The Downside of Quantitative Easing

Stocks have rallied significantly since August 10th on the hopes that the Federal Reserve will engage in a third round of quantitative easing (QE) — a form of money printing. While QE1 and QE2 were successful in juicing stock prices, this is not what the Fed is supposed to be doing.

The Fed’s current mandate was established by the U.S. Congress in 1977 in the Federal Reserve Reform Act. This legislation requires the Fed to establish a monetary policy that “promotes maximum employment, stable prices and moderate long-term interest rates”. Manipulating stock prices is not supposed to be on the Fed’s agenda. Quantitative Easing was unknown in 1977 and was therefore not specifically addressed by Congress.

If anything, the Fed has significantly overshot in its goal to keep long-term rates moderate. The Fed Funds rate has been kept at around zero percent since December 2008. The Fed has stated it will maintain this rate until 2013. The interest rate on the 10-year treasury fell below 2.00% at one point this August — a record low. Two-year rates fell below 0.20%, also record lows and well below the bottom rate during the Credit Crisis. Low interest rates indicate an economy in recession and not deflation as is commonly claimed in the mainstream press. Maintaining interest rates at a low level for too long is inflationary however.

The Fed announced its first quantitative easing program in November 2008 (according to an analysis of its balance sheet, it was begun somewhat earlier). The second round ended this June. How has the employment situation changed during the two rounds of QE? When QE1 started in November 2008, the official U.S. unemployment rate was 6.8%. When it ended in June 2011, it was 9.2%. The high was 10.1% in October 2009. The post-World War II average has been 5.7% and unemployment has fallen to the 3% range when the economy is strong. With respect to employment, quantitative easing seems to have been a failure.

So what about price stability, the Fed’s other mandate? While the inflationary effects of quantitative easing are most evident in commodity prices, the typical American consumer has seen them in gasoline, food and clothing prices. The average price of gasoline was as low as $1.60 a gallon when the Fed started QE1 and it almost reached $4.00 a gallon during QE2. A number of commodities, including cotton and copper, hit all-time record-high prices during QE2. Gold, the ultimate measure of inflation, rose to one new price high after another. Silver went from under $10 an ounce to over $48 an ounce. Quantitative easing obviously hasn’t led to price stability. In fact, it has resulted in much higher prices and is therefore counterproductive to the Fed’s goal of limiting inflation.

There is no question that quantitative easing has helped the stock market and resulted in higher stock prices. This is not exactly a secret however and all Wall Street traders are well aware of it. They will therefore push stock prices higher if they think more quantitative easing is on the way and much of any rally that results will occur before it even takes place. Quantitative easing is also no panacea for stock prices. It doesn’t insulate the market from external shocks. While it doesn’t make crashes more likely, it will make them worse when they occur. A default on Greek, Spanish or Italian debt and any number of other crises will have greater impact than they would have ordinarily because the market has been pumped up to artificially high levels. The market has also become dependent on quantitative easing and has not been able to rally since late 2008 without it. Almost as soon as it stops, the market drops and those drops will become more serious after each succeeding round.

Daryl Montgomery
Author: “Inflation Investing – A Guide for the 2010s”
Organizer, New York Investing meetup

http://investing.meetup.com/21

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.