Opinion: 3 Reasons the Fed Should Not Announce QE3 This Week
We’ve seen just about everyone else’s opinion on QE3 in recent days (see here and here) so I’m going to put my head on the chopping block here again (I’ve had a decent string of successful calls on these Fed meetings, but my luck has to run out eventually, right?) and try to predict the madness of central bankers. Here’s my thinking on QE3 as if I were sitting in on the FOMC meeting advising Dr. Bernanke on where we should go next.
Here’s where we are. The economy is weak. Everyone knows it. Unemployment is far too high. Inflation is not a big concern, but slightly above our target. The stimulus doesn’t seem to have helped a huge amount, but no one knows for sure. The economy appears to be showing some signs of life in the real estate sector, but we can’t hang our hat on another housing recovery to drive us out of this rut. The government needs to do more and we aren’t completely out of ammo (at least we don’t think so). That’s the 30,000 foot view. Let’s take a closer look:
- The Fed is an independent entity and seeks to avoid politicizing its role in the economy. There is nothing more political in America than a Presidential race. So the Fed has to tread very carefully here. Does recent economic data really warrant appearing political and implementing what will be viewed as a hugely important stimulative package just weeks before a Presidential election? I don’t think so. We can afford to wait and the prudent thing to do is to wait.
- Core inflation remains above the Fed’s comfort zone. Inflation is not a concern, but by the Fed’s measures we’re failing on both the price stability AND the unemployment front. Clearly, we aren’t having a huge impact on the unemployment front, but the effect of QE on inflation is less clear. With core inflation at 2.1% we’re over our target of 2% and at risk of tipping above that if QE is implemented. Again, this indication says we can afford to hold off.
- The signalling effect is just about the strongest tool the Fed has left. So far, the threat of QE3 has appeared to have a very strong signalling effect. The Fed really believes in the wealth effect and the positive influence of rising asset prices so milking this signalling effect for all it’s worth is another reason to hold off. If the portfolio rebalancing effect and the wealth effect are two of the primary transmission mechanisms for QE then let’s keep market participants staring at this bazooka on the table for as long as we can.
All in all, there are signs that the economy is stronger than some suspect and the above three points give us reason to hold off for another few months. We meet again October 23-24 and then again in December so that’s ample time to assess more data, avoid appearing political in front of the election and keep the markets staring at this nice big bazooka we have placed on the table with QE3.
My recommendation to the FOMC would be to hold off. The December meeting is an obvious time to implement QE3 and from a strategic perspective it makes a great deal more sense to implement the policy then.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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20 Comments
Sounds reasonable, but I think BB is in a rush to implement QE3. It’s coming this week.
When you evaluate the inflation rate are you using public numbers or do you have access to the real time numbers from the Billion Prices Project?
I am using the CPI, but the BPP is even lower. As is my independent gauge….
Completely agree! If the Fed unleashes another round of QE do we see $5.00 gas as war in the middle east becomes more probable? Libya?
I thought the reason for QE was to build reserves so banks would be insulated from an unknown systemic shock from our recent financial and housing shock?
Wouldn’t it be more of a Operation twist #2?
Remember, QE is an asset swap that changes the composition of the pvt sector’s financial assets, but doesn’t add net financial assets. This is why QE was effective. It took crappy mortgages off the bank balance sheets and switched them for reserves. QE2 took high quality assets and swapped them.
http://www.bloomberg.com/news/2012-09-12/fed-seen-starting-qe3-while-extending-rate-pledge-to-2015.html
“The Federal Reserve is likely to announce a third round of bond purchases tomorrow, according to almost two-thirds of economists in a Bloomberg survey, while also extending the duration of its zero-interest-rate policy into 2015.”
I am afraid even if Bernanke is sympathetic to your points, the board, dominated by doves such as Yellen, won’t allow him. They can easily feed his own words to his mouth.
As another point of the ineffectiveness of QE. If one looks at the wealth distribution (how many assets the lower and middle classes own), one can easily see this “transmission” effect won’t work.
So even if asset prices rise significantly, the lower and middle classes won’t benefit much. It is the transfer payments that keep the economy moving. This is consistent with the balance sheet recession view.
I would only add that QE benefits all incumbents so it keeps a lot of people happy with the fed. A flagging economy at election time tends to piss them off.
Cullen, a couple questions… thanks in advance..
1) Is it accurate to say that there is no direct transmission mechanism throug QE’s, and therefore the only reason QE’s can “work” is out of the markets ignorance that QE is actually money printing?
2)Are QE anti-stimulative because Reserves pay a lower rate of return than Treasuries, and therefore less income via interest payments (lowering deficit spending)?
3) Only somewhat related here: is it acurate to say that for the banking system as a whole (looked at in the aggregate), the potentil supply of reserves is unlimited… but when looking at individual banks at the micro level, they are constrained by their capital? i.e. the ability of any individual bank to engage in Loans Creating Deposits is only contrained by some percentage at which that bank can leverage its capital? If so, what is that percentage?
1) It depends JK. There are ways in which QE can help. For instance, QE1 helped because they cleaned up bank balance sheets by buying bad assets and swapping for reserves. So I wouldn’t say there is no transmission mechanism at all. But the way it’s been implemented in recent years has certainly lacked a powerful transmission mechanism. I’ve argued that pushing up equities and other assets is backwards thinking. Kind of like manipulating a stock higher even though the revenues at the company are cratering….
2) QE does reduce the deficit. Remember, I think of this as a flow. So when the govt stops paying high interest rates this flow slows. If it’s not offset by fiscal policy then the govt is essentially turning off the spigot. That’s what this will look like.
3) Yes, banks are always capital constrained. You’ll have to check the BIS requirements. The capital levels are different depending on the type. http://www.bis.org/publ/bcbs189.pdf
Hope that helps.
Just be aware ” sell the news”. It could happen in a hurry. There should be a script somewhere to election (foreign policy and economy).
Cullen,
A central tenet of your explanation of MR is that banks are never reserve constrained when it comes to lending money. I have pondered over the implications of this idea for a long time and it occurred to me that demand for loans is two sided: demand by the end-user and demand by the bank for loans that meet their standards.
So in theory wouldn’t QE’s transmission mechanism be the igniting of “animal spirits” and risk-taking which would then increase the demand for loans by consumers/business and in turn cause the banks to lower their credit standards?
Demand for mortgages is starting to grow but actual completions are greatly impacted by the failure of the consumer to qualify for the loan. Business loan standards are still very tight.
Your thoughts?
In theory, that’s right to some degree. But new loans are not just a function of animal spirits. They’re primarily a function of balance sheet health. Can the bank afford to make loans and how risky can these loans be? And can the consumer afford to take on more debt and at what cost? In a normal environment (not a BSR) I’d say animal spirits play a huge role. But in this environment I’d say balance sheets are far more important because balance sheets have been wrecked. They’re improving slowly over time, which is why we’re seeing the loan demand pick-up, but we’re not back to full health.
I would link the BSR directly TO animal spirits and not try to separate them. BSR keeps animal spirits depressed. Reducing personal debts lets animal spirits rise. Debt loads and animal spirits are inseparable, tho’ animal spirits response to debt loads varies…witness homeowners willingness to take on huge mortgages..
oops, need to complete that thought…..take on huge mortgages back in the subprime boom….
rhp
Do you think that factor such as oil prices gauging higher are taken in consideration into deciding for QE or that has nothing to do with the dual mandate?
Why have QE tomorrow when the stock market is at all time high for the year?
Logically, objectively, what you laid out made sense. In fact the questionable impact of QE on employment coupled with less questionable impact of QE on higher crude oil, CPI..one would think that the impact of the QE series on sentiment (from rising asset prices. let’s face that is the main impact, no?) will soon come to its end. Its remains to be seen if Feds can do a QE4 with strong positive impact on investors sentiment (it all depends how CPI will run away this time after QE3… note precious commod, crude oil and even food prices are high as it is prior to QE3). With limited ammo in the bag, it makes good sense for Feds to keep it till Dec. Should we face a real fiscal cliff threat post election, this one good ammo will come in useful. Afterall there is no real urgent need for a QE3 right this month… unless you consider the need to keep asset prices high prior to the Presidential election
Still, as with most things in life, sometimes decisions are not made objectively. As you pointed out, it seems odd that Feds have been talking up QEs even prior to recent bad data numbers. Perhaps they were hoping to talk up to avoid having to act prior to Presidential election… but that is not really their job is it? to talk up when the economic environment does not quite warrant something as drastic as QE? So their actions so far does suggest a strong motive to keep the asset prices high going into the Presidential election. The outstanding question remains whether they would take the big step to do a QE3 weeks before one! If you will get the sack if the other party wins, wouldn’t you keep at what you have been doing (even if the environment does not quite justify it yet) and save your job at the same time?
all very conspiracy theory and very cliche I know… perhaps he has more integrity than most financial professionals.
It’s not entirely clear what another round of QE would accomplish, besides lowering rates even further and giving politicians more leeway in making fiscal adjustments. Both of which could have unintended consequences. Bernanke has consistently stated that the Fed cannot accomplish with monetary policy what policy makers need to do. I don’t see any rational reason to announce a new bond buying program.