The Fed turbo-charged the printing press yesterday, turning QE3 into QE4. Yet the stock market closed flat on the day -in fact it sold off after an initial sugar rush rally. Why no party? Perhaps because despite being more open ended (no calendar end date), it is a more constrained edition of QE than previous versions. Operation Twist has been running since September 2011 and has managed to convert $667 billion of short term Treasury Notes into intermediate term Treasury Notes on the Fed's balance sheet. You may recall Operation Twist was the Fed stimulus program wherein it sold $45B/month in short term Treasury Notes to fund buying of intermediate term Treasury Notes, thus avoiding new money printing and balance sheet expansion. However, since the Fed's inventory of short term bonds (3 years and less) is now gone, it won't be able to continue Operation Twist. Instead, it will use $45B per month in freshly printed dollars to fund its purchases of intermediate and longer term Treasury Notes. The Fed is also going to continue buying $40B per month in agency-backed mortgage bonds (what was QE3). So in total, this new action (QE4) will see the Fed buying $85B per month in U.S. Tbonds and Fanny/Freddie bonds with newly printed dollars -essentially debasing the dollar by 1 $trillion per year. The Fed will continue doing this until:
- The unemployment rate drops to 6.5%;
- The inflation rate tops 2.5%;
- The cows come home and the fat lady sings.
The Fed's press statement had this comment included (emphasis mine).
The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.
That last part -it turns out- is very important. Stock market perma-bulls (equity fund managers, for the most part) will point to this statement and suggest it means the Fed may further still enlarge QE4 to a QE5 in the future. I suggest that's not likely what the Fed meant (but it is probably happy to get a free lunch from any over-optimism this generates). Just as the U.S. Congress has the "fiscal cliff" as political cover for introducing unpopular yet responsible fiscal policy in 2013, the Fed needs cover too. It will come in the form of inflation. The cold reality is each time QE is launched, we get less wealth effect bang for the buck, and more inflation. The following chart makes this clear. (Note: I'm using CPI because everyone is familiar with it.)
So when might QE4 slam into the inflation wall (as all its predecessors did)? Probably early 2014 -but it could be as early as Q4 2013. QE4 is $85B/month -- only slightly more than QE2's $75B/month. Other things being equal, we should expect an even faster rise in inflation than shown in the figure above. However, there is likely to be a major body-blow dealt to inflation in Q1 & Q2 2013 as the sobering reality of tax hikes and spending cuts hits the U.S. economy. This will be a huge deflationary force -and the Fed knows it. That's why it launched QE3 a couple months ago, and why it is expanding QE3 to QE4 now.
The Fed's preferred inflation indicator is the Personal Consumption Expenditure (PCE). And since the Fed does not want to take the blame for its actions causing food and fuel prices to rise, it strips that bit of reality out and uses something called core PCE. Here's what core PCE has looked like for the past few years -- and my estimate until QE4 is switched off. Do see a rather obvious problem?
I'll admit that I'm cutting with an axe here, but the upshot is that by early to mid 2014, we'll see QE4 switched off because total PCE and real-world total CPI will be in the 5%+ range.
2014 looks like this:
- A real-world 5%+ inflation rate
- Stagnant income growth
- $5/gallon gas
- A mythical 6.5% unemployment rate that is really 10% or more
- Higher taxes and lower government spending
- A Fed that is finally and obviously out of bullets
- A new Fed chairman (probably Jeffrey Lacker -- you saw it here first).
You didn't think I was going to let that new QE4-ending 6.5% unemployment target slip by without a comment did you? I call this a mythical unemployment target because 12-13 million Americans will have fallen out of the unemployment system, and out of the labor force without a job. The real-world unemployment and underemployment rate will still be north of 10%.
Side note: to those that are observant and inquisitive, you may wonder about the shading used to depict QE2, QE3, QE4 in the figure above. I deliberately chose a color that might be interpreted as golden by some (if you think QE is beneficial), and brown by others (like me). I love symbolism.