The Unintended Consequences of Quantitative Easing

Since the US Federal Reserve initiated a second round of quantitative easing (QE2) - supplemented by the recent extension of the Bush tax cuts - we have observed an increase in investors' appetite for risk but little in the way of fundamental improvements that would suggest a further rebound in the economy and/or employment. We believe this has led to an overly optimistic assumption as to the strength of the US economy. Hoisington Investment Management Company published an interim report on 12/9/10 that we neglected to spotlight until now.

Among their observations in the short note was the following:

Many consider QE policy to be on a successful path because the psychology of its orchestration has boosted the stock market, thereby creating a wealth effect. However, QE has also set in motion unintended consequences. The same factors that have boosted equities have also lifted commodity prices and mortgage rates, both of which are damaging to economic activity.

The Fed's actions have served to increase bank reserves but, unfortunately, these reserves are largely left on deposit with the Fed because a) financial institutions' capital continues to erode due to loan delinquencies/defaults, and b) consumer debt ratios remain at or near record levels.

Other observations from Hoisington (although the very short note is worthy of a full read):

The economy has been expanding for 17 months, yet both the labor force participation rate and the employment to population ratio stand at new cyclical lows and beneath the cyclical lows of the prior expansion. This is an unprecedented development.

The November employment to population ratio was 58.2%, its lowest reading since 1984. In fact, another 478,000 full-time jobs were lost in November.

The tax compromise reached on December sixth between President Obama and the Republican leadership is in many respects like QE2. It plays to psychology but does little to improve fundamental economic conditions.

As we noted in an earlier reference to the Permanent Income Hypothesis, the kind of temporary income boosts that are contained in the Obama compromise are generally not spent. Consumers tend to save temporary income gains and tend to spend only those they interpret as permanent. Moreover, there is a substantial economic drag on the very near horizon:

When the state legislatures return to work in January, they face combined deficits in the vicinity of $280 billion. At this stage, most of the quick fixes and rainy day funds have already been exhausted. Deficits of this magnitude mean that cuts in spending and higher taxes are likely outcomes.

The very bright folks at Hoisington conclude that long-term US Treasury bonds remain attractive.

The 30 year bond yield is currently well above 4% yet inflation is less than 1%, resulting in roughly a 3% real yield. The real yield has averaged about 2% over the last 140 years, suggesting value at these levels.

We tend to agree.