Quantitative easing II: pros and cons

It looks like the US Federal Reserve will start a second round of Quantitative Easing (dubbed QE II) later this week.

what it is

conventional policy

Under normal circumstances, the Fed–or any other national monetary authority–conducts it money policy by controlling the price of the overnight loans it provides to commercial banks.  When it wants to slow the economy down, it raises the price of such loans (meaning the interest rate it charges for them) ; when it wants to boost economic activity, it lowers the price.

What happens, though, when the price hits zero–in effect, where it is now?  In theory, by this time the Fed has done all it can.  If this isn’t enough, it steps aside and the country looks to the president and congress to introduce fiscal stimulus (that is, temporarily boost government spending or lower taxes) to get activity moving at a more rapid clip.

But what if Washington is dysfunctional and can’t get it together to do anything?

an analogy

A doctor sees a man lying on the side of the road, bleeding.  He stops, administers first aid and calls for an ambulance.

Two ambulances show up.  The crew of one says the best thing to do for the ailing man is to leave him there to heal himself.  The crew of the other says the best thing is to arrange for insurance that will cover him in the case of a future accident.  A fist fight between the two crews breaks out.

What should the doctor do?

unconventional policy action

The doctor probably doesn’t walk away.  He probably does something unusual, something that substitutes for the ambulances and that he thinks will help the person lying by the side of the road.

This is the position the Fed believes itself to be in.

what to do

What it has decided to do is to buy longer-dated fixed income securities that the banks have on their balance sheets.  This will put even more money into the hands of banks to lend to customers.  This is QE II because the Fed has already done this once during the early days of the financial crisis, buying up, in particular, highly illiquid bonds whose presence on banks’ balance sheets was thought to have paralyzed their new lending departments.

In theory, QE II would also tend to lower longer-term interest rates and possibly weaken the currency.  And in fact, after the Fed first said it stood ready to start QE II operations several months ago, the interest rates on longer-dated Treasury securities has declined and the US$ has fallen by about 10%.

why the Fed feels comfortable

Maybe “comfortable” isn’t quite the right word.  “Willing” might be better.  It thinks there’s a need for faster economic growth to reduce the unemployment rate.  It knows Washington won’t do anything.  It understands that if it pumps too much money into the system and keeps it there for too long, inflation will result.  But it doesn’t see inflation as a threat anytime soon.  In fact, it would like a little more inflation than we have now, because it thinks deflation is a greater possibility.  And deflation is always the greater threat.

In short, the Fed would probably prefer not to use unconventional means, but it sees no near-term downside.

why not everyone else is

Bond fund managers are very clearly opposed.  The head of PIMCO, the largest such organization in the US, calls QE II “somewhat of a Ponzi scheme.”  Why?  QEII may well help accelerate an anemic domestic economy.  If not, it will at least raise the worry that inflation will resurface in a way the Fed doesn’t expect and can’t easily control.  Neither is good for bond prices, nor for their management fees.

Some economists fear that because unconventional measures are just that, they are poorly understood.  They may have unintended negative consequences.  Even conventional Fed measures can have unintended negative consequences, they point out, in the way that too loose money policy in the early part of the decade led to a housing bubble with devastating consequences for the US.  Others worry that the Fed may leave money too loose for too long, either because it makes a mistake or because it feels political pressure.

So is China.  For bond funds, the worry is that the marketing promise of an economic moonscape–bereft of economic growth or inflation for as far as the eye can see–that will keep their shareholders from ever losing money will prove to be a pipe dream.

For China, on the other hand, where everything is part of political struggle, QE II will likely be seen, not as the result of Washington’s ineptitude but the conclusion of a Machiavellian scheme to create inflation.  The point of doing so?  –to reduce the real value of the trillions of dollars in treasury securities the Middle Kingdom holds.

my thoughts

QE II is on the way, whether we like it or not.  This forces us as investors to be sharply on the alert for signs of either inflation or of a pickup in economic growth.  Both run counter to the Fed’s suppositions.  They would signal a potential sea change in the character of the financial markets that would require portfolio reorientation.

Stay tuned.

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