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QE2: The Ship Is Leaving The Dock
From The Daily Capitalist
You can always tell when something is up when the Fed presidents are making news. For the past several days we've heard Bernanke, Bullard (St. Louis), and now Evans (Chicago) talk about quantitative easing. The NY Fed's President William Dudley and Brian Sack Exec. VP in charge of carrying out FOMC decisions, have made major speeches about it. You have to understand that the Fed always has a purpose in its communications with the public, and rarely do its interlocutors stray from the official script.
The gist of each of these communiques has been that the Fed will soon, perhaps by the November 2 meeting, start massive additional purchases of Treasurys in order to create inflation. They wish to create inflation because they are clearly worried about "deflation."[1] According to a recent report by Goldman Sach's Jan Hatzius, as reported in todays Zero Hedge by fellow reporter Tyler Durden, GS believes that the Fed will buy at least $500 million of medium-term Treasury's, probably $1 trillion, and "possibly much more."
The Fed hierarchy believes that price inflation is necessary to enable them to carry out their mandate: maintain stable prices and full employment. They will attempt to stimulate the economy by massive quantitative easing (QE), a process by which the Fed monetizes the debt of the federal government. This is one of the ways the Fed can expand money supply. Price inflation, they believe, will create economic activity by reducing the debt burden on borrowers, maintain asset values, improve credit, and create additional income from consumers. And, importantly, they believe it will prevent price deflation.
Today I went through 30 pages of reports including the official texts of Messrs. Dudley's and Sack's speeches, whom I believe to be the most important players at the Fed next to Ben Bernanke.
What is infuriating to me is that they still do not have a clue why i) the boom-bust cycle occurred, ii) why the monetary and fiscal remedies have failed, and iii) what will happen when they print massive amounts of money in QE ($1 trillion plus).
President Dudley according to my review of his lengthy speech, is the ultimate post-Keynesian, neoclassical, econometrician Monetarist tinkerer. He states that the Fed can set goals for the economy with some precision and carry them out. I believe that much of this kind of talk is "communique" from the Fed that is meant to make financial actors believe that the Fed is in control of the situation. He says:
As the central bank, we and we alone can control inflation—if not precisely in the short run, then over the medium term. By clarifying our intentions, we can reduce the risk of further disinflation.
And, in reference to the Fed's exit strategy, he said:
[T]he Federal Reserve has the tools to control financial conditions and credit creation even with an expanded balance sheet.
In fact they are far from being in control and Dudley's speech is both fascinating and frightening at the same time. One could raise the questions: If they were in charge of things, i) why did they let the crisis happen, and ii) why haven't they revived the economy two years after October 2008?
I'm going to take you through Mr. Dudley's speech and point out to you why we are in so much trouble.
First we need to examine his, and I assume the Federal Reserve's, view of QE. Dudley says:
I am very mindful of concerns here and abroad that balance sheet expansion could be interpreted as a policy of monetizing the federal debt. However, I regard this view to be fundamentally mistaken. It misses the point of what would be motivating the Federal Reserve. The FOMC would only engage in large-scale asset purchases in order to push the economy more rapidly toward the dual mandate goals of full employment and price stability. Once these goals were accomplished, there would be no basis for further purchases regardless of the government’s fiscal position because additional purchases would not be consistent with this mandate.
This is an astounding statement from an economist so prominent as Mr. Dudley. He is saying that debt monetization isn't really debt monetization when they do it for good reasons. He says they wouldn't do it for bad reasons, such as if the economy was fine but the government was still running massive deficits. He notes that those reasons don't fit into their mandate. But since I am certain that the government will continue to run massive deficits, would not the result be higher interest rates, putting a halt to the inflationary boom they create with QE? Perhaps he should have read Mr. Bernanke's speech on Monday:
In the short run, "concerns and uncertainty about exploding future deficits could make households, businesses, and investors more cautious about spending, capital investment, and hiring," he said in remarks prepared for a meeting of the Rhode Island Public Expenditure Council.
"In the longer term, a rising level of government debt relative to national income is likely to put upward pressure on interest rates and thus inhibit capital formation, productivity, and economic growth," Mr. Bernanke said.
In reviewing this and other statements by Mr. Dudley, I believe we will have the desired for inflation they wish for, but it will not be mild.
Most disturbing to me is that Mr. Dudley's explanation of the boom and the bust fail to mention anything about the role of the Fed in the cycle. He discusses the conventional wisdom explanations such as the run up in housing prices, the decline in mortgage standards, the rise of CDOs, and the spending financed by home equity loans. Nowhere does he mention the real causes of the boom: lowering the Fed Funds rate to 1%, thus exploding the money supply, or the role of the federal government and GSEs in guaranteeing the mortgage market's abandonment of common sense underwriting standards.
To his and the NY Fed's credit he fully acknowledges the problems that exist in the economy, including the credit crunch, the decline in real estate values as collateral for loans, deleveraging in all sectors of the economy, increased savings by consumers, lack of loan demand by businesses and consumers, and the reality that there may be a "sea change" in consumer spending-savings patterns.
Then Mr. Dudley gets to his point: we need price inflation to prevent price deflation. He explains the need for more price inflation than we are currently experiencing (1.5% per the PCE deflator).
[A] decline in inflation expectations that drives up the real interest rate and thereby increases the real cost of credit cannot be offset by simply lowering the federal funds rate. Thus, in a very direct sense, a fall in inflation expectations when the target interest rate is at the zero bound represents a de facto tightening of monetary policy and of financial conditions. Such a tightening would clearly be highly undesirable at a moment when unemployment is too high, inflation is too low and the economy has only moderate forward momentum.
And why are falling price inflation expectations important?
As the central bank, we and we alone can control inflation—if not precisely in the short run, then over the medium term. By clarifying our intentions, we can reduce the risk of further disinflation—or even an outright debt-deflation spiral that would make it still more difficult to accomplish the necessary balance-sheet adjustments.
Deflation is the core of the Fed's anxiety. By creating price inflation debt can be paid off cheaply. Who are the big debtors right now? The consumer and the federal government (actually all governments). If we experience price deflation, money will be more valuable, debtors will have a greater burden, creditors will benefit, but the upside is that goods will be cheaper.
But, Mr. Dudley is, of course, on the side of debtors, not creditors. He believes that by careful purchases of Treasurys, perhaps at least $500 billion, they can effect a reduction of long-term interest rates from 50 to 75 basis points. They will target maturities from 2 to 10 years, average 5 years, and thus reduce the holding period price inflation risk premia for such debt. This would reduce interest rates or at least prevent a further decline.
The benefits of such renewed price inflation:
Even in today’s challenging circumstances, lower long-term rates would support the economy through a number of channels. Lower long-term rates would support the value of assets, including houses and equities and household net worth. Lower long-term rates would make housing more affordable and support consumption by enabling households to refinance their mortgages at lower rates. This would increase the amount of income left over for other spending. Of course, this channel can be made more powerful to the extent that further progress can be made in efficient mortgage debt restructurings that allow households with negative equity in their homes to take advantage of the drop in mortgage rates. In addition, lower long-term rates would reduce the cost of capital for businesses, thereby fostering higher levels of capital spending for any given economic outlook.
This is of course is an economic chimera. What he fails to see is that by benefiting debtors, he reduces the incomes of creditors. Thus there is really no net gain when you think it through. The price inflated dollars used to pay back creditors are now worth less than when the debt obligation was originally created, so in effect, this policy just transfers money from creditors to debtors. But then the federal government is a debtor. In essence, they are trying to avoid the consequences of the housing boom and bust by creating a new inflationary boom.
There are further depressing mistakes he makes about the economy. Such as the idea that with capacity utilization low, it might be hard to start price inflation. Of course, that just isn't true. During the stagflation of the 1970s we had high price inflation and low capacity utilization. These little ideas are the reason we are still having big problems.
The important question is: how much? Mr. Dudley and Mr. Sacks refer to research that supports their contention that $500 million of new QE will result in a long-term interest rate reduction of 50 basis points. Goldman Sachs believes that will be the minimum number. I don't really know, but half a billion now sounds right to me. The key to the intensity of their efforts will be the unemployment numbers. Lately they appear to be bottoming out and new jobless claims are on the decline. I believe that a lagging manufacturing sector will spillover into the general economy and keep a lid on employment, perhaps even decreasing it further. If the data coming in from the EU and other buyer of US goods continue to soften, then a slowdown will hit the multinationals as well.
If unemployment does increase or fail to trend down, then you could see the QE2 exploding well beyond $1 trillion. This, despite Mr. Dudley's protestations would monetize more debt which would lead to higher inflation than the Fed ever intended. This of course is difficult to predict because you have to tell me what the Fed and the government would do in the future. As Mr. Dudley said:
In making our assessments about next steps, we need to be a bit humble about our capacity to forecast how market participants would respond to our actions. We do not control their behavior nor have much historical experience that we can draw on to easily assess how they are likely to behave. Even viewpoints that turned out to be incorrect could persist for a long time and generate adverse consequences. It is not enough for us to be right in theory. We also have to be convincing in practice and in explaining why concerns we think are misplaced are indeed unwarranted.
He has no idea how right he is. I am still convinced the Fed has no idea what it is doing.
_______________________________________________
1. In order to not confuse my readers, I need to be more precise in how I define inflation and deflation. My definitions are different than the Fed's. The Fed and most economists say inflation is a general rise of prices and deflation is the opposite, a decline in prices. In Austrian theory, inflation is an increase in money supply and deflation is a decrease in money supply. Thus inflation and deflation are monetary phenomenon. One of the results of inflation is rising prices. Other impacts are a distortion of the entrepreneurial process which leads to our typical boom-bust business cycles. I will refer to the Fed's usage as "price inflation" or "price deflation."
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Oh fuck me. Now you tell me that Ben's not real confident all this shit'll work.
What disturbs me (and Louise Yamada) is the 30 / 10 spread. Boom, Baby.
http://www.economicpolicyjournal.com/2010/10/bernanke-tells-truth-united...
Did anyone see this?
Ben is not too confident that this will all work anyway.
These people are idiots.
I am an idiot - BUT - I am less of an idiot than they are. IT WILL NOT WORK.
The reason that King Cnut (Canute) sat in front of the waves was NOT to try and prove that he could control the waves but to prove (to his sycophantic courtiers) that he COULDN'T (http://en.wikipedia.org/wiki/Canute_the_Great).
How can so much education lead to so much stupidity?
DavidC
Let's just print money and see what happens - no one knows the future! Maybe something good will occur. If not, we will be out of office and it will be someone else's problem.
QE 2 will not go to the financial industry directly and I am betting that this will be small business liquidity tied to job creation and innovation. (world wide)
The fore closures will happen faster so the bank can lock claim to the real estate at the current lower prices.
The markets will rally to 2013 PE expectations.
China exports will jump and allow for a Yuan appreciation without destruction and social unrest
Inflation will hit 14% by 2015.
Commodity holders will reap the rewards.
My bets are:
buying Vietnamese manufacturing and parts producers ( all of them)
Increasing my Canadian dollars holdings through mining stock (nickel)
Buying Chinese Aluminum producers (free electricity).
Eastern Silk Industry.
Wanna reduce the US debt? Put some M1A1s on E-Bay.
RCBS offer dies in 105mm?
We've lost. The only answer is to stop paying taxes, mortgages, anything that funds banks or governments. Starve them to death. Only way to defeat tyranny is to stop playing their game and fight back with our own "shadow banking." It's called cash, gold, silver and FU to authorities.
Hard to do with Stingers virtually unobtainable....
Goldman Sachs Group Inc. said the U.S. economy is likely to be “fairly bad” or “very bad” over the next six to nine months.
http://www.bloomberg.com/news/2010-10-06/oldman-sachs-says-u-s-economy-t...
Can we get some color coding like 'Yellow is fairly bad' and 'Orange is very bad' or 'brown spots means it's hit the fan'
I need colors like that homeland security color thingy
Excellent analyse, outlining the worthlessness
of QE at this stage of the game: just take a look
at the results of the British Q.E, to remain current.
Ben, Timmay and Bushobama have one goal in common: debasing
the USD
David Rosenberg attacks the Fed's intentional Ponzi approach
http://pragcap.com/david-rosenberg-attacks-the-feds-intentional-ponzi-ap...
.
"Lower long-term rates would make housing more affordable and support consumption by enabling households to refinance their mortgages at lower rates. This would increase the amount of income left over for other spending. Of course, this channel can be made more powerful to the extent that further progress can be made in efficient mortgage debt restructurings that allow households with negative equity in their homes to take advantage of the drop in mortgage rates.'
News flash, Dudley: no one can refi due to L/V ratios being out of whack. So those rates remain tantalizingly out of reach. So, refis are out - make the rates zero and it still doesn't fix the L/V ratios since real estate prices are declining or steady at best, in the face of ZIRP (god forbid where they'd be if the rates were higher). Moreover, you can't just "lower the rates", or recast the mortgages without causing severe damage to bank and other mortgage holders' balance sheets.
That is a seriously whacked out dude. He's in charge of what? I wouldn't count on him to properly make change at a CVS Pharmacy.
Geithner Sees `Damaging Dynamic' in Currency Policies
http://www.bloomberg.com/news/2010-10-06/geithner-sees-a-damaging-dynami...
Thank the gods we have this genius leading the way......... To Currency HELL.
The FED isn't worried about the economy, so stop saying that it is.
It is making certain that its primary duty is carried out. And that is keeping rich bond holders very wealthy.
Everything else that comes about by their actions is purely collateral and expected damage.
Don't be surprised. You can't get a job at the Fed unless you believe that rising prices cause inflation. Presumably, you are also required to believe that wet sidewalks cause rain.
actually, wet sidewalks do cause rain since eventually the water evaporates, see, and then rises up in the air to form water vapor, which turns into clouds and then. . .
I remeber some months back when Zero Hedge had a video in which William Dudley accidently admitted that the Fed IS monetizing the debt, but only "a little"! Since when is $1 trillion, $2 trillion, or more just "a little"?
Every POMO day is a debt monetization day.
This nonsense is the antithesis of zero hedge.
Apparently few agree with you, but I do. It is utter nonsense.
So, oh great Karnaks two, why?
In the second paragraph, didn't the author intend to write "$500 BILLION" with a "b" instead of "$500 MILLION" with an "m"? That's the only way that paragraph makes any sense to me.
I would be grateful if it was a mere $500 million!
When its all over, the Feds claims of success will be analagous to a local, rural fire departments "We ain't never lost a basement...."
What I am not hearing....
Are solutions....
Solution ????
Tax structure change...
ie the FAIR TAX....
Eliminate the IRS and the FED....
And the US WILL TAKE OFF LIKE A ROCKET....
And if the IRS and FED are not removed....the US goes down like the Titanic...
It is as simple as that....
Reading about the past with no solutions is getting quite stale....
The Fair Tax has a few upsides. It would be nice to dump the IRS and shift a great deal of unemployment pain onto tax lawyers.
However, keep in mind that one of the effects of the Fair Tax proposal is to shift an even greater tax burden onto the poor and working classes. The poor and working classes, which at this point comprises about 90% of the population, spend ALL their income on consumption. Fair Tax taxes consumption. The extreme upper-income citizens spend a lower percentage of their income on consumption. Fair Tax is a tax cut for them.
We've been shifting increased tax burden onto (what used to be) the middle class for the past 50 years, and so far it hasn't seemed to do us a great deal of good.
Couple this with the fact that it bases Federal funding completely on a highly-volatile form of revenue collection and the Fair Tax proposal looks like it would be a total disaster waiting to happen. We're in disaster now anyway, so maybe it doesn't matter.
Anyway, hey, Fair Tax is simple. So people tend to like it.
http://www.apttax.com/
Reading about the past with no solutions is getting quite stale....
There are many solutions that have been proposed/discussed here, most entail the reduction or elimination of central planning for our economy starting with the Fed and continuing through interference from the rest of government at all levels. A return to sound money and fair business practices without the crony capitalism is also a common theme.
IMHO, we are faced with a cultural crisis of which the economy is just a symptom. At its root our problems are a result of the aberant behaviors of the populace and the lack of accountability for these behaviors. Want to fix America? We need to fix ourselves first.
Read Cashill's book "What is Wrong with California" for a good view of how these problems manifest.
We didn't get here overnight and there are no quick fixes.
sschu
sschu, we gotta break it real good before we can fix it the way we want.
Doing it like Congress does stuff just creates unforseen problems.
RR,
we gotta break it real good before we can fix it the way we want.
I fear you are correct. It is the nature of man to want the easiest way out, however. :-)
Every wonder why government is so big? Ever wonder why we need a central bank to finance the deficits? Take a look at most major US cities and at every level the culture has failed. Look at your suburbs and what is going on in the schools, the out of wedlock birth rates, the divorce, the substance abuse, just to name a few. Read the Book of Kings, it has happened before.
Government cannot fix these problems, although they will try. And they will bankrupt us by their efforts.
sschu
It has been discussed fervently here at ZH. Complex systems tend to break, and the more complex the more broke they get. Overlapping governmental agencies is a good example. Years ago I saw a small butane tanker truck that had simply driven too close to the shoulder on a country blacktop road. He was just stuck, that's all. As I passed it I saw Sheriff's cars, several fire trucks, local constabulary, and the police from a nearby town. All standing around waiting for the wrecker -- which is all he needed in the first place. Too much in the way of resources all getting in each other's way. More people would have been killed if the truck has blown up than just a tow truck driver. A potential catastrophe. One of the cops was even lighting up a smoke!
On a macro level we have federal gov't agencies catering to each other's "clients". Once an agency is born it never dies! Well, it's time and the only way to kill the parasites is for the host to die -- and rot.
2006/7 = 100
100= total credit and assets
60 ....2010
40....2012
And the Fed/US Govt. solution is:
Accounting fraud
Money counterfeiting
Which further negates the 40....
...........................
And hyperinflation in a deflationary spiral is the outcome....
..........................
Over 90% of the jobs are created by entrepreneurs with relatively short shelf lives....That's America....
Today....The govt. is 1000% Fascist....
The US never gets back to 100+ unless the entrepreneurs are nurtured...and quickly so....
What does this mean ?
Drastic reduction in the size of government....
Tax structure change....ie the FAIR TAX....eliminate the IRS....eliminate the FED....so that REAL CURRENCY that is reliable can exist...
Next...totally revamp the securities exchange such that RETAIL runs the show....and is serviced not played by the banks....
This is not complicated...
In other words, we're going down like the Titanic.
Don't I know that's true!
What if theyre not clueless at all, and know exactly what theyre doing? Ensuring the total destruction of the US.
Not total, as the people they work for, the Very Wealthy, are getting their money's worth. The FED is doing precisely what the UBER wealthy want them to do. And they are all that matters.
The true question then is philosophical in nature. Do they get the results that they want or is a black swan going to ruin their intended goal?
Black swans are engineered. The whole "fly in the ointment" argument is an obfuscation.
I am sure many blacks swans are engineered. The concept of idiots like Bennie and Timmay being in complete control does not sit well with me. Neither of the two are that bright or have that much sway.
I find it interesting how the Fed is debasing the USD. What money they are printing is nothing in comparison to the true market value the dollar will be when the asset bubble pops. If the only thing propping up the dollar over the last 10+ years was debt growth, the USD is eventually going to find its true value, toilet paper.
Hmm, I am considering "investing" in some 10 year treasuries. The Fed is essentially saying we will insure your investment increases in value somewhat (drive 10 year rates down), in exchange for the fact that the measly 2.4% interest rate will be less than the inflation they want to create. All with Gold at $1,340+ and oil at $83+ and rising. What?
And the investor should believe this? If they lose control or are reigned in and rates spike driving down the value of my treasuries, I am totally screwed both ways. Who pays then?
Is this what they are peddling? Given the political climate, if this does not work, there will be revolt and Bernanke will be asked to step aside - or frog marched out of his office.
Hey Bennie, Robespierre is calling, are you available to "talk"?
sschu
did you mean $500 billion and "half a trillion" ?
Damn those decimal points, but what's a few quadrillion among friends;)
Very thoughtful, thorough piece. Well done, e-phile.
yes thank you, found it quite interesting.
When I read this:
"I am still convinced the Fed has no idea what it is doing."
I immediately thought of this particular comment by Bernanke at Jackson Hole:
"...believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed's balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions..."
And so the experiment continues...it Dudley's words:
"...We do not control their behavior nor have much historical experience that we can draw on to easily assess how they are likely to behave."
Guess they'll find out.
For the benefit of those of us who are not bond dudes, or dudettes, what is the legal foundation of the 35% holding limit, and how firm is it?
Somebody needs to communcate to the lunkheads at the Fed, "The Law of Diminshing Returns."
Yes gold, et.al. will/may rise....to convert it into fiat/inflated currency is pointless. Don't you think?
Unforunately we're getting reports of rising water levels in the forward hold...
Don't I know that feeling!
Oops - whale bump
http://www.wbutler.com/bbutmap.htm
relieve borrower debt burden.?!
unbelievable, pathetic.
but why did the borrower borrow initially?
higher prices due to easing induced bubbles and inflation for stuff the borrower wanted.
we have become a cat chasing its tail, who forgot he was a cat.
amazing to watch the markets move these metals.