Federal Reserve chairman Ben Bernanke has hit the hustings in the past three weeks to sell his effort to improve the U.S. economy via some innovative monetary policy. Everyone from Sarah Palin to the hippos and giraffes at the zoo think it is a bad idea, so it must have something going for it.
One of the most amusing (and occasionally profane) complaints comes in the form of a cartoon video at YouTube (click here to view). In it, a bear refers to the Fed chief as “the Ben Bernank” and I’m afraid that I will never be able to call him anything but the Bernank from now on.
Today I want to give you two new views on what the monetary policy is intended to do, how it is being implemented, and how Bernanke wishes it to be understood. The more you know about what is actually being done and why, the more you will realize that critics probably don’t really understand it. The main points, if you don’t want to read any further, are that a) Bernanke does not care what other countries think of the program because he’s doing it on behalf of the United States; and b) it probably will not create inflation or debase the currency in the way critics perceive.
First up with a short comment is Larry Jeddeloh, of TIS Group in Minneapolis. And next is an excerpt from a research piece published late last week by Jan Hatzius, who is chief U.S. economist at Goldman Sachs — and despite that is a very perceptive and helpful analyst. The Hatzius piece is long but if you’re into this stuff I think it does a great job of explaining what’s happening.
Jeddeloh, an original thinker who specializes in global macro research and consulting, had this to say about the message that he believes the Bernank was trying to deliver to China and Germany in an important Frankfurt speech last week.
“We (the United States) have talked to you endlessly about rebalancing the world economy. We have bought your exports and run up huge debts to do that, but you went on your merry way and even criticized us for over-consuming, when you were one of the beneficiaries of that consumption. Now, we at the Federal Reserve will use our reserve currency status to force a rebalancing.
”Exports drive economies such as yours and countries relying on accumulating U.S. dollar reserves will be hurt the most. We have asked you to let your currencies rise and instead you have manipulated them lower. Enough is enough. We are moving to weaken the dollar and it may be useful for you to recall what Treasury Secretary Connolly said years ago: “It’s our dollar and your problem.”
That’s a tough point of view but accurate as far as I can tell. Jeddeloh is saying it’s “game on” for a new round of economic battle between the U.S. and the rest of the world.
The investment upshot, in my view: If the new mantra is the geo-economic equivalent of “every man for himself,” then commodities are going to rise as countries battle ever more stiffly for position to control the raw resources necessary for growth. Key funds for that idea are SPDR Mining (NYSE: XME), SPDR Energy Service (NYSE: XES) and Junior Gold Miners (NYSE: GDXJ) and resource exporters iShares Chile (NYSE: ECH) and MV Indonesia (NYSE: IDX).
What Goldman Sachs Economist Has To Say
Now let’s move on to Hatzius, who thinks anxiety about the inflationary consequences of quantitative easing is misplaced. The reason is that the U.S. economy and financial system are not well described by the simple ”money multiplier” model, in which increased bank reserves automatically result in an inflationary lending boom.
Instead, he says, it is better to think of QE2 as a swap of cash for Treasurys on the asset side of the private sector balance sheet. This swap should lower the bond term premium (i.e., interest rate) and thereby boost growth, at least to some degree, but it does not automatically lead to a large expansion in broader money and credit aggregates. Even if it did, the first effect in an economy operating with as much slack as the U.S. economy has would probably be to boost output rather than prices.
Hatzius says his team estimates QE2 is likely to boost real GDP by about half a percent per $1 trillion spent. While that is not a very large number, he notes that the team believes that the benefits exceed the costs so long as the political backlash does not restrict the Fed’s independence.
Here’s the rest of Hatzius’ views, in Q&A format. You may need to read a few of these more than once to appreciate what’s going on.
How does QE2 really work? Says Hatzius: ”Fed officials will buy $600 billion of longer-term Treasury securities and create $600B in additional bank reserves in exchange. This increases the Fed’s balance sheet as well as the monetary base (currency plus bank reserves) by $600B.”
So are Fed officials ”printing money”? Hatzius: ”If money is defined as the monetary base, the answer is yes. Each $1 in LSAPs will result in an additional $1 in bank reserves. However, if money is defined as one of the broader money or credit aggregates — which matter much more for economic activity and inflation — the answer is not necessarily. Unless banks decide to leverage the extra reserves by increasing lending, QE2 is simply a shift of assets held outside the Fed from longer-term Treasuries to cash and bank reserves.”
If that’s all it is, why the worry that QE2 will cause much higher inflation? Hatzius: ”The concern is that the increase in bank reserves will cause a sharp increase in bank lending, which in turn will boost demand and ultimately prices to an excessive degree. It is based on the traditional ”money multiplier” theory, which holds that the availability of bank reserves is the key constraint on the amount of bank lending. When the Fed adds reserves to the system, the story goes, banks scramble to make more loans until these ”excess” reserves have been turned into required reserves that are needed to support the higher level of bank loans. The supposed explosion in credit then leads to an unsustainable boom in demand and ultimately inflation.
‘However, we believe that the money multiplier model is a very poor guide in the U.S. financial system. It stands and falls with the assumption that deposits subject to reserve requirement are the only source of bank funding, when in fact more than 90% of bank funding comes from other sources (including many deposits on which reserves are not required). Thus, bank lending was not constrained by the availability of reserves even prior to the increase in bank reserves. Relieving a non-existent constraint cannot be expansionary, and it cannot be inflationary. Hence, the standard story for how QE will result in inflation is incorrect, in our view.”
Are you saying that QE2 has no effect on lending, output, and inflation? If so, why do it?Hatzius: ”It does have an effect, but it works through a different channel. The shift in the composition of the private sector’s asset holdings from longer-term Treasuries to cash should raise the price (lower the yield) of longer-term Treasuries. A lower Treasury yield should feed into a reduced discount rate and therefore a higher price of risky assets, and it may also weaken the dollar. In turn, easier financial conditions — i.e. lower long-term interest rates, higher stock prices, and a weaker dollar — should boost economic activity.
”Stronger economic activity will also deliver a small boost to inflation. In addition, there is likely to be a positive effect on inflation expectations. So we do think that there is a link between the Fed’s actions and future inflation. It is just far less dramatic than in the typical ”printing money” story, and much farther off in the future.”
If the effect is supposed to occur via lower long-term interest rates, why have Treasury yields in fact risen — and financial conditions tightened — since the QE2 announcement?
Hatzius: “Probably mainly because the market has actually reduced its expectation of the cumulative amount of QE2. While the cumulative purchase announcement of $600B itself was modestly ahead of market expectations, the somewhat slower-than-expected pace of purchases, the backlash against the decision at home and abroad, and the better economic data of recent weeks have created a lot more doubt whether Fed officials will buy more assets beyond June 2011.”
How big is the boost to growth? Hatzius: ” That’s a hard question to answer, but our best estimate is about half a percentage point of additional GDP growth per $1 trillion in LSAPs. Our estimates: 1. A $1 trillion asset purchase lowers the term premium by around 30 basis points. 2. A 30 basis-point drop in the term premium eases financial conditions as by about 80 basis points. 3 An 80 bp easing normally raises real GDP growth by three-quarters of a percentage point in the first year; however, given how clogged the housing channel is at present, we believe a more realistic figure may be half a percentage point.”
Why do QE2 if its effect is so small? Hatzius: “For one thing, it’s not that small in absolute terms. An extra half percent of GDP amounts to $75 billion per year and perhaps corresponds to an extra 400,000 jobs. That’s not a lot relative to nearly 15 million unemployed workers, but it’s a start.”
Are there any other potential costs? Hatzius: ”The most obvious cost is the political risk, including the possibility that Congress will curtail the Fed’s independence and ability to deal with future crises. That is not our expectation, but it is not impossible either. Another concern is that lower long-term interest rates may increase commodity prices, which would weigh on growth for a net commodity importer such as the United States. This could weaken — or in an extreme case even reverse — the positive impact of QE2 on growth.
“There is also some risk to the Fed’s prestige if QE2 isn’t followed by a visible improvement in the economy and the labor market. The best analogy is the stimulus package of early 2009. Although we believe this helped the economy in 2009-2010, the effect was not large enough to overcome the underlying weakness. The package thus probably helped discredit activist fiscal policies in the eyes of many Americans. The problem is that it is difficult to distinguish between the ‘baseline” — the path of economic growth and employment in the absence of the stimulus — and the impact of the stimulus itself.
“The Fed is running some risk of a similar outcome with QE2. If the recovery continues to disappoint, QE2 will undoubtedly be viewed as a failure, even if it in fact helped matters at the margin. However, the difficulty of distinguishing between the baseline’ performance of the economy and the effects of QE2 cuts both ways. If growth picks up, the Fed would likely receive part of the credit, even if the improvement occurs because the private-sector deleveraging process slows, or because of other non-monetary factors.”
Is it possible that the Fed will in fact decide to stop the purchases before they reach $600B? Hatzius: ”That is highly unlikely. Although the Fed promised to review the policy regularly, we believe that the hurdle for actually stopping the purchases is very high. The only realistic scenario, in our view, would be a very substantial increase in inflation expectations to a level clearly above the recent norm. Otherwise, Fed officials would almost certainly complete the $600bn program. … In any case, however, it is better to think of QE2 as a type of ‘holding operation’ that reduces the likelihood of deflation. QE2 is unlikely to turn the economy around, even though it probably does help at the margin.”
I hope that helps you understand what’s happening. It really is more complicated than the “printing money” sound bite, and important for us to comprehend over the next six months.
For more insights like this, check out Markman’s two daily investment advisory services: Trader’s Advantage for short-term traders and Strategic Advantage for a longer-term investors.
