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As Far As The Eye Can See

On September 13, 2012, Ben Bernanke, the US Federal Reserve Chairmen, issues the most important statement of the year, and no where does it actually say QE 3 in the statement.

Even so, QE 3 has arrived and the market has interpreted the statement correctly. Additionally, the statement leaves options open for the Fed.

The announcement of $40B in MBS purchases per month, if you parse the statement correctly, is the doorway into unlimited monetary expansion.

Here is how the market is interpreting the FED statement issued on September 13th:

"Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability."

This statement is the standard reminder that there is a dual mandate of the Federal Reserve Bank of the United States which is to maintain price stability, and to achieve maximum employment.

"The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions."

The Federal Reserve's opinion is that economy is growing less than the population rate, which is the definition of below trend. In the opinion of the Fed, the economy needs a push so that job creation at least matches population growth. The mere fact that job creation lags population growth is indicative that economic activity is below potential.

" If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities,

The Federal Reserve believes that continuing purchases of MBS's should, at least at the margin, increase home buying and help the economy by providing support to real estate prices.

"undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. "

And that was the QE 3 announcement, explained below.

The statement,

"undertake additional asset purchases"

leaves open the door to expand the MBS purchases. It also opens the door to modifying the program to include additional Treasury purchases (for example, short term, 30 day to -to 5 year, Treasuries in the intermediate term, in the next 2-5 years).

In retrospect, the market will look at future statements announcing Treasury purchases, and will notice that this statement already alluded to that possibility. Zero Rate Interest Policy (ZIRP) is alive and well, but short term Treasury auction's bid to cover (BTC) contains risks in that ZIRP is dependent on the BTC, and if investors eventually fail to step up, then the Fed will. In response to such an event the Federal Reserve now has a mechanism to step in and fill the gap, and maintain ZIRP.

The Fed's hope is that QE 3 inspires money movement. Inflation inspires velocity as un-invested money (NASDAQ:CASH) is eroded in an inflationary environment. Cash should go into something that would preserve purchasing power, and maintain liquidity. For large institutions that appears to be commodities, or stocks. However, when those assets get invested into commodities, that will drive up the cost of goods and services sold, and margins get compressed, not good for stocks.

For the little guy, the average investor, and the middle class, unless wage appreciation happens, QE 3 won't matter. The main flaw in the strategy is the belief that QE 3 will provide incentive to the masses to borrow, and begin another credit cycle/bubble.

The money isn't getting to the general population, either they are tapped out, or are psychologically tired of monthly credit payments. The baby boomers are scaling back spending in preparation for retirement, and their children don't have jobs, live at home, and have lots of student debt.

QE 3 will hurt in the form of increasing input costs, decreasing supply of goods, increasing inflation in general. If wages continue to fall behind inflation, as it has for a decade or more now, then QE 3 is a failure, and 9/13/2012 is the date at which we can say "hmm, maybe not a good idea on that last QE."

A world without QE 3

On the contrary, the risk is that interest rates eventually increase without more QE, and the government is forced to roll over short term 0% debt to .25%, then .25% to .5%, etc, just on the short end, might be difficult to sustain from a fiscal perspective without creating money by the Federal Reserve.

Debt Reduction

Hopefully congress moves on the fiscal front, because the Federal Reserve has no real option (nor should it) to address the fiscal situation other than QE. QE 3 may have a side affect in devaluing the purchasing power of the dollar, which would also devalue the debt, but that is not responsibility of the Federal Reserve.

In reality though, the US could run up debt to 200% of GDP (which would be $28 Trillion, not including social security, medicare, medicaid), QE for the reason of debt devaluation is a smart thing at this time, as it gets in front of the fiscal problem, instead of waiting until the national debt actually reaches $28 Trillion, and investors lose confidence in the US's ability to cover it's obligations.

It's a peculiar situation, without action the current path will continue which would be problematic, maybe not now, or in 10 years, but eventually the barbarians will show up at the gate, and want to paid in real assets.

So ZIRP as far as the eye can see, and 40B USD a month is a good start.

In a year, it will become clear that QE made for a bad stimulus program, because in reality, QE doesn't generate economic activity. It has the net effect of diluting "shares" (capital in US dollars), people spend in anticipation of price increases, and the machine of inflation begins. The illusion of economic activity might be there based on the number of dollars being moved around but when adjusted for inflation, the affect will be little in terms of real GDP.

The real, and intended, imo, impact, will be debt reduction across the board.

We can get away with unlimited QE without breaking the system. It will come with inflation, but as long as the US has physical assets, amplified with confidence, to back its fiat money, and the rate of QE expansion, with fractional reserve lending, doesn't exceed the rate of creation of physical assets, the currency will still be backed by real assets, although losing purchasing power vs. time.

The US as a whole does actually have physical assets that far exceed whatever debt that's been accumulated. For example, let's say every major US city is worth a trillion dollars, on average, and we have quite a few major cities. Theoretically, the currency is backed by these real assets.

The US runs like a business that has a fat balance sheet with net equity, but is running a perpetually negative cash flow. This is fixable, albeit difficult. Unlike a business, a sovereign can't be dragged into court by creditors for immediate payment on default, the sovereign can create money to cover the payments on the debt, unless, heaven forbid, congress makes that illegal.

The national debt itself right now isn't actually the problem yet, it's the rate of spending that been growing exponentially.

QE is in now in the foreseeable future. Congress is unwilling and impotent to address the fiscal situation, which adds to the necessity of unlimited monetary expansion.

Be fully diversified with physical gold, real estate in US dollars, on margin, foreign currency baskets (not the Euro), short the US Dollar.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.