WASHINGTON´S FISCAL RECKLESSNESS RULES OUT QE3 / THE FINANCIAL TIMES ( A MUST READ )

June 29, 2011 12:06 pm

Washington’s fiscal recklessness rules out QE3

By Edward Yardeni

Will there be life after QE2? Fed chairman Ben Bernanke first introduced this new monetary policy last year on August 27 at the Fed’s annual conclave in Jackson Hole, Wyoming. It terminates at the end of this month after the Fed purchased $600bn in US Treasuries under this second round of quantitative easing. The stated aim of this controversial programme was to stimulate faster economic growth in an effort to lower unemployment and avert deflation, as required by Congress under the Fed’s dual mandate.


Now that QE2 is about to terminate, the economy continues to grow at a sub par pace. Unemployment remains high. Inflationary expectations, briefly boosted by QE2, seem to be declining again. Meanwhile, Mr Bernanke seems to have lost enthusiasm for QE, suggesting another round is unlikely even though he and his colleagues are concerned about disappointing economic performance.


Mr Bernanke may be starting to realise that monetary policy can’t fix all of the problems weighing on the economy. Last summer, Fed officials were concerned about the sudden slowing in economic growth though it was easily explained by the termination of tax incentives to purchase houses and appliances. Rather than wait for the economy to rebound on its own, they devised QE2 as a way to lower the federal funds rate by 75 basis points, which was the rate cut required to revive the economy according to the Fed’s econometric model. Of course, the actual rate couldn’t be lowered that much because it was already close to zero. In my opinion, any model requiring a negative federal funds rate is either badly flawed or indicates that the problem cannot be solved by monetary policy.


Nevertheless, QE2 did seem to boost stock prices, which might have had a positive wealth effect on the economy. The S&P 500’s market capitalisation rose 31 per cent or $3,000bn from August 26, the day before Mr Bernanke’s Jackson Hole speech and through this year’s peak on April 29. The Fed chairman said he expected that QE2 would have this impact on the stock market.


He didn’t expect that the 10-year Treasury yield would rise from 2.50 per cent on August 26 to this year’s high of 3.75 per cent on February 8. However, this could be taken as proof that the Fed’s new policy was averting deflation as the expected inflation rate embedded in the 10-years Tips yield rose from 1.55 per cent to 2.36 per cent over this period.


The problem is that this expected inflation rate is back down to 2.24 per cent and may be falling again. May’s unemployment rate was 9.1 per cent, not much better than 9.7 per cent during October 2010, the month before QE2 was implemented.


One of the unintended consequences of QE2 was to boost food and fuel commodity prices. Speculators must have concluded that as long as the Fed was implementing QE2, the federal funds rate would remain near zero, confirming the Fed’s mantra that this would be so for an “extended period.”


From August 26 through April 29, the price of a barrel of West Texas Intermediate crude oil rose 55.3 per cent to $113.93. In the futures market, large speculators in effect cornered a record 78.6 per cent of US crude oil inventories during the week of March 11. Of course, turmoil in the Middle East certainly contributed to the massive speculative long positions. However, QE2 may have contributed to the turmoil in the Middle East by also boosting grain prices.


In any event, rapidly rising food and fuel prices forced the central banks of emerging economies to tighten monetary policies. Even the European Central Bank raised its official rate by 25 basis points in May despite the worsening of the sovereign debt crisis in the eurozone. In the US, soaring gasoline prices depressed consumer confidence and spending.


So let’s hope that there won’t be QE3. Fed officials need to admit that they have done all that can reasonably be expected of them to meet their dual mandate. The problem is fiscal recklessness in Washington, which QE2 enabled by allowing the Treasury to borrow $600bn effectively at only 0.25 per cent, the rate the Fed pays on the excess reserves held by banks. That’s because the Fed returns any income above its expenses to the Treasury.


But how will stocks perform now that QE2 is over? The recent drop in oil prices should ease inflationary pressures and pause monetary tightening around the world. Lower fuel prices should revive consumer confidence and spending. Auto production and sales should rebound as Japanese car parts become more available following the supply disruptions caused by Japan’s earthquake.

Corporate earnings should continue to grow. Stock investors are likely to remain defensive this summer until this scenario becomes more visible and while the EU continues to sort out its debt crisis. Then stocks have the potential to move higher during the autumn without QE3.
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Edward Yardeni is president of Yardeni Research
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Copyright The Financial Times Limited 2011.