Alert:QE II Has Lit the Fuse !

For a very long time I have been calling for, expecting and otherwise anticipating the day that the Federal Reserve would begin openly monetizing government debt. I knew the day would come intellectually, but in my heart I hoped it wouldn’t. But with the Fed’s recent decision to directly monetize the next 8 months of federal deficit spending, that day has finally arrived. I have to confess, while my prediction has proven accurate, I’m still stunned the Fed actually did it.

In this report I examine the risks that this new path presents, what match(es) may finally ignite the decades-old pile of dry fuel, what the outcomes are likely to be, and what we can and should be doing in preparation.

How is this Quantitative Easing (QE) different from the prior QE?

There are two main points of departure between the two QE programs:

• The level of global support for such efforts
• Where the money was/is targeted

Let’s take the second point first.

QE I consisted of all sorts of liquidity efforts that went by various acronyms, but the main act was the accumulation of some $1.25 trillion in MBS and agency debt. Some might note that taking MBS paper off the hands of financial institutions, which then bought treasuries with the cash, is little different than the recently announced QE II program because at the end of the day, money was printed and Treasuries were bought. In this regard, they’re right.

But let’s be clear about something: the first QE effort had the specific aim of repairing damaged bank balance sheets. That is, banks and other financial institutions had made some colossally poor and risky financial moves that didn’t work out for them. They needed some help, and the Fed was more than happy to oblige by handing them free money to patch up their losses.

Of course they didn’t do this outright by saying, “Here take this money!”; they did it somewhat sneakily. But when the Fed hands you huge piles of money (for your dodgy debt) and then let’s you park that very same money in an interest bearing account at the Fed, there’s really no difference between that and just handing you free money. No difference at all. If the Fed ever offers you free money that you can then park in an interest bearing account with the Fed, you should take them up on it, and you should do it as much as they will allow.

Indeed, that’s exactly what happened. These parked funds are called “excess reserves” and this chart clearly displays the massive program undertaken by the banks and the Fed:

Now, it’s also true that the Fed does not pay a lot of interest on this money, just 0.25%, but on a trillion dollars that pencils out to some $2.5 billion a year, handed straight over to the banks. I call this program “stealth QE” because it is nothing more than printing money and handing it over to the banks with a slight bit of complexity thrown in just to put the dogs off the scent. A couple of billion may not sound like much these days, but I raise it to illustrate the many and creative ways that QE I was about getting the banks back to health, and not much else.

So QE I (and the ‘stealth QE’ program) was directly aimed at banks to help them repair their balance sheets and make them whole on their terrible decisions and losses. It turned out, though, that fixing the banks did absolutely nothing for Main Street. The rest of the economy remained mired in a rut, with banks either unable or unwilling to make additional loans. They kept their QE lotto winnings and parked them with the Fed.

QE II, then is about getting thin-air money to the government which, the Fed rightly assumes, will immediately spend and push out into the economy. Here’s how the head of the Dallas Fed, Richard Fisher put it in a recent talk he gave:

A Bridge to Fiscal Sanity?

The Federal Reserve will buy $110 billion a month in Treasuries, an amount that, annualized, represents the projected deficit of the federal government for next year. For the next eight months, the nation’s central bank will be monetizing the federal debt.

This is risky business. We know that history is littered with the economic carcasses of nations that incorporated this as a regular central bank practice.

There it is in black and white. You might want to read it a couple of times to let it sink in. The Fed is directly monetizing the next eight months of excess(ive) spending by the federal government and is doing it despite being perfectly aware of the extent to which history is littered with the remains of those who have traveled this path before.

Presumably we are supposed to console ourselves with the idea that the Fed will be successful where others have failed, and sometimes failed miserably. Yes, we are talking about the same Fed that fueled that last two destructive bubbles by keeping interest rates too low for too long; failed to see the housing bubble as late as 2007 for what it was, and apparently entirely lacked the capability to foresee any of the current mess. That Fed.

The one run by the gentleman who said this to the House Budget Committee on June 3, 2009,

“Either cuts in spending or increases in taxes will be necessary to stabilize the fiscal situation…The Federal Reserve will not monetize the debt.”

~ Ben Bernanke

In summary, the difference between QE I and QE II is that QE I went primarily to the banks and QE II is going directly to the government. While this may be something of a semantic difference, it shows that the Fed is changing its strategy again. We might ask: why this shift and why now?

How is QE II being viewed outside of the US?

In a word, poorly.

The German finance minster called the Fed’s application of US monetary policy “clueless” and argued that the Fed decision would “increase the insecurity in the world economy.” 

China was predictably unhappy too, but initially used more diplomatic language:

Xinhua: G-20 Should Set Up Mechanism To Monitor Reserve Currency Issuers

BEIJING (Dow Jones)–China’s state-run Xinhua News Agency published a commentary on Tuesday calling for the Group of 20 industrial and developing economies to supervise the issuance of international reserve currencies, and harshly criticized the U.S. Federal Reserve’s new round of quantitative easing.

The G-20 should “set up a new mechanism that effectively monitors the issuer of the international reserve currency, especially when it is not able to carry out responsible currency policies,” Xinhua said, making an apparent reference to the U.S. as the issuer of the dominant reserve currency.

“Considering the influence of the policy moves in the major international reserve currencies on the global economy, it is necessary for the issuer of the international reserve currency to report to and communicate with the G-20 Group before it makes major policy shifts.”

All of the above is loosely coded diplomatic speak for “The US really bummed us out here, they should have stuck to the agreements we thought we had after the Pittsburg meeting. Going off-script like this was really not appreciated. We think an intervention is needed here.“

Later, an advisor to the Chinese central bank went further and called the US actions “absurd.”

READ MORE HERE> >            Part 2 link here >    Alert: QE II Has Lit The Fuse – Part II