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Project Weimar: Why QE2 Could be More Inflationary Than You Think
Two simple charts tell it all. Bonus: at the end, we explain how to make Paul Krugman squirm.
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"In my darkest moments, I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places."
-Dallas Federal Reserve Bank President, Richard W. Fisher, October 19, 2010
This is the condensed version of what I wrote the other day. Just about everyone now expects the Fed to purchase half to a cool trillion or more in Treasury purchases over the next year. As Tyler pointed out a few weeks ago, "The problem, as we also concluded, is that there are simply not enough Treasurys across the entire curve, in existing or projected issuance, to satisfy the Fed's possible total monetization needs!" Indeed. But, the possibility remains that the money simply ends up as excess reserves at the Fed like last time, right? Why worry about inflation as the 10 year grinds ever lower and lending continues to fall? As I wrote:
The thinking goes: the Fed bought $1.75 trillion in assets. The banks took some of this money, levered it, and ramped the risk markets for a year. They left a trillion (or so) parked at the Fed to earn 0.25% interest, where it remains today. If the Fed prints another half (or whole) trillion over the next year to purchase Treasurys, we can expect more of the same. Banks don't want to lend, and what they don't use to bid up risk assets (such as junk stocks, Indian rice futures and now gold), they'll continue to deposit at the Fed.
This assumes, however, that the Fed's bank subsidies vis-à-vis its permanent open market operations are uniform in effect across asset classes, which is not the case. The Fed's $1.25 trillion in MBS purchases merely covered the banking system's collective lousy bets on the mortgage industry. The banks happily put their MBS securities to the Fed and for the most part left the digital zeros in their reserve accounts. The $200 billion in Agency debt purchases (Fannie and Freddie paper) allowed China, et al to swap out its Agency holdings for Treasurys, as Chris Martenson explained in August, 2009. Finally, it was the Fed's $300 billion in long term Treasury purchases that really goosed the risk markets, as we concurrently explained.
This should be no surprise, as Treasurys are highly liquid, "riskless" securities, and have been the Fed's instrument of choice in managing short term interest rates for years. If the Federal Funds rate strayed too far above from the target rate, the Fed would arrange a temporary (or sometimes permanent) purchase of Treasury bills or coupons on the open market from its primary dealers. The intent and result was that the PD's would put the newly minted money to work, where it would compete with other short term investment money for yield. With a greater supply of money available for short term lending, yields would fall accordingly. The opposite would apply when the Fed Funds rate is below the target rate, whereby the Fed would extract liquidity by selling Treasurys to raise short term rates.
From time to time, the amount of money printing or extraction required to achieve a target rate is deemed to be too much by the Fed, so it capitulates and the FOMC adjusts the target rate. This is why the actual Fed Funds rate usually leads the target rate, leading some to believe the Fed is impotent when it comes to interest rate policy. However, the Fed's modus operandi is that it leads the markets as much as possible with expectations, then matches or exceeds expectations until the markets demand too much, after which it backs off a bit. Make no mistake, the Fed exerts considerable influence over interest rate and monetary policy--more now than ever with its unprecedented collection of interventionist tools.
The below chart shows the progression of Bernanke's mad science experiments. Readers have likely been immunized against shock by the hockey stick monetary charts that have littered the blogosphere for nearly two years; however, what is likely a new presentation is the breakdown of bank reserves by bank type. The Fed's H.8 Release (Assets and Liabilities of Commercial Banks in the US) divides banks among the largest 25 domestic banks, all other (small) domestic banks, and foreign banks. The line item for Cash Assets is an excellent proxy for reserve deposits, as it:
Includes vault cash, cash items in process of collection, balances due from depository institutions, and balances due from Federal Reserve Banks
Such balances (Fed reserves) comprise most of the Cash Assets and the other items do not fluctuate enough or are not large enough to be of concern. Accordingly, the below story unfolds:
Notable is that Federal Reserve balances have been drawn down from the February 24, 2010 peak by $249 billion, of which $169 billion is non-borrowed (those extra reserves that banks can, and have, removed from Fed custody). While the small banks have kept their cash assets nearly constant since December, 2009, large banks have withdrawn $211 billion and foreign banks $96 billion from their respective peaks. These are material sums. Also notable is that QE Lite, now two months old, is not popping up in bank reserves. Importantly, though, we do see M2 ticking up again.
For anyone who still doubts the power of the Fed's open market Treasury ops, it's instructive to zoom in on the second and third quarters of 2008--a time when fears were escalating over the imminent Bear Stearns collapse.
Like a good shop-vac, Treasury open market operations work just as well in reverse--risk on/risk off. Judging by the spread between the 13 Week T-Bill rate and the Fed Funds target rate, it's clear that the markets were demanding more than a 75 bps drop at the March 18, 2008 FOMC meeting. Regardless, the order was given to reign in liquidity until the two converged, which they nearly had by the last such operation on May 21, $144 billion later. The dramatic slowing in money supply growth was noted by EPJ at the time. Whether Gentle Ben was blindly targeting an arbitrarily set metric or deliberately tightening while talking an easing game to engineer one of the century's greatest market meltdowns is unknown. Historical Fed duplicity tends to make one think the worst, though it's important not to ascribe too much prescience to these people--much less omniscience.
My conclusions can be read at the end of the post, but summarized, are quite simple. Treasury purchases and sales have historically influenced short term rates and, in turn, the money supply. However, even in a post-IOER world, the primary dealers don't and won't have the inventory to make the future purchases sterile. The amounts are multiples of what was done in 2009 (at least with respect to Treasury purchases, which is the juice). The minimum expected amount of QE2 Treasury purchases is $500 billion over the next year. Add in another $320-$360 billion for QE Lite, and we have a total minimum of $820-$860 billion. Current domestic bank inventory of Treasury and Agency debt is only $550 billion. We know there will be asset price inflation and monetary base inflation, but the numbers suggest the broader money supply will be inflated as well, especially if the upper end of expectations of $1.5 trillion are fulfilled.
Okay, now to the fun stuff:
As Econophile pointed out the other day, and as Robert Wenzel at EPJ updates this morning, Austrian economics author and scholar Bob Murphy has challenged Paul Krugman to a debate. If Krugman simply accepts, funds donated through The Point ($31,535 and counting) will be passed along to FoodBankNYC.org. CNBC's John Carney also wrote about it here.
If you'd like to watch Paul Krugman's eyes turn brown as he defends the worst economic decisions since the Great Depression (or look like a complete dick for denying a worthy charity of critical funds), don't hesitate to vote with your digital wallet here. All were asking is a measly tithe--that is, 10% of ZH readers' funds gained from front running the Fed's POMOs.
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$4 TRillion
I want to watch that Krugman match, it will be a killer. Also this QE2 thing is a shot in the dark and many know it.
The author is just wrong.
If the Fed buys what I think is going to be more like $4 billion in Treasuries, it will be buying high and, later, when interest rates go up, selling low.
The banks will jump at the chance to buy those bonds.
As long as deflation will allow it, theory holds that a sovereign can monetize as much as ALL its debt. They're simply trading cash that is valuable because it's fungible for ultra-low-yielding bonds that have become a trap.
So the banks have a lot of cash on their balance sheets - so what? What, in a deflationary environment, are they going to buy that you don't want them to buy? Corporates? Mortgages? Gold? Loans to actual businesses and people? Who cares?
It's ridiculous for a sovereign to "borrow" at 0%. At 0%, just print the money.
The zero interest point is the big blinking red light pointing to the gold bullion dealer. Gold is also paying zero interest. Which would you rather be holding, paper or gold? It is just that simple. Start tracking oil/gold and other commodities, etc. / gold to get some perspective.
Fine, but irrelevant.
The author is even more wrong than I thought.
The author's entire thesis is based on the assumption in the report Tyler cited that the Fed can only own 35% if what's available in any maturity space. That's not a valid assumption.
In fact, theory suggests that as long as inflation will bear it, the Fed can buy up all the federal debt it feels like buying. At prevailing interest rates you're buying near par, so that might be the best possible thing to do. And - again, if inflation will tolerate it - you print money to pay the government's bills until you've extinguished enough debt.
Do you really think it adds liquidity if a banks sells the Fed treasuries that it actually owns? No sir. The Fed is bidding that crap up as an easy short for the bankers.
Would be nice to see Krugman squirm like a nematode on hot pavement.
I obviously agree with the conclusion, but I can't follow the argument, which boils down to a claim that Fed buying of Treasuries is inflationary whereas Fed buying of agencies and MBS is not. I don't understand why the author believes that, nor can I think of any reason myself why that would be true.
The main reason why QE2 will be infationary unlike QE1 is that QE1 was launched amid sudden sharp contraction and severe cash shortage, whereas QE2 is going to be launched amid prolonged stagnation and cash plenty. I explain this and other reasons why QE2 will be inflationary in this article I wrote last month: http://keynesianfailure.wordpress.com/2010/09/24/why-this-time-qe-really-will-spur-inflation/
The point that the Fed was selling Treasuries during the first several months of the recession is a good one and mostly forgotten. Actually the Fed sold $300 billion from December 07 to July 08, including $210 billion during the peak period marked in the second chart. The reason for this selling was very simple: the Fed was sterilizing an equal amount of early crisis lending to banks through repos and term auction credit. Issuing $300 billion within 7 months of emergency lending and not sterilizing it would have been highly unorthodox and totally unprecedented. Remember that the official message during this time was that we probably would avoid recession, so nobody wanted to do anything that seemed alarming, pretty much right up until Lehman went under.
The top chart is very good, and crowded enough already, but there's a very important factor not represented: Treasury cash on deposit at the Fed. When Treasury sells Treasuries and keeps the receipts on deposit at the Fed (instead of spending them), it drains liquidity in exactly the same way as when the Fed sells Treasuries. Treasury did a huge amount of that in September to November 08, to sterilize Fed emergency lending before Congress gave the Fed the right to pay interest on reserves. Treasury did another $200 billion of that early this year, apparently for no monetary reason, but to build a buffer in case Congress plays tough with the federal debt limit. Likewise, when Treasury depletes its cash deposits at the Fed, as it did in December 08 into early 09, that increases liquidity.
Tom, good article. To answer why I think MBS is not inflationary and Treasury is, I could frame it with your argument "QE2 will not meet any pressing demand for cash". MBS purchases plugged the holes in the banks' balance sheets while Treasury purchases provided the froth to the prop desks with which they ramped the risk markets. If the Fed purchases MBS in the future, it will be for the same reason--to plug holes and meet a pressing demand for cash (as a result of roboforger writedowns).
I'm aware of Treasury's SFP and have written about it prior when Treasury announced it would completely liquidate its SFP deposits at the Fed as it approached the debt ceiling. I did have space considerations, otherwise I would have included some other things too, such as consumer credit.
Yes but plugging the holes in the banks' balance sheets prevents the deflation which would otherwise result, so MBS purchases are in that sense iflationary.
Right, I agree with Tricky Dick here, though he looks more like an Archie. Another way of saying what I'm saying is that QE1 produced no inflation because it countered deflation. Without QE1, banks et al would have had to sell assets into the markets to raise cash. There would have been more deleveraging and money supply shrinkage. It didn't matter what the Fed was buying - Treasuries, MBS, red, white and blue shoestrings - just that the Fed was buying.
Archie mistakenly believed that his hero was named Richard E. Nixon, not Richard M. Nixon. Hence my moniker and avatar. Convoluted, I know, but it always cracked me up.
just by way of comparison a few years ago, REPOs were the devils trident (Feds tool of choice, but POMO is 100 proof.) So much of this Fed activity is whistling past the graveyard, shadow reality. It became necessary to prop up the big banks, and their derivative problems, because they held America's sweat money. Now Ben is buying up Treasuries, which raises two long term issues, what about the federal debt that paper signifies, are we going to pay that off in cash, will that ruin the dollar once and for all, and is that their plan, ha ha fooled you? There was no strong dollar policy? And why take Treasuries off the market today, unless you thought you would have to pay even less interest to the holders who want to buy Treasuries tomorrow? And would you care about the holders of that older lower interest paper, if rates suddenly went higher? (Now GS is bying 50 year bonds looking for yield)
I honestly think the Fed doesn't want anyone to get stuck with near zero return on their investment, when rates go higher, although it would certainly benefit the UST. So what gives, is Ben a god or a devil? Or does he want to move everyone out to the 50 year bond and past that, by buying up (relatively) short term notes. Remember when Greenspan closed the 30 year, Ben may close the 30 year, in an effort to move everyone to the long end. What does that accomplish? Probably helps them maintain ZIRP, and keeps the bond vigilantes at bay?
If things go haywire, watch them do involuntary rollovers of short term paper, one part of their nefarious plan, a 2 yr note is suddenly a 10yr note, what happens then? Short term rates can rise? Maybe. Whatever the Fed wants the investor class to do, do the opposite, that's my motto. (sorry Bill Gross, you were always wrong to try and frontrun them)
If things go haywire, watch them do involuntary rollovers of short term paper, one part of their nefarious plan, a 2 yr note is suddenly a 10yr note, what happens then?
The end of the Treasury market.
Argentina rolled over short term notes into 30 year zeros, presto! change-o! you're now accruing non-interest and you have not been the victim of "confiscation". Refer all language issues to Orwell's 1984 for definitions as you need them. Regardless of the phony workout, you are left with "worth less currency/bonds". This debt can not be paid off in any ratonal economic system so something irrational or "new economical" will occur. This is not good.
DOW weekly chart shows the rising wedge contained within the megaphone pattern. This remains a very bearish picture and we should
get a breakout soon.
http://stockmarket618.wordpress.com
I definitely hear what you are saying SheepDog, i have an uneasy feeling about anything the market seems so sure of.
However i do believe that at the least they will announce a gradual QE which will be done in incremental steps (such as $100 Bil. in purchases per month for the next year or so)
Excuse my ignorance, but this doesn't make sense to me. The amount the Fed needs to monetizes to keep rates down is directly related to the supply of debt (both new and re-issuance). The Fed doesn't have a "total monetization needs". They might have an estimate of how much they need to buy to bring rates where they want them, but that amount can't be more the the actual supply, unless they want negative rates across the curve! lol
It ain't just about the rates. The PD's flip the treasuries to buy risk, which is in keeping with the Fed's dual mandate of causing economic stagnation and funding the government.
I see, thanks 3Ts. I knew i was missing smtg.
Don't delude yourselves, QE2 is a certainty. There is no way that the FED doesn't announce it next week.
Weimar Germany went kaboom when German government was printing 50 percent of the budget. Mark just collapsed over few months. Federal budget is about 2.7 trillion dollars so QE2 shot over trillion dollars might be at least flirting with hyperinflation.
The Fed has accomplished the goals of QE without even implemementing it.
The meeting is lined up for the day of the mid-terms and just after a key GDP figure. Qe2 is not a given.
Exactly, the FED has accomplished Q/E2 as a media propaganda engine to gun markets 10% in a month, without doing anything except a few POMO adrenaline shots to the foul beasts heart, and all the while the FED is squeeky clean because THEY never mentioned Q/E2 ever!
So on Nov 3rd when everyone is sitting with their jaws on the floor demanding to know why Bernanke went back on his promise of a massive Q/E2, he can say 'Ive never mentioned anything about a Q/E2 of many trillions, review your video records, I dont know what youre all talking about'.
Its perfect.
I do concede a QE2 no-show as a possibility on Nov 3, but not the most likely one. I think QE2 is announced, but it is in a balance-sheet targeting form that looks "tame". In reality, it will not be tame and I think we'll see a big uptick in M2 over the coming months. I wrote about this here.
I was very interested in an analysis of Dr. Bernanke from his own writings and statements that was published on the Gloom Doom and Boom web-site. I believe he is a a species of "true-believer" ; the classic carpenter with a hammer to whom everything appears as a nail. I really believe the only possible response we can get from him to any sort of "Lagging, or sagging" economy is massive monetary injection. Geithner has an identical belief system, which is probably deeply involved in why he was appointed. It's perfectly clear that price inflation is alive and well as we speak, and in general I tend to agree with you. Once again, for the readership, this has no relation to employment; that relationship exists only in the mental map of the monetary true believer. Cheers.
Here would be the real shocker:
Republicans pick up majorities in both the House and the Senate, then afterwards, Obama asks for the resignations of both Geithner and Bernanke.
It's the only way Obama has a rats-ass chance of saving his re-election hide.
Sure, the chances are miniscule, but...
Definitely I think best case scenario is a Q/E disappointment.
"Ben, it's Barack. Yeah I know it's after midnight but I've been up watching election results. Man we took a beating. Look, on that QE announcement tomorrow, I really need you to come in with a lowball number so I can blame the resulting market crash on the Republicans winning back Congress. Thanks man. 'Night."
What makes you think Ben pays any attention to whoever happens to live at 1600 Penn Ave.?
Ben would not even answer the phone. His secretary would pass the message.
Clue: Ben doesn't care. Ben's boss doesn't care. Inflation is the only game in town.
D.C. 1968, I love the smell of realestate in the evening.
"Hey B.O. Yeah, you guys really got smoked. Anywho, I'll check with my bosses in the morning and get back to you on the lowball request. Shouldn't be a problem, as they'll have plenty of time to line up the books before the announcement. Shalom out."
Ding-ding-ding! We have a winner.
Bingo
Why anybody should give a shit about Paul Krugman?
Just because Paul Krugman got a Nobel prize and publishing his BS in the New York Tines? Obama also got a Nobel prize. So, anybody really care what Obama really thinks about world geopolitics?
You people are full of it!
+1000
QE2 will be all about keeping cities and states afloat, meaning a lot of public sector salaries and projects will be directly paid by printing money. QE1 was just keeping banks afloat and money did not went into broader circulation.
For more, M1 money supply aka cash is still growing, people are liquidating their long term savings from (now unofficial) M3, that is shrinking quite fast. So more and more money is turned into fast liquid money. That is especially bad in case of panic buying. Dollar is also vulnerable against all out currency speculation attack plus the inverse relationship between dollar and price of commodities. All of those four components together could lead to hyperinflationary explosion.
Nicely crafted article, EB. Good comment, Tim. I would like to read a well written response to the contrary, but I know Krugman is not up to the task.
Wrtie the response to the contrary yourself; or do it mentally, or take notes for the paragraphs; this is frequently the best thing to do; it's very enlightening. For instance, I cannot write a rational response to the contrary. "Maybe we'll get lucky" doesn't seem adequate, somehow.
The revolution will be televised.
QE1 just allowed major banks to write off their bad debts, however, the money marginally went in a circulation.
QE2 will go directly into a circulation with a hyperinflation becomes inevitable.
QE2 will go directly into a circulation with a hyperinflation becomes inevitable.
Dreaming with visions of sugarplums
Yet to hear a plausible explanation how hyperinflation will actually benefit anyone,
especially B & G
In 518 years America has not had hyperinflation, Continental and Greenbacks notwithstanding
America had a debt default deflation depression Jubilee each century, sometimes two
518 years, Huh ? Boy, you're really on top of it alright. Continental notwithstanding; so you just write, "notwithstanding", and it never really happened, huh ? that's really remarkable.
What Q/E2? Ive heard lots of hype about it from the media and anal-cysts and Wall St banksters, but never heard it mentioned by Ben Shalom.
You haven't been paying attention:
Fed chief Ben Bernanke signals more easing to counter high ...
Bernanke makes case for cautious easing The Fed - MarketWatch
FT.com / US / Economy & Fed - Bernanke hints at further stimulus
And about 100,000 more.
Those who can afford it already bought protection against the inflation, and those who have to much debt to do so, won't really care if it all turns.
NOW BRING IT ON BENNY B.!!! BRING IT ON!!!
krugman you're entering a world of pain
Paging Mish Shedlock, paging Mish Shedlock. Please report to the information desk. Thank you.
Mish may be fighting a seemingly losing battle against the psychopaths in power but he is spot on about one thing : unions are parasites. Public service sector in general is nothing but a tax on the hard working , productive part of society that keeps the wheels spinning. And im glad someone has the balls to actually call out teachers for what they -generally- are : abso-fking-lutely useless . Second class teleprompter readers and nothing more. I apologise for the thousands of superb tutors that ive maligned but overall the teaching and education profession per se is a shambles. Screw unions and screw the public sector.