BIGCAPITAL's Blog

October 19, 2010

The Federal Reserve has talked itself into a corner QE2

Filed under: Uncategorized — bigcapital @ 12:21 pm
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The Federal Reserve has talked itself into a corner QE2

By making it clear the next step for monetary policy will be further quantitative easing, the Fed has ignited a frenzy of market activity. Investors’ experience was that the original round of QE triggered a massive rally in risk markets from their lows in the spring of 2009. So another round of QE justifies yet more speculative demand for assets. Speculative demand begets speculative demand.

Which brings us to where we are now–market expectations for something in the region of $1 trillion to $1.5 trillion of additional quantitative easing by the Fed. It’s also worth noting that the Fed’s QE is expected to be followed by yet more Bank of England and Bank of Japan action as well.

This raises two not inconsequential problems for investors: what if the Fed fails to deliver as much QE as the market demands; or what if it does and either it doesn’t work or works too well.

Fed Chairman Ben Bernanke hinted at some of the reasons the central bank might be reluctant to do as much as the market expects in his speech last week. He accepted that “nonconventional policies have costs and limitations that must be taken into account in judging whether and how aggressively they should be used.”

Other central bankers, including the Bank of England’s Paul Fisher, have begun to think publicly about the mechanics of how, when the time comes, to extract central banks from the vast amounts of quantitative easing they have done.

The more QE central banks do, the more of a dominant position they take in the markets in which they operate. The Fed, for instance, has an overwhelming position in U.S. securitized mortgages, while in the U.K., the Bank of England owns more than half of some gilt issues outstanding and at least 20% of the majority of the rest.

There should be no problems getting more sovereign debt onto central bank books, after all, the U.S., the U.K. and Japan will be running large deficits for a long time, so supply isn’t an issue. But what happens a few years down the line when governments continue to pump out supply but central banks also need to sell their holdings? If they do, they run the risk of creating disorderly markets. If they don’t they run the risk of inflationary consequences of debt monetization.

So central banks are likely to be cautious about what they do. But even if they fulfil market expectations, there’s the risk they fail to ignite underlying aggregate demand because the problem with economies isn’t the lack of liquidity but rather the need to deleverage from a debt binge. In which case, more QE could fail in its intention. Indeed, it could more than fail, but actually be damaging by stimulating speculative demand for commodities. This jump in commodity prices then eats into consumers’ pocketbooks, dragging demand down even further.

On one or other count, investors seem destined to suffer disappointment with QE2. And there’s not a lot central banks can do about it

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