Desperate Fed Launches Unprecedented QE3

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
September 18, 2012

IN THIS ISSUE:

1. Fed Announces QE3 or “QE-Infinity”

2. Questioning Bernanke’s Logic on QE3

3. Why QE3 is Dangerous & May Not Work

4. Why QE3 is Unprecedented

5. Does Quantitative Easing Mainly Help the Rich?

Fed Announces QE3 or “QE-Infinity”

It came as no surprise that the Fed announced a new round of quantitative easing last Thursday at the end of its two-day policy meeting. It was widely anticipated that some new action would be taken in an effort to stimulate the struggling economy. But what the Fed announced was far beyond what anyone had expected.

Fed Chairman Ben Bernanke announced that the Fed would immediately begin monthly purchases of $40 billion in mortgage backed securities and would continue to do so until there are signs that the economy is improving significantly. This is an unprecedented action by the Fed in that it is in effect open-ended. As a result, some deemed it “QE-Infinity.” It certainly appears to be an act of desperation.

The Fed policy committee also voted to continue its “Operation Twist” program at least through the end of the year. The Twist, if you recall, is the action whereby the Fed sells shorter-term securities and uses those funds to purchase longer-dated Treasury securities in an effort to bring long-term interest rates down further. Here is an excerpt from the Fed’s latest policy statement:

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.

The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.

These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative. [Emphasis added.]

Wall Street cheered the announcement. The major US stock indexes, which had been firming all month in anticipation of QE3, soared to the highest levels in five years in the Dow and the S&P. Since the new stimulus program is open-ended, at the Fed’s sole discretion, it is widely expected that stocks will challenge the all-time highs set in late 2007 in the days and weeks ahead. That remains to be seen, of course.

Not surprisingly, gold prices shot up and the US dollar plunged lower just after the Fed announcement. Gold bulls are convinced that all this QE will eventually lead to higher inflation. The fact that the Fed will now be printing (digitizing actually) $40 billion in new dollars each month is bearish for the greenback.

Questioning Bernanke’s Logic on QE3

As noted above, QE3 is unprecedented on several levels as I will discuss below. There are many legitimate questions about the Fed’s thinking as it made this very unusual decision. And there are lots of assumptions floating around about why Bernanke engineered this latest controversial plan. But before we get into that, I would like to offer a bigger picture perspective of where we are.

Thirty-three years ago, inflation was raging in the US. In August 1979, Paul Volcker was installed as the Chairman of the Federal Reserve with a mandate to bring down inflation, which was running around 14% in 1980. As Fed Chairman, Volcker aggressively sold bonds, drained cash from the economy and remained resolute in doing so, even in the face of soaring interest rates and the recession that followed.

In the end, it worked and we survived the recession. Gold plunged, the US dollar soared and the contraction in bank reserves and the money supply extinguished high inflation. Volcker’s actions launched a multi-decade period of relatively low inflation.

Over the last couple of years, current Fed chairman Ben Bernanke has embarked on an absolute reversal of Volcker’s policy. He has launched a monumental, unprecedented campaign to buy bonds, inject vast new money into the economy and drive interest rates to near zero in an effort to reignite economic growth and job creation. It’s like history is repeating itself, but in reverse. Gold is soaring, the dollar is falling.

One wonders if the Fed really knows what it’s doing. As noted above, QE3 is open-ended and it will be up to the Fed’s discretion when the program will end. When might that be? The answer is a resounding nobody knows. In Bernanke’s own words: “We haven't yet come to a set of numbers, but we're guaranteeing that we won't tighten too soon.”

That statement alone should create some discomfort with American taxpayers, as the unaccountable (to voters) Fed is admittedly setting a far-reaching policy with no qualifiers. But naysayers are glibly refuted, as Bernanke demonstrates in a statement discussed later.

Printing money floods the market with more dollars, which makes dollars worth less (supply and demand: more supply equals lower value), which means that tangible assets priced in dollars – such as food and oil – end up costing more over time. While the first two rounds of QE did not lead to higher inflation, QE3 could well push the edge of the envelope.

One of the arguments against prolonged low interest rates and flooding the money supply is that these actions punish savers in two ways: 1) Artificially low interest rates hit savers’ accounts directly; and 2) Printing money hits them a second time and forces them into higher-risk assets as they try to keep up with inflation.

In a weak attempt to address the fact that his policies punish savers, Bernanke responded with this glib argument: “You can't save without a job.” Yes, that’s a true statement, but it’s not a legitimate argument. Even in this depressed labor market, there are still far more Americans with jobs than without them, and there are more and more retirees struggling to survive on savings being held in accounts that currently yield virtually no return.

Bernanke’s argument is that creating yet another $40 billion in new money each month to lower the unemployment rate (maybe) justifies punishing everyone else because you can’t save without a job. That’s like saying “You can't die in a car wreck if you don't have a car.” Assuming that you don’t ride in someone else’s car, that may be true, but it hardly applies to the economy and Fed monetary policy.

Bernanke’s statement also assumes the underlying presupposition that the new QE3 program will actually improve the labor market, and that assumption is not a given. There is an ongoing debate over how much influence the Fed actually holds over the labor market, and that question was asked of Bernanke at last Thursday’s press conference.

The question was, “How does boosting [Fed] assets really help the real economy?” Bernanke replied, “There are a number of different channels: mortgage rates, corporate bond rates, and increase in home prices and stock prices.”

This is another non-answer that avoids the real question. Bernanke responds that there are “different channels,” but he does not establish that these channels have any direct causation in creating more jobs. Nor did he establish how these channels materially differ from what’s already been tried in QE1 and QE2.

Interestingly, Esther George, the president of the Federal Reserve Bank in Kansas City, recently asked this rhetorical question: “Is there anyone not borrowing today or purchasing a house because interest rates aren’t low enough? Do we expect that businesses will hire if their long-term rates are lower?” That was a real zinger!

Bernanke argued that the justification for QE3 was to help create jobs and improve the economy. In that light, the real question to be asked is, “How did QE1 and QE2 do in terms of creating jobs?” While Bernanke argued in Jackson Hole that QE1 and QE2 were very effective, let’s take a look at the following chart.

Civilian Employment-Population Ratio (EMRATIO)

QE1 began in November 2008 and ended in March 2010. QE2 started in November 2010 and ended in June 2011. Need I say more? Yet Bernanke wants us to believe that this time is different. And it is different to the extent that QE3 is open-ended both in terms of size and duration.

Why QE3 is Dangerous & May Not Work

While the Fed’s latest announcement of QE3 was hailed on Wall Street (and I’m sure in the White House), there are many others who believe strongly that not only is it a dangerous course, it may very well not work.

In order to explain why QE3 is dangerous and may not work, let me quickly revisit how QE was supposed to work in the first place. Quantitative Easing is government-speak for creating more money out of thin air – about $2.5 trillion thus far, before QE3 kicks in.

The Fed uses this newly-created money to buy bonds from the big banks (at a nice profit), with the expectation that the banks will in-turn use the new cash to make loans and stimulate the economy. The problem is that the banks, in light of the financial crisis, have adopted more stringent loan requirements that are very hard to meet. Plus, businesses are so worried about the economy and higher taxes that they are hesitant to even apply for loans. So the net effect is that the banks simply park the new cash at the Fed and earn interest.

While the above illustration is greatly simplified, it does explain why QE1 and QE2 haven’t worked. Yes, there are some who argue that the economy would be worse off had it not been for the first two rounds of QE totaling about $2.5 trillion.

They also argue that fears that inflation would rise as a result of QE1 and QE2 were totally unfounded since inflation remains relatively low. However, since QE3 is open-ended, there is no way to know how much money the Fed will create and spend this time around. And let us not forget that inflation remains low only until it doesn’t.

The Fed has been reduced to QE because its usual go-to monetary tool, which is lowering interest rates, has long been maxed-out and ineffective. The Fed funds rate at 0.0% to 0.25% is already effectively negative when you factor in inflation; thus there’s nothing more to be done on the short end in that regard.

The yield on the 30-year Treasury bond fell to only 2.5% this summer. Here too, how much lower do they think this rate can go? When will investors and foreign governments decide that it’s just not worth it to loan us money for 30 years at a rate that is about the same as inflation?

Finally, one wonders if the major credit rating agencies will further reduce America’s debt rating yet again. One such agency, Egan-Jones, already cut its rating to “AA-“ last Friday following the Fed’s QE3 announcement. Will the others follow suit just ahead? We’ll see.

Why QE3 is Unprecedented

Everyone agrees that the Fed’s announcement last Thursday is a bold and aggressive move. Several features of the program mark a stark departure from past practices. QE3-Infinity is unprecedented for three main reasons.

1. Open-Ended Expansion. In the past, when the Fed announced a Large Scale Asset Purchase program (LSAP), it indicated its maximum size and duration. Sometimes it revisited the duration or size, expanding the programs as necessary. But this time, the Fed has explicitly declared that QE3 will continue until economic conditions improve. What’s more, the Fed said it would undertake additional LSAPs and employ “other policy tools” so long as the economy is underperforming.

2. Targeted at Labor Market. Perhaps even more importantly, the Fed’s QE3 policy is very explicitly tied to the labor market. The FOMC policy statement is very clear: “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved…” This explicit tying of QE3 to the labor market is unprecedented.

3. Not Tied To New Weakness. The Fed’s policy statement was actually fairly upbeat about the economy. Specifically, the statement noted that economic activity “continued to expand at a moderate pace” in recent months. The only downbeat note in the statement was about the jobs market. But that’s hardly news. The point is, the Fed believes that the recovery will continue and is not afraid that the economy is tipping back into a recession.

What the Fed did Thursday was announce that its policy was not based on a forecast of things getting worse, but on a desire for things to improve faster. In short, it announced that the central bank intended to change the pace of recovery. That is a bold new world for Fed policy.

Does Quantitative Easing Mainly Help the Rich?

In August, the Bank of England issued a new report which concluded that their central bank’s quantitative easing program (similar to our own) had benefited mainly the wealthy. Specifically, it said that its QE program had boosted the value of stocks and bonds by 26%, or about $970 billion. It said that about 40% of those gains went to the richest 5% of British households.

The report is instructive for the United States. The latest round of QE announced by Bernanke on Thursday has sparked growing controversy about how Fed policy has mainly helped the wealthiest Americans. Even Donald Trump said on CNBC last Thursday: “People like me will benefit from this.”

The reason is simple. QE drives up the prices of assets, especially financial assets. And most of the financial assets in America are owed by the wealthiest 5% Americans. According to Fed data, the top 5% own 60% of the nation’s individually held financial assets. They own 82% of the individually held stocks and more than 90% of the individually held bonds.

By helping to reinflate the stock market in 2009 and 2010, the Fed created a two-speed recovery. The wealthy quickly recovered much of their wealth as stocks doubled in value. But the rest of the country, which depends on houses and jobs for their wealth, remained stuck in recession.

Put another way, most Americans have most of their wealth tied up in their houses (about 50% for most). For the top 5%, homes account for only 10% of their wealth, while financial assets account for between one-third and 40%. By boosting the value of financial assets, the Fed has helped the pocketbooks of the wealthy but not for the broader population.

Bernanke is obviously aware of this criticism, which is why the latest round of easing is focused on mortgages. But here too, there is a divide between the rich and the rest. As noted above, despite much lower interest rates, banks remain strict on lending, thereby restricting access to credit for most Americans.

Of course, low interest rates also penalize savers, and the wealthy as a group have the largest savings pool in America. If you ask the wealthy today what their biggest investment challenge is, it’s finding low-risk yield when CDs and Treasuries pay next to nothing. But that hardly undoes the advantages of QE.

According to Spectrem Group, the wealthy have only about 13% of their investible assets in cash. The vast majority of their investible assets are in stocks, bonds, mutual funds, ETFs, precious metals and alternative investments – all of which have benefited from quantitative easing.

So the answer to the question posed at the beginning of this section is yes – QE has disproportionately benefited the wealthy. Does that help to create jobs for the rest of America? Some but certainly not nearly enough. But that could change materially depending on the outcome of the election.

The wealthy, small business owners and entrepreneurs see a world of troubling uncertainty, especially when it comes to higher taxes, increasing regulation, healthcare, etc. If the voters decide to make a change in the White House, a good deal of that uncertainty may go away, and those with money to invest will feel better about creating jobs. Just my opinion.

And finally, there are many who have questioned whether the Fed’s latest QE3 decision was a bold move to help assure that President Obama gets re-elected, especially given the time of the announcement. Yet we are continually reminded that the Fed is a non-political, non-governmental entity. I’m not questioning that.

However, it is true that if Governor Romney is elected, Ben Bernanke is out of a job; Romney has made it clear that he would replace Bernanke if elected president. Some have argued that even Big Ben is not above wanting to keep his job. Either way, we’ll never know for sure.

Very best regards,

Gary D. Halbert

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