The Enchanted Quantitative Easing

Dear Readers,

Hawks and Doves do not produce a harmonious melody if they all sing at the same time. This has been clearly demonstrated when the Federal Reserve decided to implement quantitative easing (dubbed as QE2). Since then, markets have been subjected to a cacophony of conflicting speeches by members of the FOMC – from Thomas Hoenig of the Kansas City Fed calling looser policy a “dangerous gamble”, to Charles Evans, of its Chicago counterpart, saying that “much more policy accommodation is appropriate today”. Quantitative easing is unloved and deeply unappreciated. The sky is falling you may scream: the FED is pouring forth dollars in such quantities that they will soon be worthless. And its not far from the truth. Things could start getting pretty ugly for the financial world for the coming months.

Under QE2 the Fed buys long-term bonds with newly created money. This lowers long-term yields and chases investors into riskier, alternative investments. The real yield on ten-year, inflation-indexed Treasury bonds has fallen from 1.05% to 0.5%, a result of relatively flat nominal yields and a rise in expected inflation. The yield on their five-year cousins is negative. Share prices are up by 14% in the same period. Lower yields make the dollar less appealing: it has duly fallen by 5% against the Japanese yen, by 9% against the euro and by 5% on a trade-weighted basis “.

The truth is that many economists fear that an out of control Federal Reserve is "crossing the Rubicon" by announcing another wave of quantitative easing. Have we now reached a point where the Federal Reserve is simply going to fire up the printing presses and shower massive wads of cash into the financial system whenever the U.S. economy is not growing fast enough.

If so, what does the mean for inflation, the stability of the world financial system and the future of the U.S. dollar? The Fed says that the plan is to purchase $600 billion of U.S. Treasury securities by the middle of 2011. In addition, the Federal Reserve has announced that it will be "reinvesting" an additional $250 billion to $300 billion from the proceeds of its mortgage portfolio in U.S. Treasury securities over the same time period. So that is a total injection of about $900 billion. Perhaps the Fed thought that number would sound a little less ominous than $1 trillion. In any event, the Federal Reserve seems convinced that quantitative easing is going to work this time. So should we believe the Federal Reserve?

Federal Reserve has tried this before. In November 2008, the Federal Reserve announced a $600 billion quantitative easing program. Four months later the Fed felt that even more cash was necessary, so they upped the total to $1.8 trillion.

So did quantitative easing work then?

No, not really. It may have helped stabilize the economy in the short-term, but unemployment is still staggeringly high. Monthly U.S. home sales continue to come in at close to record low levels. Businesses are borrowing less money. Individuals are borrowing less money. Stores are closing left and right.

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he Fed is desperate to crank the debt spiral that our economic system is now based upon back up again. The Fed thinks that somehow if it can just pump enough nearly free liquidity into the banking system, the banks will turn around and lend it out at a markup and that this will get the debt spiral cranking again.

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.

So will $900 billion be enough to get the debt spiral cranked up again?

Not really

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f 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. The damage is just too vast as Charles Hugh Smith recently explained....

Anyone who believes a meager one or two trillion dollars in pump-priming can overcome $15-$20 trillion in overpriced assets and $10 trillion in uncollectible debt may well be disappointed.

In fact, economists over at Goldman Sachs estimate that it would take a staggering $4 trillion in quantitative easing to get the economy rolling again.
Of course that may eventually be what happens. The Fed may be starting at $900 billion just to get the door open. 

To be continued .... 

Yacine Dessouki