WHY QE3 WILL NOT WORK AND WILL NOT HAPPEN
With equity markets (SPY) plummeting and economic activity indicators falling off a cliff in the USA and around the world, many are calling for the Fed to act decisively in order to prevent a recession. Specifically, many are calling for another round of quantitative easing (QE).
In this article I will explain why a QE3 – in the mold of QE1 and QE2 – would not work and why it will likely not be implemented.
WHY THERE WILL NOT BE A QE3
Why would the Fed not implement another round of QE? It is not because the first two rounds did not work.
Contrary to popular belief, QE1 and QE2 served their purposes just fine. Let us review what the objectives of QE1 and QE2 were.
· Provide the financial system with sufficient liquidity.
· Counteract the massive organic contraction of the money supply that was occurring.
· To accommodate the massive growth of the fiscal deficit.
These three purposes were, in fact, admirably served.
So, what is the situation today?
· There is ample liquidity in the banking system. This is evidenced by the massive excess reserves in the banking system and very low funding rates.
· The growth of the money supply, which was actually contracting throughout much of 2009 and 2010, has passed from moderate growth to growing very rapidly as of a few weeks ago. This phenomenon is explained here.
· The government is having absolutely no problem financing its deficit. This is evidenced by the fact that 10Y Treasury yields (^TNX, TLT) are at historic lows.
At this point, the Fed would accomplish virtually nothing substantial in terms of credit creation and/or economic growth by injecting more liquidity into the financial system or even by pushing 10Y Treasury yields down from 2.1% to 1.6%.
Banks are awash with liquidity and both funding rates and lending rates are extremely low. Substantial economic activity will not be stimulated in this manner, and Fed officials understand this.
Finally, it is clear that there would be substantial internal dissent within the Fed if a new round of QE were proposed. Fed actions work largely through psychology. An openly divided Fed, seemingly in disarray, would produce a negative psychological effect that could negate any minor stimulus that a QE3 could provide.
QE1 and QE2 accomplished their objectives admirably well. Indeed, the objectives were accomplished so well that a QE3 is not needed. Indeed, with ample systemic liquidity, an expanding money supply and historically low interest rates, another similar round of QE would be almost pointless.
Thus, it is my view that QE3 – at least in the form that it existed in its first two versions – is not in the cards.
I am not claiming that the Fed will not buy any more Treasury bonds. I am also far from claiming that the Fed is powerless in a so-called “balance sheet recession”, as some economic commentators have claimed. What I am claiming is that any new countercyclical monetary policy will have a very different orientation.
In my next article, I will describe one bold alternative that the Fed may have and could potentially announce as soon as the Jackson Hole meeting next week.