Sunday, June 5, 2011

Is QE3 In Our Future? You Better Hope Not

As I’ve mentioned many times previously on this blog, quantitative easing is the Keynesian admission “we’ve run out of arrows in our quiver”. If you try to control the economy through a central bank (as we unfortunately do, in the United States), your best control is through the raising and lowering of interest rates. However, when rates begin to approach zero, that option is taken off the table. In a rare instance of economic policy accuracy, Wikipedia gets this one right:

Ordinarily, a central bank conducts monetary policy by raising or lowering its interest rate target for the inter-bank interest rate. The central bank achieves its interest rate target through open market operations – where the central bank buys or sells short-term government bonds in exchange for cash.[5][7] When the central bank disburses or collects payment for these bonds, it alters the amount of money in the economy, while simultaneously affecting the price (and thereby the yield) for short-term government bonds. This in turn affects the interbank interest rates.[33][34]

In some situations, such as with very low inflation, or in the presence of deflation, the central bank can no longer lower the target interest rate, as the interbank interest rates are either at, or close to, zero.[8][9] In such a situation, referred to as a liquidity trap, quantitative easing may be employed to further boost the amount of money in the financial system.[10] This is often considered a "last resort" to stimulate the economy.

Yes, it’s a last resort. It increases inflation risk, especially in an economy that isn’t growing, and the way we’re using it, it increases our credit risk as well. During this last round of quantitative easing, QE2, the Fed was the largest purchaser of U.S. debt, acquiring nearly 70% of it. QE2 ends at the end of this month, and the Fed has said repeatedly that there will not be a QE3.

However, I’ve read several articles in the last week saying that such an event is not just likely, but inevitable. At the risk of being redundant, I will point out again that former Governor Sarah Palin (R-AK) predicted this quite some time ago. And as she said then:

Do we have any guarantees that QE2 won’t be followed by QE3, 4, and 5, until eventually – inevitably – no one will want to buy our debt anymore? What happens if the Fed becomes not just the buyer of last resort, but the buyer of only resort?

I discussed this problem before as well, here.

Like so many problems we face today, the big part of the problem here is admitting to ourselves what the problem is. By having a QE3, we’re admitting that QE2 has failed. So, why should we think QE3 would succeed? In fact, the inflationary effects of successive QEs make their ongoing failure more likely, rather than less. Unless we admit the failure and put that arrow back in the quiver, we end up with a failed economy and a $100 cheeseburger at McDonald’s.

Some are already predicting a bear market, should a QE3 occur, and a bear market combined with a devalued dollar is indescribably bad.

“We become excessively bearish if the Fed goes to QE3,” Belski said in an interview on Bloomberg Television’s “In the Loop” with Betty Liu. “We do not want to see QE3,” the New York-based chief investment strategist said. “We think that only prolongs the inevitable when the Fed has to eventually sell these securities that they have been buying.”

But who’s going to buy these securities? Anyone? Let’s review what the Fed is holding.

But beginning in late 2008, as financial institutions careened towards insolvency, the alphabet soup of Fed lending facilities (TAF, TSLF, PDCF and the CPFF just to name a few) bought all kinds of assets that the Fed never before held. Through quantitative easing efforts alone, Ben Bernanke has added $1.8 trillion of longer term GSE debt and Mortgage Backed Securities (MBS). (In fact, the Fed now holds more of these mortgage instruments than their entire balance sheet before the crash.) This has drastically changed the complexion of the assets it must now sell.

But as the size of the Fed's balance sheet ballooned, the dollar amount of capital held at the Fed has remained fairly constant. Today, the Fed has $52.5 billion of capital backing a $2.7 trillion balance sheet. While the size of the portfolio expanded three fold (and the quality of its assets diminished), the Fed's equity ratio plunged from 6% to just 2%. Prior to the bursting of the credit bubble, the public was shocked to learn that our biggest investment banks were levered 30 to 1. When asset values fell, those banks were quickly wiped out. But now the Fed is holding many of the same types of assets and is levered 51 to 1! If the value of their portfolio were to fall by just 2% the Fed itself would be wiped out.

Anybody got a spare $3 trillion lying around that they’re willing to invest in toxic assets? No? Hmm. What a surprise.

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