QE3: Big Debate, Little Impact

by Fisher Investments | December 10, 2012 9:14 am

Mid-September’s announcement of the Fed’s now third round of quantitative easing was preceded by heated debate. Monetary hawks warned of the heightened risk of out-of-control inflation due to more Fed stimulus. Doves countered that the Fed should do more to stimulate the economy to lower a persistently high unemployment rate.

Yet overall, we believe the more likely outcome of QE3 is one where neither rampant inflation nor a vast, liquidity-driven hiring binge is likely to occur — a lesson we think the Fed might have well learned after QE2. The reason is the policy isn’t likely to be very effective in depressing rates materially and, as Ken Fisher recently discussed, is actually contractionary and deflationary policy.

First, consider the Fed’s objective to stimulate the economy by lowering long-term interest rates (never mind that long-term interest rates were already at multi-generational lows prior to September’s announcement). Since then, 10- and 30-year Treasury yields have barely budged. Mortgage rates (30-year fixed) fell a bit, but is the dip truly likely to impact homebuyer behavior much? Rates, again, were at generational lows before QE3.

Exhibit 1: 10- and 30-Year Constant Maturity Rates in 2012

Optimists at the Fed — seeing even modestly lower long rates as an incentive for borrowers to seek loans — might yet have hope for more results from QE3. But the reality is, markets — in this case, the Treasury market — move in front of anticipated events, not after the press release hits. Perhaps that’s why the lowest rate seen in 2012 is more than a month before QE3 (though, admittedly, that could be driven by other factors as well). So any impact of QE3 likely is already felt, and rates haven’t fallen much as a result.

And it’s a good thing they didn’t.

You see, flattening the yield curve — which depressing long rates does, since short rates are near zero — reduces the incentive for banks to lend and is an odd goal for the Fed to have, particularly when its stated aim is to stimulate.

Banks typically borrow short-term money (at rates near the Fed Funds Target Rate) and lend longer for things like business, commercial and mortgage loans. The spread is their profit, and their incentive to initiate loans. More profitability likely would drive more lending, so the Fed’s statement and actions seem utterly at odds. They’re focusing on what might stimulate borrower demand to the exclusion of lenders’ motivation, which simply isn’t likely to result in much of a lending boost.

Exhibit 2: Term Spread (10-Year Constant Maturity Yield Minus Three-Month Constant Maturity Yield)

But the policy confusion seemingly continues from there. Add to that the Fed’s own policy of paying banks interest just to park excess reserves at the Fed — an additional disincentive to banks to lend more aggressively. Instead of having to extend loans to earn a return on excess reserves, they can get paid a small (though risk-free) rate just to leave their reserves at the Fed.

Exhibit 3: Excess Reserves on Deposit at the Federal Reserve

I guess a silver lining in the immediate future is the risk of hot inflation remains rather low. As Milton Friedman said, “inflation always and everywhere is a monetary phenomenon.” To get accelerating inflation, more money must circulate as banks expand deposits by making new loans. But in our view,  this isn’t likely in the immediate future — if banks have little incentive to lend (thanks to the Fed), velocity likely won’t increase materially.

Even if banks were to shift gears and boost lending, significant slack remains in the U.S. economy — historically low rates of capacity utilization and sticky unemployment are high barriers to rising inflation. But, again, this seems perplexing when the Fed hasn’t indicated that its goal is to hold down inflation but to stimulate the economy. Its actions aren’t stimulating much of anything.

Still, despite the Fed’s rather puzzling monetary policy over the last few years, the U.S. economy has continued to grow. Not gangbusters, but growth is growth — speaking to the remarkable resiliency of America’s economy.

For those who believe the Fed’s actions are artificially propping up the economy and markets, it’s my suggestion their thesis needs to be rethought.

Michael Weston, Fisher Investments.

This article constitutes the views, opinions, analyses and commentary of the author as of December 2012 and should not be regarded as personal investment advice. No assurances are made the author will continue to hold these views, which may change at any time without notice. In addition, no assurances are made regarding the accuracy of any forecast made herein. Past performance is no guarantee of future results. A risk of loss is involved with investments in stock markets.

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