A few weeks ago QE3 (Quantitative Easing 3) was announced by the US Federal Reserve. While the average citizen may have completely ignored the announcement based on the complexity of Fed operations, this decision is one that has the potential to profoundly impact lives in the US and worldwide. From my point of view it is extremely disturbing short-term thinking.
The Federal Reserve is a complicated and powerful organization that dictates US monetary policy. They do this by a few different methods (buying federal debt, lending money to banks, or setting requirements for bank lending), but the end result of each method is a manipulation of the money supply.
The value of any particular currency is dependent in part on how much of it is out there. The Fed is able to manipulate this supply by creating money out of thin air. It’s not subject to the limits of the rest of the world or even the rest of the Federal Government that say “if you want to spend a dollar you either have to earn it or borrow it.” If the Fed thinks it would advance it’s policy to spend $1 billion dollars, they don’t have to raise it; they simply say “we now have $1 billion to spend.” It didn’t come from anywhere, so it is a new billion dollars being added to the pot (increasing the money supply).
What is the Fed Doing with QE3?:
Quite simply, the Fed is “printing” (not physically, but by fiat) money and buying assets from banks at an incredible rate for an indefinite period of time. They will be purchasing over $40 billion in assets per month from lending institutions, with the idea being that the cash they spend on these assets will benefit lending in general. If banks have assets off their books in exchange for cash, they will be able to lend more money. If there is increased demand for debt (with the addition of a massive new buyer in the Fed) the cost of borrowing will decrease, helping the institutions that need to borrow a lot.
Guess what the biggest borrower in the land is? The Federal Government. The Federal Reserve is going to magically make money and buy up to half a trillion dollars of their own debt per year. It’s printing money and pretending you aren’t via an accounting trick. Neat. I’m sure that this will work to some extent, but you can’t “print” money like this without long-term consequences.
What might be the negative consequences of QE3?:
The big problem of these massive QE programs would likely materialize when the economy improves. We’ve injected trillions of dollars into the money supply, but that money hasn’t flowed through the system, so it hasn’t caused significant inflation. If economic factors improve, the banks will be suddenly incentivised by the market to start making all the loans they can with that money, causing the “velocity” of the money to dramatically increase. The equation for inflation can be approximated as Money Supply x Velocity / Real Output = Price. If we have drastically increased both Money Supply and then the Velocity picks up, the result isn’t just a linear increase in prices.
Sure, many would point out that right now a major measurement of the money supply, M3, is estimated to be at approximately the same level as it was pre-recession. We’ve injected a tremendous amount of cash into the economy via the Fed already, but lending slowed down significantly because the economy was bad. Guess what? The opposite happens when the economy improves. Once conditions improve in the economy, the M3 losses will rebound, but the Fed injections will remain out there on top of that. Hello inflation.
The Exit Strategy:
The only possibility of avoiding massive inflation at that point would be for the Fed to roll back the new supply of money they put out there. There’s a couple of reasons for concern on the ability to pull back:
1: significant portion of the assets that the Fed is purchasing is Federal Debt. In other words, they are buying the debt that is issued by the other branches of the government in order to keep interest rates low and keep down the impacts of the massive government spending. If they want to suddenly undo this policy, the result would be a flood of a few trillion dollars of government debt into the market all at once. There simply isn’t the appetite in the market to buy all of those bonds at once (especially since the economy will have improved and companies and individuals will have more aggressive assets they want to invest in). The result could be the collapse of US debt, and an economic slump the likes of which we have never seen.
2: Many of the investments that are being purchased are supposedly less-than-desirable assets that banks have been stuck with on their balance sheets. Again, if you sell these investments quickly, the bottom will completely drop out of the market for such investments. There are still many organizations that hold those assets, so we would be stalling the economy back out. Furthermore, selling a massive number of similar assets can never be performed at an appropriate value. The Fed would have to sell them on the cheap, meaning that a significant portion of the money supply would remain out there. Yes, this would mitigate some of the inflation, but it wouldn’t be a cure-all.
I suppose there is the theory that the Fed can make sure the economic recovery is gradual, and not quick, which would allow them to sell assets over time. However, the Fed can’t figure out exactly what the economy is doing until a few months after the fact, so how are they going to manage such a complicated transaction?
The “Market Loves It” Argument:
I’ve seen a lot of reports that the market loves the prospect of QE3 after there was a surge following the announcement. First of all, stocks are not the economy. Secondly, though, people should take a look at what stocks moved up, and where the money came from. The list of top movers for the market included mining companies, oil companies, and banks (who are essentially getting free money from this). So people are moving money to those who benefit from this and those who will not be affected by the fallout. Furthermore, the money is being removed from government bonds (down) and cash (US Dollar down). This isn’t a statement of confidence, it’s a move to capitalize.
QE3 is a dangerous proposition. It may work, it may not, but the consequences for either are significant. We’ve essentially locked ourselves into a lose-lose situation for the purpose of trying to make sure the economy picks up within the next couple of months. I think that at this point it is a good idea for individuals to hold a larger portion of wealth in hard assets or stable foreign currencies (a little hard to find these days) and to avoid significant cash positions, government bonds, or stock in companies that are adversely affected by a weak dollar. Bear in mind that these consequences aren’t going to be on us immediately, but depend on when the economy recovers. When it does, watch out.