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QE2 Was No Help - Hoisington Investment Management

April 24, 2011

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 (Table 1). Thus the Federal Reserve engineered a rate increase, and the injection of excess reserves had several other deleterious ramifications for the U.S. economy.

Speculation and Lower Growth

By definition, the massive increase in the Fed's balance sheet encourages speculation and lifts the fear of inflation. Banks have had few customers who wish to borrow for productive means. Bank credit has been falling since 2008 when the Fed-induced housing bubble burst (Chart 1). However, large hedge funds and other financial investors/speculators have an inexhaustible supply of credit to underwrite derivatives and leverage to anticipate and profit from the inflationary atmosphere the Fed seems to be attempting to engineer. According to the outstanding monetary researcher, Rod McKnew, Ph.D. of Newedge, the Fed facilitated inflation through a more direct channel than expectations. He points out that reserve balances, which are not money, increased much more than money. In the past two years, M2 rose 6% while total reserves jumped 85%. But this does not mean that unused reserve balances had no influence on prices, and in particular on commodity prices. To quote McKnew, "In a world of advanced derivatives, high cash balances are not required to take speculative positions. All that is required is that margin requirements be satisfied." With reserve balances at unprecedented levels, margin risk is minimized for those market participants who wish to take positions consistent with the Fed's goal of higher inflation and have either direct or indirect access to the Fed's mammoth reserve balances, which can satisfy margin requirements.

These activities, while profitable to speculators in the short run, slow real economic activity in several ways. First, the rising interest rate environment also raises mortgage rates (Table 1). Of course this means more marginal buyers are priced out of the market and unable to purchase homes. Is it any surprise that this beleaguered sector of the economy has taken another leg down in terms of sales and price (Chart 2 & 3). Consequently, this sector has become more of a drag on economic growth. Second, homes happen to be the largest net worth asset on consumer balance sheets, and the prospect of their largest asset moving lower in price hardly inspires greater willingness to spend.

Third, the speculation encouraged by the Fed has led to near record margin debt in the stock exchanges, and has raised stock prices, benefiting the upper income segment of society. Further, the open-ended credit lines for speculation have assisted in lifting commodity prices dramatically during QE2, just as they did in QE1 (Table 2). Commodity and stock price movements are susceptible to a myriad of demand/supply factors that include cartels, war, and weather. But the speculation created by QE2 suggests financial players are aiding and abetting the normal price movements. Evidence of this is the Commitment of Traders Report which indicates record speculation. Also, supply disruptions have not been evident in the gold and silver markets, which suggests that speculation is a dominant force in two of the markets where price increases have been most rapid.

The combination of a rise in interest rates, stock prices, and food and fuel commodity prices has reduced disposable personal income, depressed the net worth of the average American family as home prices have fallen, and caused consumption to slow, increasing the income divide between the higher and lower income categories.

In the six months since Bernanke announced QE2, real average hourly earnings declined by a sharp 2.1% as inflation accelerated. Not surprisingly, several measures of consumer confidence are hitting two year lows. Both the University of Michigan and Gallup confidence measures in March fell back to 2009 levels, and real consumer expenditures moderated sharply.

While much data is missing from first quarter GDP calculations, the available evidence indicates that real growth has not been any better in the past six months than in the two quarters prior to QE2. Moreover, the first quarter shows a marked slowdown. Inflation, however, was sharply higher. Such results are a replay of the 1960s and 1970s in that the general welfare worsened materially.

Consumer Led Recession?

To be sure, the civil unrest in the Middle East has led to reductions in oil output, and reinforced the upward pressure on oil prices. This has led to further transfers of spending from discretionary goods to these essentials. The burden of adjustment has been greater on median to lower income households, causing their standard of living to decline. This is an unwelcome development since the rise in food and fuel prices is already problematic for the U.S. economy. Prior to and during recessions since 1970, the food and fuel expenditures share of wage and salary income increased by an average of 2.2%, with a range of 1.1% in the 2000-01 recession to 3.7 in the 1973-75 recession. Based upon the available figures for the first quarter, food and fuel is already up 2.3% from Q2 2009, or slightly above the average for the past five recessions (Table 3). This suggests a further slowdown in consumer spending and near-recessionary conditions.

The rise in short-term inflationary psychology and increased speculative activity, however, did not change investor expectations for real growth, as measured by the 10 year Treasury TIPS yield. When QE1 was announced, the real yield was 2.8%, and the latest reading was down to 1.1%.

The Fed has defended their decision to forge ahead with their QE2 plan by arguing that they base their policy on core CPI rather than the headline inflation rate. Objective evidence indicates this is a thin reed argument. Since 1958, or the entire history of both series, the difference between the headline CPI and its core is a mere 0.04%. The two inflationary measures can, and have, diverged sharply over the short-run, but ultimately there is no difference.

Repeating Past Failures

One of the major tenets of Keynesian economics was the Phillips Curve, which posits a stable inverse relationship between the rate of inflation and the unemployment rate. Yale professor James Tobin (1918-2002) and others argued that the social outcome could be improved by a more activist monetary and fiscal policy. Specifically, it contended that the unemployment rate could be lowered causing only slightly higher inflation. To judge the effectiveness of this policy, an objective standard is needed. Arthur M. Okun (1928-80), Yale colleague of Tobin, developed such a standard, which he called the Misery Index – the sum of the inflation and unemployment rates.

Under the activist Phillips curve based policy, some reduction in unemployment was temporarily achieved. However, inflation accelerated much more than was anticipated, and the net result was higher unemployment and faster inflation, an outcome not contemplated by the Phillips Curve. The Misery Index surged from an average of 6.7% in the 1950s to 7.3% in the 1960s and to 13.6% in the 1970s, with peak rates above 20% in the early 1980s (Chart 4). Many U.S. households suffered. Wages of lower paying positions failed to keep up with inflation, and when higher unemployment resulted, many of those people lost jobs. Those on the high end had far more resources that enabled them to protect their investments and earned income, so the income/wealth divide worsened. A half century later, the United States has never regained the prosperity of the 1950s.

Working independently in the late 1960s, economists Milton Friedman (1912-2006) and Edmund Phelps, who would both eventually be awarded the Nobel Prize in economics, determined that while the Phillips Curve was observable over the short run, it was not apparent over the long run. Economic experience in the U.S. proved that the tradeoff was ephemeral.

Misery Rises

In the second quarter of 2010, or the quarter prior to the Fed signaling a second round of Quantitative Easing (QE2), the Misery Index was 9.1%. The index has marched steadily higher since then to an estimated 14% in the first quarter. While annualizing quarterly percent changes in the CPI may exaggerate the deterioration, the Misery Index averaged 12.4% for the past three quarters, up from just 10.9% in the prior three quarters. Based on Okun's impartial arbiter, the Misery Index, economic circumstances worsened. The Bernanke Fed provides fresh confirmation that trying to substitute higher inflation for lower unemployment harms the economy.

This QE2 episode serves as a reminder that the nature of the problems facing the economy are very complex, including a variety of deep seated structural problems such as excessive indebtedness, and an unstable and debilitating fiscal policy. The Fed's freedom to act does not eliminate the need for wise decisions. Untested monetary solutions for non-monetary problems should not be attempted. Sympathy for high unemployment is not sufficient when Fed actions produce undesired feedback loops that increase misery. While the Fed has the dual mandate to keep inflation and unemployment low, the path to achieving those dual objectives is to base decisions on the inflationary implications of their policy. If the Fed's goal is to limit unemployment, the path to success is to ensure low, not accelerating inflation, a lesson we have just learned once again.

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.

Ending QE2

The historical record on massive Federal Reserve intervention is minimal but indicates that as QE2 terminates at its scheduled end on June 30th, the inflation/risk trade will also fade. Accordingly investors should gradually move into Treasury securities and other high-grade 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.

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