Let’s talk about QE, inflation, and consumer demand

The Fed, for whatever reason, has induced a shift in private portfolio preferences simply by talking about something.  But I think the point commentators like the Pragmatic Capitalist make is indisputably correct.  The policy itself does nothing.

QE is predominately about yields adjusting to levels where investors in aggregate that make investment decisions decide to hold cash rather than longer term securities. The real question is whether lower rates in general cause what were investors to become consumers.   There isn’t much evidence of this happening anywhere, including Japan, so the next question is why not.

My guess is the interest income channel – lower rates mean less income for the economy in general because the government sector is a net payer of interest.  and QE directly reduces government interest payments as the Fed earns the interest on the securities it buys, rather than the private sector.  So rates are lower, which might encourage consumption, and might encourage borrowing to consume, but income over all is lower as well.

And, of course, without real asset prices rising lenders are less inclined to lend as they don’t have rising collateral values to bail them out.  A 70,000 mortgage on a 100,000 condo or house can easily turn into a loss if the borrower defaults, for example, just from fees, commissions, closing costs, depreciation due to neglect.

So why would QE have any impact at all? Because to get those excess reserves into the banks, the Fed buys something from them. What did the Fed buy? Good, safe (mostly short term) treasuries, and bad, toxic waste, mortgage backed securities. Now, so far as treasuries go, they are effectively reserves that pay a higher interest rate; they are like a saving account at the Fed rather than a checking account. So when the Fed buys treasuries from a bank, it debits the bank’s checking account and credits its saving account. This will have no appreciable impact on the bank’s behavior and thus will have no discernible economic effect.

But, as Randy Wray has said

if the Fed buys trashy assets, and at a nice price (what Ed called qualitative easing) the banks are able to shift losing junk they don’t want off their balance sheets and onto the Fed’s. And if the Fed were to do that in sufficient volume, it could turn insolvent banks into solvent ones. In truth, the Fed did buy a lot of junk, but banks were left with trillions of dollars of toxic waste assets—probably much worse than the trash they sold to the Fed—so they are still massively insolvent. Thus, while QE1 was useful, it did not come close to resolving the insolvency problem. It bought time for some of the trashiest banks, which they devoting to ramping up their dangerous and largely fraudulent activities, digging the hole ever deeper—but that, too, is a story for another day.

With QE2, the Fed proposes to buy longer term treasuries. Since these are not toxic, it will not help the banks. It is like transferring funds from CDs they hold at the Fed to their checking accounts, thereby reducing their interest earnings. I suppose the idea is that the Fed is going to reduce bank income, impoverishing banks to the point that they will finally throw caution to the wind and begin to make loans to struggling firms and households. It is simultaneously a strange view of banking and also a scary remedy to a financial and economic crisis that was created by excessive bank lending to those who could not afford the loans—sort of like sending a covey of nymphomaniacs to the hospital bed of a nonagenarian suffering from myocardial infarction initiated by an age-inappropriate tryst.

The only plausible scenario in which this can prove useful is that QE2 pushes up prices of long maturity treasuries, lowering their yields. This could cause other longer-term interest rates to fall through competitive bidding by banks seeking better returns in alternative assets. Now, mortgage rates are already at historic lows, and what is needed to spur real estate markets is not lower interest rates (which will only generate big problems later when rates rise, crushing the holders of legacy mortgages that earn well below 4%) but rather the recovery of real estate markets. Only when it is clear that home prices have reached bottom and turned up will real homebuyers step forward — that is, buyers other than the vultures making speculative purchases of blocks of homes at pennies on the dollar. So far as business borrowing goes, the problem is the market for firms’ output, not excessively high interest rates. So the “bang for the buck” in terms of inducing domestic spending by lowering long-term rates cannot be very large and may not even be positive, since reducing interest rates also reduces the income of savers, which could depress spending.

Just What is Bernanke Up To?, Randall Wray

Now, a friend of mine wrote me, saying:

Marshall, what Bernanke said in the WaPo was that lower interest rates would help people get mortgages and help the housing market (rates are already at record lows, and that’s clearly not the issue with housing), help businesses finance their activities more easily and cheaply (corporate issuance is already totally ramped, so again not an issue) and boost stock prices, so that people would feel wealthier, and start spending, and the increased economic activity would then allow fundamentals to catch up to those higher stock prices.  Obviously, the evidence that will work is extremely shaky, but of the three it’s the only one with even a shred of plausibility.

I find it hard to characterize QE2 as much more than a wing and a prayer from a Fed that’s flying by the seat of its pants, and which views the situation as so desperate that it’s willing to throw anything against the wall, hoping it will stick.  The best I can say about it is that if it succeeds in elevating asset prices, it will be a sop to the wealthy (assuming they can sell before the bubbles it creates burst and destroy more “wealth”) while at the same time it will exacerbate the pressure on the middle class and the poor, through higher food, gasoline, and heating costs.  I don’t see how you can say anything but that Bernanke has completely lost his way, charitably assuming he knew what he was doing at some earlier point .

My reply? I know what Bernanke said.  But I think he’s wrong. Surely, you don’t take him at face value, do you?  In any case, there’s very little evidence to suggest that his gambit will work.  And I think the markets will find that he’s wrong and will react adversely accordingly.  The vast bulk of the price action came before the Fed actually did anything.  So how can one ascribe that to QE?

Ed said in turn:

That’s what is the news here. This whole song and dance about QE not being inflationary misses the point that QE is about asset prices.  The true believers – retail customers and the inflationistas – may not be on to the pump and dump here – but guys like David Tepper know that this dash for trash has a sell by date and they will be out of risk assets in due course.

Yes, they are cynically playing the game, but I doubt they are doing so because they believe that the policy is ultimately successful. As my friend Scott says,"desperate measures for desperate times seems like the best characterization." I think we all agree here:  It’s totally ineffectual.  It makes the Fed look like a bunch of amateurs.  But by the same token, it’s absurd to describe the policy as one which "debases the currency" or "prints money" when most of the dollar decline happened prior to the outset.  Moreover, there were lots of reasons why the announcements were "effective", but that had more to do with the economic backdrop than the "open mouth" policy per se. By the same token, yes, the Fed makes serial attempts to blow bubbles.  That’s a terrible policy. I don’t think any of us think otherwise.  But I don’t think QE2 can be held responsible here.

  1. haris07 says

    While agreeing with almost everything said above, I still think that this causes (or at least sets us up) for inflation. The key point is that the cash being printed to buy these Treasuries replaces one set of govt liabilities (the “cash”) for another set of govt liabilities (Treasuries). Presumably, the Treasuries being bought back were issued to finance “productive assets”. Yes, I know that Treasuries need not be issued at all and govt can just credit bank accounts and do away with issuing bonds altogether, but that’s not the way the world operates and in any case, to avoid confusion with the word “financed”, lets say the govt spent money into existence to allow the private sector to productively build assets. Now, the excess cash that is being printed to buy back Treasuries is going to sit on bank books as excess reserves, which will be channeled into wholly unproductive uses/speculation. Effectively, this is excess cash that is used not credte “value” but to speculate. Taken to the next step, govt will want to spend to “buy votes” (in some form of legal fashion, I am not saying that they will actually buy votes), and the Fed will create excess cash to help them achieve that….inflation is excessive deficit spending.

    Whether this shows up in core inflation when there is so much slack in labor and capital is besides the point. Money printing w/o channeling that to productive causes WILL cause inflation (otherwise every govt would do just that and citizens would then say “why bother working”, just build asset bubbles and wait for govt to print money to bail us out). Markets everywhere are front running this by bidding up real assets, which as far as I am concerned, is just as inflationary. Said another way, when excess $ are created w/o adding value, the value of the existing $ declines, which is just another manifestation of inflation.

  2. ds says

    Although I don’t think QE2 is a bad thing, and I am skeptical of the argument that it is deflationary via reduced interest income, I do agree that its effects will be minimal at best. In the end, QE does nothing to help existing debtors, who, it seems to me, are the people who need to start spending again. With respect to mortgage rates, the problem really is that almost a quarter of mortgages are underwater, and most likely almost half are above 80% LTV. So despite these record low rates, people can’t refinance. If I remember correctly, the average mortgage rate homeowners are paying is still around 6%.

    Although the credit-easing operations — maiden lane, mortgage paper in QE1, etc — have a better chance at success than just buying Treasuries, the problem still remains that too many people are stuck deep in debt with flat-lining incomes and are simply unwilling to spend more. And until people spend more, demand for investment will be weak. There is nothing wrong with QE2 per se, but after 20+ years of widening income inequality and trade imbalances, interest rate policy has run out of ammunition.

    Thanks for the post.

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