This is going to be a bit longer post than usual, but in order to get a somewhat full picture on what is happening in regards to the next round of quantitative easing, one needs to look a quite a few things, namely:
- What is the Fed saying currently in public about monetary policy changes?
- 1st mandate: What is happening with PCE and core CPI “inflation” rates?
- 2nd mandate: What is happening with employment?
- Unofficial mandate: Wealth-effect through stock exchange
- Key commodity prices that might render the QE completely inefficient if they are too high
- Total money and credit in the system and total banking liabilities
- Overall economic growth
- US dollar’s value
- Long-end of the yield curve
- Housing market: prices and new units
- Who will finance US deficit now that Fed is out?
- Have the previous rounds of QE been successful?
- What the Fed can and cannot do?
- Were has the money gone previously?
- Inflating the government debt versus future unfunded liabilities
- How did the Fed justify the QE2 program?
- There are more, but the ones above should give a good start
Firstly let’s see what the Fed has been saying lately on the subject of additional debt monetization:
From the semiannual monetary policy report to the Congress:
On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support. Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings.
From the latest FOMC meeting minutes:
On the one hand, a few members noted that, depending on how economic conditions evolve, the Committee might have to consider providing additional monetary policy stimulus, especially if economic growth remained too slow to meaningfully reduce the unemployment rate in the medium run. On the other hand, a few members viewed the increase in inflation risks as suggesting that economic conditions might well evolve in a way that would warrant the Committee taking steps to begin removing policy accommodation sooner than currently anticipated.
Here are the latest economic projections by the Fed:
From the Federal Reserve Act:
The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
Or triple mandate really. And lately it has been unofficially amended with an additional create wealth through the stock market mandate. I will refrain myself from discussing the paradox that is the dual mandate or reaching it with Fed’s current arsenal this time and simply highlight where the Fed is currently in achieving in or failing with these aforementioned goals.
Few days ago, I wrote a piece on US employment based on the latest data from June: US June employment update: +18k, 9.2 per cent, getting worse. As I highlighted there, the “recovery” has been disappointing to the green shoots brigade and in fact the employment situation is getting worse by the month. The official U3 unemployment rate is up three months in a row, from 8.8 per cent in March to 9.2 per cent in June. US economy is still creating jobs, but the last few months have looked pretty bad and I fully expect to see negative prints on even total private payrolls although it is the government that is pushing the overall figure down for now. Regardless of whether we see any significant negative prints on payrolls, the official U3 rate will continue to go higher, because there are huge amounts of people counted in not in labor force, although a lot these people guaranteed need a permanent full time job. The weak employment situation clearly gives room for monetary stimulus (thinking like Fed here) and since it is explicitly stated in Federal Reserve Act, I doubt the Fed can look at negative payroll prints and 0.2 to 0.4 increases in unemployment rate without appearing like they are doing something to remedy the situation.
And it is not just the unemployment that is getting worse, it is the entire economic growth as latest estimates from Goldman put the Q2 GDP growth at 1.5 per cent following the 1.9 per cent growth on the first quarter. I foresaw this development quite a bit earlier (April that is); back then Goldman was looking for 4 per cent growth.
The growth has clearly slowed down and looking forward the government component is going to be a drag unless of course Obama administration wants to ram through another 100 to 1 objected stimulus package. Moreover, its interesting that although the federal government is trying to force growth in the economy by borrowing and offering unlimited handouts while at the same time lowering the payroll tax, the personal consumption component decreased. Furthermore, the weakness of this “recovery” is ominous considering the rather extraordinarily strong stimulus.
Expect to see the GDP growth slow down even more and if the Fed does not extend their quantitative easing scheme, which is about to run out of steam this summer, Q4 will see a negative print on the GDP. If they do indeed continue to monetize debt, then the second leg down will be postponed by few quarters.
Moving onto price stability mandate. The first chart presents consumer price index, producer price index and PCE price index with year-over-year change for the last five years. The ramp-up and subsequent collapse in the PPI came mainly from oil price which boosted and decreased energy costs for produces. That let aside, the price annual price increases have definitely come up from the recession lows probably making it little harder for the FOMC to justify additional monetary “stimulus”.
The next chart shows core PCE and core CPI price indexes with year-over-year changes for the last five years, the core part referring to everything less food and energy as they are seen somewhat more volatile to various factors. The core figures might give a little better picture of the effects inflation is having on consumers and these are the figures the Fed is looking. They give a somewhat different picture than the overall indexes, but nonetheless the annual rates have definitely picked up during the QE2, which would support the view that there will not be another round of QE coming, at least not immediately.
The latest report by BLS showed the monthly CPI coming in at -0.2 per cent while the core CPI came in at 0.3 per cent. The annual rates were 3.6 per cent and 1.6 per cent, respectively.
The 12 month change in the all items index remained at 3.6 percent. The change in the index for all items less food and energy edged up to 1.6 percent, its highest level since January 2010. The food index has increased 3.7 percent over the last 12 months while the energy index rose 20.1 percent.
High oil and gas prices, especially prices close to or higher than 100 dollars a barrel and 4 dollar a gallon are likely to push Fed away from further money printing although they do not admit that QE could possibly have anything to do with commodity prices. The following chart depicts spot oil price for WTI and average US gas prices for the last five years. One can see that the strong increase in prices following the recession have eased a bit.
One place where the QE3 belief is still very strong seems to be gold as it has been hitting all-time-highs one after another. However, gold does not reflect just inflation expectations. In fact gold has not even been that stellar investment during heightened inflation. Gold tends to move up also with events that transpire deflation. However, I fully expect gold to make new high quite a bit above the current 1600 dollar level and the same goes for silver that is currently trading close to 40 dollars.
Total credit in the system
To get a little better understanding on the inflation debate, one needs to look at some aggregate money and credit figures and banking liabilities. This is what the Fed is probably truly worried – seeing the total credit contracting. The Fed has managed to reverse that trend with quantitative easing. And for the banking liabilities, Zero Hedge had some nice details taken from the Z1 release. To put shortly, the collapse of non-traditional liabilities has eased enough for total liabilities to grow sequentially.
Moderate long-term interest rates
Key target to be achieved with QE2 was lower long-term interest rates. The chart below shows 5, 10 and 30 year treasury yields. The QE2 program was announced in early November, but it was strongly hinted already earlier. And if you look at the chart, the long end of the yield curve rose, it didn’t go down.
One area where the QE2 definitely worked (I don’t mean it was positive, just that it worked), is the stock market. SP500 has been going up hand in hand with money printing. Yet it escapes me how does the Fed not understand that this only creates wealth for the top 10 per cent of the population?
Another key thing to look at – the dollar. With the trade weighted exchange index close to its lows, the Fed must be at least a bit at unease about compromising the currency’s credibility any further. But note that during the recession and a premise of deflation, the index skyrocketed and that is going to happen again, if US slowly falls into another recession as I expect.
Reviving housing was said to be one of the goals for quantitative easing, but it has so far failed completely with housing starts at all-time-lows and housing prices in double dip. The chart below shows new privately owned housing units started and S&P Case-Shiller 20 city home price index for the last 10 years. Housing recovery is nowhere to be seen. This is interesting, because there has never been a economic recovery overall without housing recovery and the boom after the tech bubble was achieved primarily with a housing bubble. The lackluster housing picture gives some ammunition to those FOMC members looking for excuses to launch QE3.
One area where the Fed has been rather realistic and trustworthy in their view, is housing. The following is from the semiannual monetary policy report to the Congress.
Residential construction activity remains at an extremely low level. The demand for homes has been depressed by many of the same factors that have held down consumer spending more generally, including the slowness of the recovery in jobs and income as well as poor consumer sentiment. Mortgage interest rates are near record lows, but access to mortgage credit continues to be constrained. Also, many potential homebuyers remain concerned about buying into a falling market, as weak demand for homes, the substantial backlog of vacant properties for sale, and the high proportion of distressed sales are keeping downward pressure on house prices.
US deficit and unfunded future liabilities problem
For several months now similarly to the first QE, the QE2 has essentially monetized the entire US budget deficit meaning that the money for reckless government spending that is keeping the sinking ship afloat has not been away from anyone else (that would eventually be the case, but on the short-term). Now the situation is a bit different; US is on the market for 1600 billion dollars of funding annualized and that has to come from someone else. I wish you the best of luck PIIGS and small businesses. But, it gets a little worse. CBO pegs the deficit through June at around 1000 billion, but the fiscal year has a budgeted deficit of 1600 billion and that year will end in September. Now because of the budget theater, Obama has been plundering government pensions and running the cash balance as low as possible, which means there is going to plenty of extra issuance once the clowns on Capitol Hill come to the great compromise of no spending cuts and no tax increases. As a wild guess, US will increase its debt-load by about a trillion dollars by the end of the year without Fed buying the bonds if there is no QE3.
Now introduce another debt related issue – the unfunded future liabilities. I wrote a little bit about it here. It is hard to put a exact figure on this thing put for the moment let’s assume it is 50 trillion dollars, 5 times the government debt held by the public. This problem renders the idea of inflating the government debt away useless as, you see, printing money makes it easier to pay your current dues, but it increases the future costs of Medicare and Social Security and thus, it increases your unfunded future liabilities. Though, it is still important to understand that this is not actual debt yet and US can get away from this problem by significantly slashing Medicare and Social Security payments, but how easily will that go through while U6 unemployment is, let’s say at 20 per cent.
Where did the money go with QE2?
Zero Hedge provided some great insight into this a month ago. In essence the cash went to bolster balance sheets of foreign banks that operate in the US. And below, I present the excess reserves of depository institutions that just goes to show how well the banks are putting the money to work in the economy.
It does not take a genius to see that the freshly printed cash did not go to lending and there are probably several reasons for it:
- Households are debt-saturated and cannot buy more iPads with debt they cannot pay back
- Small and mid-sized businesses cannot borrow because government deficits are consuming all available cash or they don’t want to borrow because there are no profitable opportunities for them.
- Banks are not telling the truth about their balance sheets and they need cash in order to cover hidden losses on their balance sheet, such as junk sovereign bonds held at par or second-lien mortgages held at par although the home is in foreclosure. This nicely fits the fact that mark-to-market rules do not exist currently, because as we know, true values are bad for stability.
Did the QE2 work as intended?
In one word: no. Housing is still depressed, yields went up, employment situation is almost as bad as it was and now it is getting worse, commodities went up causing margin compression for a lot of businesses, dollar almost saw all time lows, lending to businesses has not increased, but on the plus side stock market is up markedly. Will the next one work? I’ll happily go through that once they announce the details sometime in the future. There are things Fed is capable of achieving, but there are also some pretty strict limits. The Fed can create money out of thin air and thus, inflation, but they have barely no power to direct where the money will go.
What prompted Fed to launch QE2?
From the FOMC statement:
Information received since the Federal Open Market Committee met in September confirms that the pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.
To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.
Based on what triggered the continuation of QE the last time, it should not take much more than slightly weaker private payrolls than currently and decreasing y/y core PCE inflation and we are at the same point we were in last November, and QE3 will commence.
I did not expect the Fed to launch a new round of quantitative easing immediately after the QE2 ended not too long ago, because the previous ones did not work the way the Fed intended them to work, there is a future unfunded liabilities problem that won’t go away and I suspect the Fed has realized that since there are massive amounts of excess reserves in the system, there is little point of force feeding Wall Street with free cash that can be promptly used to prop up food and energy prices in addition to SP500.
However, I have to balance out the failure and inefficiency of quantitative easing with the fact that it is the only thing that Bernanke & Co have left and once the economic situation gets bad enough, they are most likely not going to want to admit that QE was just a way to postpone the trouble. Instead they will launch another round of treasury buying. The program might very well come in some other form than the QE2, like long-term interest rate caps, which would allow them to print money indefinitely.
Remember though that printing money and monetizing government debt is not going to work on the long-term, it is simply a way to postpone the hangover.
Setting a timeline is a bit risky, but I expect to see the next round of accommodative measures launched sometime in the 4th quarter of this year as a result of deteriorating economic growth. While I expect the QE3 to launch this year as a response to weak enough economy and core inflation getting lower, It will be postponed if by some miracle the economic “recovery” continues or the excess liquidity in the system currently is enough to absorb some of the deflationary developments.