The Fed's impending blunder
By Ambrose Evans-Pritchard Economics Last updated: October 27th, 2010
OK, I’ve calmed down after a week of Jamon Iberico and Rioja in Granada’s Albaycin, so I will try to be polite about the US Federal Reserve. Try, that is, not necessarily succeed.
For a good insight into the thinking of the New Keynesian priesthood that rules our money and our lives, it is worth reading “QE2: How Much is Needed?” by Jan Hatzius from Goldman Sachs.
His argument – crudely – is that US interest rates at zero are 7pc too high given the Taylor Rule on output gaps, et cetera (not that Professor Taylor himself happens to agree, but let us not quibble).
Since rates cannot be minus 7pc, the Fed would need to launch a $4 trillion blitz of fresh bond purchases to fully compensate, such is the mess that America’s leadership has inflicted on the Great Republic. I have over-simplified: Goldman Sachs relies on a “policy gap” concept, which factors in fiscal tightening et al.
This would push the Fed balance sheet to $6.3 trillion, above the $5 trillion pencilled in as the upper limit during the Great Crash.
Mr Hatzius is not saying the Fed will do this, or should do this. His forecast is that the Fed will start off with baby steps of $500bn spread over six months or so, rising over time to meet the bank’s “dual mandate of low inflation and sustainable employment”.
(Actually the Fed’s mandate is “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Stable prices are not the same as low inflation. It takes Ben Bernanke’s maniacal obsession with the doctrine of inflation targeting to twist this into a mandate for printing large sums of money at a time when the Dallas Fed’s `trimmed mean’ measure of annual inflation has jumped from 0.5pc in May, to 0.8pc in July, and 1.5pc in August. But again, let us not quibble).
Mr Hatzius said the Fed sees “tail-risks” in using QE to the full, but may nevertheless do another $2 trillion in the end.
I have no doubt that this report reflects thinking at the Fed Board in Washington, and among Bernanke allies at the San Francisco Fed and Boston Fed – though not of course at the Dallas Fed where Richard Fisher confesses: “In my darkest moments I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places.”
What we have is a glimpse into the Sanctum Sanctorum of money creation, a glimpse of Jesuitical fanaticism.
Now, I put my hand up and confess to having supported QE when the financial system was imploding in late 2008 and early 2009, and I continued to do so as the M3 money supply collapsed at 1930s rates earlier this year. I persist stubbornly in thinking that it was the right thing to do, AT THAT TIME.
But we are no longer in a systemic financial crisis, and the Fed’s motives have become subtly corrupted. Having argued during the boom that it was not the business of central banks to stop asset bubbles – and specifically that any fall-out could “safely” be cleaned up later – Bernanke now seems to determined to validate this absurd doctrine, bending all the sinews of the US economic and financial system to this end. One error leads to the next.
In a sense QE has worked all too well. M3 has stabilized. The M2 gauge used by the Fed – which was still contracting in May – has been growing annual rate of 8.4pc over the four weeks to mid-October. The pace has been accelerating for months.
OK, 8.4pc is not Weimar, but it is not imminent deflation either.
And what about velocity, the other part of the monetary cocktail? It is coming back from the dead as you can see below?
Simon Ward from Henderson Global Investors said his measure of velocity is rising at a robust rate of 8.7pc. “QE1 was justified during the crisis because monetary velocity was collapsing at that time. But now that velocity is recovering further QE is not needed. In fact it is potentially very dangerous,” he said.
This is the theme of Chapter 17 entitled “Velocity” in Jens O’ Parsson’s book Dying of Money, the cult text of our brave new world.
If I may recycle a passage from a column I wrote about the book in July: “Each big inflation – whether the early 1920s in Germany, or the Korean and Vietnam wars in the US – starts with a passive expansion of the quantity money. This sits inert for a surprisingly long time. The effect is much like lighter fuel on a camp fire before the match is struck.
People’s willingness to hold money can change suddenly for a “psychological and spontaneous reason” , causing a spike in the velocity of money. It can occur at lightning speed, over a few weeks. The shift invariably catches economists by surprise. They wait too long to drain the excess money.”
“Velocity took an almost right-angle turn upward in the summer of 1922,” said Mr O Parsson. Reichsbank officials were baffled. They could not fathom why the German people had started to behave differently almost two years after the bank had already boosted the money supply. He contends that public patience snapped abruptly once people lost trust and began to “smell a government rat”.
No doubt the Bernanke Fed views monetarism with contempt, despite paying lip service to Milton Friedman. This is a grave error. Surging M3 gave forewarning of the credit bubble from 2005-2007, and then rang alarm bells before the banking crash in late 2008. Ignore money and velocity at your peril.
The immediate effect of the Fed’s QE2 rhetoric has been to drive up commodity prices, negating much of the benefit. “How this possibly helps out the moribund US economy is anyone’s guess,” said David Rosenberg from Gluskin Sheff.
“If there is an `imbalance’, it is in the US pretending it can solve structural headwinds, overextended balance sheets, chronic unemployment and a massive housing inventory backlog with untested Fed policy tools,” he said.
Nor is it clear that Bernanke’s aim of driving down interest rates serves any useful purpose at this stage. As GMO’s Jeremy Grantham argues, this policy is reducing pensioners to penury. “Lower rates always transfer wealth from retirees (debt owners) to corporations (debt for expansion, theoretically) and the ﬁnancial industry. This time, there are more retirees and the pain is greater, and corporations are notably avoiding capital spending and, therefore, the beneﬁts are reduced. It is likely that there is no net beneﬁt to artiﬁcially low rates.”
If you crunch everything in the mixer you can perhaps claim that QE2 will be a net plus of sorts. But is it really wise policy to embark on such a contentious adventure at a time of deep misgivings among the public and in Congress, and in the face of blistering criticism from China, Germany, Russia, as well as a lot of Western economists?
I hate to cite Alan Greenspan but he is right this time to warn that the Fed is playing a “dangerous game”, whatever the claims of New Keynesian economic theory. Politics matter.
Yes, the Fed is right to worry that protracted deflation would be lethal in an economy with total debt at 350pc of GDP. Those who call for a liquidationist policy of mass bankruptcy and default are an even greater danger to political stability than the Bernanke Fed. That policy was enacted from 1930-1932, with observable results.
But I suspect that something else is happening at the Fed. Bernanke is refusing to accept that the US must go through the slow painful cure of debt-deleveraging. He is trying to air-brush away the consequences of 20 years of debt creation and Fed error.
The proper role for the Fed from now on is to steer a narrow course between the Scylla of deflation and the Charybdis of inflation, for year after, for as long as it takes, until America is properly purged. AND THEN NEVER COMMIT SAME IDIOTIC MISTAKE AGAIN.