After more than a month of expectation, QE2 time has finally arrived. Both debt and equity markets have been excited in anticipation despite the fact that no one really knows, including, it seems, the Fed itself, what the Fed intends to accomplish by bloating up its already pregnant balance sheet. There are likely to be serious unintended consequences.
QE2 faces an economy in a liquidity trap. Monetary theory has always focused on the "M" in the MV=GDP equation, postulating that growth in "M" will impact GDP if "V", the velocity of money, stays constant. But, in a liquidity trap, an increase in "M" is offset by an equal decrease in "V" resulting in no new economic activity. The U.S. economy has observed a rapid decline in "V" over the past two years as the Fed has bloated its balance sheet. Excess reserves at banks have exploded while loans outstanding have continued to decline.
Thus, the Fed cannot be hoping that QE2 will spur loan growth. Given historic lows in interest rates, they can't be foolish enough to think that lowering them by a few more basis points will have more than a marginal impact. So, what can they possibly be thinking? The following comes to mind:
- The "wealth effect"
- Raised inflation expectations
- A weaker dollar
The Wealth Effect
Over the last month, the announcement of QE2 successfully inflated equity prices. If QE2, the reality, doesn't disappoint, the "wealth effect" of rising equity values may cause rising consumer confidence and more consumer spending. Of course, that is a big "if." Even assuming that QE2, the reality, doesn't disappoint, studies of the "wealth effect" suggest that its impact is small compared to other policy tools. Thus, the size of QE2 would have to be gigantic to have a significant impact. The latest scuttlebutt from inside the Fed indicates that QE2 will not be "shock and awe." Thus, the impact of the "wealth effect" is likely quite small.
Rising inflation expectations actually either raises interest rates and/or weakens the dollar relative to the currencies of its trading partners. Bill Gross of PIMCO recently postulated that QE2 will spell the end of the 30-year bull market in bonds precisely because increasing inflation expectations will add an inflation premium to bond yields across the yield curve. In a market struggling with a lack of demand, rising rates via inflation expectations, would be a negative unintended consequence. (Note: When interest rates are at or near zero, except for an anomaly or two of negative yields as witnessed with the Treasury Inflation Protected Securities (TIPS) auction, there is really only one way for rates to go, and eventually, they will go up. The only question for bond managers is "when".)
The announcement of QE2 caused a near run against the dollar in the currency markets. Today's conventional wisdom says that a weaker dollar will cure the trade deficit and bring jobs back to the U.S. Unfortunately, it is foolish to believe that any improvement in the trade deficit caused by a weaker dollar will have any sort of immediate impact on U.S. jobs.
First, many companies have invested in plant and equipment overseas, so their commitment isn't reversible in the short-term. Second, most companies look for a business environment where they are comfortable, i.e., where there is visibility into the future tax and regulatory environment, something that the U.S. currently lacks. Third, and what isn't widely recognized, is that a weak dollar policy (QE2) drives dollars (capital) to other countries in the attempt to protect its purchasing power. As dollars flow to places with more stable tax and regulatory environments and where there is stronger growth, it is invested there, thus enhancing economic growth there, not in the U.S.
Negative for Consumers
The impact of QE2 is likely to be negative for consumers. First, if inflation expectations take a while to ramp up, and they will, the initial lower yields resulting from Fed purchases of securities in the open market are another negative hit to the incomes of consumers who save or for those living on the cash throw off from wealth accumulations (like retired seniors). Consumption is lower as a result. Also, a weakening dollar means higher commodity prices as attested to by the behavior of industrial and agricultural commodities since the announcement of QE2.
Rising commodity inputs in the manufacturing process will result in either higher prices to consumers (if businesses can pass the price increases through) and/or in lower profit margins. Either case implies lower economic growth. In addition, the prices of imported consumer goods will rise, a negative for income constrained consumers. Further, the dependence of the U.S. on foreign oil and the impacts of rising gasoline prices on the economy could well be another unintended negative consequence of QE2.
Fiscal Policy More Potent
The Fed is out of major artillery and it is embarking on a perilous path that may well do more harm than good. The truth is that fiscal policy would be a much more effective weapon to battle the current economic malaise. Unfortunately, Congress has already shot trillions of dollars worth of blanks, and the public no longer trusts them with fiscal policy or deficits.
There are fiscal measures that would be much more effective than QE2, like tax holidays, or out and out tax reductions, or a revamped tax system that favors savings over debt accumulation. Fiscal measures of this sort would have to be matched with spending reductions, a subject that never ever is discussed seriously in Washington, D.C. (They only talk about how to raise taxes!) And so, we are stuck with policy tools (QE2) whose effects appear to be weak at best, and which may very well have significant negative unintended consequences.
This post by Robert Barone has been republished from The Street.