THREE LESSONS FROM QE1 & THOUGHTS ON THE END OF QE2
As we get closer and closer to the end of QE2 it’s wise to begin game planning for the potential impacts. The following are some goods thoughts from Glenview Capital regarding QE2 and lessons from QE1:
The first lesson we should take from 2010 is to respect the end of quantitative easing, either as an actual or psychological calendar event that could trigger a change in liquidity and economic activity. There are three reasons we should be concerned about the end of QE2 and the unlikelihood of QE3:
1) QE2 is set to expire in June, and it took seven months last time before a new round of quantitative easing was enacted. Thus, it seems reasonable to expect QE2 to lapse, particularly as the economy has rebounded and deflation seems contained as a risk (see #2).
2) US Fed Chairman Bernanke said in his most recent congressional testimony on March 1 that the “risk of deflation has become negligible.” If that is the case, it would be odd for the Fed to come forward four months later with further extraordinary monetary stimulus.
3) Two days later, the ECB President Trichet said that an increase in rates at the next meeting (April) is possible. Again, this doesn’t seem consistent with an extension of QE2 globally.
As such, we will be closely watching liquidity and economic conditions as the first elements of the unprecedented level of global monetary stimulus are withdrawn.
Second, we believe that the markets are next going to deal with the economic ball bouncing off the “right gutter” of inflationary pressures in early 2011. We already have seen extreme spikes in food and textile commodities, and since late August, the price of oil has risen 50% as a result of global demand and Middle East turmoil. Interest rates on the US 10-year Treasury bond rose over 100bps from the early October lows and, as described above, the tone and tenor of Central Bank commentary are now more weighted towards the risks of inflation.
Finally, it appears that the practical implications of a rising federal deficit ($1.3 trillion) in the US and a renewed emphasis on deficit reduction in Congress (not only the “Tea Party” but across both major parties) will likely slow the growth of both Federal and State/Local spending that has played such a key role in reinforcing the economy to prevent a double-dip recession. This is playing out in state legislatures in Wisconsin and New Jersey, in the President’s budget that calls for reductions in discretionary spending, and in the debates this month about extending the debt ceiling to accommodate additional federal deficits.
Taken together, these factors pose a complex scenario for our relatively simple and straightforward gutter guard scenario: just as the ball seems to be bouncing off the inflation gutter guard, both Congress and the Fed seem to be removing the left gutter guard. This is of course logical – if we want to fight inflation, we should first stop fueling it. However, it does beg the question – if the contemporaneous removal of extraordinary monetary and fiscal stimulus through the expiration of QE2 and a move to a more balanced budget does in fact slow the economy, will there be sufficient time, will and resources to re-establish a left gutter? Such is the danger of a zero interest rate policy, as it gives you little incremental room to provide incremental stimulus.
Source: Glenview Capital
Sell in May has never been more important. We are all clear thru April.
Yikes – I think we all have the same playbook.
What are precisely the differences between the US monetary system and the Euro system?
Thanks all
karlson,
USD is used by people under 1 monetary and political set of structure. 1 Government and 1 Central Bank. What the Fed does affects those in Arizona and Ohio, and those same people are governed under one Federal Governemnt.
EUR is used by people under a multiple Governements, charged with fixing different and sometimes opposing economic and monetary needs. So there’s one unifying Monetary policy, but not one unifying Government.
The ECB headquarters is in Germany and is headed up by the former President of the Banque-de France. So, if you are in a ‘peripheral European country, do you think the ECB may not be as responsive to your economic/monetary needs as they are to France, Germany and Spain’s, you’re a small fish.
But because the USD exists in a place with unified overarching government, the Fed is not going to prefer or even consider one US State over another.
TPC/Mediocrats/Peter could explain it better, but I saw no one had responded.
Because I must have been low on blood sugar or something when I wrote the above post, addendum:
The Euro is different from the dollar in that it is a single currency system. When the US (and the rest of the developed world) was on the gold standard, there was one specific thing backing all of the different currencies.
The Euro is comparable/similar even though its “fiat” money, because its used by many different countries as their currency and those countries do not have control over the monetary policies governing that currency.
The USD is true sovereign fiat currency because we have 1 Central Bank for our 1 Nation.
Wildly fictional comaprisons to make the point. The USD and EURO would become more similar if:
Canada and Mexico adopted the USD but remained their own soverign nations.
Or,
If some or all US states broke peacefully from the Federal Government, but continued to use the USD.
Ok thank you Chris… and within the MMT approach, what is the difference between European governements and the US government?
Is europe doing the same as the US does, that is the US spends first of all money, then they tax? And for the bond system also: is it also a monetary tool only, and not a fiscal one?
Sell in May? You should already be out.
thepigman,
Why do I get the feeling you have no money to be ‘in’ the market?
Since many are thinking, sell in May an go away. Perhaps the big boys are already buying their shorts on any rally and will sell heavy come April. As usual the down volume is much heavier than the up.
Econoday, Bernanke, San Diego, March 23 2011:
“Fed Chairman Ben Bernanke in today’s speech implicitly indicated part of the reason that the Fed is keeping rates so low for an extended period. He stated that banks face “still difficult” economic conditions, specifically noting that there are continued uncertainties in real estate. While many commercial banks are recovering and reporting stronger performance, hard-hit commercial banks still need time to repair their balance sheets, according to Bernanke. ”
QE motivations are clear: push asset price higher untill banks balancesheet will be repaired. They don’t care about inflation.
Wrong, Bernanke will do QE3 in late Q3 or Q4 in order to “help” the housing market. He doesn’t care for inflation.
In case anyone’s interested in this thought experiment, Jim Rickards has come out with the thesis that QE will “never end”, as the process of continuously rolling over the Fed’s current balance sheet means it has no need to create further QE programs from here on out:
http://kingworldnews.com/kingworldnews/Broadcast/Entries/2011/3/12_Jim_Rickards.html (audio version)
“The criticism of QE2 has been intense from Republican circles, Tea Party adherents and international trading partners such as China, South Korea, Brazil and others who are suffering the effects of inflation caused by QE generally. The Fed may have pushed this program to the limit. For political reasons, more so than economic, the Fed will end QE2 in June and will make its intentions known. But is this the end of QE? The answer is no.
Recall that QE2 was not really $600 billion but was $900 billion if you add the $300 billion of reinvested principal payments on the original $1.5 trillion of mortgage-backed securities from QE. Since this $300 billion of principal paid out in a seven-month period from November 2010 to June 2011, it’s reasonable to assign a principal payment run rate of $500 billion per year for the next two years on that portion of the Fed’s portfolio. Treasury securities are different because they don’t amortize the same way mortgages do, but the Fed still has about $1.3 trillion of Treasury notes and bonds on its balance sheet today and will likely have $300 billion more by the end of June as a result of new purchases under QE2. So, $1.6 Trillion seems like a reasonable estimate of the amount of Treasury notes and bonds the Fed will own on June 30, 2011.
It is difficult to know the exact maturity structure of all of the notes and bonds on the Fed’s balance sheet, however, the New York Fed has been transparent about the composition of the $600 billion of purchases under QE2. These have been made in all maturities from 2 years to 30 years, however, the purchases are concentrated in the 2-to-10 year sector with a weighted average maturity of about 6 years. Assuming the Fed’s entire portfolio has the same weighted average maturity, this means that approximately $250 billion of securities mature each year. Combining the $500 billion annual principal payments on QE mortgage backed securities with $250 billion of maturing principal payments on the remainder of the Fed’s portfolio gives the Fed about $750 billion per year of buying power without expanding the balance sheet.
The projected U.S. deficit for fiscal 2011 is $1.645 trillion. This will be funded by new issuance of Treasury securities over and above the amount needed to refinance maturing debt plus interest payments on existing debt. About 60% of outstanding Treasury issuance is in the 2-to-10 year maturity range. If we assign the 60% weight to the $1.645 trillion of new debt, we get $987 billion of new 2-to-10 year maturity Treasury notes issued in fiscal 2011 to finance the deficit. Therefore, the Fed’s buying power of $750 billion per year can monetize over 75% of the new 2-to-10 year note issuance needed to fund ongoing U.S. budget deficits for the next two years without expanding the balance sheet.
The Fed is now like a 400-pound man who can eat 5,000 calories per day without gaining weight because his morbidly obese metabolism requires it to function. The discussion of QE, QE2 and QE3 has become irrelevant. What we have is permanent QE until such time as the Fed decides to tighten financial conditions. This is unlikely to happen until mid-2012 at the earliest, perhaps later in view of the housing double-dip and increasing oil prices. In any case, QE will be with us for an “extended period” no matter what the Fed announces.”
http://kingworldnews.com/kingworldnews/KWN_DailyWeb/Entries/2011/3/11_Jim_Rickards_-_QE_is_dead,_long_live_QE!.html (text version)
Apparently the obese metaphor is becoming more popular. Perhaps Jim reads PC.
However, as a counter to Jim’s thesis is the following response from Chris Martenson (the only critical response I could find):
“”QE” refers to the act of creating freshly printed money to buy debt. By definition is expands the allotment of base money. Simply rolling over existing debt does not do this, it is money-neutral.
Consider these three scenarios:
1. $1,000 in Treasury debt held by the fed ‘comes due’ (matures) and the Treasury has to pay $1,000 in principal to the Fed. The Fed decides to use this $1,000 to buy another bond. This is a ‘roll over’ and while money fleetingly jumps between accounts at the Treasury and the Fed and back again, what actually happens is that one CUSIP is exchanged for another. Note that the base money is exactly the same before the transaction as after. The Fed’s balance sheet does not expand. This act does not really help the Treasury get deeper into debt directly, only prevents the Treasury from facing rising interest rates as it has to attract sufficient buyers to sell the roll-over bonds to that the Fed formerly owned.
2. A new $1,000 Treasury bond is floated at auction by the Treasury which needs more money. The Fed buys this bond using brand new credit/money. This is QE because it expands the base money. The Fed’s balance sheet expands. This is what the current program does.
3. Same transaction as in #2 but instead of using new money the Fed uses the cash flows from MBS paper it is holding. This allows the Fed to buy more Treasurys which helps out the US government with its financing needs, but it does not create any new money nor does it expand the balance sheet. This is the only mechanism by which we can support Rickards’ claim. This is ‘stealth support’ for government spending.
There is a small gray zone in here tha relates to the flow of interest money on the Treasury bonds. Technially this is a cost to the US government but with the Fed returning most of it to the Treasury it could be said that the actual cost of capital to the US government is a fraction of what is reported. For example, if Treasurys are yielding 3% but the Fed returns 2% then the cost of capital is 1% or one-third of what is reported. This is a ‘back-door’ easing which is rarely discussed except in glowing terms about how the Fed “made” “record profits” that it “returned to the government” all of which is just pure horse pucks. It is nothing more complicated than a compliant central bank printing up money and handing it over to the government.”
http://www.chrismartenson.com/forum/rickards-wrong-there-no-perpetual-qe/54566#comment-105735
A+!
Good stuff.
Good discussion!
Cullen, I have an MMT related question. Since we have seen such a large growth in the Fed’s balance sheet over the past few years, where did the money come from to purchase all these new assets? Was this money created or printed out of thin air or did it come from excess rserves in our banking system?
As Warren Mosler likes to put it, it came from “the same place the stadium gets the 3 points when you kick a field goal”.
Right. It’s best to think of the govt as never having money. It’s kind of like asking yourself where you get the air you breath. Well, you don’t really get it from anywhere. It’s just there and you’re not running out of it. Adding reserves to the banking system is like selling air to people and convincing them that they need more air in their houses so they can live. It’s just flat out stupid. Bad example, but you get my point hopefully.
Govt never gets money from anywhere. When the Fed buys UTS’s they are not altering the amount of pvt sector financial assets. They are just changing the composition. This is the only thing the Fed can do. Operationally, QE is no different than what they on the short end. They are just changing around the amount of reserves in the system. But since no one seems to understand QE they have this weird belief that it is somehow new and different and inflationary.
When the Fed implements QE they create a liability in the form of reserves and swap them with the UST’s. That’s all that happens. There is no change in net financial assets. The banks get 0.25% earning paper and the Fed gets the USTs. Whether the banks expand on the base of reserves is entirely up to the demand for loans. It has NOTHING to do with the amount of reserves in the banking system.
Cullen,
Interesting quote from Derfem’s reply above……
‘Econoday, Bernanke, San Diego, March 23 2011:
“Fed Chairman Ben Bernanke in today’s speech implicitly indicated part of the reason that the Fed is keeping rates so low for an extended period. He stated that banks face “still difficult” economic conditions, specifically noting that there are continued uncertainties in real estate. While many commercial banks are recovering and reporting stronger performance, hard-hit commercial banks still need time to repair their balance sheets, according to Bernanke. ” ‘
“…..Bernanke in today’s speech implicitly indicated part of the reason…..”‘ “part” of the reason is disingenuous. They may be WATCHING other things, but the ONLY thing that will be actionable, or determine whether their suppression of rates ends is if banks can survive their rate sensitive derivative exposure if rates begin to rise.
This is also the point I tried to make a few days ago……while the fed talks about how closely they will watch inflation and unemployment, and people like us debate ad nauseum about QE1,2,3…… and why its not working and how its causing speculative inflation ,etc………this is all a sideshow, diversion.
Bernanke will keep rates low until the banks get out from under their rate sensitive derivative exposure, period. And that could be years from now. If unemployment goes down and inflation ticks up, but rate increases will still sink the over exposed TBTFs do you think he will allow rates to rise….no way! We’ll just get more talk about how “….the growth is encouraging but there is still downside risk so rates need to remain low…..”. In Bernanke’s view of the world, the TBTFs are synonymous with the economy. Find out what exactly remains of the rate sensitive derivative exposure and the range of expirations of it, and you will be able to more closely guess when rates will finally be allowed to rise.
I see three possible outcomes with QE2 supposedly ending…..
1. QE3
2. Direct monetization (bypassing PDs) if they conclude the PD’s speculation with their round trip monetization profits, leveraged for greater impact, is becoming too big an influence on inflation or becomes too big a public relations headache for them. This isn’t likely for a couple reasons, first those profits they derive from the QE route for rate suppression are also helping to ameliorate the desperate derivative exposure the TBTFs still face, and second,the sensitive fed chair won’t want the stigma history will place upon him for agreeing to just monetize away congress’ profligate behavior.
3. They may choose this time to suppress rates by just setting them, as I think you’ve suggested before. If Bernanke decides the problems with QE (speculative inflation and bad PR) outweigh the benefits to the PDs of the QE back door profits used to speculate with, my money would be on this choice.
Bottom line, no matter which route is chosen, rates are staying low for a long time. Cross your fingers and hope inflation, or some other unexpected event like a currency crisis, doesn’t get out of hand before those banks relieve themselves of the derivative exposure, because Bernanke will abandon us before he abandons those TBTFs. Just my view, and comforting to see I may have finally found another like-thinker in Derfem! Thanks, krb
Basically agree (baring some overwhelming political or economic outside force).
I’ve cut-and-pasted this several times now …
—
Ben’s own words on why the GD happened, from his first 60 Minutes interview:
1) The Fed let the money supply contract
2) The Fed let the banks fail
http://www.youtube.com/watch?v=39AZj2z-g6I&t=0m15s (0:15 to 0:44)
No need to guess what he thinks; he says it on camera. It’s the running loop he’s been telling himself all this time. His actions make perfect sense when you understand this belief system of his.
I think the most important and only relevant lessons re QE is that 1) get rich quick schemes actually do work and 2) Bernanke’s were the most successful in human history.
The only people still complaining about QE and Bernanke are the ones who decided not to participate in this wonderful scheme.
Let’s not forget that this man helped burn down the house he is now trying to rebuild.
Question: If Japan and China are slight net sellers of Treasuries, then who in the world is going to buy all this new debt issuance?
I do think that QE3 might be a necessity to draw in buyers to finance this very large deficit. In this real estate market, raising rates is probably not an option for another year or so, unless other incentives are put on the table.
Thoughts?
Are these QE’s (or BE’s) supposed to drive down interest rates or spur the economy?
Supposedly both!
Thank you, Mr Roche!
As a fellow Hoya, I am interested to know what you think about these arguments:
http://seekingalpha.com/article/258786-fdic-bill-for-loan-losses-at-failed-banks-to-reach-30-billion
http://seekingalpha.com/article/260184-the-fed-never-have-i-seen-such-inadequate-leadership
He nails it here:
“However, the recovery seems to have taken place without the Fed’s help except for the argument that there have not been further disruptions to the recovery due to major cumulative banking failures. Certainly, one cannot argue that the Fed’s actions have provided banks with the incentives to increase their lending activity – they have not. Commercial banks are still sitting on the money.”
Dear Sir,
As I’ve poffered in one of your past posts: “The Fed is using QE to inflate stock market prices and the wealth effect… hoping this will restart the consumer engine that has faltered since the crash of 2008.”
The Fed Chairman himself, Ben Bernanke, publicly stated this position in a Washington Post article self-penned on the eve of QE2:
***************
“Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”
***************
And then you write:
************************
Second, we believe that the markets are next going to deal with the economic ball bouncing off the “right gutter” of inflationary pressures in early 2011. We already have seen extreme spikes in food and textile commodities, and since late August, the price of oil has risen 50% as a result of global demand and Middle East turmoil. Interest rates on the US 10-year Treasury bond rose over 100bps from the early October lows and, as described above, the tone and tenor of Central Bank commentary are now more weighted towards the risks of inflation.
************************
I recall just a few short weeks ago how you were writing to your readers (with a list of products and services) and telling us how there was NO Inflation in the marketplace and that The Fed’s QE program would be deflationary. While I am heartened to see you are open minded and observant and have come around to the opposite opinion on the state of inflation, it could have been a full admission for your readers if you had informed them of your very astute flip-flop, sir.
Inflation is a very frustrating term to cover a plethora of different phenomena. A demand-pull inflation is very different from supply shock or speculative inflation or asset bubbles, where by “inflation” we mean change in price of the basket of goods across time. Seems to me the correct thing to say about QE would be that it should not create any demand-pull inflationary pressure.
What I am confused about is what will happen to these excess reserves? Will they just sit there? Eventually they have to get lent out – or do they? When they do, will this lead to major inflation? If they don’t, will people become skeptical of the US monetary system and slowly reduce dollar reserves?
Banks aren’t reserve constrained. They don’t lend reserves. So yes, the reserves will just sit there. Think of it like an air salesman who comes to your home and sells you air to breath in canisters called “air reserves”. What will you do with them? You’ll put them in your cupboard for safekeeping in case your kids ever come to you and need to borrow some air. But they’ll never come for them because they don’t need more air to breath….the air is already there to be breathed. Banks are exactly the same. When customers want loans they make loans. They find the reserves later.
Cullen:
Any comments regarding Paul Kasriel’s (from Northern Trust) article today about the potential for inflation from QE2?
Thanks.
http://www.northerntrust.com/pws/jsp/display2.jspXML=pages/nt/0601/1138283684288_6.xml&TYPE=interior&er=useoDetail&c=primary/resource/1103/1301064343800_12.xml
Looks like Paul believes quantity theory which states that banks lend reserves. It’s total nonsense and has been disproven via QE1.
TPC you didn’t mention that the excess air was created via deficit spending. Most everything else is downstream from that. My friend had a dream the other night that he went to his local McDonald’s to get a burger and they would only take Euros, and he got very mad that he had to trade his $ for Euros. We all laughed and laughed ha ha ha…
Bad analogy on my part….
Is deficit spending adding rain to the ocean or a fire hose in a swimming pool? (that was half way empty in 2009)
I don’t like the air analogy too much either. Is this one is better?
The Economist’s The Big Mac index
An indigestible problem Why China needs more expensive burgers Oct 12th 2010
A WEAK currency, despite its appeal to exporters and politicians, is no free lunch. But it can provide a cheap one. In China, for example, a McDonald’s Big Mac costs just 14.5 yuan on average in Beijing and Shenzhen, the equivalent of $2.18 at market exchange rates. In America, in contrast, the same burger averages $3.71.
See the full article
http://www.economist.com/realarticleid.cfm?redirect_id=17257797
Ok thank you Chris… and within the MMT approach, what is the difference between Eurozone governements and the US government : Is Eurozone doing the same as the US does, that is spending first of all money, then taxing? And for the bond system: is it only a monetary tool, and not a fiscal one?