Goldman Warns On The (Hyper)Inflationary Consequences Of A Successful QE2
One of the more devious consequences of QE2, is that it carries the seeds of its own destruction with it. Namely, if after flooding bank basements with another $2 trillion in excess reserves, and if bank lending picks up, suddenly the amount of currency in circulation will explode by over 300% from under $1 trillion to around $4 trillion. And while a comparable increase in wages is certainly not guaranteed to occur concurrently, what this explosion in the free money will do is lead to a very rapid and drastic destabilization in the concept of a dollar-based reserve currency. The only thing that could prevent this are the Fed's mechanisms to extract liquidity from the system. Alas, the IOER process is very much unproven, and should animal spirits kindle at the peak of the biggest liquidity tsunami in history, that money will inevitably make its way to Main Street, not Liberty 33. All this has made Goldman's Ed McKelvey warn that should increased bank lending be the end result of QE2 (and ultimately that is precisely what it should be, as that would be indicative of a healthy economy), then, to put it so everyone will get it, "this would cause too much money to chase too few goods." And, as liquidity extraction then would likely be impossible, it would be the beginning of the end: "The obvious risk to this last point is if inflation expectations surge. In a stronger growth environment than now prevails, such a surge could prove difficult to control. It would require Fed officials to remove the liquidity quickly, which is why they will concentrate on purchases of Treasuries (easier to sell back into the market) and remind us continually of the tools they have developed to withdraw the liquidity (by periodically using them in small size)." Too bad the Fed will soon be forced to buy MBS (again), REITs, ETFs and pretty much everything else.
Here are the key observations from McKelvey on what QE2 would mean for those ever so critical bank balance sheets:
So what about bank balance sheets? Could they start to expand, and if so, would this help growth? Would it be inflationary? A full discussion of these issues is probably best left to another day, particularly as we also get questions about how this mechanism works. Suffice it to say that:
1. A turnaround in bank lending is always possible. QE2 helps at the margin by making yields on alternative investments less attractive.
2. However, banks must be willing to lever up their balance sheets; otherwise, this transmission mechanism will not work. This does not appear to be the current mentality of bank managements as they consider how to respond to new capital requirements.
3. An increase in bank lending is not necessary for QE2 to boost growth. This should be evident in the long list of channels under the asset price mechanism noted above, most of which do not necessarily involve bank lending (though it certainly helps).
4. In fact, it is probably better to think of an increase in bank lending as playing a supporting rather than principal role. Ask the following question: if the asset price channels did not work, would an increase in bank lending boost growth on its own? It might to the extent that lack of access to credit constrained some borrowers. Otherwise, however, bank loans might simply provide an alternative form of financing.
5. If bank lending does increase, higher inflation is not necessarily an immediate consequence. Some argue that by releasing the liquidity that the Fed has pumped into the banking system, most of which thus far has remained on deposit at the Fed, this would cause too much money to chase too few goods. However, with utilization of spare labor and capital resources low, the first effects would be to support the stimuli to growth outlined above.
The obvious risk to this last point is if inflation expectations surge. In a stronger growth environment than now prevails, such a surge could prove difficult to control. It would require Fed officials to remove the liquidity quickly, which is why they will concentrate on purchases of Treasuries (easier to sell back into the market) and remind us continually of the tools they have developed to withdraw the liquidity (by periodically using them in small size).
We are surprised that so few discuss this Catch 22 aspect of QE2: the more money the Fed prints, the lower the likelihood it will be withdrawable when and if the economy recovers... And some idiots want $7+ trillion in QE.
As for what the actual thinking of the Fed, which should be able to grasp this risk, as pertains to QE2 is, here is Goldman's take:
In the asset price framework, we see three major channels, as follows:
1. Lower long-term real rates of interest. Purchases of Treasury securities should lower the (nominal) yields on these assets as the Fed removes a significant portion of the amounts outstanding from the balance sheets of private investors and institutions. For example, if the Open Market Desk initiates the QE2 program with purchases of $500 billion in “longer-term” (2 years or longer) Treasuries, we reckon that this would reduce the amount of coupon securities held by other entities by roughly 8½%—not an insignificant amount. (To appreciate this, just imagine the effect on interest rates if the Treasury were to announce that the deficit had fallen unexpectedly by $500bn and that coupon auctions would be cut accordingly; the mechanics would be a bit different, but the effect on total supply would be the same.) In fact, the yield on 10-year notes has trended lower since QE2 first appeared on the radar of financial market participants in early August. In addition, by emphasizing that one purpose of any additional easing is to boost the inflation rate, Fed officials hope to buoy inflation expectations—keep them from falling, at a minimum, if not encourage them to increase.
Lower long-term real rates should stimulate various types of credit-sensitive spending, in particular:
a. More housing demand. This is the classic interest-sensitive sector, one that normally helps spur recovery from recession in the US economy. Because of the large overhang of excess supply, this channel is unlikely to work well, but at the margin it would probably help at least some.
b. More consumer demand for durable goods. Without the oversupply that hangs over the housing market, this channel has more potential, though access to bank credit could be a problem for some borrowers.
c. More capital spending. Companies are sitting on a hoard of cash, which they can either invest in financial assets or in the physical (or human) capital with which they produce goods and services. By reducing the real yields on financial assets, QE2 should encourage companies to redirect money to the more productive assets. Again, this is at the margin, as utilization of existing capacity is low, but like foregoing channels it should help.
d. More construction by state and local governments. This is a credit-sensitive form of activity that many observers overlook. However, since most such projects are financed by borrowing, they are sensitive to movements in interest rates. As with the private-sector activity, it is hard to imagine large effects given how preoccupied these jurisdictions are with constraints on their operating budgets, but the same point applies—such activity may benefit at the margin.
e. Refinancing of mortgages. Although this is more properly thought of as facilitating the borrowers’ access to capital for spending of any sort rather than as credit-sensitive spending per se, there is no question that borrowers who have sufficient equity in their homes are benefiting from this. Since QE2 first appeared on the radar in early August, the Mortgage Bankers Association’s index of refinancing applications has risen about 25%. Unlike the heady days of mortgage equity withdrawal, borrowers are more likely to seek a reduction in monthly carrying expense than a wad of cash; even so, this will enable them to spend more than they might have otherwise.
2. Higher equity prices. As expectations of QE2 have pushed prices of longer-term bonds up and helped assuage concerns about a double dip recession, equity prices have soared. Since late August, when Chairman Bernanke confirmed that some Fed action was likely, the S&P 500 Index has risen more than 12%, to a level that is about 5% above its early August readings.
Higher equity prices help economic activity in two ways:
a. A positive wealth effect. If households see their stock holdings rise in value, they are more apt to spend. In the current circumstances, some would express this in terms of confidence that the Fed will do what it can to promote growth and keep the economy from sliding back into recession, but it amounts to the same thing. At the margin, households will be more willing to open their pocket books even though the jobless rate remains high.
b. A lower cost of equity capital. When equity prices are high, companies are more likely to raise additional capital to expand their operations. This obviously is subject to the same caveats as noted above for the effect of lower real rates on capital spending (via a similarly reduced cost of debt capital).
3. A lower exchange rate. The effects of QE2 on the dollar exchange rate get a lot of attention in the financial markets, but mostly in the form of fretting about the effect on foreign investors’ appetites for US-denominated assets, the risk of competitive “beggar-thy-neighbor” policies as other central banks or finance ministries seek to offset the appreciation of their currencies, and/or the ultimate effects on inflation. While these concerns all have some degree of legitimacy, to the extent the dollar does depreciate it stimulates exports and steers some domestic demand away from imports toward domestically produced output.