Why The Fed Will Launch Another Round Of Quantitative Easing

In November 2002, Fed Governor Ben Bernanke introduced the concept of Quantitative Easing to the world. In a speech entitled “Deflation: Making Sure It Doesn’t Happen Here”, he explained that the Fed could prevent deflation from taking hold in the United States by creating money and using it to acquire government and agency (i.e. Fannie Mae and Freddie Mac) bonds. He proclaimed that this “unorthodox monetary policy” would be particularly efficacious if carried out in combination with an expansionary fiscal policy.

With this speech, Bernanke reassured the banking industry and the rest of the speculating community of the Fed’s omnipotence. In doing so, he encouraged even more aggressive credit creation and risk-taking. As a result, the credit bubble, which had already grown quite large, became very much larger. When it imploded six years later, Fed Chairman Bernanke, in cooperation with Treasury Secretaries Paulson and Geithner, responded to the crisis using the exact policies Bernanke had described in 2002. The Fed began printing very large amounts of money and using it to buy very large amounts of government and agency debt. The Treasury began borrowing and spending trillions of dollars, which it was able to finance at very low interest rates thanks to the Fed’s purchases of government debt. This combination of very aggressive fiscal and monetary stimulus prevented a new great depression and the horrific collapse in prices that would have accompanied it. Therefore, while it should not be forgotten that Bernanke bears much blame for allowing this crisis to occur, it must also be acknowledged that he was correct when he declared the Fed would be able to prevent deflation through the aggressive use of unorthodox monetary policy.

Many financial commentators have noticed that bank reserves held at the Fed have increased by $2.9 trillion since early 2009. As this is equivalent to 83% of the amount of money the Fed has created during that period, they have concluded that almost all of the money created through QE has been stuck in the banks and therefore has had no impact on the economy whatsoever. This interpretation is incorrect, however.

Between 2009 and 2013, the government borrowed approximately $5.8 trillion to finance its budget deficits. During that time, the Fed acquired $1.9 trillion worth of government bonds. If the Fed had not bought those bonds, either the government would have had to spend $1.9 trillion less, which would have removed $1.9 trillion of aggregate demand from the economy, or else the government would have had to borrow the $1.9 trillion from the financial markets. That would have drained liquidity from the system and pushed up interest rates (resulting in old fashioned Crowding Out). Higher interest rates would have pushed the collapsing property market down even further and damaged the economy in countless other ways. QE allowed the government to boost aggregate demand through deficit spending and to finance its deficit spending at very low interest rates.

The Fed also bought $1.7 trillion worth of agency debt or, in other words, the mortgage-related debt issued and guaranteed by Fannie and Freddie. That pushed up the price of those bonds and drove down their yields. By acquiring that debt at a much higher price than would have otherwise prevailed, the Fed helped restore the solvency of the crippled financial industry, which was then teetering on the edge of the abyss. By pushing down the yield on mortgage-related debt, the Fed stopped the collapse in property prices and later, under QE 3, brought about their rebound. Higher property prices helped reflate the economy by pushing up household sector net worth. If the Fed had not bought $1.7 trillion worth of mortgage-related debt, the yield on that debt would have remained high (or moved higher), the owners of that debt would have been stuck with impaired assets and the property market would have weakened further instead of rebounding.

In these ways, QE greatly strengthened the economic fundamentals of the United States. Recognizing this, equity investors drove the stock market higher each time a new round of QE was announced. Surging stock prices also served to reflate the economy. Between the rebound in property prices and the sharp rise in stock prices, household sector net worth increased by $25 trillion (or by 45%) from the low it reached in 2009. It is now 17% above its pre-crisis peak. This increase in wealth was the result of Quantitative Easing. What else could possibly explain it? That surge in net worth clearly created a wealth effect that allowed much more consumption and, therefore, economic growth, than would have been possible otherwise.

It was not a coincidence that net worth rose by $25 trillion at the same time that the central bank was creating unprecedented amounts of fiat money and using it to acquire financial assets. It is certain that QE reflated the US economy by pushing up asset prices. It is not at all certain, however, that the economy will remain “reflated” when QE ends in October. In fact, the odds are quite high that it will begin to deflate again. Should that occur, the Fed would then have to decide whether to do nothing and allow everything it has accomplished to unravel in a process most probably leading back to severe recession and deflation or else to launch yet another round of Quantitative Easing. I believe it will be an easy decision for the Fed to make. After all, what’s a few trillion dollars more (shared) among friends?

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5 comments

  1. While I certainly agree, I thought that maybe it was becoming clear that the Fed was passing the QE baton over to Draghi in Europe who seems to be facing more timely growth problems in the EU. You know, like, take turns. With the USD moving strongly upward, that will benefit Europe relative to the US, and help their situation. Japan is doing its thing weakening the Yen, and they are, like Europe, in a more desperate situation than the US (right now).

    Today was an interesting day in the US markets as Q2 GDP printed very hot, and rate sensitive stocks sold off hard, so someone somewhere believes that the Fed will be raising rates sooner than they figured yesterday. I don’t think there’s a chance in hell Yellen will do so. She knows perfectly well how fragile the situation is. She would love to see some inflation! But of course she can never even hint at such a stance.

  2. Richard – my question is did the Fed ever taper, or did they just say they did but kept on buying? It doesn’t appear the Fed cut their bond purchases during the three month period November 2013 through January 2014.

    Beginning in the same month (Nov 2013) the Fed was supposedly tapering tiny little Belgium decided it would step up and purchase $141.2 billion of US Treasury bonds. Now, where the hell did Belgium come up with enough money to allocate during a 3-month period 29 percent of its annual GDP to the purchase of US Treasury bonds?

    That money likely came directly (or indirectly) from the US Fed (where else), and the purchase was laundered through Belgium in order to hide the fact that the Fed never tapered at all. Which begs the question, can you restart something you never stopped?

    I also highly doubt the Fed will announce to the world that they must reverse course and restart QE – this would be an epic PR disaster and this alone would likely crater the markets.

    As evidenced by the Belgium backdoor money laundering scheme, they will simply claim victory and announce the end of QE, but simultaneously they will secretly keep on buying … after all, as you so eloquently point out, at this point they have no choice.

    1. It’s possible that the bond purchases from Belgium were actually bought by China (or even Japan); and that they were just booked through Belgium to hide their real origin.

      You may be right about the Fed’s unwillingness to launch another round of QE, but they have done just that twice already. QE 4 would just be one more. Having said that, I do recognise that they may come up with a new way of stimulating the economy (or a new trick, if you will). But what that could be, I still can’t guess.

  3. It is my understanding that China and Japan’s Treasury holdings have dropped since the end of 2013, and Belgium is simply another name for Europe, which would not be the likely buyer of 141 billion in Treasuries, however they would gladly facilitate the Feds backdoor purchase – a purchase mind you that was timed perfectly with the taper announcement – no doubt intended to prevent an inevitable temper “tantrum”. Occams Razor.

    As you point out, the Fed has done QE1, 2 and 3 so what’s the big deal about a 4th? Yes, launching a 4th QE would be quite easy, with one teeny weeny minor exception: after QE3 they announced to the entire world they were done with QE.

    To do a 180 and reverse course on this would be a very public admission of policy failure, which they cannot afford and will never do knowing full well the dire implications of a confession such as this.

    The Fed understands to tight rope they are walking. A relaunch of QE would irreversibly damage their credibly, causing the market to not only question the confidence they place in Fed guidance, but also doubt the economic recovery narrative. This alone would be enough to unravel 5yrs of Fed handiwork.

    Therefore the Fed has no choice but to continue QE and no choice other than doing it secretly, aka, lying to the public and hiding what they are doing.

  4. Richard,

    I don’t mean to be impolite, but I don’t agree with any of your conclusions. In one interview (I think with Sprott) you said that if we had a depression that it would last decades, that people alive today would never be alive to see the end of it. I can’t tell whether you’re really an Austrian who has his tongue firmly in cheek, or if you really believe that if countries defaulted on their debt that we’d never see the end of it. There are many examples of country default where the country did not disappear. Argentina defaulted in 2002 and still had access to the credit markets. If the US defaulted, China would just take over.

    I do believe that the US will do QE4, but this will be the last one. Why? Because it will be open ended until the dollar system implodes.

    You have advocated going back to gold in 2008, so I suspect you may be an Austrian that is playing devil’s advocate for a bit of fun.

    I think we are in a depression and we’ve been in one for maybe a century or more. Why? Because we still house hundreds of millions of people in crappy homes, rather than beautiful homes. Because we have to spend $30 or more to see a doctor to get a prescription for a drug, rather than be able to research it ourselves and order it online without a prescription. Because we make life more cumbersome than it would be in a free market, and yet we think this burden of paperwork is the price we have to pay for a ‘free market’. No, it’s the price we have to pay for a regulated, repressed market. I believe in a free market we’d not only have all the Apples and Googles of the world, we’d have much MORE than we do have.

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