QE2 Is Launched With a Whimper

Since I won’t have time to post tomorrow, I ought to squeeze in a comment about the Fed’s launch of QE2 today. They have announced a plan to buy up $600 billion of assets in an effort to provide the economy with enough cash to get something going.

Not good enough.

Particularly when we consider that they didn’t raise their inflation target.

Opinion immediately split as to whether this was going to do any good, and as I have said above I add my name to those who think it insufficient.

Here’s my reasoning:

First: the economy is knee deep in cash. To say the banks are loaded is an understatement. Flooding in a whole lot more cash is very unlikely to make much difference while business expectations are so weak and banks are being very tight with their credit standards. To put it bluntly: no amount of available cash seems to be enough to spark a period of more rapid growth.

Second: this implies that a great deal of the cash will simply end up parked back with the Fed as bank reserves. Worse, some of it will leak out onto the global economy as investors look for returns that aren’t zero. This could – I emphasize could – spark some bubble like inflation in emerging markets which is where those higher returns are to be found. This could, in turn, cause all sorts of wobbles in the currencies of those economies and end up forcing them to take remedial action that would reduce their growth. So a move intended to inflate US growth might end up deflating world growth. Whoops.

Third: it simply isn’t big enough anyway. If the you haven’t got the attention of the economy so far, what makes you think that a mere $600 billion will wake it up? There had been discussions about a much larger effort, in the $2 trillion range, but apparently that was too much for the Fed to swallow. More likely the tussle between the expansionists and the austerity hawks ended up neutering the entire program. Yet another instance of the damage compromise can do?

Fourth: the idea of pushing the purchases out on the yield curve sounds nifty, and might have had more effect had the yield curve not been so flat at the short end. Buying bonds in the 5 year maturity spectrum doesn’t cut it when they are yielding around 1.0%. The signal you are sending is insufficient, and I suspect the market may simply yawn. Specifically the Fed is removing an extremely small part of the market’s duration risk: it works out to the equivalent of reducing rates by about 0.01%. Not enough.

Fifth: what about inflation? Our problem continues to be that we are wallowing in a liquidity trap of epic proportions. In order to break free we need to engender higher inflation expectations. And those expectations have to be based on credible goals. It is no good to set a goal of 2.0% when unemployment is so high. Especially when inflation is sinking rather than rising. Right now expectations seem to be disinflationary rather than inflationary. So to shift the market to another level we would need to be talking about something above the normal target: I guess 4.0% to 5.0% inflation. The point here is that the relationship between full employment and an acceptable inflation rate is the policy objective of the Fed. As of now they are failing to produce either full employment or acceptable inflation. The one is too high, and the other too low. Hence the need to adjust.

Lastly: not to sound churlish, but the way I hear it the Fed has been asking around on Wall Street about what level of QE would be acceptable. In other words they’ve been trying to get an idea of what dealers think is expected. But … isn’t the idea here to alter expectations rather than to meet them? We are supposed to be shifting the market from its doldrums, not accommodating it. Oh well.

Frankly I just don’t see this effort meeting any of the Fed’s goals. QE2 has been launched and will end up stuck halfway down the slip.

Our era is dogged by half measures. This is simply one more.