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Thursday, September 13, 2012

QE under the microscope

There seems to be a big consensus that the FED will announce a full blown QE program today  The FED has talked out of both sides of its mouth if you listen closely.  Bernanke has talked about both rewards and risk.  The Dallas FED put out a paper talking about the risk of unintended consequences.  Some FED people have even been talking about unlimited QE.  People only seem to notice QE yes talk and ignore QE no talk.  There is talk on both sides.

I don't believe the QE decision is anywhere near as simple as people make it out to be.  The majority of economists do not believe we are in a recession.  Before the latest unemployment report many economists were talking about how the economy was picking up speed.  The latest unemployment data was not as bad as it was earlier in the summer.  So why are people more sure about QE now then before?  I almost think people have talked each other into it, LOL.  Every speech by Bernanke is the same.  He says QE worked and they stand ready to do something if needed.  Well, what is the if needed part?  Have we reached that yet with SPX at bull market highs?  What happens if the FED does QE now and some crisis happens afterwards?  Will further QE help calm markets when a current QE program was already in place?  Is that a risk Bernanke thinks is minor so he goes ahead with QE?  What do the charts say about QE1 and QE2?

Here are several charts that may put some perspective on things.

Here is the world food index chart.

Here is the dollar index chart.

QE1 clearly sent interest rates higher.  QE2 sent interest rates higher in the initial stages, but they cooled down some later on.  That was likely a result of GDP coming in at .4% growth in the first quarter of 2011.  If the economic growth had not slowed down so dramatically would rates have continued higher?

Notice what happened to the price of oil, the world food index, and the CRB commodity price index during both QE1 and QE2.  The break out and run up in the price of oil during QE2 coincided with the peak in global stock markets and the start of the global economic slowdown.  A good part of the oil price surge was caused by the situation in Libya.  It is a bit hard to quantify exactly how much was due to QE2.  The CRB actually started flying up in Sept. 2010 when everybody believed QE2 was coming after the Jackson Hole Bernanke speech at the end of Aug.  It kept racing up after the implementation of QE2 started in Nov. 2010.  The 2011 peak in the CRB most likely occurred because of the slow down in the global economy combined with a bit of front running the end of QE2.

Where are we now?  The CRB is pretty close to where it was when QE2 started.  The dollar index is a bit higher then where it was.  Oil and food are both considerably higher then when QE2 started.  Interest rates are a lot lower now then at the beginning of QE2.

If past history is any indication here is what is likely to happen under QE3.

1. Commodities rise, probably including food and oil.
2. Dollar index likely to jump around at first, but should trend lower at some point.
3. Interest rates may actually rise.
4. Stocks go higher if QE3 bigger then what is priced in.

Numbers 1 and 3 would do more harm to the economy then good.  Number 2 would be good for the U.S. if the dollar goes down, but the consequence of that would be the Euro rising.  That would be bad for European exports to the U.S. and could harm their already fragile economy.

Because of bank failures there was a serious liquidity problem in 2008 when QE1 was implemented.  This program rebuilt bank reserves and shored up the financial system.  It worked and prevented the crisis from getting worse.  However, QE2 did nothing useful.  Commodity prices increased and started a global economic slowdown that is still in process today.  Economic growth in this country also dropped considerably in the first half of 2011.  There were more factors then QE of course, but QE did nothing to help the situation.  I have yet to hear an economist in the media that actually believes QE at this time would do anything good.  Interest rates are low and we are awash in liquidity.

One risk of doing a new QE program now would be that rising commodity prices and interest rates could choke off what little economic growth we have.  The only reward seems to be possibly higher stock prices.  That would be short term if the economy ends up choking though.  If the FED does QE now, I think it will go down as one of the biggest central bank blunders ever.

The flip side to all of this is the risk of a stock sell off if the FED does not do QE now.  Would that be a big enough sell off to affect the economy in a negative manner?  Bernanke has a lot to think about.  I wonder how well he has been sleeping the last few nights.  It is possible that whatever he does, there are some adverse consequences at some point.


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