Thursday, June 30, 2011

The End of QE2

QE2, i.e., quantitative easing two, the program by the Federal Reserve Board of buying longer-term government bonds to “support the economy” ($600B this time) is slated to come to an end June 30, 2011, today. One might ask what this round of low interest rates and easy money has done? I am sure that the governmental types will proclaim to the land that they have averted major disasters and saved civilization by their actions. Sure. Others will say that the results are a significant additional amount of inflation. Perhaps. One can definitely say that the level of reserves that the banks who are members of the Federal Reserve System (nearly all banks) have risen to new, even scarier heights. Before September 2008, the total reserves of these member banks were in the $50B range. Soon after that fateful September, the reserves rose to over $1T! Now the reserves are about $1.6T. What is good is that the “money” (which the Fed merely created out of the air) is sitting in the reserves and not roaming around the economy. Other than inflating the reserve figure, I don’t see anything beneficial that the QE2 creation of an additional $600B has done. The economy is not doing well. And much of the damage of the run up to the 2008 meltdown has not been undone, either.

Maybe what has happened is that the economy has floated along on the Fed cushion for the first half of this year. It is growing slightly, say less than 2%. At this point in most “recoveries” the economy has achieved much higher growth. The current economy has not gotten back to even, yet. Some prices have fallen, e.g., real estate. Residential real estate prices have probably not fallen enough and the sector is still in poor health, with foreclosures still happening at a high level. Employment as a percentage of the working population is still low. It is even lower when the actual productivity of the many of the new “jobs” is taken into account (i.e. government “jobs” that produce nothing). Moreover, for various reasons, some having to do with money creation around the world and some having to do with enforced shortages in the face of growing demand, the prices of some basic commodities are high, meaning a lower standard of living for all.

So QE2 comes to an end. Many suggest that the economy, left to its own resources does not have the strength to continue to grow, or, if at all, at a very low level. Employment, which is only doing better because of some statistical manipulation by the Labor Department, will suffer. Our standard of living will continue to fall.

The counter trend to the government’s activities is that there are millions of people in our country running businesses and working to be more productive and profitable. In spite of all the government does, some very basic elements in our economy are growing. So much of what I see from Objectivists assumes that the government is all-powerful and ignores what the non-government sector is capable of doing. Remember, the practical attack on capitalism has been going on for over 100 years (as opposed to the philosophical attack that has been going on much longer). The attack is still only partly successful because the ingenuity of the American capitalist works around and through the laws, regulations, and direct interference put in place by our politicians. The failures, when they occur, can be big, e.g., the Gulf oil spill. But on the whole, American businesses have coped pretty will with the interference. There is a limit to how much they can overcome, and we may be getting close to that limit (re. Atlas Shrugged), but American capitalists and their workers are trying, still. Whatever QE2 and its aftermath, the real economy will influence the results. This is a major reason why the consequences of government actions are so hard to predict. It is also why people do not take the predictions of doom seriously. Long-term doom just doesn’t seem to happen (as opposed to short-term doom like the sub-prime/financial meltdown). Things don’t seem to change much on the surface. We seem to still have capitalism. To the extent that capitalism has been undermined, we are in for a rough time, unless change for the good happens. (We are experiencing long-term deterioration, but we are experiencing it like a lobster in a tub of heating water, and we aren’t noticing our losses.)

To the extent that QE2 has been propping up the economy, that support will disappear. To the extent that participants in the economy thought that QE2 was providing some real support for the economy, the loss of that support will make them weary and less confident. To the extent that QE2 has been fueling the rise in the stock market and commodity prices around the world, that fuel will disappear and perhaps those prices will drop. To the extent that QE2 has been keeping longer-term interest rates low, they will now begin to rise. To the extent that QE2 has been glossing over problems in the economy those problems will reassert themselves and they will have to be addressed by the markets in a more rational manner.

The end of QE2 will be a good thing if the government and the Fed do not start tinkering again. There is another program that the Fed has ongoing, that is not changing. It has a lot of bonds and mortgage-backed securities, say about $1T. Those securities are maturing and being paid off as time goes on. The Fed has been taking that money, and buying Treasuries, about $250B a year (according to news reports). This isn’t really a good thing, since the original funds to purchase these “toxic” securities was made-up money. It would be better if the money was retired, and the member bank reserves reduced (that is actually where the money went in the first place). But at least it isn’t new made-up money.

There is a lot of talk about the reappearance of Fed “support”, say QE3 at some point within the next year if the economy begins to founder. Right now the pressure in the much of the world is for interest rates to rise. For instance, the Bank of International Settlements issued a statement that criticized developed countries for keeping interest rates so low. Other countries have raised their rates recently. Raising rates now is inconsistent with any of the Fed’s QE’s. To engage in another round of quantitative easing the Fed may have to fight a worldwide trend. Such a trend of rising interest rates would put further pressure on U.S. Treasuries since money would tend to seek higher rates of return, and Treasuries would have to have higher rates to compete for funds. This is especially true with the recent public statements from S&P and the IMF regarding the Treasuries deteriorating soundness. The U.S. government may be ignoring the negative evaluations of U.S. government debt, but the rest of the world isn’t. (On the other hand, with the problems in the Eurozone, Treasuries are viewed as very safe by comparison and there could be no significant upward interest rate pressure on them. When things are going bad, it isn’t going to be very clear what will suffer and what won’t. That kind of uncertainty is the nature of government-induced instability.)

Once interest rates begin to rise, we shall see how badly the Fed is prepared for the real world. It is suggested that to avoid significant consumer price rises the Fed will have to aggressively soak up all the liquidity that they have put into the system since 2008. That is so even if that liquidity resides only in “member’s reserves”. “Sopping up the liquidity” means doing just the exact opposite from what the Fed has been doing the last three years. It means doing just the opposite from what Ben Bernanke has built his professional life around and what he has been hailed a hero for doing. Does anyone think that the Fed is really ready to reverse course in any significant way? If there is any reason to give credence to the hyperinflationists it is the prospect of interest rates rising and the Fed allowing the policies of the last few years to run their course. It is definitely the reality that if the Fed keeps things as it is now we could see hyperinflation. Our immediate future may depend upon how the Fed reacts to rising interest rates. To that extent our future rests in the hands of a few deluded, self-proclaimed geniuses.

I am not going to forecast what will happen over the next couple years. (I have been expecting interest rates to rise for over ten years.) We just need to keep a very careful eye on events here and abroad, especially in Greece and the Eurozone. We could also see problems in China.

Let me tie my most recent Inflation Update to the end of QE2. In the inflation update I am talking about the money supply and its effect on prices. The end of QE2 will reduce the upward pressure on the money supply some. Keep in mind that QE2 was aimed at longer-term Treasuries, thinking that lower longer-term rates would spur major borrowing. The Fed is still aiming to keep short-term interest rates low, and will continue buying Treasuries where necessary to keep those interest rates in the target area of zero to 0.25%. This upward pressure on the money supply will continue.

Let us suppose that QE2 did act as Bernanke anticipated. Businesses were attracted by the lower interest rates and did invest. Then, with the end of QE2 and interest rates increase because there is less money available to loan, then we should see less borrowing, less investing, less hiring, lower growth, and perhaps less money for the equity market. And still there will be pressure on the money supply, high commodity prices, and probable upward pressure on consumer prices (from various sources).

So, the bottom line is that the next few months offer even greater uncertainty than we have been living with since the residential real estate mortgage crisis began. I think that the only thing we can be certain of is that our governmental leaders, who have nearly unlimited sway over the money taps and financial/legal gimmicks that they can produce, are going to generally make wrong decisions.

I have final note about interest rates. I have seen reports that foreign central banks, big buyers of Treasuries in the past were absent in the last Treasury auction (and the Fed stepped in and made up the difference – indirectly). As the Fed will stop buying at the end of June, if the foreign central banks do not return, the Treasury is going to have to raise rates to attract buyers, from somewhere. I don’t want to suppose at all what levels the rates are going to have to be to sell the bonds that they need to. Actually, hitting the debt limit may be helpful to the Fed’s program because the Treasury will be limited in the quantity of bonds it can offer for the next few months. The interest rate tale will begin after the debt ceiling is lifted.

It is difficult to see what the foreign central banks are doing. There just aren’t many places for them to put the excess cash they are accumulating. Probably Japan is expecting to spend a lot on its reconstruction (meaning that their money supply will expand and the Yen vs. other currencies will get stronger as the central bank buys yen). But there really isn’t another source of even decent, high grade (which is a relative term), large volume bonds besides the US government. China has told the EU that it will continue to “support” them in the face of their expanding credit crisis. I haven’t seen an exact definition of “support”. It may mean that they won’t sell out of European bonds. It may mean that the Chinese will continue buying as they had before. I doubt that it means China will increase their buying. Europe is certainly not a candidate to replace the US as a place to park hundreds of billions of dollars a year. Remember that China has a large trade surplus with the Eurozone that rivals its dollar surplus and it is already buying lots of bonds from Europe. Is China just keeping cash? We shall see.

As was pointed out in an analysis I read (an email), the funds that the Treasury can attract to replace the foreign central bank buyers would be from the US private sector, who would want higher yields. But, if the money goes to the Treasury, it won’t go into equities or other investments, and thus, for sure, the stock market’s fun days will turn into sad ones. Also, the prospects for job creation, productive jobs, will diminish further (if that is possible). Unkle Ben is expecting a rebound in the last part of the year. HA!

So what would Bernanke do then, when interest rates start going up and the true lack of recovery is obvious? What does he advocate for every instance? What has he done? Make-up more money! Watch for QE17!!

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