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The Arguments Against More Quantitative Easing

As we discussed in last week's (October 25, 2010) Weekly Economic Commentary, the Fed is likely to announce on Wednesday that they are embarking on another round of QE with purchases of large quantities of Treasury and agency and/or Mortgage-Backed Securities (MBS) in the open market in an attempt to reinvigorate economic growth. As in the first round of QE when the Fed began purchasing MBS in November of 2008 and announced a larger purchase of MBS and Treasuries in March 2009, this second round is likely to push more dollars into the global financial system, lower interest rates, and lower the value of the dollar. However, in contrast to the first round of QE, QE2 should result in higher inflation and inflation expectations, more lending by banks and more borrowing (at lower rates) by both businesses and consumers, and eventually more hiring and expansion by businesses and more spending by consumers.

However, not all market observers agree that the Fed should embark on QE2. Some think that it simply will not work, so why bother doing it. Others note that the economy does not need more help and that the Fed should wait longer before it decides whether to do more. Some point to banks' inability or unwillingness to lend as the main reason why QE will not work. The so called "transmission mechanism" of monetary policy-"transition mechanism" is just a fancy name for the banking system-has been called into question by the aftermath of the subprime mortgage crisis, and more recently the "transmission mechanism" argument has gained some steam. In recent weeks, it has come to light that some of the nation's bigger banks have apparently struggled with foreclosure documentation and the threat of put backsmortgage investors threatening to force the banks to buy back the mortgages they sold during the mid 2000s. The bottom line is, with banks focused on the bad loans they have made in the past, they are less likely to be laser focused on all the new lending they need to do to reinvigorate the economy in the weeks and months ahead.

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We acknowledge that one of the biggest risks of doing more QE is that it will not work, or will not work as effectively as the Fed would like. However, the Fed's view (which we share) is that it cannot stand by and do nothing as the economy flounders. We believe that the economy needs more help, and in our view, the Fed has made the case quite well, citing an unacceptably high unemployment rate, rapidly decelerating inflation, and lack of support from fiscal policy at either the federal or state and local levels.

Because of the goal of QE is to spark inflation and inflation expectations, some observers think QE2 will allow these inflation expectations (and inflation itself) to become unhinged, leading to a late 1970s/early 1980s-like bout of inflation. In our view, the risk of deflation (falling prices) outweighs the risk of inflation by a wide margin at this point in the business cycle, and by pumping more dollars into the system, the Fed is simply "filling in" a deflationary hole, rather than stoking an already inflationary economy. The Fed shares this concern (i.e., unhinged inflation expectations) but Fed officials are confident that they can remove QE before it pushes inflation and inflation expectations too high. Indeed, the Fed has been outlining it's so-called "exit strategy" from QE almost from the moment it began using QE in early 2009. While we understand the market's fears here, we do not share the concern that another round of QE will unleash a late 1970s/early 1980s-style inflation environment.

Some market observers believe that the Fed will be wasting taxpayers' money buying up more government debt, especially if it will not be successful in boosting the economy. Often this argument is lumped in with the other arguments that the government is too involved in the economy and financial markets. In this case, it is important to note that the Fed is not taking the money for QE2 from the Treasury. In fact, the Fed is simply making an accounting entry on it's own balance sheet, and is effectively conjuring up the money out of nowhere to facilitate the next round of QE. The risk here is that the market (especially foreign market participants) believes that the Fed is "monetizing" the debt of the U.S. Treasury. This is not the Fed's intention, and policymakers will keep a close eye on these types of claims as the process progresses.

An argument by some participants in the market for U.S. Treasury notes and bonds is that the Fed's likely purchase of large quantities of Treasuries in the open market will limit the effectiveness and openness of the Treasury market itself. This argument is somewhat related to the previous argument, as it stems from the idea that the government/Fed is too involved in markets. We point out that if the Fed does indeed purchase as much as $1 trillion in Treasuries over the next 12 months, it will essentially buy up all the new Treasuries expected (by most experts) to be issued over that time. This will certainly raise the ire of some, and indeed, of some in Congress whose purview it is to oversee the Fed.

This leads us to yet another concern about QE2 in the marketplace, and that is the loss of independence by the Fed because of a potential QE2 failure. On the one hand, QE2 could fail to boost lending, borrowing and inflation, which may lead some in Congress to review the Fed's dual mandate of price stability and full employment. On the other hand, if QE2 does indeed generate high inflation and rising inflation expectations, Fed policies might also prompt more scrutiny of the Fed by Congress. Either outcome would likely lead to less independence for the Fed, which would push monetary policy closer to the hands of politicians, which, in our view, would be the worst outcome for QE2.

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