Friday, July 29, 2011

QE3 and debt ceiling - Ari Paul

A month ago, Bernanke hinted at a possible third round of quantitative easing in response to weak employment and manufacturing data. It's just a hint for now but he appears more open to the idea than most pundits expected. It was this hint that sent gold and silver flying and provided broad support to most risk assets.

With QE1 and QE2, the Federal Reserve was the effective buyer of 95%+ of new mortgages and 100%+ of new treasury issuance; this kept interest rates low and prevented further declines in housing prices. The fed purchased these massive quantities of securities directly from the big banks at prices above market value, thus generating quick profits for the financial sector at the expense of taxpayers. The flood of cash also helped prop up commodity prices and trickled into just about every risk asset on the planet.

Most pundits believe a third round of quantitative easing is unlikely for political reasons, but most (myself included) were saying the same thing about QE2. A month ago, Bernanke hinted at a possible third round of quantitative easing in response to weak employment and manufacturing data. It's just a hint for now but he appears more open to the idea than most pundits expected. It was this hint that sent gold and silver flying and provided broad support to most risk assets.

The second key theme has been the US debt ceiling. I believe the risk of the US entering a state of actual default to be exceptionally low, but the market is hoping for a sustainable solution in the next few days. A good primer on the issue can be found here. The assumption, probably accurate, is that a solution that produces a sustainable long-term budget will result in a significant short-term equity rally. However, spending cuts and tax increases directly reduce GDP. To illustrate the point - an immediate reduction in government spending of 10% would induce an immediate recession. Admittedly, any plan will reduce spending gradually, spread over a long time period. Bulls can also argue that the greater certainty and confidence in US finances will promote corporate spending and hiring (a practical version of Ricardian Equivalence). Many business leaders have taken to bullhorns lately to explain that they are hoarding cash because they are worried about the unsustainable deficit; perhaps a resolution will loosen their purse-strings.



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