The Bennett Newsletter
Any reader of the American media will discover that a second round of quantitative easing (QE2) is a done deal. The only question is how much the Fed will spend.
There is a conspiracy of silence on QE2 and I question the alleged motive of reducing unemployment. I wonder if its real purpose is to surreptitiously boost the stock market, as it has been doing since August.
US policy is obviously to increase aggregate demand in order to get business moving and increase employment. The strategy adopted is QE. This has been adopted despite no evidence that the first bout helped to reduce unemployment. Nor was it effective in Japan.
It is a dangerous strategy because it is an experiment, and experiments on this scale can bring catastrophe to the world. It is opening the floodgates of inflation and it is going to raise the price of all commodities, enhance a currency war, and perhaps set off a series of bubbles.
I have two further major reservations. First, I believe that statesmen should always have a plan b. If one strategy starts to fail, one should make tactical adjustments or give up reinforcing failure and revert to a second strategy. QE has no plausible successor. When it finishes, and it must finish sometime, it could still leave the US in the grip of deflation, while inflicting massive problems upon the world.
QE is going to use enormous financial resources and add to Federal liabilities. It now has an enormous balance sheet, and the US has rapidly escalating debt. There are no more shots in the locker: this is an all-or-nothing initiative.
My second point is QE2 is a unlikely way of ‘reducing unemployment’: perhaps more effective and cheaper measures can be attempted. Interest rates are already set at zero and lowering longer-term interest rates is an expensive and ineffective indulgence.
So what is in it for the Fed? The promise/threat of QE2 is lifting the stock market in an election year and increasing a sense of well-being in the US as so many pension plans are linked to Wall Street. Therein is the real target: the S&P 500. QE2 is about the stock market.
I believe the Fed is desperately anxious to raise the stock market and will argue that it has been intervening frequently since August.
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QE2 claims
QE2 is designed to lower long-term interest rates to encourage business to borrow and consumers to spend. Consumers have dis-incentives to save as deposit rates and bonds will have negligible nominal returns and perhaps real negative returns if inflation sets in.
It is perplexing that this massive undertaking, with an optimal outcome of a small lowering on already record low interest rates, will be undertaken without a cost-benefit analysis.
Bernanke makes much of his dual mandate to maintain employment and price stability. He wants inflation of close to 2% and unemployment closer to its long-run average of 5%. He confesses that: “Whereas monetary policy makers clearly have the ability to determine the inflation rate in the long run, they have little or no control over the longer-run sustainable unemployment rate, which is primarily determined by demographic and structural factors, not by monetary policy”. So Bernanke is confessing that monetary policy is a poor tool for increasing employment. But it is a good tool for boosting the market.
Supercharging Wall Street
The Stock market is in a period of exceptional gains. The return for the last quarter was 13% on the world index. Wall Street had its best September since 1939. There is a hidden hand at work. The market was worried in July and the best returns came from dividend paying stocks with predictable earnings. Concerns about a double-dip mounted in August, and markets turned negative. Chartists were predicting “Armageddon”. But The Fed saved the situation by talk of QE. A new bull market erupted.
The new market favoured cyclical rather than defensive stocks. Risky fixed income also benefitted. The Barclays Capital high yield Index, for example, rose 6.7%. Stocks and fixed interest made as much in a few weeks as they might in a good year.
Commodities also soared on the back of a supposedly improved outlook. Oil gained significantly, but so did most metals, some fertilizers, foods (wheat and corn) and soft’s, especially cotton and coffee.
Gold was the markets non-verbal verdict on QE. It zoomed in the sure knowledge that the dollar was no longer a reasonable store of value. The market knew that Bernanke wanted a lower dollar to stimulate exports and import inflation. The US dollar plunged against many currencies: by 10% against the euro, and about 5% against the Kiwi in September alone.
Needless to say this is perceived as a competitive devaluation carried out unilaterally, rather than in co-ordination with G20. The EU, Japan and China deeply resent it, as do Kiwi exporters. The thought arises that the US is using QE to devalue. That is possible, and it is also compatible with creating inflation to ease the US’s excessive debts.
Stock market boost
The Dow increased by 7.7% in September because the Fed pumped in about $20 billion each week. This is not admitted, but is deductable. If one examines volumes it is clear that August and September had daily volumes of about 900,000 shares which is half that of the genuine bull market earlier this year.
The market has been very calm, with the VIX moving down to 15. The market has been very unusual with relatively few shares making new highs. Normally a bull market has a high number of new highs. If ones examines daily markets the pattern is that the market opens strongly. This can be interpreted as the Fed taking out the short sellers, and this opens the way for hedge funds, algorithms and black boxes to get involved. (Complex systems account for 70% of trades). If the market falters, there is a burst of buying. This does not drive up the market for long, and a new wave of buying occurs.
The buying seems to be coming from the 18 Primary dealers (which includes Goldman Sachs, JP Morgan etc) who take the capital from maturing treasuries into the stock market.
Bernanke’s helicopter drops are dangerous in eroding value and giving the big traders easy gains by going long on shares and commodities and short on the dollar.
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