QE2, Junk Economics, and Be Careful What You Wish For

This article originally appeared on The Daily Capitalist.

This is an interesting time, an interesting week. I hope you all had a chance to read DoctoRx's essay on gold. I think it has a lot of merit.

The Fed is on the cusp of embarking on QE2 money printing to stimulate the economy. The data is still very weak and I think QE2 will happen. I still see stagflation in our future as capital is continuing to be destroyed and yet the dollar gets weaker. Germany is recovering, the UK is embarked on reining in spending which will lead to recovery, China is tightening, Japan is mixed as is the rest of the EU.

Yesterday we found that housing is still weak.

The Case-Shiller index of 10 major metropolitan areas fell 0.1% in August compared with July, while the 20-city index declined 0.2%. Adjusted for seasonal factors, the 10-area index fell 0.2%, while the 20-area declined 0.3%.

Prices had been climbing since April, boosted by the expiration of the government's first-time home-buyer tax credit that lured waves of people to purchase homes before it expired. Growth had slowed in recent months as its effects waned. Before prices had started rising, they had fallen sequentially for six straight months.

David M. Blitzer, chairman of S&P's index committee, called the latest figures "disappointing," noting that prices declined broadly. He added, "17 of the 20 cities and both composites saw a weakening in year-over-year figures, as compared to July, indicating that the housing market continues to bounce along the recent lows."

Is anyone surprised by this? The west coast still looks good, but the rest of the metro areas weakened. As I've mentioned, my own anecdotal evidence from the west coast bears this out. Even with interest rates at historic lows, folks are still worried about their jobs. And in many of the sinking areas there is still a big surplus of homes. As we know, the unemployment needle is stuck in high. Add to this the Mortgage Bankers Association prediction that home lending in 2011 will be the lowest since 1996, below $1 trillion. They expect interest rates to rise and limit the flood of refis.

The Consumer Confidence report also came out today basically unchanged and weak according to the Conference Board, even though it rose slightly. This is basically in line with the U. of Michigan report that came out last week that was a bit more negative. Even though retail sales have been creeping up, analysts say consumers are driven by sales. A Gallup survey on Christmas spending was "disappointing." Here is what they found:

Before we get back to the Fed, I think it is important that we are seeing a growing trend in regional and local banks to dump nonperforming assets. This is critical to any recovery. Banks have been reluctant to foreclose on commercial real estate (CRE) because of a lot of reasons, but mainly that it would negatively impact their Tier 1 capital. Recent reports shows that they are making money mainly by releasing nonperforming loan reserves, which were set aside to reserve against loan losses. This indicates that they are more aggressively dumping nonperforming loans. In the banks surveyed by American Banker, Fifth Third, BB&T Corp., SunTrust Banks Inc., First Horizon National Corp., Comerica, M&T Bank Corp., and TCF Financial Corp., all were selling off hundreds of millions of dollar of CRE and more aggressively foreclosing on residential loans.

Even the big banks, Citi and JP Morgan Chase are having problems. Citi just announced that they won't see daylight until sometime in 2012. And that bastion of capitalism, Goldman Sachs, had a bad quarter, down 40%. Don't shed a tear: bonuses so far are $13.1 billion.

Then there is inflation: flat (1.1% YoY). You would think this is a good thing, but the Fed wants to see it double.

The Federal Reserve Open Market Committee (FOMC), the policy committee which votes on Fed policy such as setting the Fed Funds rate and its Primary Open Market Operations (POMO) policy (QE), meets on November 2-3, and there has been a lot of speculation about how much they will eventually pump into the economy to stimulate price inflation.

By then they will have a good idea what the preliminary GDP numbers are going to be for Q3 (the preliminary numbers will be released on Friday). I expect GDP to be weaker in Q3 than in Q2. That is based on a lot of data that has been sinking in the charts. Readers will be familiar with the data.

I have said that the Fed will pump at least another $1 trillion to into the economy. That was based mostly on some Goldman Sachs research reported on Zero Hedge ($500 billion to $1 trillion). Now the esteemed Tyler Durden reported on Zero Hedge two days ago that GS's latest research has revised its estimate upward to $2 trillion of QE is needed to achieve the desired inflation goal of 2%+. But here is the kicker: GS says they really need about $4 trillion in QE to hit their target! They say the Fed won't do that of course.

The whole analysis is based on what is called the Taylor Rule. That rule is an econometric formula that determines what kind of stimulus is needed to achieve an inflation target. It is a complex rule based on neoclassical models of aggregate economic behavior, which in my opinion is a bit of witchcraft, but more importantly most economists at the Fed believe it and it will guide their actions. If you wish to know more about the Taylor Rule, here is a Wikipedia explanation, and if you really want to know why it doesn't work, see this analysis at the Mises Institute by Frank Shostak.

But GS believes it too:

Our analysis is therefore consistent with additional asset purchases of around $2trn if the FOMC's forecasts converge to our own. It is unlikely, however, that the FOMC will announce asset purchases of this size in the very near term. Rather, our analysis suggests that the timing of the announcements should depend on whether, and how quickly, the FOMC's forecasts converge to ours.

I think GS may have a pretty good take on what the Fed will do. They think like the Fed, they follow Fed research and speeches, and use the same analytical tools as the Fed.

If you think about it, you could ask why we have inflation at 1.1% or any inflation at all. Why don't we have deflation? A lot of it has to do with the way the CPI is measured. Or how the Fed's measure of price inflation, chained personal consumption expenditures (PCE), is measured. Based on declining real estate values, you would think it should offset other price increases per their measurements. But that's not how price inflation is measured. It is possible that we are actually in price deflation and the measurements are faulty by not throwing in real estate values. This is another discussion.

I think the reason why we have some price inflation is because of the QE1. After all, the Fed did inject almost $1.2 trillion into the economy and that money had to have some impact on prices. So, another $2 trillion of QE to break out to the target of 2% price inflation is not a stretch. Of course, it could backfire on the Fed, and it is entirely possible that price inflation could far exceed their target. I firmly believe they have no idea what the real outcome of QE will be.

Comments

[Coldfire]

QE∞. Because central planning worked so well historically.

[Escapeclaws]

William Hugh Smith is the most clear-headed commentator I've seen. He reasons on the basis of "cui bono". Of course the answer is the elites. So he figures if you want to see what scenarios are likely, don't be cynical and bitter, just consider what is most likely in the elite's best interests. Based on that he comes up with the following scenario. I would love to hear what ZH'ers think of this.

This is from his blog on 10/25/10

"If I had $5 billion, and the political power that goes with spending a tiny sliver of that on political donations and lobbying, then here's what I would do, as an entirely "obvious" Grand Strategy:

1. I would slowly liquidate my common-stock equity and long-bond positions, and maintain my precious-metals positions (preferably ownership of the mines than the bullion) and my preferred stock in global corporations.

Insiders selling 1,169 to 1 (zero hedge)

2. I would engineer a global recession that implodes all the asset bubbles around the world--Chinese real estate, commodities, emerging market equities, etc., as demand collapsed and supply was suddenly revealed as overly abundant. (Please see my oil "head-fake" entries for how this works: Oil: One Last Head-Fake? (May 9, 2008)

This would create a mad dash for dollars and other cash to pay down debt taken on in the "easy money"/ZIRP era (i.e. 2008-2010), and lead to wholesale dumping of all assets which still have value. The higher the value (i.e. gold) the quicker they will be unloaded for cash: for instance, oil and energy-based equities.

3. I would sit on my hoard of cash while the selling created a positive feedback loop and prices plummeted in a downward panic spiral.

4. As net worth vanished in the tens of trillions of dollars/yen/yuan/euros, interest rates would rise dramatically as those desperate for funds compete for dwindling free cash. Revenues of oil exporters and other exporters crash, drying up a once-reliable source of cash.

5. When premium real estate properties and equities are selling for 10%-20% of their pre-crash valuations, I will begin buying. I won't buy long-term bonds until the yields skyrocket; then I will jump in with all four feet.

6. As the long-term shortage of commodities eventually re-asserts itself, then I (and my other Financial Power Elites cohort) will own most of what the world needs to function, including the Central State tax revenues which will increasingly be directed to making interest payments.

7. I will be a strong supporter of food stamps and other low-cost rebellion-reduction programs, and "soft" and "hard" power to enforce my ownership of assets which I purchased.

8. As interest rates rise, the U.S. dollar will strengthen, further increasing my purchasing power.

9. I will oppose inflationary policies as needless reductions in my purchasing power. I don't owe debt, I own debt as an asset.

Bottom line: expect a crash in commodity prices and other asset bubbles, a much stronger dollar and rapidly rising interest rates. I am playing it as it lays, and this is precisely what I expect to unfold between 2010 and 2014."

As you can see, he believes mild deflation is what the elite would prefer for the near future. This is based on the idea that the elite are owners of debt and do not want that asset losing value due to inflation. His blog is a treasure trove of common sense.

[alien-IQ]

That's a horrifyingly accurate take on what and how things will most likely play out.

terrific post.

PS: What's the blog? Name or link?

[RoRoTrader]

Think this is the link; http://www.oftwominds.com/blog.html

Charles Hugh Smith

That's it; http://www.oftwominds.com/blogoct10/grand-strategy10-10.html

Tnx EC

I just skipped over the article and the first impression is that Smith is probably onto something. If the banks were paid record bonuses from the first QE pass and already another round of record bonuses is being mentioned under the cover of QE to infinity to pretending to address unemployment then the simple logic implies the taxpayer/debtor is about to be gangbanged again, only harder this time and probably with a design that trancends race, nationality, religion, language and culture......or to put it much more crudely; perversely objectified in the worst sense of the word.

Thinking through the initial impression a bit more I think Smith may be talking about a return to a sort of czarist kind of rule.

[Thinkor]

$1 trillion is only 7% of GDP.    When do we get to a Krugman-style stimulus?

[tony bonn]

"I think the reason why we have some price inflation is because of the QE1. After all, the Fed did inject almost $1.2 trillion into the economy and that money had to have some impact on prices."

nyet. the banksters turned around and deposited the money in fed....some leaked out....john williams reports continued inflation...the voodoo economics of the fed is to stoke more inflation to fuel more wealth transfer to the banksters...

[Econophile]

I disagree. It went into the financial markets.

[Sudden Debt]

OH MY GOD!!

SO YOU MEAN...

I'LL GET LESS CHRISTMASS PRESENTS!!!

I...

this is...

but there...

I need alcohol...

[RockyRacoon]

Make mine a double.

I'm getting QE fatigue.  Wake me when it's over.   I hope you come to in time to see the biggest of the turds hitting the fan.

[President Palin]

"... I think GS may have a pretty good take on what the Fed will do. They think like the Fed, they follow Fed research and speeches, and use the same analytical tools as the Fed."

Or maybe... the FED is really GS in disguise (and a bad disguise at that)...

[razorthin]

Disinflation is good - a natural purgative of free markets.  When will these educated arseholes understand no one will invest and consume until the price is right.  Until the market is cleared and the private sector is able to snap up some some real bargin assets on the basement floor, there won't be meaningful job growth, and therefore meaningful economic growth.  I may be a simple man, but isn't it really that simple?

[Bartanist]

It is of course that simple and the Fed is not so stupid as to understand it. There are a couple of obvious conclusions:

a) the Fed has no intention of creating job growth and economic growth

b) the Fed and the Fed cronies are lying to people and assuming they are too stupid, docile, corrupt or frightened to do anything about it.

[GoldSilverDoc]

Yes.