QE2: Confusion And Chaos Reigns

I’m struck by the extent of the divisiveness of opinions that the Fed’s announcement last week about a further US$600 billion in asset purchases has raised. And then there’s the fact that the FOMC’s vote on the matter was not unanimous.

But to illustrate the chasm between opinions on the Fed’s “quantitative easing” (aka printing money) program, have a look at these two articles in Bloomberg:

Bernanke Can’t Use ‘Poison as the Cure,’ Burry Says

Nov. 5 (Bloomberg) -- Michael Burry, the former hedge-fund manager who predicted the housing market’s plunge, said Federal Reserve Chairman Ben S. Bernanke is trying to use “poison as the cure” by pumping more cash into the economy to spur growth.

Bernanke’s Fed pledged this week to use $600 billion in additional Treasury purchases to help lower a 9.6 percent unemployment rate, close to a 26-year high, and to avert deflation.

The attempt to bolster growth is reminiscent of Alan Greenspan’s actions to revive the economy after 2001, Burry said in a telephone interview from Cupertino, California. The former Fed chairman helped create an unsustainable boom in U.S. property prices with his policies, leading to the worst global financial crisis since the Great Depression, he said.

Boosting the economy “was the point of inflating the housing bubble,” Burry said yesterday. “It was the intent that the house would become the ATM machine, and help us through those rough times, post-dot-com, -Enron, -WorldCom, -Iraq and - 9/11. That’s why I say they’re using the poison as the cure.” …

…The Fed’s support for asset values isn’t helping the “real” economy, and is creating “dangerous signs of a potential free fall” in the dollar and will be unsustainable, he said in the interview. It’s also probably causing investors, including fixed-income buyers, to take too much risk, in a repeat of their behavior in the period before markets began to collapse in 2007, he said.

The bad decisions then included investments in so-called collateralized debt obligations filled with default swaps tied to subprime mortgages, which helped to hobble some of the world’s biggest financial companies, he said. Banks and insurers through so-called synthetic CDOs wagered on homeowners making their payments, while firms such as Scion Capital and John Paulson’s Paulson & Co. took the opposite side of the trades.

“All those synthetic CDOs were a product of the stretch for yield,” he said.

This year, sales of high-yield corporate bonds have jumped to a record as the Fed held short-term interest rates near zero and completed purchases of $1.7 trillion of long-term debt, according to data compiled by Bloomberg. Some securities backed by risky mortgages have extended gains to almost double their lows in 2009, Barclays Capital data show...

...“I’ve expected Bernanke to act as he’s acting,” he said. “So with QE2, anything I was doing I expect will work even better.”

While it would damage the economy in the short-term, Burry said he would focus on curbing government spending to prevent harsher measures later...

…Burry isn’t necessarily a supporter of the so-called Tea Party movement, which helped Republicans gain control of the House this week and whose goals include trimming the size of government.

“I’m not a big fan of populism at either the extreme right or extreme left,” he said. “Hard choices can’t be made when everyone is screaming at each other.”

And the dissenting view:

Bernanke ‘Absolutely Right’ With Easing, Biggs Says

Nov. 5 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke’s decision to purchase Treasuries to boost the U.S. economy was “absolutely right,” hedge-fund manager Barton Biggs said.

“We still are in a very precarious situation,” Biggs, the managing partner of New York-based Traxis Partners LLC and former chairman of Morgan Stanley Asset Management, said in an interview today on Bloomberg Television’s “In the Loop” with Betty Liu. “The economy could easily tip back into a double dip, and Bernanke did what he had to do.” …

…“We’re going to have higher stock prices for a while,” Biggs said. Bernanke has “gotten the stock market up, which is what he wants to do. The stock market is an important symbol of confidence.”

The S&P 500 has rallied 17 percent since Bernanke indicated in August that he had the tools to prevent another recession. This week, The central bank left unchanged its pledge to keep interest rates low for an “extended period” after Bernanke said it could be modified in some way. While Bernanke’s near- zero rates policy and $1.7 trillion in asset purchases helped end the recession, the Fed said progress was “disappointingly slow” in bringing down joblessness close to a 26-year high.

Biggs said last month that U.S. stocks may gain 10 percent after the Fed announcement and that a bubble, or unsustainable rally, is occurring in emerging markets.

The MSCI Emerging Markets Index of equities in 21 nations has gained 35 percent since its 2010 low in May, and surged more than 150 percent since October 2008, when it reached the weakest level in four years. The Shanghai Composite Index has rallied 32 percent since reaching its 2010 low on July 5, while Brazil’s Bovespa index has jumped 25 percent since May 20.

“We probably are going to have a bigger bubble because of what Bernanke has done,” Biggs said today. “But it’s not my job to try to correct the past. I’m just saying what he’s done is the right thing now and it’s fueling liquidity.”

Biggs said in August that investors should avoid the mistake he made in July, when he cut equity holdings in half to about 35 percent of his assets. Traxis gained 38 percent in 2009 after Biggs bought shares as the S&P 500 fell to a 12-year low in March.

So which is right? What’s really ironic is that both sides are seeing the same effects – just valuing the impact differently. That the Fed’s new QE program will fuel excess liquidity in financial markets is a given, and so is the impact on currency volatility. Which side of the debate you take depends on which you think is more important.

But I take comfort in one thing, which is that this QE program will be far more restricted than the original, which was three times larger in scope and targeted risky assets – QE2 is focused only on US Treasuries (US Govt bonds). To the extent that holders of treasuries are probably more risk averse than holders of CDOs and other ABS, that means proportionately less funds will flow outward to emerging markets in search of yield (and also relatively less currency turmoil). But that also means that there will be correspondingly less “real” impact from the QE2, not withstanding the effect it has already had on expectations of nominal growth and inflation.

One thing I do have to point out though is that this is probably a seminal moment in monetary policy theory and practice. Lots of things have been done over the past couple of years (QE, interest on reserves, unconventional asset purchases, central bank coordination) that will feed debates, research papers, and PhD theses for years to come. If we come up with a better understanding of how money and finance interact with the real economy, then there’s hope that policy makers will be better equipped to handle future crises, or better yet, know how to best avoid them in the future.