Economic Notes: QE-2 - Sailing In Uncharted Waters
11/08/2010
By Patrick O'Keefe, Director of Economic Research, J.H. Cohn
The Federal Reserve has launched another round of quantitative easing (“QE") in response to a “disappointingly slow” recovery.
Over the next seven months, the Fed’s balance sheet will increase by about one-quarter as it purchases some $600 billion of U.S. Treasuries. By next July, the Fed’s balance sheet will be more than triple what is was in March 2008, just prior to the demise of Bear Stearns.
QE is intended to increase liquidity, further reduce interest rates, and, the Fed believes, stimulate the general economy.
The new initiative has been dubbed “QE-2” to distinguish it from the 15-month monetary expansion that ended in March after the Fed had purchased some $1.7 trillion of mortgage-related securities and Treasuries.
The acronym’s nautical reference, Queen Elizabeth II, has prompted some allusions to another famous ship: the Titanic. But holders of U.S. dollars and debt might think a more apposite simile is the Serapis, which John Paul Jones commandeered as his battle-damaged ship sank.
Since March, when it allowed QE to lapse, the Fed has executed a policy u-turn. A month before, it had increased a key interest rate. At that time the Fed saw financial stabilization and the “green shoots” of recovery.
But subsequently, those shoots became stilted stalks and failed to produce the anticipated bumper crop of jobs. In August, Fed Chairman Ben Bernanke hinted at QE-2, essentially lip-synching John Maynard Keynes to the effect that “when the facts change, I change my mind.”
Since then, markets have reacted largely as expected. Financial assets have soared (e.g., the Dow Jones Index is at its September 2008, pre-Lehman level), the dollar has dropped (down almost five percent) and key commodity prices have risen (although some of the increase reflects supply/demand shifts).
Although QE-2 has produced an array of forecasts, its proponents and opponents agree on one thing: the Fed is in uncharted waters. Earlier experience in the U.S. and Japan produced ambiguous results, but suggests that the potential benefits are limited.
While the risks are also unquantifiable, they appear larger than the potential benefits.
There is, for example, the potential for commodity-specific price hikes (e.g., oil) which, while distinct from generalized inflation, could nonetheless squeeze businesses and households thereby diminishing purchases of other goods and services.
Of greater concern is the potential for competitive currency devaluations, as nations seek to retain/increase their share of global trade. The resulting “currency wars” could easily become the equivalent of the tit-for-tat tariffs spawned by enactment of Smoot-Hawley in 1930.
Finally, as even its proponents admit, there is considerable uncertainty regarding how QE-2 will work in practice (i.e., the channels through which additional liquidity finds its way into the general economy), particularly when, as now, the financial system is awash in excess reserves. There are, to be certain, unforeseen risks ahead.
The Fed weighed these considerations against “disappointingly slow” progress toward its twin mandates of maximizing employment and stabilizing prices. It launched QE-2 confident that it can meet both the known and unanticipated risks.
Here’s hoping Bernanke’s QE-2 crew can penetrate the fog better than Ed Smith’s.
***
The statements, opinions, and conclusions contained herein are based solely upon the author’s own studies, research, and personal experience. Neither J.H. Cohn LLP nor the author makes any representation or warranty as to the accuracy or completeness of this information. J.H. Cohn LLP and the author expressly disclaim any liability for any loss or damage which may be incurred, of any kind whatsoever, as a result of or arising from the use of any of the information contained herein or reliance on the accuracy or completeness of it.
Patrick J. O’Keefe is director of economic research at J.H. Cohn LLP. He can be reached at pokeefe@jhcohn.com or 877-704-3500.