QE Forever


This week, we experienced an earth-shaking political event that will affect the daily lives of every American and billions of people around the world.

I’m, of course, referring to the release of the minutes of the latest meeting of the board of governors of the Federal Reserve System. (What? Did you think I was referencing yesterday’s election pageant? Nah, if voting could change anything, they wouldn’t let you do it.)

Anyway, this was by far and away the most hotly anticipated Fed meeting of the year, mainly because it was widely reported that Chairman Ben Bernanke would announce the commencement of the second round of “quantitative easy,” commonly known as “QE2.”

As euphemisms go, QE rivals “Diversity” in both mendaciousness and malign effect. “Easing” was formerly known as money printing. Essentially, the Fed will try to push down long-term interest rates by creating new dollars out of thin air and using them to buy Treasuries, mortgage-backed securities, and other junk. The increased demand -- which the Fed can potentially expand infinitely since it creates money as paper and digits backed by nothing -- will, the Fed hopes, lower bond yields and long-term interest rates and spur Americans and businesses to become more indebted. We’re saved!

Goldman Sachs predicted that QE2 would be as high as two trillion -- and suggested that at least four trillion in bond purchases would be required to stave off dreaded “deflation.” As it turns out, QE2 will be a measly 600 billion -- though Ben stands ready at the printing press if more is necessary!

Even the usually Fed-friendly media have acknowledged that printing money to buy treasuries is an act of desperation. Indeed, QE would seem an inherently self-contradictory policy in that the Fed seeks to lower interest rates in order to cause inflation -- which would itself raise interest rates!

(That said, it’s important to remember that QE is by no means the Fed’s last weapon in its arsenal… more on that below.)

The markets have been anticipating monetary expansion for some time now, which explains both  higher stock prices as well as the surge in gold and silver to over $1350 and $25 an ounce respectively. As a gold bug, I’m bound to like this. And I have little doubt that QE will eventually lead to hyperinflation. But in the near term, I’m of the view that its outcome will be sharply lower asset prices (and thus a stronger dollar).

Here’s why.

Whenever the Austrians criticize QE, they’re apt to call it “money printing” and make analogies to the Weimar Republic and wheelbarrows full of cash. I’m part of this camp, of course, and I think such shocking comparisons are warranted. (Note that Bernanke himself referred to QE as “printing money” in a 60 Minutes interview from last year! See 7:55 of this video).

Ben Bernanke

But it’s important to remember that though Bernanke might be creating money, he isn’t handing it out on the street -- much as he famously threatened to drop dollars from helicopters in a 2002 paper. The Fed’s money creation will, in the near term at least, remain confined to the bond and mortgage markets. This will, no doubt, create distortions and new variations on the dollar “carry trade,” but it won’t achieve the desired effect of immediate, readily perceptible inflation.

It’s similarly unlikely that QE2 will spur new credit creation from the banking sector for the simple reason that no matter how low the Fed has pushed its fund rate, banks don’t want to lend out their reserves. The Fed has set short-term rates at near zero for the past two years, with little effect in the way of loans to consumers, homebuyers, corporations, and small businesses. With high unemployment, falling home prices, and political uncertainty, banks would prefer to sit on their cash -- or else borrow money from the Fed to buy Treasuries and fund the government while collecting interest.

My guess is that we will head into late winter and spring of 2011 with no discernible positive effect from QE2 -- housing will still be floundering; unemployment will remain in double digits; the public mood will be depresed etc. -- resulting in a precipitous crash in most asset categories and a new consensus that deflation can’t be stopped. (That sentiment will be wrong, of course, and the first sign that run-away-inflation -- that is, the consequences of QE -- is just around the corner.)

And as alluded to above, Q3 is by no means that last arrow in the Fed’s quiver. That is printing money and handing it out directly to the public, much like the “stimulus checks” George Bush sent to consumers in the spring of 2008 -- only bigger and worse. And though it might sound unlikely now, the government might choose to federally mandate that banks make loans to consumers and businesses and extend credit limits.

Money from helicopters.