- James I. Clark III
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Is QE3 On the Horizon?
Now that QE2 (quantitative easing 2) is winding down – and with the economy sputtering – will Federal Reserve chairman Ben Bernanke call for a new round of stimulus in the form of QE3? The answer likely is “no”, although it’s doubtful that the Fed will tighten monetary policy until the economy is stronger. The central bank’s strategy has been to buy Treasury bonds to increase the money supply and foster growth. The second round of such purchases, worth $600 billion, ends June 30.
Writing in the Washington Post, Neil Irwin says that “The lousy unemployment report comes on the heels of other disappointing economic data, but Fed officials view the current situation as different from the conditions that led to last year’s bond buying. The recent round of data is neither alarming enough nor definitive enough to make them reconsider the unconventional monetary policy. For one, much of the economic slowdown in the first half of the year was likely driven by temporary factors. The Japanese earthquake and tsunami appear to have disrupted the supply chain at U.S. factories more than initial forecasts, contributing to the drop in manufacturing activity and May’s sluggish employment report. And although oil prices spiked earlier in the year, they have ebbed downward since late April.”
Mohamed A. El-Erian, CEO and Co-CIO of Pimco, agrees, noting that “Notwithstanding the historical parallel, I suspect that it is very unlikely that there will be a QE3. This view is based on an assessment of economic, political and international factors. As Chairman Bernanke noted in his August Jackson Hole speech, and reiterated in his first press conference, policy measures should be judged in terms of the expected balance of benefits, costs and risks. I suspect that there is now broad agreement that, in the case of QE3, this balance has shifted: lowering the potential gains and increasing the probability of collateral damage and adverse unintended consequences. It is also clear that, in its attempt to deliver ‘good’ asset price inflation (e.g., higher equity prices), the Fed also got ‘bad’ inflation. The latter, which essentially took the form of higher commodity prices, is stagflationary in that it imposes an inflationary tax on both production and consumption — thus countering the objective of QE2.”
There’s also the point that QE2 has had mixed results. According to Bernanke, “Yields on 5- to 10-year nominal Treasury securities initially declined markedly as markets priced in prospective Fed purchases; these yields subsequently rose, however, as investors became more optimistic about economic growth and as traders scaled back their expectations of future securities purchases. Equity prices have risen significantly, volatility in the equity market has fallen, corporate bond spreads have narrowed, and inflation compensation…has risen to historically more normal levels.”
Philadelphia Fed President Charles Plosser warns that QE2 provides excessive stimulus: The central bank has “a trillion-plus excess reserves,” he noted, which could be “the fuel for inflation.” Anticipated inflation could explain the sudden increase in long-term yields that began last November. But the rate for 10-year Treasury Inflation Protected Securities (TIPS), rose at the same time, which contradicts that interpretation. At the same time, the five-year TIP rate didn’t rise. Had that rate increased, there would have been a sign of a stronger economy in the next five years.
UBS thinks that QE2 failed and is strongly opposed to another round of stimulus. Maury N. Harris, UBS’ Managing Director and Chief Economist for the Americas, says that “The evidence that QE2 boosted economic activity is lacking. Yields moved higher and equity markets did as well, although the latter was justified by rising corporate earnings. They importantly reflected better volumes, which probably cannot be traced to any believable instantaneous response to policy that works with a lag. Despite the recent weakness in the data, we continue to view the recent slowing as insufficient to prompt further QE from the Federal Reserve. Relative to conditions in August 2010, when QE2 was floated by Chairman Bernanke, labor market conditions are better. Additionally, the threat of disinflation last fall has given way to a somewhat more disturbing build-up in inflation pressures as core inflation continues to accelerate.”