Van Hoisington shares a good analysis at the reverse psychology that the prevailing crowd grasped, and yet was completely lost on the Ivy League educated Academics at the Marriner Eccles building.
If the objectives of Quantitative Easing 2 (QE2) were to: a) raise interest rates; b) slow economic growth; c) encourage speculation, and d) eviscerate the standard of living of the average American family, then it has been enormously successful. Clearly, with the benefit of 20/20 hindsight these results represent the Federal Reserve’s impact on the U.S. economy, regardless of their claims to the contrary.
For example, the Fed promoted the idea that implementation of QE1 and QE2 would lower interest rates. Apparently this fantasy was based on the assumption that the flow of their purchases would heavily offset (and in the case of QE2 almost fully offset) the flow of new debt being issued by the U.S. Treasury. This flow analysis appears irrefutable in concept, but actually interest rates rose across the yield curve in both cases. Why? Concentrating on the flow of Treasury debt, apparently the Fed failed to take into account that the existing stock of outstanding Treasury debt totaled nearly $8 trillion. The holders included individuals, mutual funds, pension plans, insurance companies, state and local governments and foreigners. Their actions indicate that they perceived Federal Reserve activity to be inflationary, and therefore harmful to their position. Their response was to reduce their relative holdings of Treasuries and purchase riskier assets. Interest rates rose. One large investor famously sold all his Treasuries—a rational choice in the shorter end of the Treasury market as some day QE2 will have to be reversed.
Why the Fed would believe the economy could benefit from the addition of $600 billion (the QE2 target) in reserves to a banking system that already had over $1.1 trillion in unused, idle, but potentially inflationary reserves on hand nearly defies understanding. The action, however, was not lost on holders of the $8 trillion Treasury securities outstanding.
This increase in the level of interest rates occurred, not only during QE2, but in QE1 as well. Thus the Federal Reserve engineered a rate increase, and the injection of excess reserves had several other deleterious ramifications for the U.S. economy.
According to Van Hoisignton this is what needs to happen:
Presently the Fed is odd man out among the world’s leading central banks. A major divergence in opinion has risen between the Fed on one side, and the European Central Bank (ECB), the Bank of England, and the PBOC on the other side. These major foreign central banks, unlike the Fed, believe that extreme monetary intervention has contributed to higher inflation. For that reason the ECB has taken rates higher to stop inflation tendencies and the BOE is preparing to take initial steps to remove extreme monetary accommodation. Such actions are likely to produce lower inflation and better results than Fed policy. While terminating QE2 will not result in a restoration of the Fed’s balance to a reasonable size, this is an essential first step. Such a move will serve to reinforce actions by the ECB, BOE and PBOC. As such, the global upturn in inflation will reverse, thereby placing the global economy on a more stable footing. risk adverse investments. This will release funds for the mortgage market and credit worthy state and local governments. Upward pressure on commodity prices will abate. This will begin to mitigate the downward pressure on real wage income and consumer confidence. The lower commodity prices will also serve to unwind the corporate margin squeeze that resulted from the higher commodity costs.
While the economy will slow initially, the drop in inflation over time should lift real income and serve to stabilize the economy. The dollar should firm, encouraging foreign investors to place additional funds in U.S. markets. Taken together, these factors should give the economy the opportunity to stand on its own, rather than rely on massive governmental interventions whose potentially negative and unintended consequences are unknown.
The evidence of the past three years seems clear in that monetary and fiscal policy have been unable to improve the average American’s standard of living. Time will be required to reestablish balance sheets to more normal levels, and in the interim disinflationary/deflationary tendencies will be ascendant. This environment is favorable for holders of long dated Treasuries. Positioning for an inflation boom will prove to be disappointing.
We agree. Which is why this outlook will never be realized. The Fed will simply never accept the risk of another bout of deflation. Period.
Full letter:Hoisington 1Q11 Update