Why the Fed's Quantitative Easing Is Overblown This Time - Rick Newman (usnews.com)

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Rick Newman
Why the Fed's Quantitative Easing Is Overblown This Time
By Rick Newman
Posted: November 3, 2010
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When the Federal Reserve outlined an aggressive "quantitativeeasing" plan in March 2009, investors were startled. The Fed hadalready embarked on a plan to buy about $500 billion worth ofgovernment securities, which Fed chairman Ben Bernanke had described as"credit easing" meant to pump money into banks so they'd lend more.Then the Fed dramatically raised the stakes, announcing it would buy anadditional $1 trillion worth of government debt and mortgage-backedsecurities to further stoke the economy.
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The "shock and awe" approach worked. Bond prices jumped andlong-term interest rates fell, just as the Fed had intended. Stocksrallied on the day the Fed announced its big QE plan, and kept ongoing. The Fed's announcement, in fact, effectively ended the worststock market slide in decades. From its low point in March 2009, theS&P 500 surged by about 83 percent over the next 13 months—toppingout right around the time the Fed ended its huge spending binge.
QE1, as the Fed's original plan is known, was supposed to pumpsome air into the economy, then wind down as growth picked up on itsown. But that hasn't happened. GDP growth is slowing to a paltry 2percent or less, not accelerating as the Fed hoped it would 18 monthsago. Most companies still aren't hiring, with the unemployment ratelikely to once again hit 10 percent or higher. Instead of the inflationthat would normally happen when the central bank injected over $1trillion into the economy, there's a risk of deflation, which is a farmore pernicious problem. And the Republican surge in the midtermsseverely reduces the odds of any more fiscal stimulus, which Bernankewould like to see.
So the Fed is at it again—except this time, quantitative easing willprobably have far less impact on the economy. Investors hoping foranother huge market rally may end up deeply disappointed. And if QE2fails to meet inflated expectations, it could even do more harm thangood. Here are four reasons why:
It's much smaller than before. The Fed plans to buyan additional $600 billion worth of government securities throughmid-2011, less than half of what it purchased during QE1. Moody'sAnalytics has calculated that every $1 trillion worth of Fed assetpurchases would add six-tenths of a percentage point to GDP growth, andreduce the jobless rate by four-tenths of a point, over the next yearor so. So quantitative easing that amounts to significantly less wouldhave a marginal impact on growth and unemployment. On the plus side,the Fed can always enlarge its purchases, and a live QE program signalstoinvestors that the Fed is well aware of the economy's weakness and prepared to act aggressively.
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Still, many analysts—including some at the Fed itself—worry that anyadditional easing makes the risk of inflation down the roadunacceptably high. That in turn could force the Fed to raise interestrates while the economy is still fragile, risking another recession.Thomas Hoenig, president of the Kansas City Federal Reserve Bank and amember of the group that makes key Fed decisions, said in a recentspeech that more easing was "a very dangerous gamble" and a "bargainwith the devil." He also opposed the latest Fed move. That kind ofopposition could damage the Fed's credibility if not much comes of QE2.
Investors are already banking on it. There's no element of surprise this time. TheFed has been telegraphing its plans for QE2 since late August, whenBernanke gave a thoroughly dissected speech in Jackson Hole, Wyo.,hinting that more QE was coming. Stocks have risen ever since and arenow about 14 percent higher than they were before Bernanke took to thepodium that day, with investors clearly hoping to cash in on a rallylike the one the Fed ignited in 2009. But this time, the rally could bemuch more fleeting. The markets were at a genuine bottom in March 2009,having fallen 57 percent from the peak in 2007. It was just startingto become clear that massive government intervention would help avertwidespread bank failures, after all. QE1 and the Fed's bank stresstests, which came about six weeks later, effectively ended the financialpanic and set the conditions for a sharp rebound in stocks.
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Today, the stock market may be overinflated due to government aid that masks the depth of problems in the economy. Aset of charts posted recently at the blog Zero Hedge,for instance, illustrates how key indicators like GDP growth,employment, income growth, and home sales are all tracking belowaverage compared to the way the economy recovered following pastrecessions. The only thing overperforming is the stock market. Thatmight be because big firms today earn nearly half of their profitsoverseas, so they're able to cash in on rapid growth in emergingeconomies that are recovering faster. But it could also indicate astock-market bubble fueled by the Fed'seasy money,just as the housing bubble was. It's also possible that all the moneyheaded for the stock market is already there, with no further gainslikely from QE2. So there may be no further "wealth effect" from thevalue of rising stock portfolios than there has been already. The smartmoney is prepared for that.
Falling interest rates may not accomplish much. TheFed hopes that pushing rates even lower than the record levels they'reat now will increase lending and spending. Lower mortgage rates,theoretically, should induce more people to buy homes, and morehomeowners to refinance their existing mortgages, effectively puttingcash in their pockets. And businesses ought to take advantage of lowrates to borrow more money they can invest in equipment and people.
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The problem, however, is that the usual conduits for passing throughthe virtues of low rates are clogged. The foreclosures fiasco hasgunked up the whole housing market, since it's not clear if paperworkflaws on thousands of foreclosures are mere technicalities orwidespread fraud, and the controversy could freeze the market formonths as investigators sort it out. Meanwhile, the housing bust dragsinto its fifth year, as buyers wait for a bottom and a sense that it'stime to buy. As prices continue to drop, more homeowners are underwaterand unable to take advantage of low rates to refinance. Businesses,meanwhile, have already borrowed vast amounts of money at low rates,with big firms sitting on $1 trillion in cash. Yet they're not using itto hire more workers. Instead, businesses of all sizes are waiting forone thing to happen before they start hiring: Sales to increase. Givenall the slack in the economy, it's not clear how lower interest rateswill help accomplish that.
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The Fed can't do it alone. The Fed is the singlemost powerful institution affecting the economy—yet it's still easy tooverestimate the Fed's powers. Back in 2009, the Fed's actions werecomplemented by a big stimulus program, the bank bailouts, a tax creditfor home buyers, vastly expanded FDIC loan guarantees, and a bunch ofother government measures. Though it's unpopular today, the stimulushelped speed the end of the recession and propped up GDP growth whenprivate spending had shrunk. Today, the stimulus is fading, and anincoming Congress dominated by small-government Republicans seemsunlikely to add much fiscal oomph to the Fed's monetary maneuvers. Thatleaves the Fed trying to marshal a recovery like a quarterback whoseoffensive line has been depleted. Maybe Bernanke & Co. will pulloff a Hail Mary pass. But the odds of a fumble are a lot higher thanbefore.
Twitter:@rickjnewman
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There is something completely fishy
about any scheme for one arm of government to use printed moneyto buy debt issued by another arm of the same government. I think theywho say the Fed is "out of ammunition" are right.
As for the new tea-drunk Congress. If the House passes more taxcuts for the rich, Obama just has to say "no". The past tax cuts arethe reason for today's high unemployment (and the broke government), notany kind of remedy.
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Muserof NM@Nov 04, 2010 01:08:43 AM
Les
The Fed is openly monetizing the federal debt. It's nothingmore complicated than that. The Fed has intentionally left the programopen-ended with an initial commitment of 850-900 billion dollars intreasury purchases over the next eight months, exactly the same amountexpected to be issued by the Treasury. This is not an attempt to revivethe economy. That is what fiscal stimulus in the form of spending andtax cuts do. Central bank purchases of financial assets is an attemptto artificially set prices that would otherwise be set by the market atlower levels.
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Louieof VA@Nov 03, 2010 21:39:56 PM
Central Bankers and what they know
The use of quantitative easing by the Federal Reserve shouldindicate to investors that Mr. Bernanke has run out of ammunition andthat the economy is in far worse shape than he is publicly admitting.Quantitative easing by the Bank of Japan has failed to bring its economyout of decades of doldrums and have resulted in an overvalued yen andtwo “lost” decades. In the case of the United Kingdom, quantitativeeasing by the Bank of England has done little to stimulate theirmoribund economy and has pushed the pound sterling to the level where itis undervalued. Apparently, there is very little in the way of eitherpredictability or science in the “science of economics”. Trying topredict the behaviour of banks, businesses and consumers is like tryingto herd cats; it can’t be done. While we shouldn’t expect our centralbankers to be prescient, they should at least have common sense.
Here are some candid and rather frightening comments from acentral banker showing us exactly how much central bankers are able toforesee what is likely to happen to the world’s economy:
http://viableopposition.blogspot.com/2010/11/mr-bean-strikes-again-more-candor-from_01.html
It is unnerving to think that we are trusting central bankers with our fiscal futures.
Quantitative easing – such a nice, non-threatening way to say“print more paper money in a desperate attempt to inflate the economy”.