The Fed didn’t announce QE2
Fortune published an op-ed piece by Keith R. McCullough at Hedgeye (h/t to my Mom). He argues (not very well, I might add) that QE2 is the doomsday scenario for “markets”.
I’d like to point out the following (mostly because this is a common mistake): what the Fed announced is NOT QE2. Furthermore, the Fed’s been considering investing options for months now, why the shock and awe treatment from markets?
Here are the FOMC’s announced investment intentions:
…the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.
The Fed announcement is NOT a second version of quantitative easing (QE2). Quantitative easing is a “super” policy response, where the Fed grows its balance through reserve creation and the purchase of (usually) government assets.
The Fed is reinvesting the principal of maturing securities into longer-dated Treasuries from reserves already created. Therefore, the Fed is simply shifting the asset side of the balance sheet toward a Treasury-only portfolio. Reinvesting maturing Treasuries is regular practice for the Fed. No new quantitative easing.
The announcement should not have been a surprise; it wasn’t to me. According to the FOMC minutes, the Fed has been considering investment options regarding the principal of the maturing securities for months now. From the June 22-23 FOMC minutes:
First, the Committee could consider halting all reinvestment of the proceeds of maturing securities. Such a strategy would shrink the size of the Federal Reserve’s balance sheet and reduce the quantity of reserve balances in the banking system gradually over time. Second, the Committee could reinvest the proceeds of maturing securities only in new issues of Treasury securities with relatively short maturities–bills only, or bills as well as coupon issues with terms of three years or less. This strategy would maintain the size of the Federal Reserve’s balance sheet but would reduce somewhat the average maturity of the portfolio and increase its liquidity.
The Committee decided to go with the second strategy, but in an altered form: reinvest the proceeds of maturing securities to maintain both the size of the balance sheet and the average maturity of the portfolio. And a few members favored the Fed’s August announcement:
A few participants suggested selling MBS and using the proceeds to purchase Treasury securities of comparable duration, arguing that doing so would hasten the move toward a Treasury-securities-only portfolio without tightening financial conditions.
So you see, the FOMC announcement to buy longer-dated Treasuries is not QE2; is not a surprise; and for reasons that I did not describe here, doesn’t portend economic collapse (see this policy brief, or the working paper, by Randy Wray and Yeva Nersisyan, where they refute the application of the Reinhart and Rogoff findings).
Rebecca Wilder
So call this QE-2 Lite. It is still QE.
The Fed has been telling us for a year it has an exit strategy. One of those was to let its book run off as things matured. This would have reduced the Feds balance sheet. It would have been the right thing to do.
But now they are going in the opposite direction. They are buying Treasuries. They are funding the deficit with printed money. This will end very badly. It will destroy everything that we think is important to our economy and our way of life. It will make us poor. It will will take at least a decade to recover from.
History will show that we started QE2 this week. From there the Fed will advance this in incremental steps. The only thing that will stop the Fed from this insanity is if the markets reject what they are doing and just collapse. This would force Ben B to wake up and realize that without confidence there is no hope for a true economic recovery. If Ben does not listen and doubles his efforts you will see equity markets fall by 30%. It will happen fast. When that happens we will have a depression that will look much like the 30’s.
Ben’s trying to save us with QE 2. I think he will kill us instead.
I see it as more of a holding pattern or a “wait and see” strategy. They maintain the size of the Fed’s balance sheet, shift the composition slightly from MBS to Treasuries, and push down the long end of the Treasury yield curve a bit, while they continue to monitor economic conditions.
I don’t see where Bruce is coming up with this catastrophic ending. The more likely outcome, IMO, is a repeat of Japan’s experience – a decade or more of slow growth, high unemployment (without Japan’s social arrangement that limited it there), mild deflation, and constantly slipping in and out of recession.
The Fed isn’t adjusting to the fact that we need more stimulus, not a holding pattern. Stronger QE and other measures are required. As Rich says we’re looking at the Japanese experience. Financial institutions need to write down their bad debts, restructure, and get on with it. These assets are an anchor on the economy and keep us in place moving neither forward or backward. The result is reduced expectations reflected in lower PEs for equitites and lower long term rates. With these financial forces in place, only the government, however inefficient, can stimulate real value in the economy through greater involvement of labor rather than just more capital.
Marshall Auerback says it well: “We’re spending all of our time trying to avoid ‘becoming like Greece’ and in doing so, we are becoming more like Japan.”
See this YouTube video of Richard Koo at the INET conference in May. He makes some very interesting points in the last 10 minutes of the talk.
Basically, policymakers can zig-zag around what needs to be done: allow the private sector to deleverage. And while the private sector deleverages, the public sector must leverage up. If the government tightens too early, then GDP will fall.
Rebecca
Bruce,
In order to qualify as QE, what the Fed is doing ought to involve E. It doesn’t. The Fed is not easing. It is avoiding tightening.
Rebecca,
Asha Bangalore has offered a nice solution to the nomenclature problem. The Fed is engaged in QN. N is for “neutrality”, I think. Or may N is for “neutralizing”. It’s not for “nothing”, though that is a reasonable option.
The excess reserve number is still huge. If the fed allowed their balance sheet to roll off like they said they would as the “slow motion” part of the exit strategy, it would reduce excess reserves and would have no practical effect on monetary stimulus, same as doing QE had little effect.
The proper name would be Quantitative Excess part 1 and part 2
Now if there was some reason to buy long term securities, that they did.
But some day if inflation perks up and they want to withdraw liquidity in a hurry, it works less well because the price of your long term securities get nailed and the fed doesn’t get all the “money” back.
The name for this should be Quirky Exit.