The Fed, QE2, and Inflation

Today’s gyrations in the stock market reflect a change in thinking amongst investors. Whereas last week we saw a surge in optimism as the notion of QE2 being launched in early November took hold, now we see a dampening of those spirits as the reality of QE2 sinks in.

What are we to think?

First: QE2 may well be a huge effort. Not on the scale of the $2 trillion “shock and awe” of first wave of support back in the dark days of deep crisis, but very substantial nonetheless.

Second: It is becoming clear that the new round of easing may well show up as a series of smaller, incremental, steps as the Fed adjusts its approach to unfolding events. I think it is this realization that caused the sell off of stocks. The original burst in optimism was based on the idea the Fed would undertake a massive one time easing and thus the impact would be considerable and swift. This slow drip method of support seems innocuous by comparison and thus less attractive to investors.

Third: As we saw this week with the issuance of negative coupon bonds there is quite a degree of confusion as to the trajectory of prices. The big question is: whither inflation? The market appears conflicted. Fixed coupon Treasuries are yielding very low rates. This suggests the market has no fear of imminent inflation. Yet those negative coupon bonds were snapped up quickly. This suggests that there are plenty of investors hungry for an inflation hedge. I explained yesterday that the negative bonds may also have sold so well because they offer deflation proofing as well, but I think the more common view is that inflation is on the horizon. Hence the eager way in which those bonds were snapped up, and the rumors of very long term bonds being launched. The idea of selling very long term bonds – with 50 year maturities – makes sense if investors are willing to take a view on inflation over that time span. The risks of lending that long are obviously very large. The volatility that long term bonds can have is a function, in part, of the inflation outlook over their life time. So talk of a launch of 50 year bonds seems to suggest quiescence rather than bumpiness.

In any case we should all recall the basics of the interplay between interest rates and inflation.

Any bond interest rate includes a “risk premium” portion which is the return an investor requires as compensation for the perceived possibility of default by the borrower. Obviously all investors want to get their cash back, so to the extent there is a chance they won’t, they want to be paid for the risk.

In addition all rates include an “inflation premium” which is designed to offset the loss in purchasing power caused by inflation over the duration of the bond. If inflation has been high the cash returned by the borrower at the maturity of the bond has less purchasing power than the same amount did at the inception of the bond. Thus the bond’s interest rate is raised to compensate for that loss.

The final component of an interest rate, if there is one, is simply that needed to induce a supply of credit onto the market place. In other words it is the rate at which the supply of bonds equals the demand for bonds. This is, at least, the way in which textbook economics views the way in which rates are set. Keynes adds some bells and whistles to all this by linking investment decisions to the marginal efficiency of capital, but we can overlook that here.

So what?

Well, now we come back to QE2.

If the market sees the flood of money being pumped into the economy as inflationary, then it bids up market interest rates to reflect that opinion. Hence the demand for inflation hedging bonds like those negative coupons sold this week. But offsetting that rise in inflation should be a reduction in risk: with a healthier economy default risk should fall.

But let’s ponder that for a moment.

Is the market making a mistake?

Possibly.

The conundrum is this: some analysts are arguing that QE2 will hurt the economy simply by raising prices, and thus will undo and good effects that the flood of cash may have. But this is not true unless prices rise in inflation adjusted or real terms. A rise in nominal or unadjusted prices has no effect of demand. Its a question of relativity. Once demand is rising we should expect to see real prices rising. That is a function of supply and demand. So with real demand rising we expect to get problems appearing in things like commodity prices. But that problem only occurs once demand is rising. It does not occur simply because there is more cash in the economy. The extra cash simply raises the price of everything. There are relative effects. Once we get GDP growing there will be real, relative effects. And, yes, they could be damaging.

The point is this: for QE2 to damage the economy through a hike in inflation, it first has to get the economy humming. In other words inflation is a side product of its success.

So inflation is something the Fed would welcome. In fact they probably want to induce some.

I should note, after all this, that I still object to QE2 as a primary policy response to the ongoing malaise in our economy. This is because its effects are very indirect. Far too much of the cash could end up in bank vaults doing nothing. In an economy so beset with fear we cannot rely on “normal” cause and effect relationships. Keynes taught us this: market mechanisms fail under such circumstances. A far more reliable way to boost the economy is via fiscal policy with the government creating jobs directly. What those jobs do is less important than that they exist. They create income to boost demand and taxes to reduce the deficit. Adding more cash to already high corporate hoards, or to bank reserves, or even to household savings accounts doesn’t help us at all.

I don’t expect to see such a policy. Especially after the Republicans take over Congress. In that case I look for extended malaise, and possibly a lost decade. So QE 2 is better than nothing, but only very slightly better. We should have done so much more.