What's All This Talk About QE II?

We know that is not the QE II in the picture. It is an artist's rendering of the Titanic. However, we decided it captured more appropriately our view of QE II (the monetary tactic, not the ship) than one of the beautiful pictures of the majestic Cunard ocean liner.

In the US, the first round of QE (Quantitative Easing) was initiated when the crisis was in its early days. It involves the central bank creating money out of nothing and then using that money to buy financial assets. In theory (i.e. hopefully) this will increase bank reserves and facilitate the lending that will put the economy back on a growth track. It is an aggressive treatment for an ailing economy and is therefore generally not risked unless more traditional monetary policy (low interest rates) has failed.

PIMCo's Chief Executive and Co-Chief Investment Officer, Mohamed El-Erian wrote on the Financial Times' comment page last Friday (10/8/10) about the coordinated action that averted a global depression. It was a short, 9-paragraph column that we highly recommend. Here is the first paragraph:

When the financial crisis erupted, policymakers around the world gathered in Washington for the International Monetary Fund’s annual meeting, and responded impressively. They won the war against global depression by showing an unusual and much-needed common purpose. Now those returning to meet at the IMF in Washington this weekend, and especially policymakers from industrial countries, need to do much more to secure the peace.

Well, the IMF had their meeting this past weekend. Unfortunately, nothing meaningful was done and the current non-cooperative environment hardly seems likely to change.

At present, we can not imagine a less cooperative policy environment. The developed countries (the US, Japan, the UK, etc) are competing to see who can devalue their currency the fastest. It is a game in which there will only be losers.

Quantitative easing strikes us as the wrong tool for what ails us. US banks are holding more than $1 trillion in excess reserves. Additional reserves are unlikely to have much (if any) impact. US corporations have more cash on their balance sheets than any time we can remember (i.e. dating back to the early '80s). Pushing more cash into the system strikes us as unlikely to make much difference. US consumers are hunkered down, paying down and/or not taking on any new debt and limiting spending to essentials. A further 1% decline in long-term interest rates seems unlikely to motivate many to change their behavior.

It is said that when all one has is a hammer, everything looks like a nail. With the Fed Funds rate at zero, the Fed's only remaining tool is quantitative easing. So that is the tool of choice, the likelihood of success be damned.

Our view is it will not help much (if at all). Moreover, the long-term costs and unintended consequences of such tactics will likely be substantial. Consumers and businesses do not need more dollars shoved at them to get out of this quagmire. We need rational monetary and fiscal policies that are well communicated. We need to know how to plan. With substantial new taxes and regulations coming at us, many of which are certain but of unknown magnitude, we have anything but an environment of rational monetary and fiscal policies much less any clear communication of what policies will be implemented in the near future.

If you don't believe us, listen to Bill Dunkelberg, Chief Economist of the National Federation of Independent Business:

“Members of Congress fled with no action on important issues such as extending current tax rates, leaving the cloud of uncertainty larger and darker,” said Dunkelberg. “In response, consumer sentiment fell and owner optimism remained anchored solidly in recession territory. Owners won’t make spending commitments when sales prospects remain weak and decisions such as tax rates and labor costs remain so uncertain.”

The next meeting of the Federal Reserve's Open Market Committee is November 3. Election day is November 2. It might well the day before the Fed's meeting that has the greatest impact.