QE3 — And We Are Not Talking About an Ocean-Going Ship

(written on September 12/2012)

A paltry 96,000 jobs were added in August 2012, while at the same time there are an estimated 120,000 to 140,000 net new additional people entering the workforce – and that happens every month. So in reality, unemployment got worse. But that was not the case statistically, since the U.S. government changed the classification of 581,000 people that in July were deemed unemployed, but by August were classified as not in the workforce. Yep—you got that right. The number of people deemed unemployed in July shrunk by more a half a million in August even though just 96,000 people got a new job. This must be the new math that is being taught in schools. If I could come up with a similar argument for my personal income taxes, the U.S. government would owe me money. Alas, that is not the case. I guess I should have paid more attention in the new math class…..

Governments have two primary drivers to steer a lackluster economy to growth or to decelerate a quickly expanding (and often inflationary) economic landscape. Monetary policy is controlled by the Federal Reserve Bank in the United States and it is through the process of altering the amount and cost of the money supply that the twin goals of low unemployment and relative stability in prices (read that as minimal inflation) are obtained. Fiscal policy relates to the taxation, government spending and related borrowing of the federal government. Altering these can impact investment and consumption decisions by businesses and consumers alike, ultimately impacting the economy.

Given the abysmal jobs report last Friday, economists are expecting the Federal Reserve Bank (the Fed) to attempt to lower interest rates for the third time since 2008 by using the non-conventional monetary tool called quantitative easing (QE)—hence the term QE3—the time the tool is being used in the current economic downturn. Quantitative easing is a monetary tool of last resort when the options for other tools are not available.

Here’s how quantitative easing works. The central bank (which in the U.S. is the Federal Reserve Bank), takes new money (define that as freshly created money that did not exist prior to this event and thus was not in the money supply), and purchases financial securities from banks. In the first round of QE in 2008, the Fed bought up mortgage-backed securities from banks. Many of these financial securities were likely to fail, and the Fed purchased them and gave the banks cash in exchange. This process enabled the banks to off-load high-risk securities. In many circumstances, had the security gone into default, the bank itself may have failed. The purchase of these securities increased the demand which in turn increased prices for these financial instruments. And since these securities paid a constant dividend, as the price of the security rose, the effective yield fell—hence lowering interest rates. After the Fed bought the securities, banks had increased cash, larger reserves and an increased ability to make loans. This added supply of money had the effect of lowering rates, hopefully stimulating businesses and consumers to borrow more at lower rates to buy things which in turn would increase jobs.

The money supply has literally exploded since mid 2008, with M1 (which includes cash, demand deposits and checking accounts), increasing by almost 69 percent. In the past four years we have seen the greatest increase in M1 in the history of the U.S. And that money is sitting there earning a zero yield (and is actually losing money given some inflation present).

 

 

 

 

 

 

 

 

 

 

 

 

 

Will the next round of QE stimulate the economy? I seriously doubt that it will since the purpose of QE is to both increase liquidity and lower interest rates. Even before we commence with a potential QE3, we already have the largest M1 Money Supply on hand in history and Treasury rates are bumping historic lows. The table below shows the current, maximum, mean median and minimum Treasury yields observed in the past year for U.S. Treasuries at varying duration.

 

 

 

 

 

 

 

 

 

The 10-year Treasury currently yields 1.7 percent. People are loaning money to the U.S. government for 10 years and will receive just 1.7 percent per year. Do you believe that lowering that rate will result in greater borrowing by business and consumers? I do not. In the past 10 years, the compound annual inflation rate as calculated using the Consumer Price Index for All Urban Consumers was 2.42 percent. Thus, if inflation remains the same for the next 10 years, today’s buyers of 10-year Treasury bonds are actually building in a net after-inflation loss of 7/10ths of 1 percent per year.

So why is the Fed contemplating QE3? Perhaps it’s simply the notion that “we have to try something.”

Will lowering interest rates impact the economy under differing circumstances? Without question. The problem today is that rates are so low, reducing them further entices no business to borrow and expand nor any consumer to borrow and buy. Think back to 1981 when 10-Year Treasury bond yield was in the 15 percent range. Lowering rates at that time increased borrowing and brought about greater economic activity.

In nautical terms, I believe that QE3 is merely a cruise to nowhere. Low rates today are keeping individuals and businesses from deploying and investing their capital since their opportunity cost is almost zero (note in the table that the 1-year Treasury now yields just 0.18 percent).

What do we need to do to stimulate the economy if it is not QE? I believe the uncertainty in future tax rates, rules and the massive federal debt (created by the U.S. House, Senate and President) are keeping investors, business and consumers on the sidelines. The sooner that we know what the long-term tax rates, rules and federal deficit will be, the quicker this record amount of M1 will be invested or consumed.

Do I see that that happening soon? No—our politicians are way too busy trying to get reelected with no time left evidently to make difficult decisions so desperately needed today.

Stated a different way, we need a lot a more leaders in Washington, DC, and many fewer politicians.

Your comments?

Ted

Comments

  1. Roy

    Prof.,

    “In nautical terms, I believe that QE3 is merely a cruise to nowhere. Low rates today are keeping individuals and businesses from deploying and investing their capital since their opportunity cost is almost zero (note in the table that the 1-year Treasury now yields just 0.18 percent).”

    The temporary “risk free” rate is necessarily the “opportunity cost”? I think not.

    IMHO money is not being deployed more due to psychological and market reasons, the fear of the unknown and uncertainty. THIS is what the QE3 is hoping to resolve. By stating that it is “indefinte” and extending the low interest rates farther on into 2015. They are trying to build certainty. If it works or not, it’s a different issue.

    Thank you for your fantastic blog!

    Roy

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