The hot issue these days in the market is quantitative easing, the Fed’s method of trying to stimulate the economy.  The Fed is in the midst of its second round of “QE,” and the reviews have been critical.  Research strategy firm ISI estimates that critics of the policy outnumber supporters by three to one.

 

Before we get to QE2, let’s review the traditional tools of the Fed.  The Fed typically carries out monetary policy through manipulation of the interest rate that banks charge each other for overnight loans – the federal funds rate.  But rather than setting the rate, it manipulates it through open market operations.  This consists of buying and selling US government securities in the open market.

 

Currently, the fed funds rate is close to zero, so the Fed is limited in how much more it can ease, in the traditional sense.  This, in combination with the fact that the economy is progressing at a slower pace than desired, is why the Fed has chosen to implement quantitative easing.  Even though it has a different name, it is actually similar to its traditional open market operations.  The Fed is still purchasing government securities but is now going farther out on the maturity curve.

 

What is encouraging about the Fed’s strategy is that it demonstrates an awareness of the potential destructiveness of a slow-growth, deflationary environment.  Japan has been mired in such an environment for two decades, and Chairman Bernanke has studied the Depression of the 1930s extensively.  He seems determined to avoid a repeat by providing liquidity to a system that is in retrenchment/deleveraging mode.  This logic does not appear unsound.  There has been a dramatic decline in the “velocity” of money, or how frequently a unit of currency is used.  The quantity theory of money holds that money times velocity = price times quantity of goods and services.  So in order to maintain a given level of output amidst a decline in velocity, one must increase money.  That is what the Fed is doing.

 

Many still remember the inflation of the 1970s and are fearful we are headed down that road again, given loose monetary policy.  Bernanke recognizes that an erosion of purchasing power is damaging, but knows that deflation can be even more pernicious because it leads to delayed consumption (since prices will be lower in the future), which slows economic output, which reduces wages, and so on.  Bernanke and the Fed have opted to err on the side of inflation.

 

We don’t want to imply that there are no risks, or minimize this policy; it is clearly a change, but it doesn’t seem to be as radical a shift as many are contending.  That said, there are issues that are concerning.  Primary among these is the explicit targeting of stock prices.  Bernanke has verbalized the goal of raising stock prices through QE, knowing that consumers and executives feel more confident and are thus more willing to spend if share prices are higher.  While the wealth effect of a rising market is real (as an example, ISI shows that there is a strong correlation between the performance of the stock market in the fall and the strength of the holiday shopping season), to target asset prices like this is a dangerous precedent.  It smacks of a manipulated market, something one is more likely to find in a centrally controlled society.  To be clear, we think the stock market is on sound footing and has enough strength on its own – the corporate profits that drive equity values are healthy, real, and are not being overvalued in our opinion – but the central bank should not be trying to “goose” the stock market in hopes that it will jump-start the economy. It is one thing to be aware of such a dynamic, but another to explicitly target it.

 

We are also concerned by the increasing talk in Congress about the Fed.  In the wake of the financial crisis, there has been stepped up criticism and even talk of making the Fed a government agency.  Any reduction in the Fed’s independence would be a major negative.  Fortunately, this does not appear to be on the horizon.

 

Another potential pitfall of QE is the effect it has on commodity prices.  Looser money can lead to higher commodity prices.  This raises the price of gasoline and food, which acts as a tax on consumer spending.  Since QE2 began to be discounted by the market, commodity prices have risen.

 

Interestingly, while one of the goals of QE is to lower long-term interest rates in order to stimulate the economy (particularly the housing market), the policy seems to be having the opposite effect, as rates have risen recently.  This also occurred after the implementation of QE1 in 2009.  In a perverse way, this may actually indicate that the Fed’s strategy is working, as higher rates generally reflect a healthier economy.

 

We tend to favor allowing the free market to work its magic and find an appropriate equilibrium.  And there are potential unintended consequences with the implementation of a new policy tool.  That said, in a time of deleveraging and reduced velocity of money, a policy of loose money strikes us as having some merit, or at least something that is not deserving of the harsh criticism it has engendered.

 

(c) Oak Associates

www.oakassociates.com