The Problem With QE2
Economic growth remains extremely subdued and a double dip is still a strong possibility. In the first 4 quarters of the current recovery ended June 30th, GDP increased at a rate of 3% annualized, compared to an average of 5.9% in previous post-war expansions. Furthermore the rate of growth in the 4th quarter of the recovery (the 2nd calendar quarter) tapered off to a mere 1.7%, compared to 5.9% in the fourth quarter of prior upturns. This is even weaker than apparent at first glance since a full 60% of the growth was accounted for by a turnaround in inventories with only 40% coming from final sales.
The problem now is that the inventory thrust is on the verge of petering out with no other drivers working to sustain the economy. After the garden-variety recessions common in the post-war period, economic recoveries were sparked and sustained by inventories, housing, employment, consumer spending and widely available credit. This time around only the inventory turnaround has worked while the four other factors are too weak to make substantial contributions.
By summertime the Fed realized that the green shoots that it previously expected to flower into a normal expansion was failing to take root and that more help was needed. With the political climate making any further fiscal stimulus highly unlikely, in August Fed Chairman Bernanke began floating the idea of a second big round of quantitative easing (QE2), an initiative that is widely expected to be announced following the next FOMC meeting on November 3rd. The anticipation of the announcement has sparked rise in stock prices, a decline in bond yields, a drop in the dollar, a jump in commodity prices and a belief by investors that a double dip in the economy would be avoided.
In our view QE2 is unlikely to be of much help, and, in addition could have unintended negative consequences. Between the Administration, Congress and the Fed, we have already witnessed massive stimulus in the form of TARP, budget stimulus, $1.7 trillion of Fed purchases of Treasuries and mortgages, the auto industry bailout, cash for clunkers, the homebuyer tax credits, extended unemployment benefits and near-zero interest rates. All of that has so far resulted in an exceedingly weak economic recovery that is showing signs of unraveling as growth remains below stall speed.
The supposed purpose of QE2 is to lower long-term interest rates even further and increase the amount of bank reserves in the hope that some of it will find its way into the economy and spur sustainable growth. The problem is that long-term rates have already come down from a high of about 4% in April to a historical recent low of 2.4%. It is thereby unlikely that another decline of perhaps another 50 basis points will really make much of a difference. As for increasing bank reserves, we note that excess reserves are already close to $1 trillion and corporations are sitting on piles of cash.
The problem is that what’s holding down the economy is not related to high interest rates or lack of liquidity and monetary policy is therefore not the solution. As we pointed out many times the major problem is an excess of debt and the necessity to deleverage. Consumers are in the process of attempting to increase savings and pare down debt. Banks are protecting their balance sheets by preparing for further problems with residential and commercial real estate loans and potential additional writedowns. Corporations are hoarding cash because they can’t find enough attractive opportunities and are reluctant to place an overreliance on outside financing after their experience in the credit crisis. All of this is typical economic behavior following a credit crisis.
The Fed knows that that it is about to undertake a great experiment with unforeseeable results and potentially unknown consequences. Just the expectation of QE2 has weakened the dollar and helped force up commodity prices including food, energy and cotton. This could result in possibly higher prices for consumers without any significant increases in jobs, a result that would be opposite to its intended effects. On the other hand corporations will probably find it very difficult to pass their commodity price increases along, resulting in a squeeze on profit margins. Already, in recent days a number of companies have reported disappointing results for that very reason. For these reasons the Fed in recent days has attempted to dampen expectations of a "shock and awe" strategy by leaking to the media its intentions of instituting QE2 in small increments rather than all at once.
In our view additional stimulus in the form of QE2 will not be able to offset the effects of deleveraging. Monetary policy does not work well when banks are reluctant to lend, corporations do not have enough opportunities to invest and consumers are unwilling or unable to borrow. As somebody recently said (we don’t remember who), if you lead a horse to water and he won’t drink, then it doesn’t help to add more water. We believe economic growth will remain under the long-term average with return to recession a strong possibility. This outcome is not reflected in current stock prices.