain). The easiest route is more QE. The currency angle is a wildcard. In either case, we think they will probably announce something by year end.
Since posting this we have found support for argument on the limitations of Fed policy from Jeffrey Lacker, president of the Federal Reserve Bank of Richmond. Reported in USNews, in an interview with The Associated Press, he said that the Fed can only do so much to lower the 8.3 percent unemployment rate. There are a lot of people overestimating the extent to which monetary policy is capable of having any sustained effect on growth or labor markets.