What Is It That Wall Street Thinks QE Does, Ctd

I think the garden variety wall-streeter views the QE as debt monetization old school style. And, thinking of themselves as rugged individualists of the Teddy Roosevelt/Gordon Gekko hybrid ilk, find it morally wrong.

They do not fully understand, or want to understand that the FED monetizes and UN-monetizes on a massive scale. Print/Unprint.

They don’t understand the transmission mechanism (private credit), for now, is off. They wrongly view the QE as FISCAL POLICY gone haywire. Straight cash homey. (Arguably, though, QE is deflationary. Strips interest income out of the private sector and onto the FEDs balance)

They view the QE as ready to spend funds that are gonna drive the price of Wheaties thru the roof.

Well intentioned, sort-of. But they don’t get the architecture of the building they are evaluating.

Here’s QE from what I understand it does.
(Before I start, its important to know that QE is NOT money printing, QE is merely an ASSET SWAP. FED gets treasuries, and in return credits reserves (cash). Its like if I gave you $100 million in cash for your $100 million worth of bonds. No change in the private sector. The treasuries are no longer in the private sector, so no increase in Net Financial Assets (NFA) for the private sector. I like to think of it that whatever the FED buys, it ends up in a “blackhole”)

1) By lowering interest rates by removing supply from the market, the FED is trying to “stimulate” the economy. In a normal environment, this would work. However, as we know, the recession we witnessed in 2008-2009 was abnormal than the previous recessions dating back to the Great Depression.
The recession caused a balance sheet recession (BSR), where the private sector is looking to save/pay down debt rather then spend/invest/borrow. Because of this, lowering interest rates have little effect to “jump start” the economy.

2) However, QE is not all that ineffective. There are some “side-effects”

A) Lowers Interest Income, + deflationary
-Since yields are being lowered, the private sector is receiving LESS interest income, which would actually in this economy (the one of a BSR) be more stimulative THAN lower interest rates. So the fact that the private sector is receiving less NFA because of lower yields hurts the economy. If for example I was receiving 2% on my CDs instead of 1%, then I would be able to spend more (or use it to pay down debt, thus speeding up the BSR)

Also, because of the fact that QE is an asset swap, the very operation of conducting QE is actually deflationary because a 2% yielding financial asset (for example, using the 10 year) is being swapped with an asset (cash aka reserves) that yields 0-0.25%.

B) Chase for yield + risk
-QE causes structural change though. Because yields are being lowered, that causes pensions/funds who have to meet certain requirements “chase yield’. The go for more risky assets yielding higher like IG, HY, RMBS CMBS and etc.)….
This chase for risk also leads the market higher as people decide to buy Equities in the face of lower yields.

C) Psycholigcal component
-This is big IMO. People think “QE” is money printing so they go out and buy assets that would protect themselves against inflation (stocks, gold, commodities), and sell assets that would lose value in the face of inflation (bonds, US Dollar).
-

D) Banks hurt b/c of lower rates
-QE actually hurts banks ability to make a profit because ias we know banks borrow short and lend long. When that spread narrows, they make less.

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“Supposed negatives”

-QE is money printing thus the dollar loses value.
QE is NOT money printing, its an asset swap. The private sector does NOT recieve any new NFA (in fact they lose it). Anything that goes into the FED is a “black hole” (aka not in the real economy).

-Low rates will cause a bubble.
That wont happen in a BSR environment where nobody is borrowing. Yes, if we continue QE for years (>2015), then yes once the environment normalizes, then bubbles might start forming. But if the FED is not conducting QE now, what makes anybody think they will do it in the (healthier) economy (presumably)?

i can only tell you my interpretation: the financial press is looking for signs that the fed is committed to closing the output gap and not prematurely tightening. more qe is a sign the fed is comfortable with speed and would like things to speed up.

in terms of real effects, the fed says it lowers effective long term rates

as far as risks, i think you see the same variety of opinions in economists (williamson, Taylor, etc): the risks of inflation getting unhinged (esp from old school monetarists looking at reserves, not accounting for the relatively new IOR policy.

a lot of opinions at banks flow from fed watching economists. Fisher says QE has big risks. ask him.

more importantly: the financial press is more about eyeballs than analysis. i doubt youll get a thoughtful response. theyll print what gets the most attention regardless of veracity. when it comes down to it, you can find a talking head to put on and advocate any crazy idea

The area I work in is highly senstivie to monetary policy. These seem be the three main points conveyed by others:

1) Interest rate policy is the Fed’s only tool.

2) QE does little/nothing to impact the economy as the cash just sits on bank balance sheets due to IOER.

but…

3) The expanded monetary base and securities holdings present significant inflationary risk upon Federal Reserve exit from ZRP.

I think the Austrian economists make the most sense and have been the most accurate in predicting what was going to happen… to a T

Here’s a nice power point presentation by Roger W. Garrison Professor of economics at Auburn University:

Here’s a YouTube of TV interviews of Peter Schiff predicting the housing bubble, with the “experts” mocking him, & Bernanke explaining why he didn’t think there was any bubble:

Here’s what Mr. Schiff had said in May 2004:

http://seekingalpha.com/article/181514-bernanke-denying-the-obvious

“That so many are currently opting for ARMs reflects a level of real estate speculation unparalleled in American history. Homebuyers have been lured into this foolish choice by… a Fed chairman desperate to keep the real estate bubble inflating. Unfortunately, the longer the Fed remains “patient” with regard to raising short-term interest rates to appropriate levels, the more homeowners that will be lured into the ARM time bomb.

The real losers in this whole fiasco are likely to be those who did not even participate in the mania. As over-leveraged borrowers walk away from properties in which they have no equity, the Fed will most likely attempt to bail out both debtors and bank depositors (and the government sponsored enterprises that insured the loans) with the most inflationary monetary policy ever undertaken in the history of central banking. The savings of an entire generation will be wiped out, as it will have been squandered to perpetuate the biggest real estate and consumer debt bubbles of all time.”

I work as a natural gas market analyst and have clients at most of the biggest banks and energy trading shops in the country. I have a CFA and some people consider me to be conservative although I don’t think the taditional left-right paradigm is a particularly useful way to frame politcal discussions.

I’d be happy to disccuss how I believe QE affects commodity markets. gabeharris@alum.mit.edu