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When St. Louis FRB president James Bullard opened the possibility of the Fed engaging in further quantitative easing, in reality he was threatening the banks that if they did not voluntarily increase lending to boost the economy, the Fed would shut out all other avenues for the banks to earn interest income. The market took a sudden drop July 29 after fixating on one sentence in Bullard’s paper entitled "Seven Faces of ‘The Peril’": “The U.S. is closer to a Japanese-style outcome today than at any time in recent history.”

Yet the market completely overlooked Bullard’s explanation that “the FOMC’s extended period language may be increasing the probability of a Japanese-style outcome for the U.S.” Keeping interest rates at close to 0% for an “extended period” anchors the expectation that the Fed believes the economy and inflation are weak and will remain that way for the foreseeable future. Bullard uses the European sovereign debt crisis as an example of how any negative shock that arises is interpreted to mean the Fed will “further delay the day of normalization of the policy rate farther into the future.” Current monetary policy ends up exacerbating “the idea that inflation and inflation expectations will instead fall, and that the economy will settle in the neighborhood of the unintended steady state, as Japan has in recent years.” As Bullard said on CNBC’s Squawk Box the next day, “If we promise to stay at zero for ten years, we’re going to be like Japan.”

You would think Bullard’s concerns about a Japanese deflationary decade washing up on U.S. shores would find him dissenting alongside Thomas Hoenig at FOMC meetings for the Fed to drop the “extended period” language and tighten interest rates. Although Bullard said on CNBC that he is still an inflation hawk, he is advocating the Fed return to quantitative easing by purchasing Treasuries if the situation arises.”

The Fed would be invoking the nuclear option if it ever enacted Bullard’s plan to purchase up to $2 trillion in Treasuries as the Fed would create the equivalent of a giant short squeeze in the wholesale banking market since Treasuries serve as its currency. And as I described in “Bernanke Tells Wall Street the Fed’s Hands Are Tied,” the Fed Chairman has subtly told us that venturing into these territories would “present risks” as such a move by the Fed would cause substantial damage to the plumbing of the wholesale banking system. The Treasury’s primary dealers would be the only ones benefitting from such a policy since the Fed foolishly does not buy directly from the Treasury.

Such a level of quantitative easing would force the banking system to overcome risk aversion by forcing banks to lend to consumers and businesses for their very survival as the banks would have run out of places to park money. The theory is that as credit expands, it will kick start the economy. But Bernanke has stated that falling collateral values are preventing small businesses from obtaining loans.

Forcing banks to take undue risk for the sake of the economy would result in banks recklessly engaging in the behavior that precipitated the financial crisis in the first place! Banks could still decide not to lend to small businesses and consumers, preferring to party like its 2007 by engaging in LBOs, M&A financing, etc. The outcome could easily cause a recession far deeper than has already been experienced.

Inflation, deflation, unemployment – it all becomes meaningless. Once interest rates go below a certain point, the banking system ceases to function anymore. The paradox is that the Federal Reserve as bank regulator requires a certain level of highly liquid assets such as Treasuries while at the same time competes with banks to acquire these same types of liquid assets! By engaging in further quantitative easing, the Federal Reserve would crowd out the very institutions that it would like to see stockpile high quality liquid assets.

The real economic impact of the Fed’s activities is the net amount of liquidity it puts into the outstanding currency. When the effect of the Fed’s easing is circulated back to the Fed’s balance sheet through excess reserves, little economic gain is realized. This is why I cannot fathom how an additional round of quantitative easing would produce further economic benefits.

Link: Part II of video of Bullard on CNBC July 30

Disclosure: No positios

Source: Bullard's Bipolar Fed Strategy