The minutes of the September meeting of the Fed panel that sets interest rate policy, released Tuesday, expressed a need "to make it clear that underlying inflation had been running below levels that the committee judged to be consistent with its mandate for maximum employment and price stability. . . . Nearly all members agreed that the statement should reiterate the expectation that economic conditions were likely to warrant exceptionally low levels of the federal funds rate for an extended period."
Translation: Chairman Ben Bernanke and his colleagues on the Federal Open Market Committee find deflation - a persistent decline in the prices of goods and services that is one of the most insidious and intractable economic conditions - more of a threat than inflation. And to make clear that they weren't pondering some abstract, murky, distant future, the statement highlighted "the members' sense that such accommodation may be appropriate before long."
The stock market reacted as it has to other bits of bad news that have come its way in recent weeks - with a brief pause to digest it and then a flurry of buying. The Standard & Poor's 500-stock index closed Tuesday at its highest level since May 12.
Quantitative Easing: the Sequel
Investors seem to have decided that the Fed - now that is has articulated the problem as clearly as it ever articulates anything - can go full bore in implementing a solution. The one that they are pinning their hopes on is "QE2." That's shorthand for the second round of quantitative easing, or massive purchases of Treasury bonds.
Quantitative easing first occurred in 2008 and 2009 and involved more than $1 trillion. Market strategists have been speculating about how much money the Fed will spend to buy Treasury bonds in a repeat performance and when the purchases will start.
Ethan Harris, North American economist for Banc of America-Merrill Lynch, said in a recent note to investors that he expected the Fed to announce a $500 billion program, beginning in November and spread out over six months.
Chicken feed, says Julia Coronado, an economist at BNP Paribas. She contends in a note of her own that the Fed is prepared to plunk down twice as much, also beginning in November.
Such faith in the Fed and its balance sheet probably account for much of the rally in stocks since August, although widespread anticipation of a big Republican victory in midterm elections has also given stocks a lift. Chatter about quantitative easing has been so overwhelming lately that a backlash is emerging; some commentators are encouraging investors to jump ship before QE2 arrives, describing it as a sell-the-news type of event that is already factored into prices.
A Lot of Buying Power
Coronado argues that such contrarian thinking ignores the fact that the sum likely to be spent is just too great not to move stock and bond prices higher. The doubters' "perspective misses the point of a printing press," she writes. "While market participants can rearrange their portfolios in anticipation of Fed policy, the fact is that the Fed is likely set to inject $1 trillion or more in new dollars into financial markets. This will have to find a home and will further lift asset prices over time."
That's what Wall Street is betting on, but it's no sure thing. Investors act as though QE2 will provide something for nothing, but the Fed will have to either print those new dollars that Coronado mentioned, which will devalue all the other dollars in people's wallets and investment portfolios, or else borrow them. If central bankers intend to sell securities worth hundreds of billions of dollars just to buy securities worth hundreds of billions of dollars, why not skip it and take a long lunch?
Even if you don't mind the long-term damage caused by massive printing or borrowing of money, QE2 doesn't seem like an effective strategy for reviving the economy. There's no way to ensure that it will fulfill its purpose of channeling money to businesses, for one thing. Banks are still reluctant to lend, and many companies are still too nervous to borrow.
If at First You Don't Succeed...
Before talk of QE2 became so feverish, Komal Sri-Kumar, chief global strategist at TCW Group, wrote a paper expressing doubts about its success. What his argument boils down to is this: If quantitative easing is good for what ails the economy, why does the Fed have to do it a second time?
"The clamor from some economists for additional QE in the United States comes after some two years and $1.5 trillion of such easing have already taken place. . . . The U.S. economy's growth has slowed to a crawl after just a few quarters of adrenaline rush coming from the increased liquidity. Even though newly minted cash has surged, bank lending to the private sector has not."
QE2 may produce better results than QE1, but with expectations of success so high and economic conditions so feeble, there could be little to show for it on Wall Street. The stock market may give back its recent gains, maybe more, if investors conclude that whatever $#*! the Fed does will not be enough.