Thursday, November 4, 2010

The Absolute Return Letter - November 2010: Four Rather Sick Patients

For a world which continues to be on life support – in the form of unsustainably large fiscal stimulus and near zero interest rates – policy makers are fast running out of options. One of the options left is quantitative easing and rumours are rife that the Fed and the BoE are both contemplating another round. But how effective is QE? Evidence from Japan suggests that, as a central bank continues to expand its balance sheet, the law of diminishing returns kicks in. Japan has been at it for years to the point where total central bank assets are now ¼ the size of the overall economy (see chart 3), but the results have been less than impressive. There are several reasons for this, but the most important lesson learned from Japan is that you cannot stop de-leveraging with lower interest rates.

QE2 around the corner? Inside the vaults of the Federal Reserve Bank, this fact does not seem to have sunk in yet with Bernanke seemingly prepared to initiate another round of QE shortly. He has even stated publicly that equity and bond markets are far more sensitive to monetary policy than is the real economy; hence the most effective way to stimulate the economy is through boosting financial markets. One problem with such a policy, though, as pointed out by Edward Chancellor in the FT earlier this week, is that it requires for consumers to draw on their savings to be successful. America needs higher savings and investments, not a continuation of recent years’ reckless spending.

Another problem is that it distorts currencies, but the Fed clearly doesn’t care. Not that they have said so in so many words, but their actions speak their own very clear language. I also find it remarkable that the Fed suddenly seems to be applying inflation targets. In the past, the Fed has always stayed clear of such policy. Now they are stating publicly that QE is necessary as current inflation is too low. Maybe it is, but relative to what? Officially, the Fed does not have an inflation target. The only conclusion I can draw is that they want the dollar to go lower, and equity prices to go higher, in order to fix the economic mess they have created themselves in the first place.


Related article: Capt Bernanke on course for icebergs – By Edward Chancellor