Sunday, October 23, 2011

The Fed & QE

We need to find something for Fed officials to do in their spare time. They insist on subjecting the economy to their new experimental monetary policy fixes that are extremely controversial and replete with dangerous unintended consequences. They refuse to believe that they’ve run out of policy tools. They insist they can do more to revive economic growth and lower the unemployment rate. That’s despite lots of evidence that record low interest rates and a second round of quantitative easing haven’t stimulated growth as they expected.

Although they started to implement their Maturity Extension Program (MEP)--a.k.a. Operation Twist--just last month, they are already having second thoughts about it. Rather than cease and desist, they want to do more, including a third round of quantitative easing and more “forward policy guidance.” Let’s review the latest developments:

(1) The minutes of the September 20-21 FOMC meeting, which were released on October 12, suggested that QE-3.0 is still on the table: “A number of participants saw large-scale asset purchases as potentially a more potent tool that should be retained as an option in the event that further policy action to support a stronger economic recovery was warranted.”

(2) Last week, Fed Governor Daniel Tarullo, who rarely comments on monetary policy, made headlines with a speech he presented on Thursday, October 20 in which he said: “I believe we should move back up toward the top of the list of options the large-scale purchase of additional mortgage-backed securities (MBS), something the FOMC first did in November 2008 and then in greater amounts beginning in March 2009 in order to provide more support to mortgage lending and housing markets.” One of the many benefits of doing so, he said, is that it should induce “investors to shift to other assets, including bonds and equities.”

(3) The next day, in a speech on Friday, October 21, Fed Vice Chair Janet Yellen seconded Tarullo’s consideration of another round of QE. She noted that while the Fed had only just recently implemented Operation Twist, it is a program limited by the Fed’s holding of short-term securities, and buying most of the outstanding long-term Treasuries might not be such a good idea after all since it “could potentially have adverse effects on market functioning.”

Wow, is she already admitting that MEP was a mistake?! I think she is. So what does she want to do instead? More, more! She’s ready for QE-3.0: In her opinion, “securities purchases across a wide spectrum of maturities might become appropriate if evolving economic conditions called for significantly greater monetary accommodation.”
Apparently, Ms. Yellen doesn’t have any doubts about the effectiveness of quantitative easing despite plentiful evidence that QE-2.0 actually backfired. The chart above shows inflation-adjusted retail sales since 2008. After recovering solidly from September 2009 through November 2010, it’s been flat since then through September of this year.

In my opinion, after QE-2.0 was first mentioned by Fed Chairman Ben Bernanke on August 27, 2010 and actually implemented on November 3, 2010, it depressed the purchasing power of consumers by boosting food and fuel prices. QE-2.0 backfired. It clobbered consumer spending just as the economy was on the verge of transitioning to self-sustained expansion, without any help from the Fed.

Why did Fed officials rush to implement QE-2.0? They clearly failed to recognize that the soft patch in economic growth from May through July was temporarily related to the termination of tax incentives to buy houses and appliances at the end of April 2010. Despite having hundreds of economists working at the Fed, they completely misread the economy and meddled at the worst possible time. They seem intent on making the same mistake all over again now.
The second chart in our blog today shows the performance of the S&P 500 with overlays showing when QE-1.0, QE-2.0, and Operation Twist were in effect. Stock prices rallied during the first and second rounds of quantitative easing. They sold off as soon as both programs were terminated. They are rallying again under the influence of Operation Twist and talk of a third round of quantitative easing. Pushing up stock prices has been one of the main goals of the Fed’s experiments with untested monetary policy measures. How much longer will they succeed in boosting stock prices if they not only fail to boost economic growth, but actually adversely affect it?

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