THE BIG PICTURE
Last Update: 17-Sep-12 09:05 ET
Editorial: QE3 is Deeply Troubling
Anyone who owns stocks benefitted from the Federal Reserve's announcement last week that it would launch another round of quantitative easing. Portfolio managers praised the action. It might continue to boost stocks for a while. That doesn't necessarily mean it is good policy. There are some deeply troubling issues raised by the Fed's action.
A History of Fed Watching
My career in the financial markets began as a so-called "Fed Watcher" in 1979. My job evolved into analyzing Federal Reserve (Fed) actions and what they meant for the money markets and the economy.
I was fortunate enough to enjoy some success and was asked on a number of occasions to give speeches on how the Fed operates.
One aspect of my standard speech was to explain how money supply is created. I explained that money supply, as defined, consists primarily of credit and not paper money - and that credit creation is the result of private banks making loans.
I typically added that, in the US, the government does not increase money supply by engaging in simply printing money or buying debt. That is anathema to central bankers and a policy only for desperate undeveloped countries.
Until now.
Suddenly, the Federal Reserve Bank of the US is engaging in action I never thought I would see in this country. It is embarking on a massive, open-ended round of quantitative easing. It is turning on the printing presses full scale.
Quantitative easing (QE) is a nice term for the central bank injecting newly created money (credit) directly into the economy through the purchase of privately-held financial instruments.
When government debt is purchased, it amounts to the government simply creating money to pay its debts. Many will call any form of quantitative easing "turning on the printing presses" and that is a fair description.
This is distinguished from typical monetary policy which seeks to influence the creation of credit and money supply by influencing the amount of credit private banks create. Raising or lowering interest rate targets, or altering the amount of reserves banks must hold are more traditional methods of monetary policy.
It is startling and unsettling to this aging Fed Watcher to see the Federal Reserve enact quantitative easing on such a massive scale.
Anathema to the Feds
Make no mistake, this decision for the Fed to launch a third, larger round of quantitative easing (QE3) was a very difficult one.
Engaging in massive quantitative easing is not something central bankers enjoy. It runs against every fiber of their professional training.
Central bankers are far more inclined to restrain credit, money supply, and inflation than to engage in measures that throw caution to the wind. They inherently dislike the idea of government, rather than private, money-supply creation.
The action implies that the Fed considers current conditions highly extraordinary. This is not just a case of the Fed employing one more tool in its arsenal. It is an act of near desperation, and it implies significant risk.
The Risks
There are two main risks implied by the Fed's action.
(1) The Fed may have far greater concerns about the economic outlook than stated.
(2) Intentionally creating an artificial lift to asset prices risks creating a bubble.
Economic Fears
The Federal Reserve's announcement of QE3 suggests that it has been enacted because of the need to stimulate economic growth and employment in particular. The press releases states:
"The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions."
The employment issue has received more attention than the next statement in the release that says:
"Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook."
It is my view that it is the second issue which prompted the Fed's action. Over the past few months, employment conditions have perhaps gotten a bit worse, but there is in fact some employment growth. At the same time, global economic data have deteriorated substantially.
An 8.1% unemployment rate should not be enough for the Fed to push the panic button.
The significantly worsening global economic trends, particularly in manufacturing and trade, are probably more significant in the Fed enacting QE3. As detailed in recent Big Picture columns, every major economy in the world is experiencing slowing growth or entering recession. This is cause for serious alarm.
Neither QE1 nor QE2 boosted either US economic or employment growth. It is hard to believe that the Fed truly expects QE3 to be much different.
A third round of quantitative easing just might, however, prove effective in mitigating the impact of the global storm now brewing. It could cushion a potential shock from rapidly deteriorating global economic conditions.
There is a significant risk that the market is underestimating the desperate, defensive nature of QE3 in terms of what it implies about economic risk.
Asset Prices
There is also the risk that the Fed is intentionally boosting asset prices artificially in such a way that a mini-bubble burst could result.
Fed Chairman Bernanke has stated that QE1 and QE2 probably helped lift stock prices, and that QE3 will affect asset prices such as home values and stock prices. The Fed is trying to boost these values in order to spur economic growth through wealth creation that leads consumers to spend more.
Stock market participants clearly believe that QE3 will indeed raise equity values. That is already happening.
Yet, the values are increasing primarily because of the perceived increase in liquidity in the financial markets. They are not increasing because of raised expectations for earnings.
The Fed is therefore artificially boosting equity values.This creates a risk that at some point the artificial boost reverses. It could come out quickly. The Fed is playing a dangerous game here. A sharp reversal in the stock market would quickly destroy any increased confidence created by QE3.
A History of Fed Watching
My career in the financial markets began as a so-called "Fed Watcher" in 1979. My job evolved into analyzing Federal Reserve (Fed) actions and what they meant for the money markets and the economy.
I was fortunate enough to enjoy some success and was asked on a number of occasions to give speeches on how the Fed operates.
One aspect of my standard speech was to explain how money supply is created. I explained that money supply, as defined, consists primarily of credit and not paper money - and that credit creation is the result of private banks making loans.
I typically added that, in the US, the government does not increase money supply by engaging in simply printing money or buying debt. That is anathema to central bankers and a policy only for desperate undeveloped countries.
Until now.
Suddenly, the Federal Reserve Bank of the US is engaging in action I never thought I would see in this country. It is embarking on a massive, open-ended round of quantitative easing. It is turning on the printing presses full scale.
Quantitative easing (QE) is a nice term for the central bank injecting newly created money (credit) directly into the economy through the purchase of privately-held financial instruments.
When government debt is purchased, it amounts to the government simply creating money to pay its debts. Many will call any form of quantitative easing "turning on the printing presses" and that is a fair description.
This is distinguished from typical monetary policy which seeks to influence the creation of credit and money supply by influencing the amount of credit private banks create. Raising or lowering interest rate targets, or altering the amount of reserves banks must hold are more traditional methods of monetary policy.
It is startling and unsettling to this aging Fed Watcher to see the Federal Reserve enact quantitative easing on such a massive scale.
Anathema to the Feds
Make no mistake, this decision for the Fed to launch a third, larger round of quantitative easing (QE3) was a very difficult one.
Engaging in massive quantitative easing is not something central bankers enjoy. It runs against every fiber of their professional training.
Central bankers are far more inclined to restrain credit, money supply, and inflation than to engage in measures that throw caution to the wind. They inherently dislike the idea of government, rather than private, money-supply creation.
The action implies that the Fed considers current conditions highly extraordinary. This is not just a case of the Fed employing one more tool in its arsenal. It is an act of near desperation, and it implies significant risk.
The Risks
There are two main risks implied by the Fed's action.
(1) The Fed may have far greater concerns about the economic outlook than stated.
(2) Intentionally creating an artificial lift to asset prices risks creating a bubble.
Economic Fears
The Federal Reserve's announcement of QE3 suggests that it has been enacted because of the need to stimulate economic growth and employment in particular. The press releases states:
"The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions."
The employment issue has received more attention than the next statement in the release that says:
"Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook."
It is my view that it is the second issue which prompted the Fed's action. Over the past few months, employment conditions have perhaps gotten a bit worse, but there is in fact some employment growth. At the same time, global economic data have deteriorated substantially.
An 8.1% unemployment rate should not be enough for the Fed to push the panic button.
The significantly worsening global economic trends, particularly in manufacturing and trade, are probably more significant in the Fed enacting QE3. As detailed in recent Big Picture columns, every major economy in the world is experiencing slowing growth or entering recession. This is cause for serious alarm.
Neither QE1 nor QE2 boosted either US economic or employment growth. It is hard to believe that the Fed truly expects QE3 to be much different.
A third round of quantitative easing just might, however, prove effective in mitigating the impact of the global storm now brewing. It could cushion a potential shock from rapidly deteriorating global economic conditions.
There is a significant risk that the market is underestimating the desperate, defensive nature of QE3 in terms of what it implies about economic risk.
Asset Prices
There is also the risk that the Fed is intentionally boosting asset prices artificially in such a way that a mini-bubble burst could result.
Fed Chairman Bernanke has stated that QE1 and QE2 probably helped lift stock prices, and that QE3 will affect asset prices such as home values and stock prices. The Fed is trying to boost these values in order to spur economic growth through wealth creation that leads consumers to spend more.
Stock market participants clearly believe that QE3 will indeed raise equity values. That is already happening.
Yet, the values are increasing primarily because of the perceived increase in liquidity in the financial markets. They are not increasing because of raised expectations for earnings.
The Fed is therefore artificially boosting equity values.This creates a risk that at some point the artificial boost reverses. It could come out quickly. The Fed is playing a dangerous game here. A sharp reversal in the stock market would quickly destroy any increased confidence created by QE3.
The Fed is also specifically trying to give the housing market a boost. In effect, the government is providing risk reduction for those making mortgage loans in an effort to spur purchases.
This is disturbingly reminiscent of actions that caused the housing bubble: long periods of low interest rates associated with government-supported risk reduction on mortgage loans.
Those government policies ended badly. This one could too.
What It All Means
The Fed is taking drastic, desperate action. It is initiating untried, risky policy actions. That by itself should be cause for concern.
Stock market participants are underestimating the seriousness of the global economic and credit trends that are precipitating this action. And, there is the risk that artificially boosting stock prices leads to a mini-bubble and an eventual mini-crash.
Most disturbing, however, is simply that the Fed believes the US is in a position where massive quantitative easing is necessary.
It reflects the deep problems inherent in the US running huge deficits and the stagnant nature of the US economy. To turn on the printing presses should be a measure of the very last resort. Apparently, that is where the US is today.
Many stock market participants will ignore the broader concerns about the implications of the Fed's actions because it provides a boost to stock prices. That feels good.
But it simply reflects more medicine for a sick economy. Neither QE1 nor QE2 healed the patient and QE3 won't either.
I never thought I would see the day when the Fed was this desperate. And that scares me.
Dick Green
Founder and Chairman, Briefing.com
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