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Thursday, August 4, 2011

Third Round of Fed Quantitative Easing Not in the Cards

argues Eric Parnell in his SEEKING ALPHA post, "3 Reasons Why Markets May Not See QE3 Anytime Soon".

Parnell's 3 reasons ? Glad you asked.

1. QE hasn't worked all that well in the past, especially QE2. That's put the Fed on the defensive, for driving up "asset and commodity price inflation at the expense of retiree savers living on fixed incomes and low to middle income families".

2. Under a "political microscope" because of (1) above, Fed Chairman Bernanke won't risk taking any measure that risks the Fed's continued independence. Parnell asserts that "the economy and financial markets will need to be hemorrhaging to the point where the public and those on Capitol Hill are begging him to take action".

3. Bernanke may well withhold QE3, realizing that each successive dose of QE has brought diminished returns.

So what does this all imply for markets as it relates to QE3? It may not be coming at all. And if QE3 does come, it may not come anytime soon. Instead, we may need to see a more definitive contraction in economic activity and a severe decline in stocks before the Fed is inclined to act. And even if the Fed does act with QE3, it’s efficacy may not be what stock investors have become accustomed to and are hoping for the next time around. As a result, stock investors pinning their hopes on QE3 may be setting themselves up for disappointment along the way.

The next read on the Fed and their intentions will come on August 9 with the next FOMC meeting. After that, it’s the annual Fed conference in Jackson Hole, Wyoming on August 26. Of course, it was in Jackson Hole last year that the Fed rolled out QE2, so all eyes will be transfixed on Bernanke this year. Given the increasingly struggling economy, these two events will tell us a lot more about whether the Fed plans on bringing QE3 sooner, later or at all.

* * *

Cullen Roche casts another vote against QE3 in his post, "QE3: Another Monetary Non-Event?". Roche provides a clear, perceptive analysis of QE's pernicious effects, excerpted below.
What we got from QE2 was essentially one huge margin squeeze on the economy as investors protected themselves from inflation via their market hedges (helping contribute to cost push inflation via commodity prices), but saw little to no real-world impact (no offsetting substantive increase in hourly earnings). The result was an increase in inflation and inflation expectations, but no positive follow-through in the real economy to offset the negative effect of the cost push inflation.

In terms of its real effects, QE2 could have actually been more of a drag on the economy than a form of stimulus. We know for a fact that the Federal Reserve turned over $73B in profits to the US Treasury in 2010 alone. That is largely interest income that is being taken away from the private sector as a result of their massive balance sheet expansion. Remember, this is interest income that the banks could have been earning. Instead, they are receiving 0.25% paper in exchange for their much higher yielding securities. QE does not add net financial assets to the private sector so the net financial drag appears to have been quite substantial.

In sum, it appears as though the positives (wealth effect, portfolio rebalancing and lower US dollar) were more than offset by the many negative trends that persisted. I am a bit surprised by the fact that some Fed officials are weighing another go at QE. The data appears undeniably weak arguing in favor of further “experimental policy”. We have had our experiment and it did not work. What is the point of trying it again? And have we considered the possibility that it could actually makes things worse? As a risk manager, this looks like an awfully bad bet to me. Granted, Dr. Bernanke isn’t in the business of portfolio management, but he is in the business of creating price stability and full employment. I don’t see how this program helps him achieve these goals.

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