Project Weimar: Why QE2 Could be More Inflationary Than You Think

"In my darkest moments, I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places."

-Dallas Federal Reserve Bank President, Richard W. Fisher, October 19, 2010

After yesterday's long overdue risk unwind, odds of a Fed QE2 announcement on Nov 3 have now become one decimal place closer to 100%. And, as various Fed folk continue to shoot their mouths off about the so-called liquidity trap under the false premise that one can print with impunity once short term rates approach zero, Keynesians and non-Keynesians alike might be surprised to learn that we're closer to a highly inflationly scenario than is commonly believed. That is, we could expect not only the pockets of asset price inflation that accompany each crank of the Fed printing press, but the economy-wide inflation for which Gentle Ben prostrates himself before his Keynesian shrine each night (though not necessarily the tame 2-3% doses he prefers).

The thinking goes: the Fed bought $1.75 trillion in assets. The banks took some of this money, levered it, and ramped the risk markets for a year. They left a trillion (or so) parked at the Fed to earn 0.25% interest, where it remains today. If the Fed prints another half (or whole) trillion over the next year to purchase Treasurys, we can expect more of the same. Banks don't want to lend, and what they don't use to bid up risk assets (such as junk stocks, Indian rice futures and now gold), they'll continue to deposit at the Fed.

This assumes, however, that the Fed's bank subsidies vis-à-vis its permanent open market operations are uniform in effect across asset classes, which is not the case. The Fed's $1.25 trillion in MBS purchases merely covered the banking system's collective lousy bets on the mortgage industry. The banks happily put their MBS securities to the Fed and for the most part left the digital zeros in their reserve accounts. The $200 billion in Agency debt purchases (Fannie and Freddie paper) allowed China, et al to swap out its Agency holdings for Treasurys, as Chris Martenson explained in August, 2009. Finally, it was the Fed's $300 billion in long term Treasury purchases that really goosed the risk markets, as we concurrently explained.

This should be no surprise, as Treasurys are highly liquid, "riskless" securities, and have been the Fed's instrument of choice in managing short term interest rates for years. If the Federal Funds rate strayed too far above from the target rate, the Fed would arrange a temporary (or sometimes permanent) purchase of Treasury bills or coupons on the open market from its primary dealers. The intent and result was that the PD's would put the newly minted money to work, where it would compete with other short term investment money for yield. With a greater supply of money available for short term lending, yields would fall accordingly. The opposite would apply when the Fed Funds rate is below the target rate, whereby the Fed would extract liquidity by selling Treasurys to raise short term rates.

From time to time, the amount of money printing or extraction required to achieve a target rate is deemed to be too much by the Fed, so it capitulates and the FOMC adjusts the target rate. This is why the actual Fed Funds rate usually leads the target rate, leading some to believe the Fed is impotent when it comes to interest rate policy. However, the Fed's modus operandi is that it leads the markets as much as possible with expectations, then matches or exceeds expectations until the markets demand too much, after which it backs off a bit. Make no mistake, the Fed exerts considerable influence over interest rate and monetary policy--more now than ever with its unprecedented collection of interventionist tools.

The below chart shows the progression of Bernanke's mad science experiments. Readers have likely been immunized against shock by the hockey stick monetary charts that have littered the blogosphere for nearly two years; however, what is likely a new presentation is the breakdown of bank reserves by bank type. The Fed's H.8 Release (Assets and Liabilities of Commercial Banks in the US) divides banks among the largest 25 domestic banks, all other (small) domestic banks, and foreign banks. The line item for Cash Assets is an excellent proxy for reserve deposits, as it:

Includes vault cash, cash items in process of collection, balances due from depository institutions, and balances due from Federal Reserve Banks

Such balances (Fed reserves) comprise most of the Cash Assets and the other items do not fluctuate enough or are not large enough to be of concern. Accordingly, the below story unfolds:

Click image to enlarge.

Notable is that Federal Reserve balances have been drawn down from the February 24, 2010 peak by $249 billion, of which $169 billion is non-borrowed (those extra reserves that banks can, and have, removed from Fed custody). While the small banks have kept their cash assets nearly constant since December, 2009, large banks have withdrawn $211 billion and foreign banks $96 billion from their respective peaks. These are material sums. Also notable is that QE Lite, now two months old, is not popping up in bank reserves. Importantly, though, we do see M2 ticking up again.

For anyone who still doubts the power of the Fed's open market Treasury ops, it's instructive to zoom in on the second and third quarters of 2008--a time when fears were escalating over the imminent Bear Stearns collapse.

Click image to enlarge.

Like a good shop-vac, Treasury open market operations work just as well in reverse--risk on/risk off. Judging by the spread between the 13 Week T-Bill rate and the Fed Funds target rate, it's clear that the markets were demanding more than a 75 bps drop at the March 18, 2008 FOMC meeting. Regardless, the order was given to reign in liquidity until the two converged, which they nearly had by the last such operation on May 21, $144 billion later. The dramatic slowing in money supply growth was noted by EPJ at the time. Whether Gentle Ben was blindly targeting an arbitrarily set metric or deliberately tightening while talking an easing game to engineer one of the century's greatest market meltdowns is unknown. Historical Fed duplicity tends to make one think the worst, though it's important not to ascribe too much prescience to these people--much less omniscience.

Okay, one final chart via Zero Hedge for the remaining three doubters:

What to Expect

At the conclusion of its November 3, 2010 meeting, the FOMC will likely announce a new round of de facto debt monetization (QE 2), though it may not be the nuclear announcement that has been hyped. As we said, the Fed prefers initially to get as much bang for its buck by talking while simultaneously doing as little as possible (relatively speaking, of course). The current QE2 hype phase appears to be drawing to a close.

Even if there is some initial disappointment on November 3, monthly Treasury purchases will likely be several times the current monthly amounts of ~$30 billion, and they will soon make their presence known. First asset prices, later credit and loans--as incredible as that may seem. Consider that the large banks have ceded to political pressure by dismantling their proprietary trading desks and need to generate income. Also consider that there is a strong tradition in the US and other Western welfare states of governments coercing banks to abdicate lending standards in order to buy votes. Add in some new half-baked government fix-all for the roboforger mortgage mess, and we find all sorts of skeins of potentiae (none ultimately beneficial, of course). As Robert Wenzel comments:

Will banks start loaning out their excess reserves? Will the Fed react to this by draining reserves or raising the rate on excess reserves? How high will the Fed have to raise rates, if they choose this route to counter things if money supply starts to explode.

So there you have it. In an economy that could operate perfectly fine with a stable money supply (That is, no printing of money ever). A machine has been created that can ratchet up the money supply at any time. The methods now available to control the money supply are so complex that economists are now calling for Bernanke to go nuclear, when, in fact, Bernanke has created such a structure that it has to be considered so shaky that it could turn into a financial Chernobyl.

This is not to dismiss the pervasive trend of debt deflation, as Dave Rosenberg will happily point out to you on any given day. We're merely pointing out the first pebbles of monetary inflation rolling down the mountain and how they can quickly turn into a rock slide. What we know is that the next round of large scale asset purchases will be concentrated in Treasurys and will likely dwarf the previous bout of $300 billion by 50% to over 300%. We also know that these operations are highly correlated with asset price fluctuations and that banks are unlikely to simply leave their money at the Fed. At what point this spills over into economy wide inflation is unknown, but we would keep an eye on (1) consumer credit YoY, the second derivative of which turned at the beginning of this year, (2) M2 money supply not seasonally adjusted YoY, which bottomed in April, and (3) long term Treasury yields, keeping in mind that the announcement of QE1 on March 18, 2009 was the high in Notes and bonds for months. One may watch employment as well, if only to imagine the horror on Bernanke's face as he realizes he resurrected stagflation.

Is it possible the Fed achieves asset price inflation and manages to keep the money supply in check enough to avoid rampant economy-wide inflation? For the time being, yes, though it's not the most likely scenario, in our opinion. In the long run, the answer is assuredly no. The Fed has three mandates, one of which is full employment. There is too much interventionist nonsense and resulting uncertainty for businesses to create jobs en masse, so employment statistics will not improve. The Fed is a one trick pony. It will attempt to print the economy out of depression until it eventually errs on the side of easing.

Estimates for Oct-Nov Treasury POMO

MBS prepayments continue amidst continued jaw-dropping plummeting mortgage rates. While it might be academic at this point to continue the exercise of predicting the next month's Treasury purchases (as Brian Sack was kind enough to disclose they would be $30+ billion for the next few months), we have nonetheless pulled out our slide rules and crunched the numbers.

Agency MBS Principal Payments $24,872,870,000

Agency Principal Payments 477,958,000

Agency Maturing 3,188,000,000

Est. Treas. POMO mid-Oct to mid-Nov $28,538,828,000

Last month we were about $1.5 billion shy of the actual $27 billion announced, so a similar margin of error would push this month's estimate above the expected $30 billion. It would appear as though the Fed's model not only incorporates the most recent published Pool Factors (as we do), but also anticipates next month's. We'll find out for sure next Wednesday at 2:00 pm.

Fed Portfolio Manager: Preparing for QE Ad Infinitum -- Don't Expect Any More Big Bang Announcements

Today, Brian Sack, manager of the Fed's System Open Market Account (the SOMA--or, the world's largest hedge fund), remarked on the Fed's resumption of Treasury purchases (so-called QE Lite) and the prospects for full-fledged QE 2.0. Two things to take away:

1) QE Lite purchases will increase slightly to $30 billion per month (up from $27 billion for mid-Sep to mid-Oct). (Don't be surprised for the last two weeks of October before the election to be especially front loaded with risk-market-juicing cash injections.) This is no surprise as mortgage rates continue to break records to the downside and refis continue unabated.

Chart courtesy of Consumer Metrics Institute

2) Reading between the lines, QE 2.0 is virtually guaranteed to be announced at the FOMC's Nov 3 meeting; however, there could be major changes in the FOMC's approach to establishing and communicating future QE policy. Sack proposes five questions for the Committee to consider inasmuch as it is de facto targeting the Fed's balance sheet size similarly to how it (used to) target the Fed Funds rate. From his speech:

Designing a Purchase Program

If the FOMC were to move forward with an expansion of the balance sheet, it would presumably want to take into consideration the perspective gained from the asset purchases conducted from late 2008 to early 2010. The FOMC would have to decide the extent to which a new purchase program would follow the approach from the earlier round of purchases.

An alternative approach would be to design a purchase program that shares more of the features of the FOMC’s adjustment of the federal funds rate in normal times. After all, adjustments to the balance sheet are in many respects a substitute for changes in the federal funds rate. Both instruments attempt to influence broader financial conditions in order to achieve a desired economic outcome. However, the way in which the FOMC implemented asset purchases differed in important ways from the manner in which it has historically adjusted the federal funds rate. With this contrast in mind, I raise a set of policy questions that could be considered in designing a purchase program.

First, should the balance sheet be adjusted in relatively continuous but smaller steps, or in infrequent but large increments? The earlier round of asset purchases involved the latter approach, which caused the market response to be concentrated in several days on which significant announcements were made. That might have been appropriate in circumstances when substantial and front-loaded policy surprises had benefits, but different approaches may be warranted in other circumstances. Indeed, it contrasts with the manner in which the FOMC has historically adjusted the federal funds rate, which has typically involved incremental changes to the policy instrument.

Second, how responsive should the balance sheet be to economic conditions? Historically, the FOMC has determined the federal funds target rate based on the Committee’s assessment of the outlook for economic growth and inflation. If changes in the balance sheet are now acting as a substitute for changes in the federal funds rate, then one might expect balance sheet decisions to also be governed to a large extent by the evolution of the FOMC’s economic forecasts. The earlier purchase program, in contrast, did not demonstrate much responsiveness to changes in economic or financial conditions. Indeed, the execution of the program largely involved confirming the expectations that were put in place by the two early announcements.

Third, how persistent should movements in the balance sheet be? An important feature of traditional monetary policy is that movements in the federal funds rate are not quickly reversed, which makes them more influential on broader financial conditions. A change that was expected to be transitory would instead move conditions very little. For similar reasons, one could argue that movements in the balance sheet should have some persistence in order to be more effective.

Fourth, to what extent should the FOMC communicate about the likely path of the balance sheet? The FOMC often communicates about the path of the federal funds rate or provides other forward-looking information that allows market participants to anticipate that path. This anticipation of policy actions is beneficial, as it brings forward their effects and thus helps to stabilize the economy. For the same reason, providing information about the likely course of the balance sheet could be desirable. In fact, such communication might be particularly important in the current circumstances, because financial market participants have no history from which to judge the FOMC’s approach and anticipate its actions.

Fifth, how much flexibility should the FOMC retain to change its policy approach? The original asset purchase programs specified the amount and distribution of purchases well in advance.9 However, the FOMC would be learning about the costs and benefits of its balance sheet changes as it implemented a new program. This might call for some flexibility to be incorporated into the program, providing some discretion to change course as market conditions evolve and as more is learned about the instrument.

Assuming the FOMC adopts some or all of Sack's suggestions, we can expect balance sheet targeting language to be a regular, rather than punctuating, feature of future FOMC announcements--i.e., the big bang announcements with x trillion multiples may be a thing of the past. With the markets already pricing in $0.5 to $1.0 trillion in the next announcement, there could be some disappointment on November 3.