Monday, November 8, 2010

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.


  1. QE2 simply means money goes to folks who aren't really in need of money. Productive activity needs availability and access to reasonably priced credit.
    Banks won't lend. They will trade their liabilities. Far more efficient than running a loan book.

  2. who are these "sellers" of Treasuries?

    If they are Primary dealers, how will this transform into further Credit Creation to "stimulate" the economy? Do they have some "moral" targets on Loan Growth if they sell their Treas to the Fed?

    Why do they want to sell 0 weight risk asset? R they facing a serious short term liquidity risk event?

    Something is fishy about the scheme

  3. Guys,

    Credit creation is a non-starter in my view - that's where I think a lot of the commentators are getting it wrong. It's the textbook answer to what the Fed is attempting to do, but under the current circumstances, it simply won't work.

    Two things: household and corporate deleveraging (demand side), and lending capacity (supply side). Everybody's seeing the first, but very few have noted the second. It's not that the banks are unwilling to lend, but rather they can't. There's too much potential bad stuff on their balance sheets vis-a-vis their capital ratios. Citibank for instance is just a little over 9%, which is uncomfortably low given the state of the US housing market.

    Bottom-line: forget the credit channel, it won't be relevant for years.

    What Bernanke is trying to do is push down the value of the dollar (even if he says he isn't) which cuts relative costs and raises external demand for US goods and services, and second is provide incentives for corporates to start spending and hiring by lowering the term structure of interest rates (which they can't do through the Fed Funds Rate due to the zero-interest rate bound).

    The dollar needs to drop, but because of its reserve currency and safe haven status, it continues to trade at a premium. That justifies a more aggressive monetary policy stance.

    @Flying horse

    I agree about where the money should be going. I wish "Helicopter Ben" would live up to his namesake and just give the money straight to consumers. But in the absence of congressional support, I don't know how that can be done.

  4. "just give the money straight to consumers"

    That can be done via a special penalty on idle funds (instead of paying interest on reserves) or asset mix composition which does not meet the "target"...this can be introduced via micro prudential measures in the risk based capital and reserves requirement....

    if they want...we saw in the early phase when the Treas forced the key banks to accept Capital injection(when some don't even need them) in the hope that they can channel it onwards...nothing happened and most have paid back..

    In the link u provided the author said " A shift toward other types of asset purchases is much more likely get the increase in the monetary base circulating the resolve monetary disequilibrium."

    This is a scary proposition...the long term effect of an "unnatural bid" in these markets will seriously distort the "real value" of these assets

  5. Yeah, depending on the ordinary channels of monetary policy won't work in these circumstances - everything's bunged up.

    I'm reminded of what happened in Malaysia post-1998. BNM was putting pressure on banks to boost loan growth to 8%, but it never got there until 2005 despite decent capital and liquidity ratios.

    Bro, forget changing reserve ratios, I don't think they're relevant the way modern financial systems work. If the Fed abolishes IOR, it'll just release more money into financial markets, not increase lending.

    That's why I'd rather see a bypassing of the banking system entirely e.g. Fed buys TBills direct from the Treasury, and the money distributed to all Americans - a pure helicopter drop. That's a direct addressing of the money demand problem, rather than depending on intermediaries. But since this is just fiscal policy in disguise, I don't think this will ever happen.

  6. why disguise the drop?

    Might as well increase unemployment benefits or targeted tax rebates to the segment.

    Can gain political capital as well.

    But still believes that there are many ways to skin this cat.

    Eg a more granular tax mechanism for banking system incomes can be introduced...say higher bracket for Trading profits Vs lower bracket for loan book interest incomes

  7. Bro, fiscal stimulus won't pass this new republican congress. That's why Bernanke is having to do QE in the first place. And his options are limited by the zero-interest rate boundary (Sweden did try a negative nominal interest rate - have to check and see what happened there).

    I think your proposal might help in a limited way, but then you have to deal with the banking lobby to get those kinds of changes in the tax code. Nor does it resolve the central question of excess demand for money.

    One of the ironies of having a democratic government is that it's hard to get anything meaningful done in a hurry.

  8. perhaps they should really consider this bro.....baru macho!

    Negative yeilding inflation protected treasuries have been sold ...if one can split the option part who knows maybe it's already in the negative....signs of things to come?

  9. LOL, that's precisely what a "helicopter drop" should be like!

    The yield on TIPS started falling when rumours of Fed easing began circulating - which shows you the power of expectations.

  10. Michael Snyder writes."The sad truth is that the Federal Reserve is not trying to build an economic recovery on solid financial principles. Rather, what the Federal Reserve envisions is an “economic recovery” based on new debt creation.”

    If 1.8 trillion dollars didn’t work before, why does the Federal Reserve think that 900 billion dollars is going to work now? This new round of quantitative easing will create more inflation and will cause speculative asset bubbles, but it is not going to fix what is wrong with the economy.” In fact, it will make things worse, far worse, for the average citizen.

  11. "If 1.8 trillion dollars didn’t work before, why does the Federal Reserve think that 900 billion dollars is going to work now?"

    What makes you think QE1 didn't work?

    Most critics are framing the wrong question - it's not about the fact that unemployment continued to rise to 9.6% and GDP flatlined. It's more, what would have been unemployment and the level of economic activity in the absence of QE, especially since i) the first round of QE was at least 75% less than that indicated by a Taylor Rule, and ii) the 2009 US federal government fiscal stimulus was swallowed by fiscal contraction at the state level.

    And concerns over US inflation are way, way overblown.