Post QE2 Federal Reserve Watch: Part I

Should there be a QE3 or not?

This seems to be the debate now going on given the sluggish performance of the United States economy.  Not only have most of the recent statistical releases been relatively weak, the government also released revised figures for real growth during the two years of economic recovery since July 2009 that were revised downwards from the previously released mediocre data. 

There is no joy in Mudville. 

President Obama is talking up jobs and infrastructure investment and business innovation, but his “room to maneuver” given the debt wars going on is “little” or “none”.  And, the White House is not feeling really good going into the re-election season.

Only a small minority seems to be calling for substantial fiscal stimulus at this time and they do not even seem to be a part of the current discussions going on.  They are like “voices calling in the wilderness” but few are listening. 

Thus, attention is focusing once again on the Federal Reserve and its increasingly unpopular Chairman Ben Bernanke.  Mr. Bernanke seemed to be the savior of the financial system at one time but now seems to be talking about a different world than the one most people live within.  His efforts at stimulating economic growth have achieved very little with the exception of providing liquidity for world commodity markets and stock markets in emerging countries. 

Yet, people keep looking for more “guns” or “tools” to address the economic malaise that we are now going through.  The FED seems to be the only game in town.  So, are we going to get QE3?

QE2 ended on June 30, 2011.  In the first six months of 2011, the Fed caused Reserve Balances with Federal Reserve Banks to increase by $642 billion reaching a total of $1.66 trillion on July 6.  (Just a note: on August 6, 2008, before the deluge, Reserve Balances with Federal Reserve Banks totaled less than $4.0 billion.)

As we know, most of these reserve balances were held as excess reserves, the growth of bank lending in the United States over this time was non-existent.

In July, the Federal Reserve “backed off” from its program of aggressive security purchases with almost all purchases of United States Treasury issues going to offset the run-off of Federal Agency issues and Mortgage-backed securities from its portfolio during the month. 

The only real activity that took place at the Federal Reserve in July was “operating” transactions, basically balance shifting between Treasury accounts and commercial banks.  These “operating” transactions generally “netted” out close to zero and did not result in much change in reserve balances with Federal Reserve banks. 

So, we watch and wait and listen. 

Will the Federal Reserve do anything more?  And, if they plan to do anything…what will it be?

In my analysis, so much of the county has too much debt that people, businesses, and state and local governments are attempting to de-leverage their balance sheets.  Too many financial commitments have been made relative to cash flows that there is a substantial effort increase savings and re-structure balance sheets. 

This is why people, businesses, and governments are not borrowing…and are not spending. 

The efforts of the Fed to stimulate bank lending has failed to this point because the banking system is, itself, still retrenching, financial institutions are still going out-of-business in a steady stream, people aren’t borrowing to buy houses, small- and medium-sized businesses are not hiring and are not borrowing to expand their operations, and state and local governments are downsizing and trying to keep themselves solvent. 

The economy is not growing because too many are trying to get back on their feet, they are trying to keep from drowning, and adding on more spending and more debt is not on their agenda.

Here is where the paradox comes in.  The massive shift in the income/wealth distribution in the country has put a huge burden on the less wealthy while those with more wealth can continue on.  We hear that the “expensive” stores are doing very well…and the dollar stores are not doing all that well.  We hear that there is a pickup in the sales of the more expensive homes, yet sales in the rest of the market continue to decline.  And, so on and so on.

In such an environment of “debt deflation” for a large proportion of the population (see http://seekingalpha.com/article/279283-credit-inflation-or-debt-deflation) it is extremely difficult for the government’s economic policy to overcome the drag on spending created by the restructuring of balance sheets. 

Keynes interpreted such a situation as a “liquidity trap”, a situation where the central bank could not drive interest rates any lower because people would just as soon hold cash as hold interest-bearing debt. See David Wessel’s column in Saturday’s Wall Street Journal: http://professional.wsj.com/article/SB10001424053111903454504576490491996443926.html?mod=ITP_pageone_2&mg=reno-secaucus-wsj.

Wessel presents one case for getting out of this trap…a period of (hyper)inflation that would substantially lower real interest rates.  This, one could argue, is what the Fed (unsuccessfully) tried to do in QE2 and it is what would be the objective of following QE2 up with QE3.  But, the strength of QE3 would have to be great enough to get over the “debt deflation” efforts of the people, businesses, and governments that are trying to get their balance sheets back in order. 

Wessel writes, “Failure to arrive at the correct diagnosis, in economics as in medicine, prolongs the illness; so does refusing the remedies. There's a reason the Great Depression lasted for more than 10 years.”  But maybe the correct diagnosis is that the problem is not a liquidity problem but is a solvency problem.  And, the people of a society may take a long time to deleverage their balance sheets when it took fifty years of credit inflation to get them in their current position.
If this is true, having the central bank create a policy of (hyper)inflation will not really resolve the issue but only postpone it for another day…something politicians are very good at.
And, as we contemplate the possibility that the Fed will engage in another round of monetary easing, word comes that the European Central Bank (ECB) is going to engage in the purchase of the sovereign debt of several European nations so as to support eurozone commercial banks and the newly proposed severe budgetary policies of Italy and Spain.  The ECB announcement came after several European commercial banks wrote down the value of the Greek debt on their balance sheets everywhere from 21 percent to 50 percent. 
To the ECB, it seems, the situation in Europe is still a liquidity problem.  But, if this is the incorrect diagnosis, as it may be for the United States, the ECB may have the same success as the Fed’s QE2 had.  Keep watchin’.