Monday, January 6, 2014

QE: We Don't Know How It Works

We've never been a fan of the new Fed monetary policy, and here's an excerpt from a 2012 post on the subject:
"First things first.  No QE3.  No Operation Twist and Shout. No more monetary "Shock and Awe."  Lowering rates further or keeping them low indefinitely will NOT raise the "animal spirits" of entrepreneurs and megacap corporate CEOs.  Why?  If there's no reasonable prospect for increased final demand in the foreseeable future, businesses will sit on their cash because the capacity increasing projects still won't be worthwhile even if rates decline by a further 30 bp.  They will instead pursue mega mergers and short-term measures to raise their share prices. Larry Summers makes this point in more colorful language than I can conjure up.
Fiscal policy should be aimed at nudging, cajoling, and jawboning industry to build more pipelines to move North America's increasing energy resources to where consumers need products, building LNG terminals for export, building more refineries, switching coal plants to gas, and building out the power grid and telecom infrastructure, to name a few.  We have to get rid of the budget-busting social initiatives currently in place in order to accommodate a change in the expenditure mix.
Investing in what we need to become productive in the future would be a desirable by-product of this persistent low-rate environment.  Its blind perpetuation would be a continuing transfer of wealth to financiers and speculators."
 Well, it seems that even the architects of quantitative easing don't really know how or why it works.  New York Fed President William Dudley, himself an alumnus of Goldman Sachs, should certainly be among the most qualified to understand the effects of QE on investors and on market behavior.  Instead, we read in the Wall Street Journal that,

  • Mr. Dudley and Fed Chairman Bernanke see "clear benefits" from QE
  • Mr. Dudley acknowledged that a lot is still unknown about how the bond buying works
  • "we don’t understand fully how large-scale asset-purchase programs work to ease financial market conditions—is it the effect of the purchases on the portfolios of private investors, or alternatively is the major channel one of signaling?”
One would have thought this statement would have generated some market consternation, but with the continuing euphoria the markets remain strong.  

Unwinding the Fed balance sheet, or removing $2 trillion in deadwood from commercial bank assets at the Fed, will not be simple.  The proposed reverse repo mechanism is fraught with risk and unintended consequences.  I hope to return to this in a future post.

Fed President's Plosser's consistent concerns about the Fed balance sheet have characterized him as a 'hawk,' whatever that is, but now his concerns have been echoed, in different language by a 'dove.'

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