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Retired chief investment officer and former NYSE firm partner with 50 plus years experience in field as analyst / economist, portfolio manager / trader, and CIO who has superb track record with multi $billion equities and fixed income portfolios. Advanced degrees, CFA. Having done much professional writing as a young guy, I now have a cryptic style. 40 years down on and around The Street confirms: CAVEAT EMPTOR IN SPADES !!!

Thursday, September 13, 2012

Monetary Policy -- The New Open End QE

The Fed has opted to revert to the script it followed after the economy hit bottom in 1932 during
The Great Depression. This time it has going to provide $40 bil. of mortgage backed securities
purchases a month until further notice. In a weak credit demand environment, the Fed is the primary
provider of liquidity to the financial system. Without this liquidity, the economy could well have
tipped over into a deflationary depression with catastrophic economic consequences. QE is a
strong lifeline for the economy. It is perhaps a necessary condition for continued economic
recovery, but, as we have seen since 2009, it is hardly a sufficient condition for robust economic

Since late 2008, the Fed has been expanding Fed Bank Credit periodically and primarily within a
$300 bil. band range. The very low end of the range has been hit in 2/2009, 11/2010 and here in
Sep. 2012. "Test" contractions of liquidity have preceded each major new wave of QE. The
contractions have become progressively less destructive to the recovery but have slowed it
down each time out. The Fed has not hesitated to allow liquidity it provides to exceed the top of
its $300 bil. annual range, but subsequently moves to rein it in. With the recent nearly $100
bil. drawdown of its balance sheet, the Fed can buy $40 bil. a month of securities over the next
12 months without overtaxing its silent, internal discipline.

Remember too, that the Fed still has operant currency swap lines with foreign central banks.
Should an offshore crisis precipitate a sudden, large demand for US$, the Fed will stand ready
to supply the $.

In the short run, there is still a risk the Fed waited too long to add fresh liquidity and the
economy could "break bad" on the downside. The Fed gambled with the economy as it did in
the three prior years and there is no assurance It will get away with it this time.

A large open end QE program such as the Fed is initiating does carry another economic risk.
If the labor market continues to respond slowly, QE induced financial speculation in the fuels
and other sectors of the commodities market could force the inflation rate higher, and if
business keeps wages growing very slowly, then real incomes could decline, which would
short circuit much of the benefit to growth that QE might otherwise bring.

Finally, let's assume the Fed keeps its $40 bil. monthly stipend in place over the next full
year or so and that the economy does respond rather favorably. If such were to occur, the
economy would feature considerably lower levels of slack. This development would then
put the US in more advanced expansion mode, when cyclical pressures could lead the
markets to push interest rates higher and the increased level of resource utilization could well
lead to a more normal and broader cyclical acceleration of inflation.

The first step with this new program is to see if the US can muster new confidence to avoid
"breaking bad" in the months just ahead.

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