Published by WallStreetWeather.net
Contrary to a post I wrote last month outlining why I thought Bernanke was bluffing about starting another round of quantitative easing (QE), the Federal Reserve announced Wednesday it intends to purchase an additional $600 billion in “longer-term” Treasuries between now and June 30, 2011. This does not include its ongoing Treasury purchases reinvesting agency debt and MBS.
Both the FOMC statement and an op-ed piece in Thursday’s Washington Post by Fed Chairman Bernanke explaining that another round of QE is necessary to help the Fed fulfill its dual mandate to “promote a high level of employment and low, stable inflation.” In the most blatant acknowledgement yet of the Fed’s intentional use of the wealth effect, Bernanke wrote that “higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”
But deep reflection and inspiration derived from an article in the November 1 issue of Bloomberg Businessweek has led me to conclude that the Fed is using their dual mandate as a smokescreen for currency manipulation.
In “The Keynes Solution,” Peter Coy outlines three options the US could engage in to correct chronic trade imbalances without resorting to retaliatory measures that could spark a trade war with China. While the Obama Administration is against imposing trade barriers outside of the WTO (option #1), monetary policy has already devalued the dollar (option #2), and appears to be launching QE2 as a vehicle to secretly implement option #3. This would force our trading partners to spend their dollars on U.S. goods, services, or mortgages instead of buying Treasuries. The more Treasuries the Fed is holding on its balance sheet, the fewer Treasuries will be available for both domestic and foreign investors to purchase.
Since all dollars will eventually have to be spent or invested in the U.S., the Fed is using QE2 to transform our trade imbalances to productive economic uses of capital. If the Fed’s goal is to maintain its balance sheet of between $2 and $3 trillion primarily in Treasuries, that amounts to $2-3 trillion less available for foreigners to purchase. In essence the Fed is trying to control how trade surpluses are being spent by China and our other large trading partners.
QE1 (March 2009 – March 2010) was different as only $300 billion consisted of Treasuries. With QE2 comprised solely of Treasuries, the Fed is “cornering” the market, restricting China and other countries to spend their excess reserves in the U.S. economy.
Since Bernanke knows that further fiscal stimulus is not politically feasible (especially in light of Tuesday’s midterm election results) and the Treasury’s plan to cap surpluses at 4% has fallen on deaf ears, the Fed is using QE2 to force China to provide the stimulus. The Fed is sending an under the table message to the Chinese government that says you didn’t raise the value of the yuan, so we will use QE2 as a weapon to wreck your economy and force you to buy American, lowering our trade deficit with you.
As an additional side benefit, QE2 helps the deficit. It amounts to an interest free loan since the Treasury pays interest to the Fed on its bond purchases and then the Fed turns over its profits to the Treasury.
If the Fed wants to increase employment and spending, QE2 is not the right vehicle to do it. According to calculations by Macroeconomic Advisors LLC, even if the Fed ended up buying $1.5 trillion in Treasuries it would only lower the unemployment rate 0.2% by the end of 2011. And even that might be too optimistic since economic growth normally is accompanied by an increase in the money supply.
The Fed is not increasing the money supply when it conducts QE because individuals and businesses who want credit don’t qualify. Those who do qualify don’t need additional credit as they are trying to deleverage from the previous Fed supported housing and asset price bubbles. The Fed’s traditional means of spurring economic growth is to lower interest rates to spawn speculation which causes asset bubbles. This creates more collateral “value” to expand credit. But this time is different because so far the Fed has been unsuccessful in expanding the money in circulation through either traditional or untraditional means.
The only way the Fed could help to increase employment would be by partnering monetary policy with fiscal policy. One idea would be for Congress to pass a major infrastructure spending bill that is “paid” for by the Fed monetizing the corresponding debt.
The Fed claims that inflation is too low. Yet the unfortunate irony is that price inflation without wage inflation will only end up reducing demand. Bernanke has the chicken and the egg reversed since excess capacity in the labor market will prevent wage growth even in a price inflationary environment. Creating wage inflation would require Congress increasing the minimum wage. And Bernanke knows that idea would be D.O.A.
Increasing economic growth could better be achieved through regulatory measures than through QE. Bernanke writes that QE1 “had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation.” Since Bernanke is telling us that QE1 did not work as the velocity of money did not increase, why embark on QE2 unless there is a hidden agenda at work?
If the Fed wanted to help expand credit, it could eliminate the 0.25% interest it pays on excess reserves sitting at the Fed as well as establish limits on the amount of excess reserves banks can keep there. University of Massachusetts economist Robert Pollin has proposed a 1-2% tax on the estimated $1.1 trillion in excess reserves. However, as the bank regulator the Fed has to carefully balance the potential economic benefits of these options with banks taking excess risk.
The myth that QE is devaluing the dollar is contradicted by the sterilization of QE by excess bank reserves held at the Fed. The fall of the dollar and the rise of gold are the result of ultra low interest rates and speculation. Inflation won’t occur until the actual amount of currency in circulation increases. Therefore, the only thing that Bernanke is aiming to achieve is to remove the risk free option from both foreign and domestic investors.
The commodity inflation that has evolved is actually reducing demand due to a lack of wage inflation. Unlike the 1970s wage/price inflation spiral, globalization has capped the ability of labor to keep up with price inflation.