Inflation Indicators Suggest QE3 Less Likely

A short article published in The Atlantic yesterday suggests that, based on past decision-making and Federal Reserve press releases, the likelihood that a third round of quantitative easing will occur is relatively low.  The graph below shows the relationship between the Fed’s balance sheet (blue) and core inflation (red).

Core inflation dropped significantly in 2009, and the Fed subsequently expanded its balance sheet with QE1 to combat the specter of deflation.  It again engaged in a quantitative easing program, QE2, in late 2010 when the core inflation continued to drop.  Now, however, inflation seems stabilized around the 2 percent level.  According to the Fed:

“A couple of members indicated that the initiation of additional stimulus could become necessary if the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate of 2 percent over the medium run.”

It appears that, unless inflation drops below this 2 percent level for a prolonged period, a third round quantitative easing is unlikely.

Quantitative Easing, Pt. 6: Conclusion

Summary and prediction:

Since 2007, the United States Federal Reserve has implemented two rounds of quantitative easing, as well as “Operation Twist,” in an attempt to inject liquidity within the market and lower long-term interest rates in the hopes of pushing investors into riskier assets and increasing the demand for long-term investment.[1]  As the economy continues to drag, speeches by Fed Chairman Ben Bernanke regarding the Fed’s willingness to offer further economic assistance, combined with the predictions of many leading economists, seem to point towards a third round of quantitative easing on the way.  Unfortunately for the American people, should this QE3 program come to fruition, it is highly unlikely that it will sufficiently help encourage sustained economic growth within the marketplace.  Now that deflation is no longer a looming specter, further quantitative easing could very feasibly result in an inflation rate higher than ideal, especially in the commodities market.

The relative success of QE2, or lack thereof, made it evident that the Federal Reserve does not operate in isolation, and that issues, both domestically and abroad, can stifle the effectiveness of their programs.  Domestically, political turmoil has only continued to escalate as the conflict over the debt-ceiling was so severe that it raised uncertainty about the long term viability of the U.S. government’s ability to remain solvent to the point that it led to a downgrade of the U.S. debt.  Overseas, the Eurozone continues to face a debt crisis with no ideal or foreseeable resolution in sight.  Such factors have led to a heightened sense of uncertainty so severe that despite the credit easing and liquidity raising policies of the Fed, firms and investors still remain extremely risk-averse and prefer to hold lower risk assets despite the increasingly lower returns offered.  When considering the effect that this uncertainty had on the long term effectiveness of the QE2 program, it is difficult to imagine that yet another round of quantitative easing will have any more success.  While the Fed is intended to be a politically independent entity, when considering such a large scale program as QE3, it is important to address its prospects with a degree of political pragmatism and realistic expectations given the uncertainty of the economic and political environment.

In the end, I believe that a third round of quantitative easing will be implemented despite all the signs pointing towards its high potential for ineffectiveness.  It appears that Chairman Bernanke remains convinced that if he can further flatten the yield curve and inject more liquidity into the market, businesses and individuals will move into riskier assets and banks will have no choice but to lend.  QE3 will most plausibly use QE2 as a template for implementation, resulting in a purchase of longer-termed government debt and, like with QE2, this third round of quantitative easing will result in a hike in prices for riskier assets and for commodities, yet this effect will only be temporary.  As the Fed’s asset-purchases put inflationary pressure on commodity costs, consumption will decrease as consumers devote less of their money to non-energy assets.  Politically, the environment will remain hostile and the threat of more regulation, such as with the recent IMF proposal to hike BASEL surcharges on the world’s largest banks, will perpetuate a level of apprehension amongst potential lenders and borrowers that will largely negate the effect of the flatter yield curve.[2]  It remains uncertain as to how foreign governments will react to such a program, yet given the opposition to QE2’s dollar-weakening actions, one can surmise that another round of quantitative easing will only further antagonize them.  Given the evidence offered, however, it appears that the Federal Reserve will lack the foresight to weigh these external variables, along with the economic warning indicators, and engage in an economically and politically damaging third round of quantitative easing.

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[1] Censky, Annalyn. “Federal Reserve Launches Operation Twist.” CNNMoney. CNN, 21 Sept. 2011. Web. 5 Nov. 2011.

[2] Brunsden, Jim, and Rebecca Christie. “Citi, JPMorgan May Face Highest Basel Capital Surcharges.” Bloomberg, 8 Nov. 2011. Web. 8 Nov. 2011.

Quantitative Easing, Pt. 4: QE in the United States

Current use of Q.E. in U.S. and the decision to implement QEII:

Whereas the decision of the Bank of Japan to implement their quantitative easing policy was more a result of fundamental problems which had afflicted the Japanese economy for an extended period of time, the decision by the United States Federal Reserve to undertake similar policy actions was motivated by rapid global economic decline.  For the United States, the implementation of the Federal Reserve’s quantitative easing programs occurred during two distinctive periods, known as “QE1” and “QE2”.  The first round of quantitative easing, QE1, lasted from December 2008 until March 2010, and employed a three point attack on the stagnant economy which focused on increasing liquidity both inside and outside of the banking sector, as well as easing economy wide credit by lowering a wide range of interest rates.

To fulfill their first objective, the Fed established the Term Auction Facility, or TAF, in an effort to expand access to money in their lender of last resort role.  TAF worked by using an anonymous auction system to lend funds to banks, domestic only at first, and then to international banks as well later on.[1]  To increase liquidity outside the banking sector, the Fed was authorized to purchase up to $200 billion of asset-backed securities.  Finally, to impact the yield on longer-term assets, the Fed bought $600 billion of debt and mortgage-backed paper held by federal agencies as well as long-term Treasuries.  By the end of the program, the Fed purchased $1.7 trillion of Treasury and mortgage-backed securities.  Economists at the Federal Reserve Bank of New York estimate that these Treasury purchases resulted in a drop of half a percentage point on longer-term Treasury yields.[2]  Yet despite the progress made on Treasury yields, mortgages and loans remained difficult to qualify for and expensive to obtain, and the benchmarks of the Fed’s dual mandate targeting unemployment and inflation both lagged, with unemployment around 9.6% for the period and the inflation rate lower than the generally accepted target between 1.7% and 2%.[3]

While the first round of quantitative easing worked toward accomplishing a number of goals set by the Fed, such as the lowering of longer-term yields, in the face of heightened unemployment levels, as well as the fear of persistent deflation, the Federal Reserve announced in November 2010 a second round of easing, or “QE2.”  In contrast to the more expansive and diverse actions taken by the Fed during QE1, the QE2 program focused solely on the purchase of longer-termed government securities, much like the Bank of England’s program.  Over an eight month period ending in June 2011, the Federal Reserve committed to purchasing $75 billion of Treasury securities, primarily ones with maturities of two to ten years, averaging to around five or six years.[4]  By June of 2011, the Fed had bought $600 billion worth of Treasuries in an effort continue the downward pressure on longer-termed yields.  After the initial announcement of QE2, riskier and higher-yielding assets experienced an upward jolt as the lower yields on longer-term securities pushed investors into riskier assets with the promise of higher returns.  Yet while this initial surge in prices seemed to signify the success of QE2, the true impact on the U.S. economy remains questionable, especially regarding employment levels.

As commodity, specifically energy, prices shot up, consumers spent less on non-energy expenditures and firms, which would hypothetically be more willing to undertake long-term investment projects due to the ease in credit, were faced with higher production costs.  The result has been a significant slowdown within the economy as the previously spiked asset prices have retreated.[5]  Stephen Jen, partner at the SLJ Partners hedge fund, reasoned that there would “be a few weeks of positive reaction, followed by a sell-off, as investors realize the circular and pointless logic of the argument that QE2 could lead to permanent increases in economic activities”.[6]  Daniel Thornton, Vice President of the Federal Reserve Bank of St. Louis, predicted the fact “that analysis suggested several reasons why QE2 might have little or no effect on output, or employment,” as well as cautioning that further Treasury purchases could cause “unprofitable lending due to interest rates at or below the cost of capital, thereby encouraging banks to hold excess reserves rather than make loans”.[7]

While in the short term it appeared that the program of Treasury purchases proscribed by QE2 would have a positive impact on the economy, it now appears that the gains in asset prices were artificially inflated, and eventually undermined by high commodity prices.  Additionally, given the role the dollar has in emerging economies where currencies are largely pegged to the dollar or held to a tight exchange rate, QE2 not only risked inflating commodity prices, but prices in emerging economies as well.[8]  Though a primary cause of concern within the United States, deflation, seems to no longer to be a major possibility, the inflationary pressures caused by this second round of quantitative easing on both commodity prices and within the emerging economies, as well as the continued stagnancy of the economy, suggests that the program cannot be qualified as successful.  Even the effect the program had on flattening the yield curve has done little to improve overall investment levels and lending and borrowing remains tight within the economy.  This lack of response amongst lenders and borrowers seems to signify that given the general uncertainty experienced by businesses, both from future growth prospects as well as regulatory increases, lowering the cost of long-term debt financing alone will not stimulate economic investment.  In this way, Federal Reserve action can have a positive impact on the economic recovery, yet the complexity of the economic and political issues within the country can greatly mitigate the impact of policy actions.  By realizing these limitations and potential obstacles in policy effectiveness, along with the negative effects on consumption due to the inflated prices of commodities, it becomes apparent that despite the fact that this round of quantitative easing properly targeted the fundamental issues of the economy, the real results of the policy illustrates that it was not a good decision.

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[1] See Klyuev et al.

[2] See Reddy.

[3] See Reddy

[4] See Reddy.

[5] Waki, Natsuko. “Analysis: QE3 May Do More Harm than Good| Reuters.” Business & Financial News. Reuters, 27 July 2011. Web. 8 Nov. 2011.

[6] See Waki.

[7] Thornton, Daniel L. “The Downside of Quantitative Easing.” Economic Synopses. Federal Reserve Bank of St. Louis, 10 Nov. 2010. Web. 30 Oct. 2011.

[8] See Waki.

The Rise in Global Inflation: An International Collaboration

As the global economy continues to recover from the recession following the crash of 2007, a troublesome trend of rising in inflation has begun to concern world economic leaders, especially given its timing with unemployment remaining at elevated levels.  The root cause of this problem was a major subject of debate amongst the world’s largest economic countries at the most recent G-20 summit in Paris.  Many foreign countries pointed the finger for this rise at the United States for the interventionist programs the Federal Reserve has recently enacted, most specifically their quantitative easing program or “QE2.”  Federal Reserve Chairman Ben Bernanke countered this point at the meeting by arguing that in fact the elevation in global prices is a result of growth within developing countries and currency manipulation by countries such as China.  The disagreement surrounding this global issue is indicative of the uncertain nature of economic forums, such as the G-20, and their inability to directly influence countries’ economic policies.  Whether the rise in global inflation is more a result of Chinese currency manipulation or U.S. Central Bank policy, the increase in prices is cause for concern in a global economy which remains highly vulnerable given its unemployment levels.

Germany and China are among a number of countries that have been highly critical of the Federal Reserve in recent months, a trend evident at the November meeting of the G-20 held in South Korea.  That meeting came days after the Fed had announced its second round of quantitative easing, a program which was especially criticized given its size and history of debatable success.  In theory, “QE2” was initiated in hopes of keeping interest rates lowered in the long-term to stimulate investment and growth by using a strategy which had been used by the Fed earlier in the U.S. stimulus package.  For this second round of quantitative easing, the Federal Reserve announced that it would again purchase Treasury bonds, this time in an amount of $600 billion.  While proponents of the plan heralded the Fed’s initiative and the merits of low-interest rates to stimulating growth, the program also garnered much opposition both domestically and internationally, a fact that was apparent at the November G-20 meeting.  There, countries accused the Fed of significantly contributing to global inflation and of attempting to lower the value of the dollar in hopes of making American products more attractively priced within the international market.  Yet the criticism of U.S. monetary policies, along with the accusation of currency manipulation as a root cause of increased global prices, were points Chairman Bernanke’s vehemently questioned in his rebuttal to critics of the recovery plan.  Rather than finding the United States’ policies as a direct source of international problems, he instead placed the blame upon overheating within developing economies and deliberate currency devaluation in countries such as China.

Since the announcement of QE2 and subsequent criticism at the November G-20 meeting, Federal Reserve Chairman Ben Bernanke has actively defended and argued against the belief that increased inflation globally is directly linked to this initiative.  “Spillovers can go both ways,” he stated at the most recent summit, “resurgent demand in the emerging markets has contributed significantly to the sharp recent run-up in global commodity prices.”  Additionally, he has indirectly referenced China’s monetary manipulation as an integral piece of the increase, saying “the maintenance of undervalued currencies by some countries has contributed to a pattern of global spending that is unbalanced and unsustainable.”  China’s monetary policy has been greatly challenged in the past due to their strategy of pegging their currency to the United States dollar in an effort to ensure their exports remain competitively priced within the global market.  The recent global downturn and ensuing rise in inflation has only exacerbated the calls for Chinese reform and the U.S. is hardly alone in their criticism of the practice.  While China has loosened their policy recently and allowed their domestic currency the yuan to gain value, it is still viewed as being artificially devalued.  Bernanke, along with numerous other G-20 members, have continued to call for the Chinese to allow their currency to “better reflect market fundamentals” in an effort to transition from an economy based extensively on international demand into one more centered on their own domestic demand.  Yet despite the significant rise in the domestic buying power of the Chinese consumer, China’s reluctance to allow their currency to directly reflect international market valuation has continued to increase trade imbalances and promote and unsustainable economic relationship between China and the world.

Though fervent in his defense of Federal Reserve initiatives, Chairman Ben Bernanke did not attempt to completely clear the United States from blame in the recent inflationary developments.  While criticizing countries which manipulated their currency for increasing trade imbalances and international cash flow, he also called for countries such as the U.S., which are large next importers, to increase domestic saving and balance budget deficits.  Unfortunately, the G-20 countries as a group lack any official ability to sanction or influence an individual country’s economic policy decisions.  Instead, the group must rely on the voluntary agreement of a country to submit and adhere to a G-20 policy or decision.  This is particularly significant when considering Bernanke and many countries’ desire to see countries like China loosen their monetary policy, and countries such as the U.S. to be more responsible and restrictive in their spending.  These idealistic desires, if followed, would certainly promote growth, stability and lower inflation within the international economy, yet the lack of leverage within groups like the G-20 to directly facilitate implementation of such policy means that world powers can continue to remain self-interested first and globally conscience second.  While this may seem more appealing domestically, ultimately, it also works to perpetuate issues such as the current inflationary problem dragging on global recovery efforts.

Global inflation, which has increased prices in places like China over 5% in the last year, is becoming increasingly disconcerting for the economic leaders of the world.  As exhibited especially at the two most recent G-20 summits, the cause of this rise is both uncertain and highly contentious.  Many countries feel that the United States’ domestic bond-buying programs, such as the second round of quantitative easing, have directly influenced the elevation of global prices, a claim which is far from unanimously agreed upon.  Others, such as Federal Reserve Chairman Ben Bernanke, argue that the problem is hardly a result of a single country’s actions but rather a result of the rise in demand within developing economies instigated by currency manipulation and fiscal irresponsibility amongst global economies.  While Bernanke’s calls for an increase in global consideration and cooperation amongst the G-20 members are admirable, the group’s lack of tangible power to implement these policies has continued to make international agreements frustrating and difficult to enforce.  Ultimately, this reality means that finding a solution to international economic problems within the tentative global recovery remains difficult, a fact illustrated by the current issue of global price inflation.

Fed Transparency: Good or Bad?

The Federal Reserve met for their first policy meeting of the year last week, a meeting which culminates with the Fed’s announcement of growth projections in many different sectors of the down, yet seemingly stabilized, economy.  Early speculation is that these projections, when made publicly available, will show the anticipation of a modest, yet positive growth in the economy this year amongst many of the nation’s top economists.  While many of the general public may remain discouraged that this recovery has been slow and rather unexciting, this news is probably music to the ears of a Federal Reserve which has remained the subject of intense questioning and badgering by the media and American public.  Be it Chairman Ben Bernanke’s narrow confirmation or their continued interventionist approach towards the recovery through QE2, the Fed has remained under near constant scrutiny.  This fact alone reinvigorates the age old debate of Federal Reserve transparency: how open should the Fed be in their decision making and communication of policy?  On one side of debate stand those who feel that a Central Bank should be completely transparent in their decision making, broadcasting their policies to the public and providing detailed explanation for their reasoning due, especially, to the great amount of power possess to influence the economy.  At odds with this argument are those who feel that a transparent Central Bank, in America’s case the Federal Reserve, will lead to an increase in focus on short term economic solutions due to political pressure without proper consideration of the long term effects.  ItstheStupidEconomy will explore both of these arguments more in-depth in the coming days as the Fed meetings wrap up and their increased transparency (per Bernanke philosophy) will leave them open to be assessed and scrutinized.