Britannia Radio

The Fed Is Not Printing Money

By Mike Whitney

The Fed is not printing money.

May 29, 2011 "Information Clearing House" -- I know what you've heard from "reliable sources" on the Internet, but it's hogwash. In fact, there is not one economist--to my knowledge--who would characterize the Fed's Quantitative Easing program (QE2) as a money printing operation.

What the Fed's doing is buying a bunch of long-term bonds (US Treasuries) in exchange for bank reserves. What this does is reduce the average maturity of the debt held by the public, which reduces long-term interest rates.

The Fed already controls short-term interest rates via the Fed Funds rate, right? Well, QE2 allows the Fed to control long-term rates, too....at least in theory. In practice, it hasn't worked out that well. As Paul Krugman points out, purchases by the Treasury have essentially "swamped the Fed’s efforts."

Here's Krugman: "What QE2 might have done — and probably did do for a while — is act as a signal of the Fed’s determination to do whatever is necessary,and maybe of a willingness to accept higher inflation. But this only goes so far, especially with all the political pressure on the Fed and its constant declarations, in the face of that pressure, that it remains as steadfast against inflation as ever." ("QE2 Disappointment", Paul Krugman, New York Times)

So, QE2 really hasn't made that much of a difference, has it? As for those people who've been moaning that Weimar hyperinflation is just around the corner, well, they were wrong. We're in no danger of hyperinflation because the Fed is not printing money. That's not what the program is all about.

True; QE2 did push up asset prices--mainly stocks and commodities--but that's because the Fed was reducing the supply of US Treasuries. Naturally, when the supply of one financial asset is reduced, investment shifts into other assets. That's what's happened here. Stocks went up while consumers got clobbered by rising gas and food prices. If this sounds a lot like "class warfare", it's because it is.

As for Fed chairman Ben Bernanke's claim that QE2 would add jobs and boost lending at the the banks?

Well, not so much.

This week the DOL reported unemployment claims rose to 424,000, which makes it the 7th consecutive week that new claims were above 400,000. In other words, we're not making any real headway on joblessness. QE2 has had no measurable effect on hiring.

The same is true of lending. Apart from student loans and subprime auto loans, there's been no real improvement in lending. Bank credit is basically flat with no indication of a near-term turnaround.

The same goes for GDP which was just revised to a measly 1.8% for Q1. QE2 has not spurred more growth at all. All it's done is shift more wealth to financial elites and Wall Street speculators. Otherwise, it's been a total bust.

There is a chance, however, that QE2 may have done some real damage to the economy, which is what economist Marshall Auerback mulls over in a recent article. Here's an excerpt:

"So what has QE2 actually achieved? Little in the way of positive impact, but much in terms of its deleterious impact by fomenting additional speculative activity, notably in the commodities complex — gas and food prices. Obviously, with other determinants of aggregate demand in question, commodity prices and the gasoline price in particular now matter. The price of gasoline is almost as high as it was at its brief peak in May-July 2008. In the past, increases in expenditures on gasoline could be managed by consumers because they had access to credit. That is certainly less true today. Rising fuel prices could tip the economy towards greater weakness. As it now stands, the U.S. economy has been growing around trend (2.7%) and the first quarter was probably below that. Tipping the economy towards weakness would bring growth way below the current optimistic above trend consensus.

Though it cannot be proved, in the minds of many the current wave of speculative and investment demands is tied to the Fed’s emergency measures of ZIRP and QE." ("QE2 – The Slogan Masquerading as a Serious Policy", Marshall Auerback, Naked Capitalism)

And Auerback is not alone in his criticism. In fact, Pragmatic Capitalism's Cullen Roche gives an even more blistering evaluation. Here's an excerpt:

"It’s become fairly clear by this point that QE2 hasn’t done much for the economy if anything.... In terms of its actual economic impact QE2 should have been a non-event, however, its impact on investor psychology has caused wider ranging effects. The most notable is the surge in speculative bets by market participants.....

As I’ve mentioned previously, the Fed has essentially helped investors step on the gas heading into a tight turn. Some markets (such as silver) appear to have already veered off the road. Others are remaining more buoyant. The psychological impact of QE2 has helped generate a nice air pocket in risk assets based in large part on margin debt. Should that margin debt trend reverse the end of QE2 will be seen as anything but a non-event. It will be seen as a contributing factor in what appears like growing economic instability." ("The end of QE2 should be a non-event, Pragmatic Capitalism)

I agree with Roche on this point. I suspect their will be unintended consequences from QE2 given that it has lifted the S&P and Dow Jones by roughly 20% while the underlying economy has remained mired in inertia. What will happen to stock prices once the program ends?

This is the question Nomura's chief economist Richard Koo addresses in a recent research paper on the topic. Here's an excerpt:

"The problem surfaces if people decide that today’s share prices cannot be (conservatively) justified using DCF (discounted cash flow) analysis because of factors such as persistent high unemployment, falling housing prices, and sluggish money supply growth.
That would suggest that share prices and commodity prices are in a QE2-driven bubble and that now may be an opportunity to sell assets that have been lifted higher by QE2.

Given that policy rates are already at zero, leaving no room for further rate cuts, and that fiscal policy in the US and the UK is headed in the direction of austerity, which would impact negatively on the economy, there is little prospect of policy support for an increase in DCF values, either.....

“When the situation is viewed in this light, we come to the realization that Mr. Bernanke’s QE2 was in fact a major gamble. It was a gamble in the sense that the Fed tried to raise share prices with QE2. If the wealth effect resulting from those higher prices led to improvements in the economy, the higher asset prices would ultimately be supported by higher real demand, thereby demonstrating that prices were not in a bubble.

However, I cannot help but feel that the portfolio rebalancing argument was putting the cart before the horse, in the sense that it is ordinarily a stronger real economy that leads to higher asset prices, and not the other way around." (Richard Koo: QE2 was a big gamble that now threatens economic stability", Pragmatic Capitalism)

In other words, the Fed should have embraced more traditional "Keynesian" fiscal policies to revive the economy and skipped the QE monkey-business altogether.

If Bernanke has inflated another equities bubble, we should know about it before too long. QE2 ends sometime in late June, which means that stocks should start to fall by mid-month or shortly thereafter. Look out below.