Thursday, November 4, 2010

The FED, QE2, and M2, Again

In the Washington Post today the FED Chair tells his side of the QE2 approach he takes. He states:

Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.

In our analysis yesterday we showed that under the following circumstances there could be 20% or more inflation. Let us review those assumptions:

First, we assumed that the banks would return to aggressive lending sending the M2 to FED BS ratio back from 3 to over 8. That would mean a low bank reserve and high leverage. We have seen that such was not the case. Indeed the banks who are getting the new buyouts will most likely be the same ones which got the old ones and they just turned around and bought new Treasuries and the cycle continued. Indeed the ration may drop further and thus M2 would not increase that much.

Second, we assumed the FED not just doing $600 B but a total of $1.5 Trillion over the next two years. That is less of a problem if it does not leak. It is a great problem if it leaks.

Third, we assumed that there were still markets for Treasuries, long and short term. Indeed if we continue the deficits this may not be the case and the $1.5 T may be low!

He also states:

Even absent such risks, low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating. The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009.

Yes there is spare capacity, but the core changes are often related to globalization, increased productivity, and fungible intellectual property markets. China is just one of the new economic threats and we have not look at India. The other problem is that many older people have moved what little they now have from 401K plans to fixed return instruments and the returns are near zero, so they will eat into principal. Then when inflation hits, and it will we believe, because this current administration needs and wants it, the older fixed income folks will be wiped out.

Money is tight but not because of the FED or because of economic principles studied back at MIT. It is tight due to the abject uncertainty of the economy engendered by the current administration. The irony is that the Republicans may now cause so much lockup that things may improve and the administration may even take credit, credit for nothing.