The Fed has really been put through the ringer after it decided to push its way into the Treasury market one more time and unleash Quantitative Easing II (QE2) onto the U.S. financial systems in an effort to keep interest rates low and stimulate lending, borrowing and spending. In other words, everyone and their mother think that the Fed is back at its old tricks—fighting the debt mountain and dead economy with easy money.
Most of the jabs concentrate around two questions. Firstly, does QE2 have any chance of actually working out? Secondly, and more importantly, will QE2 tip the scale towards inflation?
I thought it amusing to hear that Alan Greenspan thinks quantitative easing is a mistake; this from a man who is regarded as the poster boy for easy money. Paul Volcker also thinks QE2 is the wrong move, although his words might actually carry some weight. Then there is a neat line-up of foreign governments from China to Germany, which are against the Fed’s latest move for their own self-serving reasons. Finally, the ranks within the Fed are not as tight as they used to be, as there is a handful of insiders who believe what Bernanke has done will make things exponentially worse.
Predictably, the Fed is fighting back—but with the semantics defense. According to the Fed’s Chairman, quantitative easing and printing money are not one and the same. He said, “The use of the term quantitative easing to refer to the Federal Reserve’s policies is inappropriate. Quantitative easing typically refers to policies that seek to have effects by changing the quantity of bank reserves, a channel which seems relatively weak, at least in the U.S. context. In contrast, securities purchases work by affecting the yields on the acquired securities and, via substitution effects in investors’ portfolios, on a wide range of assets.”
Despite Bernanke’s riveting analysis, I still think that the Fed’s move is quantitative easing and I’m still seeing it further debasing the U.S. dollar, which could lead to inflation, albeit mild, most likely, as assets priced in U.S. dollars, like crude oil, for example, seek higher prices to make up for the greenback’s continuous devaluation.
Then I thought some more about the atmosphere of fear we have lived in for almost a decade. If I were truly to argue both sides of the case, I would also have to accept the possibility that if we are conditioned to fear something, such as Fed’s policies leading to hyper-inflation, eventually, whether the policies are working or not, we could all start reading too much into signals that only feed the fear theory.
This is how the worst-case scenario rooted in fear could look like: QE1 and QE2 debase the U.S. dollar beyond recognition, assets priced in the U.S. dollar seek higher prices, start the chain reaction and, voilà, inflation gets out of hand. The bond traders get really antsy and jack up yields from three percent to six, seven, even eight percent. The costs of maintaining debt at eight percent become impossible and all hell breaks loose again, potentially leading to dramatic political changes.
But if you think about it objectively, what was the root cause of the Great Recession? Credit freeze. What have central bankers around the world focused on the most during the recession? Lending, borrowing and spending. What has not yet panned out despite all the money pumped into the financial systems? Lending, borrowing and spending!
In other words, for the Fed’s latest $600-billion infusion to result in an unmanageable inflation, many factors would have to occur in near-perfect sync, primarily more lending and more borrowing to result in more spending. Yet, the reality is that the current velocity of money is anything but fast enough to produce inflation. In fact, the velocity of money keeps going down, and that downward momentum is what the Fed is perhaps trying to arrest with the recent round of QE.
All of this “arguing both sides of the case” tells me one thing: the U.S. economy has reached the point that not even $600 billion of QE is enough to impact the real economy and reduce the exorbitantly high U.S. unemployment rate. This is why stimulus proponents are already shooting for the $2.0 trillion in asset purchases, and this is why stimulus opponents go into a tizzy the moment someone mentions more economic stimulus.