Posts Tagged ‘James Bullard’

QE2: An Unmitigated Disaster?

Monday, March 7th, 2011

By Dian L. Chu

There was a debate recently between Rick Santelli of CNBC and James Bullard, President of the Federal Reserve Bank of St. Louis regarding the inflation effects of the QE2 initiative.

Bullard, the economist, cited the core inflation rate, and even the headline inflation rate as illustrative of a lack of serious inflation pressures in the US economy. Santelli, on the other hand, talked the trader`s perspective of inflation wanting to use the CRB Index (Fig. 1) as a true indication of inflation effects since QE2 was brought up at Bernanke’s Jackson Hole Speech in August 2010.

So let us compare two scenarios and ask ourselves would the US economy be doing better without the QE2 initiative?

Pre-QE2 Prices:

  1. 2.50-2.70% 10-Year Treasury Yield
  2. $2.64 US Gasoline Price (August 2010)
  3. Cotton Prices at $85 (Contract Size 50,000 pounds)
  4. S&P 500 Index 1100
  5. Copper Prices $3.25 a pound
  6. US Dollar Index at 83.00
  7. Lumber Prices at $200 (Futures Contract –Contract Size 110,000 board feet)
  8. Sugar Prices at $17.50 (Futures Contract-Contract Size 112,000 Sugar #11)
  9. Cattle Prices at $92 (Futures Contract-Contract Size 40,000 pounds)
  10. Milk Prices at $14 (Futures Contract-Contract Size 200,000 pounds Class III)

QE2 Effects So Far:

  1. 3.50% 10-Year Treasury Yield
  2. $3.50 US Gasoline Price
  3. Cotton Prices at $215 (Futures Contract -50,000 pounds)
  4. S&P 500 Index 1320
  5. Copper Prices $4.50 a pound
  6. US Dollar Index at 76.40
  7. Lumber Prices at $303 (Futures Contract)
  8. Sugar Prices at $30 (Futures Contract)
  9. Cattle Prices at $114 (Futures Contract)
  10. Milk Prices at $19.50 (Futures Contract)

About That Unemployment Rate…

This just gives a snapshot of some of the inflationary effects for the US consumer.  I cannot think of any argument where higher interest rates resulted from QE2 are good for the housing sector, which is the most troubled part the US economy.

Nevertheless, I must add that the unemployment rate is better, and we have created more jobs since QE2 but with a highly fluctuating job pool where workers give up looking and leave the labor market it is hard to gauge the real unemployment numbers.

Plus how much of the job creation is due to other factors like more business friendly policies from the Obama administration, a Republican Landslide in the Midterm Election, and the extension of the Bush Tax Cuts and a reduction in the payroll taxes for businesses?

Equity Gains Don’t Mean Much

The S&P 500 is 230 points higher which can be argued is good for the “wealth effect” but stocks usually have a year-end rally so some of these gains probably would have occurred even without QE2.

Clear Present Danger – Inflation

There are some substantial price increases in a lot of these inflationary metrics for both businesses and the US consumer, not to mention the reduced purchasing power of a much lower US dollar (Fig. 2).

More importantly, inflation data utilized by the core and headline rates are behind the curve of futures prices by anywhere from 3-6 months so the true inflation pass through effects of these higher input prices at the futures level have yet to be realized in the Fed`s measures of inflation data.

For example, gasoline prices at the pump probably lag the futures prices established by the RBOB contract by 20-30 cents. Likewise, the full effects of higher cotton prices will take much longer to work their way through the supply chain to consumers at the retail level for clothes they purchase. It may take another six months for the damage that has already occurred at the futures level to be fully experienced by consumers of cotton products, which would lead to an underestimate of the current inflationary effects in the economy.

Biflation at Work

It should be noted that parts of the economic data are deflationary in nature like housing and wages, which serve to artificially keep the inflation numbers utilized by the fed down, which is the biflation phenomenon I previously discussed.  And if you add in the 6 month lag factor for inflation effects to pass through to the data, a completely different inflation story starts to emerge.

Wanted – Lower Inflation & Interest Rate

However, this still misses the important barometer for analyzing QE2 which should be the following question: “Which scenario is better off for the US economy?” and not any argument of what the current inflation level is in the economy.

This assumes that some inflation is better than no inflation, and I would argue that being able to finance a home mortgage at 100 bps lower, and a dollar per gallon cheaper gasoline is better for businesses and consumers, and that this scenario is far better for fostering sustainable economic growth than the current scenario of QE2 and its effects.

Really Better Off with QE 2?

So the question for Bullard misses the mark if one argues with him what the current or even future inflation effects are for the economy due to QE2. The real question for Bullard is would the US economy be performing that much better without QE2? If you add up all the pros and cons of QE2, guess which scenario would 9 out of 10 independent economists pick for an environment that fosters economic growth?

It seems regardless of what the inflation data says is the overall inflation rate in the economy, QE2 gave us all the negative, anti-growth, lowered standard of living type of inflationary effects that act as a major tax and headwind for both businesses and consumers going forward, and very little of the much needed “Record GDP Growth” and “Eye-Popping Job Creation” bang for our costly buck.

Right Back Where We Started

It seems we pretty much could have gotten this same level of current GDP growth and job creation without massively devaluing the dollar in the process. Sometimes a little patience goes a long way, and if the fed would have waited until the November elections where both the business climate and economic data were improving all on their own we could have had the best of both worlds with a low inflationary price stable environment, and a slow but steadily improving employment situation.

The real fear and irony is that once the full effects of QE2 are realized in the US economy, that we start reacting to said inflationary effects both through tightening monetary policy and consumer/business behavioral changes, and the US starts giving back some of its recent economic gains, and becomes vulnerable to the very scenario that the fed was trying to avert in the first place, a double dip, deflationary downturn in the economy.

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QE = Wealth Redistribution

Wednesday, December 22nd, 2010

This post is a guest contribution by Dian Chu, market analyst, trader and author of the Economic Forecasts and Opinions blog.

James Bullard, President of the Federal Reserve Bank of St. Louis was on CNBC Monday, December 20, 2010 mostly defending the Fed’s controversial $600 billion Treasury purchasing program (QE2) announced in Nov.

What struck me as totally self-contradictory were Bullard’s statements regarding the QE2, treasury yield, inflation expectations, and inflation, which I will outline and rebuff below.

Bullard – Higher Treasury yield = QE2 success
During the interview, aside from the usual Fed PR spin that QE2 has been ‘modestly successful so far’, he also states:

“People who see the rise in Treasury yields as a sign the Fed’s purchases were not having their desired effect should look at other measures, especially the improvement in the economic outlook and the rise in inflation expectations in the market for Treasury Inflation-Protected Securities (TIPS). These are the ultimate goals of the Fed’s policy.”

Bullard – QE2 unrelated to rising commodity prices
But when Fred Smith, Chairman, President and CEO of FedEx asked whether QE2 was related to the run-up in commodity prices, fuel prices in particular, which has been up 15% in the last 90 days and acted as a tax on American consumers, Bullard had this to say:

“…Is there some independent effect coming from monetary policy other than supply and demand conditions globally…I haven’t seen very much evidence of that, but would like to keep an eye on that.”

So, basically Bullard touts QE2 as building up inflation expectations, driving up treasury yields (thus averting a potential deflationary cycle), which was the goal of the Fed QE2 initiative.  Furthermore, Bullard contends that global demand and supply factors are behind the record high prices across almost all commodities, which he believes is unrelated to QE2.

Higher Treasury yields – kills housing et al
First of all, the ultimate goal of the Fed’s securities purchases (QE2), as outlined by Chairman Bernanke in his speech at Frankfurt, Germany on Nov. 19, is to “lower interest rates on securities of longer maturities” to support household and business spending.

On that measure, QE2 has failed miserably. Interest rates, instead of declining, are rising rapidly driven by the bond markets and the bond vigilantes. The 10-year yield was at a low for the year of 2.4% in early October, and has shot up to a seven-month high of 3.56% the week of Dec. 12, before easing back to around 3.34% on Monday Dec. 20. (Fig. 1)

The yield on the U.S. Treasury is used as a benchmark to set interest rates on many kinds of loans including mortgages, and business borrowing rates in the capital market. So, the sharp rise in yields on Treasurys since the QE2 announcement in early November not only kills any flickering recovery sparks in the housing and other related sectors, but also raises the borrowing costs and interest payments of Uncle Sam.

Higher borrowing costs for Uncle Sam
The Congressional Budget Office (CBO) on Dec. 14 projects that under current law, debt held by the public will exceed $16 trillion by 2020, reaching nearly 70% of GDP. The CBO also projects the combination of rising debt and rising interest rates to cause net interest payments to balloon to nearly $800 billion, or 3.4% of GDP, by 2020 (Fig. 2).

U.S. debt downgrade – more than a warning
Now, the U.S. is at a stage where the downgrade of U.S. sovereign debt rating seems closer to reality than ever before. Although most have dismissed the downgrade initiated by China’s Dagong Credit Agency back in July, CNBC reported that this time around the U.S. Treasury Dept. is going to meet with Moody’s and other agencies in January, 2011 to make its case to prevent a downgrade from the current AAA status.

CBO’s debt and interest payment projection assumes that US borrowing cost will remain reasonable. However, a credit downgrade and/or further loose monetary policies along with continued over-spending will only prompt bond markets and bond vigilantes to demand even higher interest rates resulting in much higher interest payment than the current projections, reminiscent of the 80’s when bond yields were in double-digit.

Expectation drives inflationWhen it comes to inflation expectations, I’m actually in agreement with Bullard that the Fed has been successful in driving it up, which is reflected in the TIPS yield as well as the steepening yield curve (Fig. 3). However, as Bernanke himself puts it:

“The state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.”

Since the Fed hinted at QE2, commodity price inflation has surged at a record pace during the past six months (Fig. 4)  The manifestation of inflation is a combination of many factors including but not limited to expectations, which drives behavior, as well as supply and demand factors.

So, for Bullard to “take credit” for driving up inflation expectations, but ignore its inflationary effect on commodity prices is illogical as well as self-contradictory.

QE liquidity not flowing where it’s needed most
The bottom line is this: Unlike China where its central government can mandate banks to actually lend to business and individuals, Fed’s two rounds of QE liquidity did not go to where it’s intended; it is instead trapped on banks, and corporations’ balance sheets.

U.S. banks have been holding about $1 trillion of excess reserves for the last two years, while American corporations are flush with $3 trillion in cash.

What do they use this money for? Banks and institutions with access to the Fed’s cheap money are pumping up commodities and stocks to make their quarters, while corporations, facing higher input costs in the form of runaway commodity prices, are busy engaging in M&A’s (which typically means “job rationalization”), and share buybacks to juice up earnings per share.

Meanwhile, stagnant wage and hiring trends failing to keep pace with skyrocketing food and energy costs for consumers, coupled with higher input costs, such as fuel, hitting companies’ bottomline, will only further cut into growth prospects, and the purchasing power of consumers and even their overall standard of living.

QE = wealth redistribution
The concern of deflation is entirely overblown (thanks to Bullard’s research paper warning of a Japanese-style deflation in the U.S.) and the Fed jumped the gun. In a way, the Fed’s QEs are a form of wealth redistribution from taxpayers to banks, institutions and corporations.

The liquidity has created an artificial financial market where a disproportionate minority is benefitting through higher stock and commodity prices (without producing much output and benefit to the real economy); while the majority suffers higher input costs for essential items like food and energy.

Food and energy are some of the things that affect every consumer’s daily life and pocket book, but are excluded from the core inflation calculation, a key measure on Fed’s watch list.  This bias would only further misrepresent true inflation pressures, misguiding Fed’s future policies, and result in a net loss for the economy over the long haul.

Source: Dian Chu, Economic Forecasts and Opinions, December 21, 2010.

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