Sunday, December 5, 2010

A Primer on QE2 - Alpha

What is QE2?
QE2 is a second round of quantitative easing (“printing money to buy high-quality bonds”) by the Federal Reserve System (“Fed”), America’s central bank. It’s the world’s biggest spending spree. The Fed announced after the mid-term elections, on Nov. 3rd, that it would buy $600 billion in long-term Treasuries over the next eight months. The Fed also announced it would reinvest an additional $250 billion to $300 billion in Treasuries with the proceeds of its earlier investments (QE1). If the Fed were to print money to buy lower-quality securities like stocks or REITS, that would be both quantitative and “qualitative” easing. Economics like to use big words to hide outrageous actions.

What is the Fed?
The Fed is America’s central bank; it is the bank where every other bank stores their “reserve” deposits. The Fed’s main goals are to keep inflation low and unemployment low. These goals often conflict. For example, one easy way to create jobs in the past has been to print a lot of money and boost the economy in the short run; in the long run, this extra money chases a fixed supply of goods and services, creating inflation. Most central banks are just supposed to keep inflation low (prices rise within a 1% to 3% annual level); they have no jobs goal. The Fed also has other goals like: ensuring the financial system is stable and doesn’t collapse; regulating banks and mortgages; controlling the money supply and how much banks in the US lend. Only the Fed has the power to print money in the US; even President Obama could not do it to buy dresses and helicopters for Michelle and the kids (though he appoints the Fed Chairman and board).

Wikipedia entry on the Federal Reserve System:
http://en.wikipedia.org/wiki/Federal_Reserve_System

Meltzer’s Multi-Volume History of the Fed:
http://www.amazon.com/History-Federal-Reserve-1913-1951/dp/0226520005

Why is the Fed doing QE2?
It means the Fed is printing money because it has two worries. First, the Fed says it is worried about deflation, that is, falling prices. This is nonsense because prices have been rising between 1-3% in the last year (as the chart below shows, prices only briefly fell in mid-2009). Second and more importantly, the Fed says it’s worried about high unemployment, about 10% in the US (16-17% by some broader measures, like the U-6). Yet the Fed is disingenuous since few economists think that QE2 will create jobs (though many think it can act as insurance to keep more jobs from being lost). See the discussions by Fed Chairman Bernanke and NY Fed President Dudley here where they justify QE2.

Bernanke’s Speech on QE2:
http://www.federalreserve.gov/newsevents/speech/bernanke20101015a.htm

Dudley’s Speech on QE2:
http://www.ny.frb.org/newsevents/speeches/2010/dud101001.html

Does the Fed actually print money? Where can I get some of this cash?
No, the Fed creates money electronically, at the touch of a button; it doesn’t need to print cash. After the 2008 crash, the Fed created a lot of money (over a $1,200 billion, over a trillion dollars!) to buy “agency securities”, which are basically bonds backed by mortgages and a US government guarantee on top. This was QE1 and it was done to support the economy and the housing markets. In quantitative easing, the Fed creates money electronically and then buys high-quality bonds such as US Treasuries or agencies. This reduces the supply of high-quality bonds and forces investors to buy other assets, which tend to be lower-quality and riskier. The Fed’s actions are one big reason that stock markets in the US took off after May 2009. Anytime the Fed prints money to buy bonds, its balance sheet (a financial statement showing what it owns) gets bigger.

The Fed’s balance sheet (H41):
http://www.federalreserve.gov/releases/h41/current/

Fed Official Sack Explains the Fed’s Balance Sheet: http://www.ny.frb.org/newsevents/speeches/2010/sac101004.html

If I can’t get the cash and QE2 probably won’t create jobs, why is the Fed really doing this?
Informed observers are speculating on the Fed’s real reasons. First, QE2 acts as insurance and makes the odds of a “double-dip” second recession less likely. This would prevent more jobs from being lost. Second, QE2 puts more dollars into the global financial system and basically lowers or “depreciates” the value of the dollar compared to other currencies like the Euro. A “cheaper” or “weaker” dollar helps boost the US economy and US exports, but hurts foreign countries who then have a “dearer” or “stronger” currency. Third, the US federal government is running large fiscal deficits. This means the government is spending much more than it raises in taxes. When it does that, the government has to go to the markets to sell US Treasuries to raise money, just like any other large borrower. The easiest person to sell Treasures is to the Fed because the Fed can print money and pay for it that way. The US government needs to raise hundreds of billions of dollars every month, and the Fed has now committed to buying about $60 billion every month.

US Government Borrowing Announcement: http://www.treasury.gov/offices/domestic-finance/debt-management/quarterly-refunding/11-1-2010/Sources%20and%20Uses%20-%20November%202010%20Borrowing%20Announcement%20%282%29.pdf

Why are foreign governments so angry about the Fed doing QE2?
Foreign governments are angry for two reasons. First, they (correctly) think the Fed is starting a “currency war” by making the dollar cheaper. A cheaper/weaker dollar makes the US economy grow more strongly, but saps the strength of foreign countries like China, Japan, Germany, and Korea, since their currencies become more expensive and so their exports fall. Second, the Fed is devaluing or cheapening some country’s holdings of US Treasuries. For example, more than half of all privately-held US debt is held by foreign countries (it was as high as 61% in June 2008)! Analysts estimate China itself owns over a trillion dollars in Treasuries, with Japan holding nearly half a trillion. When the Fed weakens the dollar with QE2, it is basically making these countries poorer. It also adds rocket-fuel to the fiery price of gold.

Largest Foreign Holders of US Debt (2005): http://www.frbsf.org/education/activities/drecon/answerxml.cfm?selectedurl=/2005/0507.html

Largest Foreign Holders of US Debt and all US Securities (2009 TIC Report):
http://www.treas.gov/tic/shl2009r.pdf

What are the long-term consequences of what the Fed is doing?
As I’ve written about before, the big macro problem the US (and much of the rich, Western world) faces is too much debt at all levels of society, especially government debt. Congress in the US is deadlocked and can’t implement the optimal solution (stimulus through tax-cuts and/or spending in the short run coupled with a deficit reduction plan in the long run). Hence the Fed is doing the best it can to prevent a double-dip recession, weaken the dollar, and meet the excessive borrowing needs of the US government. It is effectively the only responsible, functioning part of the US government. Given the lack of decisions from Congress, the Fed is taking the “least painful” or “least worst” path, given a very bad set of options.

Eventually, the Fed will want to start selling the bonds it has bought to shrink its balance sheet again. However, there’s a high chance that will cause financial instability or “an extreme market reaction associated with the Fed's exit from potential purchases”, as the TBAC (an expert panel advising the US government) notes. If the reaction is too intense, the Fed won’t be able to “exit quantitative easing”, “reduce its balance sheet,” or “sell the bonds it bought” (all the same thing). That means that the money it printed is here to stay and whenever the US economy starts to grow strongly again, there’s a high probability that inflation will return and be high (above 5%). The Fed itself explains in a “goals” page why high inflation is bad (high inflation hurts economic growth, makes decision-making hard by people and businesses, hurts the tax system, and redistributes wealth).

US Government Debt Position and Activity Report:
http://www.treasurydirect.gov/govt/reports/pd/pd_debtposactrpt_0910.pdf

Minutes of the latest TBAC Meeting (Q4 2010, on Nov. 2nd, 2010)
http://www.ustreas.gov/press/releases/tg942.htm

The Fed on its Goals and Why Inflation is Bad:
http://www.frbsf.org/publications/federalreserve/monetary/goals.html

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