Thoughts on QE 2: The Fed is digging its own grave with a bulldozer [Long Post]

It's been about two weeks that Ben Bernanke has announced his latest mad experiment: the QE 2.
I would like to share my thoughts now that it's not such a hot potato anymore and that the consequences on the markets are more certain.

Here's the statement from the Fed, announcing QE2:

On November 3, 2010, the Federal Open Market Committee (FOMC) decided to expand the Federal Reserve’s holdings of securities in the System Open Market Account (SOMA) to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate. In particular, the FOMC directed the Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York to purchase an additional $600 billion of longer-term Treasury securities by the end of the second quarter of 2011.

The FOMC also directed the Desk to continue to reinvest principal payments from agency debt and agency mortgage-backed securities into longer-term Treasury securities. Based on current estimates, the Desk expects to reinvest $250 to $300 billion over the same period, though the realized amount of reinvestment will depend on the evolution of actual principal payments.

Taken together, the Desk anticipates conducting $850 to $900 billion of purchases of longer-term Treasury securities through the end of the second quarter. This would result in an average purchase pace of roughly $110 billion per month, representing about $75 billion per month associated with additional purchases and roughly $35 billion per month associated with reinvestment purchases.

1- What is QE 2?
So, in order to clarify a bit, the Fed is not going to be printing outright. They are printing the new dollar bills in order to exchange federal reserve notes against government bonds.

These two are very big different matters, as if you consider inflation in the Austrian sense of the term, it is the increase in the quantity of credit and money. Here, the Fed is exchanging new Federal Reserve Notes against existing Treasury Notes and Bills. I am not sure it's inflationary.

2- What are the effects on financial markets?
So far, since the 3rd of November announcement, markets have had an initial rally of 1-2 days, quickly reserved, and as of today:

1. Equities are lower,
2. Commodities, including Oil, Gold, Silver are lower,
3. The US dollar is 3% higher,
4. Even treasuries are lower!

3- How has Bernanke's decision been received?

• Dissensions are high, even inside the Fed, and more and more Federal Reserve Banks are opposing Ben Bernanke's decision. Like Richard Fisher and Thomas Hoenig.
• Paul Volcker is opposing QE2
• Alan Greenspan — not that his opinion matters — is opposing Ben Bernanke
• South Korea, China, Hong Kong, Brazil Complain about Bernanke's QE Policy
• Germany calls Fed's action "clueless.
• Economists and prominent asset managers are opposing Bernanke:
• Jeremy Grantham — who is a Keynesian! — wrote a piece called the Night of the Living Fed, and went on TV to show his opposition.
• Jim Rogers 

Nov. 5 (Bloomberg) -- [...] “Many countries are worried about the impact of the policy on their economies,” Vice Foreign Minister Cui Tiankai said at a press briefing in Beijing today. “It would be appropriate for someone to step forward and give us an explanation, otherwise international confidence in the recovery and growth of the global economy might be hurt.”
[...]
“Even some advanced economies are worried and concerned about that policy,” Cui said. “I remember that the finance minister of an advanced economy said that if you print too much money that is an indirect manipulation of the exchange rate.”
[...]
“The Fed owes us some explanation about their recent decision on monetary policy,” Cui said. “We hope that as the main reserve currency-issuing country, that country will adopt a responsible position on this matter.”

Nov. 5 (Bloomberg) -- “Dr. Bernanke unfortunately does not understand economics, he does not understand currencies, he does not understand finance,” Rogers, 68, said in a lecture at Oxford University’s Balliol College yesterday. “All he understands is printing money.”
[...]
“It didn’t work the first time, it’s not going to work the second time,” he said in an interview with Bloomberg News. “It’s adding up staggering amounts of debt, staggering amounts of debased currencies. It’s going to cause more distortions, and we’re going to have more currency turmoil.”

The U.S. and U.K. governments’ taxpayer-sponsored bailouts of troubled banks were “unbelievable economics” and “terrible morality,” he said.

4- Where from here?
Well, (un)fortunately for the hyperinflationists, everything is so far rolling out exactly like Robert Prechter predicted. The debate he had last week with Peter Schiff is a very good starting point for those who want to learn about his thesis.

His stance is that no matter how mad and out of control Bernanke is, people are going to oppose him and prevent him for doing much more.

And we are already seeing exactly this happen:

• Ron Paul Questions Fed Authority, Vows Another "Audit the Fed" Effort
• Ron Paul Is About to Totally Revolutionize the House Monetary Policy Panel
• The new Republican senate came with a balanced-budget constitution amendment plan — this was totally unimaginable just 3-6 months ago!
• Open Letter to Bernanke from 23 Economists Complaining About QE II; GOP Lawmakers Call for Abandoning $600 Billion Bond Purchase

And yesterday, we saw another unbelievable event: Republicans Say Fed's Dual Mandate Has Failed, Focus Should Be on Prices. Who would have predicted this would happen? Just a few of us. But so quickly? Not even in our wildest dreams!

Nov. 16 (Bloomberg) -- Republican lawmakers in the U.S. House and Senate said they want to compel the Federal Reserve to focus solely on controlling inflation, upending a congressional mandate that’s shaped monetary policy for more than 30 years.

U.S. Representative Mike Pence, chairman of the House Republican Conference, said he plans to introduce a bill today requiring the Fed to promote price stability while no longer seeking maximum employment. Senator Bob Corker, a member of the Senate Banking Committee, backed a single mandate for the Fed, saying the Fed’s dual roles are “confusing to the market.”

The central bank is currently required by a 1977 amendment to the Federal Reserve Act to promote stable prices and full employment. The Fed’s Nov. 3 decision to buy $600 billion of Treasuries in a bid to reduce unemployment has spawned critics, including officials in China, Germany, and Brazil, and U.S. economists such as John Taylor and Michael Boskin.

Corker, who met with Fed Chairman Ben Bernanke yesterday, said in an interview today that the Fed’s dual role “can create sort of a bipolar mentality,” and that his proposal would not prevent the Fed from addressing any threat of deflation or its program to buy Treasuries.

Congress should consider setting a target for inflation because the Fed’s actions can cause “a lot of confusion for all concerned,” said Corker, from Tennessee.

“The Fed’s dual mandate has failed,” Pence, of Indiana, said in a statement yesterday. He wants the proposed legislation to be considered in Congress’s current lame-duck session, said Matt Lloyd, the conference’s communications director.

Pence joined critics yesterday after an open letter was sent by former Republican government officials and economists, asking Bernanke to halt the expansion of monetary stimulus.

“It’s time for the Fed to be solely focused on price stability and not the recently announced QE2,” said the 51- year-old lawmaker. Pence said the Fed’s second round of quantitative easing will monetize the U.S. government’s debt and ignite inflation. [...]

So basically, not only was QE2 a lot smaller than what I was expecting coming from someone mad enough to be called Helicopter Ben, but now, the Fed May Hesitate on More Easing After Critics Question Employment Mandate.

We know that QE 2 will be failure, we know markets will correct sooner rather than later — if the process hasn't started yet — and it seems like Bernanke and the Fed might be close see their ends. That day would be a tremendous victory for sound money and the freedom that it brings.

Appendices:

Here are quotes from various reports showing that opposition against the Fed is mounting.

Here's the open letter to Ben Bernanke as published by the WSJ (you can also read this other report on the WSJ):

We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.

We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.” In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.

We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.

The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.

Insane Fed Should Beware Unquantifiable Outcomes: Mark Gilbert

Oct. 28 (Bloomberg) -- Albert Einstein defined insanity as doing the same thing repeatedly and expecting different outcomes. The crazy gang at the Federal Reserve should heed those words when debating how much more market manipulation to inflict on the world of fixed income.

The worrisome thing about so-called quantitative easing -- a concept still novel enough to mean whatever the Humpty-Dumptys in central banking want it to -- is that its consequences remain unquantifiable, and the perceived need for more central-bank purchases of securities should make investors uneasy.

Fed Chairman Ben Bernanke said in an Oct. 15 speech that it’s difficult to work out the “appropriate quantity and pace of purchases and to communicate this policy response to the public.” He also said that “nonconventional policies have costs and limitations that must be taken into account in judging whether and how aggressively they should be used.”
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“Nobody understands QE,” says Fred Goodwin, a strategist at Nomura International in London. “We have no idea how inflationary it really is. A patient juiced up on QE wants to party and it does not matter what anyone says. Don’t worry about what central banks are worried about; worry about unintended consequences.”

‘Dangerous Gamble’

Fed skeptic Thomas Hoenig of the U.S. central bank’s Kansas City branch called it “a very dangerous gamble” in a speech this week. “We risk the next crisis four or five years from now.” Mohamed A. El-Erian, chief executive officer at Pacific Investment Management Co., said the bond-buying program “will have costs and unintended consequences.”
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Fed Risks Its Credibility on a Bowlful of Mush: Caroline Baum

Nov. 1 (Bloomberg) -- [...] Either the Fed is operating under a misconception about how QE2 will reduce unemployment and raise inflation, or it has failed to communicate the transmission mechanism to the public. Neither is a plus.


About the best thing anyone can say about the well- advertised and anticipated QE2 is that it won’t do much good. The worst thing is that it will inflate asset prices, which we don’t call inflation.

Because Fed chief Ben Bernanke has been unwilling to admit the role low interest rates played in puffing up the housing bubble, he sees little risk from further easing, according to Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut.

At the same time, the Fed’s output gap models, which measure the difference between actual and potential growth and were “violently wrong in 2003 and 2004,” reinforce the majority view that deflation is the real threat, Stanley says.

Then there’s the Fed’s stated tactic of raising inflation expectations to lower real interest rates, a flawed concept even though it has succeeded splendidly in the short term.

In the two months since Bernanke first hinted at QE2 in his Jackson Hole, Wyoming, speech, five-year inflation expectations, the Fed’s preferred measure extrapolated from the yield differential between nominal and inflation-indexed Treasuries, have risen from about 2 percent to 3 percent.

So taken is the Fed with the notion that higher inflation expectations are the route to salvation that it has commissioned research on the subject. Last month, three Fed Board economists published a paper claiming that with overnight rates near zero, an oil price shock would be a plus for growth.

The “burst of inflation” from an increase in oil prices stimulates interest-rate sensitive sectors of the economy, the authors claim. (Aren’t higher oil prices a relative price increase unless the Fed prevents other prices from falling?) “In fact, if the increase in oil prices is gradual, the persistent rise in inflation can cause a GDP expansion,” they write.


Where are the speculators when you need them?

Ten years ago I wrote a column titled, “Fed Chairman Ali Naimi Has a Nice Ring to It,” referring to Saudi Arabia’s oil minister. The piece debunked the idea that oil prices can do the central bank’s job.

Maybe I was wrong. If you believe the research, we should be rooting for one of those old-fashioned oil shocks, circa 1973 and 1979, to fix what ails the U.S. economy!

Raising inflation expectations to lower real long-term rates has two flaws. First, it assumes nominal rates don’t move. (The nominal rate consists of a real rate plus a premium for expected inflation.) Nominal rates could easily rise in sync with inflation expectations, leaving real rates unchanged.

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The good news is he’s got plenty of fuel. The bad news: His only rations are gruel.