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28 June 2011
Before jumping into some implications of the second round of Quantitative Easing (QE2) that you have likely been hearing about, we wanted to point out a quick planning note. If you did not take advantage of the historically low mortgage rates this winter by refinancing at that time, rates have recently dropped again to the lowest levels this year. If you would like to take another look at pursuing a refinance, please let us know and we would be happy to discuss with you, work with your existing lender to figure out your options, and / or introduce you to one of our mortgage resources.
The following article discusses the implications of QE2 ending. Due to the nature of the subject, we realize that the content may be a bit lengthy and heavy for some of you. If that is the case, we close with some brief thoughts, so you may want to skip ahead. For those of you who follow the economy closely, however, we wanted to be sure to provide some insight as the program draws to a close.
President Obama's speech on Afghanistan collected most of the headlines last week, but Fed Chairman Ben Bernanke's press conference the same evening was, economically speaking, every bit as interesting. Among other things, Bernanke made it clear that the Fed was ending a widely-publicized initiative known as QE2, more formally referred to as the second round of quantitative easing by the U.S. Central Bank.
Some of you may have read dire headlines telling us that without QE2 - or a new QE3 - the economic recovery will stop in its tracks and the stock market will go into a tailspin. Elsewhere, you may have heard grumbling that QE2 has set the stage for bouts of future inflation.
People should feel free to panic if they want to, but let's take a moment to step back and really understand what they're panicking about.
Put yourself in the shoes of Bernanke back in November. You settle into a comfortable chair behind a very large desk, look at a bunch of economic reports and realize that the economy is still growing very sluggishly. You notice (not for the first time) that unemployment remains way too high. So you reach for your normal stimulus tool - the Fed Funds Rate, which, simply put, sets the rate at which banks make short-term loans to other banks.
If you lower these rates, then banks can offer lower interest rates to their individual and corporate customers and still make a profit (hence the record low rates for mortgages and equity lines today). Theoretically speaking, providing companies with access to cheap money will allow them to go out and build factories, hire new workers and report higher profits to people who might want to buy their stock. Individuals, in turn, would then have more dollars to spend and can either buy or refinance their homes with more affordable payments. Better yet, when money markets and bonds are paying next to nothing, it tends to drive money off the sidelines into what are known as "risk assets" - higher-yielding corporate bonds and stocks, causing the market to go up and making it easier for companies to raise capital. And so the theory goes...
So, as Fed Chairman, you reach for your handy Fed Funds rate instrument, and you realize that it is already down in the 0% to 0.25% range. At 0%, your central bank is giving away money. Any further reduction literally results in the Fed paying banks to borrow from it. As such, your normal method of stimulating the economy has gone about as far as it will go.
At the same time, you notice (courtesy of the Sratfor Global Intelligence Service) that some of America's global competitors are openly manipulating their currencies to gain an unfair advantage in the export markets. The report notes that Japan hoped to pull out of its post-recession malaise by intervening in the global currency trade, actively driving down the value of the yen. Brazil and South Korea were following a similar tactic. Germany, another major export economy, was benefiting from the weak euro--the result of the European debt crisis.
As all of these currencies weakened against the dollar, the manufactured products of Japan, Germany, Brazil, Korea and others were priced ever-more attractively to American consumers. The more they sell, the more money is diverted from the U.S. economy into theirs.
So here you are, sitting in the Fed Chairman's office, looking around for a way to do two things at once: stimulate the U.S. economy with a new tool that hasn't been used before, and simultaneously fire a warning shot across the bow of those exporting nations who are busily trying to pull themselves into recovery on the back of the U.S. economy.
Your solution - the Fed's QE2 initiative - is simply an announced commitment to purchase $600 billion worth of U.S. Treasury securities over the eight months from last November through the end of June 2011. It is important to note two key words at this point - "announced commitment". The US Federal Reserve does not "normally" make announced commitments.
We must also acknowledge that Treasuries are sold at auction. Everybody who wants to lend the government money submits a bid for how much interest they are willing to accept. Theoretically, the more bidders, the lower the rates. As such, QE2's first impact was to push down the rate at which the government borrows money, which has the nice side effect of reducing the government's debt burden.
If you have a little free time, you can go to a web site called Treasury Direct, and look at the weekly amounts of Treasuries that our government puts up at auction (The weekly press releases can be found here). You'll find that the government borrows about $28 billion a week in 4-week T-bills, another $27 billion a week in 90-day T-Bills, $24 billion a week in six-month bonds, $24 billion a month in one-year Treasuries, and...well, by now you probably realize that $600 billion spread out over eight months is not likely to tip the overall supply/demand numbers dramatically. Consider it a nudge in the right direction.
But QE2, plus the threat of additional future intervention in Treasury rates, had a remarkable effect on those exporting nations. Within days of the original QE2 announcement, the Wall Street Journal was quoting finance ministers and economists from Brazil, France, Korea and Germany, all criticizing the purchase and calling for an immediate cease fire in the currency wars. Meanwhile, as Treasury rates drop a little (and speculators worry that they could drop a lot), the dollar begins falling against foreign currencies, putting a little wind at the backs of U.S. exporters, and in the face of foreign imports.
This is another critically important note. While we aren't advocating for a declining dollar, the "cheaper" the U.S. dollar gets, (a) the less expensive our goods and services get to other countries, and (b) the less expensive it gets for companies to produce goods and services in the U.S. That's one reason why QE2 is considered a stimulus measure.
Another reason this is considered stimulus has to do with liquidity in the U.S. economy. Whenever the Fed purchases anything, it is effectively replacing buyers of Treasuries, who will, in turn, have to put their investment capital into something else (like stocks or steel mills). Once again, however, we are talking about more of a nudge than a hard shove. It is helpful to remember that the U.S. GDP - the value of all goods and services produced in a year - is currently running at about $14.3 trillion a year. A $600 billion infusion would probably be enough to stimulate your own personal lifestyle, but to the American economy, it represents a highly-visible, highly-publicized drop in an extremely large bucket.
Nor is QE2 likely to spur new rounds of inflation - at least, not by itself. As Stratfor pointed out last November, creating $600 billion in eight months is not dramatically different from the Fed's normal actions in managing the money supply. With $8 trillion in circulation, QE2 didn't suddenly make dollars dramatically more plentiful. Furthermore, the Fed also stated that it will continue to buy Treasuries with proceeds of the maturing debt, which would amount to "purchases of as much as $300 billion of government over the next 12 months without adding money to the financial system."
So what will be the effect on the economy now that QE2 is over? The bottom line here is that QE2's effect may have been more powerful psychologically (inflation worries, exporting nations backing down, and current fears of a double-dip if the Fed stops purchasing Treasury debt) than its actual effect on the economic landscape. If you're the Fed chairman, right now you're probably surprised that your newest policy tool stirred up so much excitement. And more than anything, you're probably also surprised that whoever writes those headlines would think that such a small (but creative) nudge could possibly be the primary reason the U.S. economy is climbing its way out of the Great Recession.
Sources:
Press conference: http://www.guardian.co.uk/business/richard-adams-blog/2011/jun/22/ben-bernanke-press-conference-live
Forex report: http://www.forex.com/post?SDN=43b28e1d-6a13-4d21-a0b4-80a9aad87d81&Pa=20db1fa6-e674-420c-9a87-2ee29261d638
Blackrock report: http://4150326.polldaddy.com/s/advisor-perspectives-end-of-qe2
Stratfor analysis: http://www.stratfor.com/memberships/175231/geopolitical_diary/20101103_washingtons_warning_shot_currency_front
U.S. money supply: http://en.wikipedia.org/wiki/Money_supply
Size of the U.S. economy: http://en.wikipedia.org/wiki/Economy_of_the_United_States
Wall Street Journal articles about the Fed's repurchase: http://online.wsj.com/article/SB10001424052748704353504575596203544367856.html
Making Sense out of Nonsense
