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VIDEOWhat Can the Fed Do?
By
James Kostohryz
Aug 31, 2010 8:30 am
Less than most hope; more than many fear.
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I think that all of this speculation overlooks a basic fact: A QE2 wouldn’t work. And since the Fed knows it, it won’t happen on a scale that could be considered meaningful.
Why a Major QE2 Is Probably Not in the Cards
Interest rates are low across virtually all maturities and asset classes -- from T-Bills to Treasuries, from short-term corporate paper to long-term “Junk” bonds. In particular, for virtually all categories of debt that the Fed can actually acquire, real rates are pretty near as low as they can get. Given the massive size of global bond markets, to drive interest rates any lower the Fed would have to increase its balance sheet by a massive amount, and probably purchase securities way out on the risk spectrum, to achieve even a marginal interest rate response. One well-publicized Goldman Sachs study, which is reportedly confirmed by an internal Fed study, suggests that the Fed would have to expand its balance sheet by an additional $4 trillion USD -- or tripling its current size -- just to be able to move the real interest rate needle.
Let’s just assume for the moment that the Fed would be willing to do such a thing. Would it? The fact is that massive Fed intervention in debt markets to drive interest rates on certain securities down an additional 50 basis points is unlikely to make any significant difference to the economy at this point. What ails the economy isn't a lack of supply of credit or its price, it's the lack of effective demand for goods and services. In this context, the Fed has virtually no influence on effective demand.
Fed committee members aren't dumb. I believe they realize that, at this point, they have little power to substantially stimulate the economy. In my view, Fed committee members understand that they would squander institutional credibility if they announce bold “action” and their policies get no results. Therefore, I don't expect any sort of Fed action that will be perceived as a sort of major QE2.
I think it's likely that the Fed will throw some “QE2 light” stuff out there just so it can protect itself from the charge that it's doing nothing. But it's my view that it's unlikely to do anything truly substantial.Was QE1 a Failure?
The very question of whether a QE2 is in the cards brings up the question of whether QE1 was a failure.
The objective of QE1 was to restore liquidity to a financial system that was undergoing a liquidity crunch, and through this strategic injection of liquidity, create the conditions for an economy-wide reduction in interest rates. On these terms, and to this extent, QE1 succeeded.
When QE1 was first announced, criticisms came fast and furious from two diametrically opposed camps.
The “inflationist” camp predicted that QE1 would cause an explosion in inflation. This didn't occur. The mistake of these inflationists is that they adhere to a simplistic and false dogma that posits that increases in the money supply will necessarily lead to increases in aggregate prices. QE1 didn't even lead to an increase in the money supply, much less to increases in general price levels. Inflationists were spectacularly wrong.
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