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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.
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http://www.youtube.com/watch?v=KC961lrFOlU
Precisely.
You should have offered a warning with that: Once seen cannot be unseen.
Ugh.
I will surely think twice before ever again visiting any link posted by you.
Revenge is a dish best served cold (blooded):
http://www.youtube.com/watch?v=qVE60zwXx1k
Sorry about that. Wanted to do something but could not come up with anything. "Enjoyed" your revenge. Yech.
Did Goldman also mention the Fed's defense of 1170 with billions of tax payer dollars today? Kind of like that 4 handle pop that happned a few minutes ago.
REITS must have received the message early!
Look at them rise today in direct inverse to the indexes! GO IYR! Wheee!
That makes total fucking sense and isn't the least bit fraudulent! Yippeee!
Man, Boiler, you and I must be long lost bros.
I, too, get that one, old painful trade stuck in my head and it never leaves. Keeps pissing me off for years.
Hang in there man. These last few weeks of 2010 are going to be fucking crazy.
REITs that own rental properties, as buying is shall we say, "less of an option," moving forward.
nice thoughts, but.....they have to complete the confiscation of the peasantry's assets. so......print away Ben....they aren't in the streets yet! almost, but not yet!
Barry: What are the ink levels like, Benny?
Benny: Looking good so far, Mr President.
Barry: Good, Benny, very good. I'm glad to hear that.
Benny: Is there something on your mind, sir?
Barry: There is actually, Benny. I am worried that the ink will run out before all the FEMA camps are completed.
Benny: How much do you need, sir?
Barry: How much have you got?
Benny: As much as you need, sir.
Barry: That's great news. I will have a chat with Michelle and then I will get back to you. Right, I'm off for a round of golf and then a bit of basketball practice.
Benny: OK, sir. I'm always happy to help.
Barry: I know that, Benny. That's why I employ you.
What is the alternative - unless they can at least approximate doubled wages (double income tax revenues) and doubled consumer prices (double sales tax revenues), the fed and state budgets are hosed.
All in exchange for Banzai Bucks.
All or nothing IMO. Either SHTF or its just a blip on the radar. I don't see any long term positive effects, maybe some transient positive effects tho.
The Basel Committee's response to the financial crisis: report to the G20
http://www.bis.org/publ/bcbs179.htm
Financial Stability Board
http://www.financialstabilityboard.org/index.htm
Connect the dots.
Well, now that they've done everything in their power to ensure QE2, they've started distancing themselves from it and are now heroically warning the world about the ruin that will come if they actually loan out any of it to the rest of us.
God's work, alright.
Why in the name of all things rational...after we have had countless hearings proving to us that unchecked ease of money when it leads to poor lending practices and propelling banks with access to this money to shove risk wherever they can without any fear causes a catastrophe that nearly ends the financial world would you atte
pt to recreate an atmosphere which will dwarf the 2008 environement?
Does Ben truly feel so politicaly untouchable that he can come out and say were going to take your fucking money serfs and just give it to the elites of the world to protect their malinvestment and assets and your gonna like it.
The Fed was just skewered for creating 2 bubbles and I reiterate Ben will not stop until he has created another more dangerous bubble. Have we ever seen such desperation? It appears to me that this is being done by design to prevent the Federal Reserve from being abolished becaae when this is all over the entire American economy will live and die as the Fed determines. The fear of a collapse not seen before while the Fed threatens to end the world will keep them in power. They are consoldiating power right now.
Ben Bernanke is now the President/Emporer of the United States and has usurped the Executive branch. The Fed and their finance generals can contract the money supply at will and use media contacts and bought politicians to craft the message to the public.
This is a coup in the making.
Exactly. The Feds main function is to make the stock market go higher. All that Mumbo Jumbo about the economy is bullshit. The stock market is the economy.
This is a coup in the making.
The overthrow already happened years ago, sorry.
The question is: now what?
I'm sure the Fed isn't thinking about this - but how exactly do they plan to pull back liquidity? Sell treasuries and MBS? They'd be lucky to get half of what they paid for those. Which means - at least a $trillion of QE1 is completely unrecoverable.
what fuck is #A Successful QE2 ???
mandate of FED is clear... low unempl and/or stabel prices..
does anyone think unempl will be better??? might be only stupid assholes in GS..
does anybody think prices will be stable?? well look NOW at commodities..
aint nothing seen yet..
alx
blood clots here, burst artery there, blood shooting all over the place and there is Dr BB standing over the economy putting in an artificial heart QE set on turbo. Net effect - blot clots break loose like bullets, more arteries burst, more blood.
The US is dependent on QE to not drown it seems.
If QE2 is supported by Fed buying MBS (evidenced by Bill Gross move on margin) and less treasuries, would this precipitate drop in the treasury bond market and see a correction there?
"And while a comparable increase in wages is certainly not guaranteed to occur concurrently"
This will cause severe hardships on the middle class. Prices are already beginning to rise and I don't think anyone is getting a raise anytime soon to compensate for the cost of living increase. Frankly I'm very dubious that it will happen before families decide its more important to fill their car with gas than pay their mortgages. You might see people buying homes just to default on the mortage and live rent free for 18 months.
Whats the point of pump priming an engine if the plugs are bust (over borrowed commercial and consumer market) and there is no battery (global economies struggling).
Why would you short gold in this environment? SKorea, China on the buying path, others no doubt intend to do the same and others will now copy and so forth. Throwing good money after bad.
Gold is like a cork now, the harder you push it down the faster it will pop up.
Seems to me the sales pitch has always been "the rising tide lifts all boats" junk. When in reality, most of the world (J6P included) is in fact anchored to the bottom.
GS must be thinking about taxes on their end of year bonuses (QE2). Probably best to wait until next year when the CONgress has time to rectify applicable tax laws.
What would you do if you were a bank that was suddenly sitting on $200 billion? Loan it to main street or small businesses? Possibly, but that would massively inflate the money supply and create the problems that Goldman is pointing out here.
But I think it's more likely that the banks would chase profits in emerging markets, as that's probably a better bet anyway. This would mitigate the inflationary pressure but also drain wealth from the USA and not contribute to growth at all. The other thing banks might do is what they've been doing with POMO funds, which is to chase leveraged bets in tech equities and hope they pull the money out before the bubble bursts. Neither of those courses would contribute to growth in the US economy, and in fact without lending the money supply would contract and the currency would move even closer to collapse.
What are you gonna do, legislate that banks must lend to small businesses? How are we going to be competitive with foreign companies without massive reforms to lower the cost of overhead (which would start with wage DECREASES, tort reform, regulatory reform, and the abolishment of Title VII, social security, medicaid, and medicare). Have fun, America, the party's over and not even the Fed can save you.
There is a 0% chance QE2 works the way this report predicts in items (a) through (e). There is no free-lunch-tree-that-grows-to-the-sky. There is only one-group-wins-one-group-loses. In this world of excess capacity and labor everywhere, there is no way QE2 filters down to increased wages for the masses. The result of QE2 will be nominal price increase in assets that are owned by TPTB along with decreased purchasing power for J6P. That will "work" until the peasants have had enough ala France circa 1789.
Maybe I am complete f*****g idiot here, but I dont see it going down this way. Lending, healthy economy... ha. Rather, I see a failed bond market as the beginning of the end. Following that is the Shazam moment when we are thrown from the reserve currency bus and the flood of selling sparks a wholesale flight from the USD into food, gas, ammo and iphones (LOL).
Meanwhile, commodities will surge and the average joe will be squeeeeeeeeezed from all ends including tax hikes, fees and such from zombie state governments, outsourced/privatized services, banks and the like. That is, we go from deflation to hyperinflation... bypassing traditional monetary inflation. The deflationary stage though feels like "biflation" to the average Joe though... which is curious but makes perfect sense in terms of the liquidity trap we are caught in.
Hmmmm, next you are going to tell me that the big banks will be giving loans to the unemployed and homeless. I call BS! QE 2 is just going to get thrown into various markets making the rich richer.
Today marks an important turing point for global markets and the USD strength I warned about has arrived.
http://stockmarket618.wordpress.com
Thanks for taking the time to discuss this, I feel strongly about it and love learning more on this topic.
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