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The Fed Is Creating A Deflationary Environment

The only thing the Fed accomplished with its weak attempt at “QE II” was to create a deflationary environment for interest rates. And just as in any deflationary situation, consumers will be motivated to delay their purchases as they wait for lower prices.

The problem is that the Fed has not gone far enough in their efforts because all they are doing is rolling over Treasuries, or recycling maturing Agency paper into Treasuries, while keeping the dollar amount of assets held on the balance sheet realatively constant (i.e. they are not printing).

The Fed's goal is to drive down interest rates on things like residential mortgages, which policymakers believe will incentivize people to buy homes. But the theory is likely to backfire and if you don’t believe me, then answer the following questions:

1. Do you think interest rates will be moving up or down over the next few months? Most will say they believe rates will fall because if the Fed is buying, chances are that the increased demand will raise prices and lower rates.

2. Are you more apt to purchase something now if you believe the price will be higher or lower in the near future? The likely answer is that you will wait because you want to get a lower price.

Now for the big question-If you are one of the lucky few looking to buy or refinance a house, are you going to do so now when you expect that rates will decline over the next few months? The answer is likely to be no if you believe the cost to debt service will decrease in the not too distant future.

That is what a deflationary environment does; it forces people to delay their purchases as they wait for a lower price. Or look at things this way-home sales accelerated when people understood that the tax rebate was ending. Why? Because people will buy as quickly as they can (assuming they are able) if they believe that price will be going up in the near future.

Aside from that, if the Fed’s balance sheet is not being expanded it means they are not printing. And if they are not printing, they are not depreciating the dollar and therefore cannot create higher values in assets like stocks, homes, etc. Remember, it wasn’t until Bernanke was interviewed by 60 Minutes back on March 15, 2009 and admitted the Central Bank was “electronically printing” that things really took off. It is a very simple relationship-depreciate the dollar and anything that is bought with dollars has to go up in price.

Depreciating the dollar is probably the best (and maybe the only) way to create jobs at this time, because it will make U.S. exports that much more competitive. Indeed, the dollar's dramatic rise in the second quarter, due primarily to market concerns regarding the European Sovereign Debt Crisis, will help to shave at least one percentage point off GDP over the period.

Any attempt to simply lower interest rates, without additional balance sheet expnasion, is bound to fail miserably at creating jobs because businesses will not hire more workers simply because the government's borrowing costs are going down On this level alone, QE II is bad monetary policy because it does nothing for the employment portion of the dual mandate.

Additionally, because they are trying to create a bond rally, other asset classes like stocks are bound to suffer from the competition. But then again, more Americans than ever are keeping their money in bonds so perhaps they will have a chance to see some appreciation.

Disclosure: None