Monday, March 28, 2011

Hussman Weekly Market Comment: QE2 - Apres Moi, le Deluge

Last week, a number of Fed officials came out in tandem with essentially the same message - the Fed's policy of quantitative easing is likely to end with QE2. It's important to think carefully about the implications of this for the markets. My impression is that investors are still in something of a "momentum" mentality both with respect to the market and the overall economy, and it's not clear that they've pieced out the extent to which this has been reliant on various stimulus measures that are now drawing to a close.

It is clear that the effect of QE2 has not been to lower interest rates, or to materially expand credit. Rather, QE2 has been built on two blunt forces. The first is that increasing the stock of non-interest bearing money in the economy toward $2.4 trillion, all of which has to be held by somebody, the Fed has created a market environment that has raised the prices and lowered the returns on all competing assets in order to accommodate that equilibrium. As asset prices are bid up, their expected future returns fall, and the process stops at the point where on a risk-adjusted basis, no asset is expected to achieve returns that compete meaningfully with cash (at least over some horizon of say, a year or two). The second force has been purely rhetorical. The opening salvo in QE2 was Bernanke's public endorsement of risk-taking in the Washington Post. Strikingly, he has seemed to eagerly take credit for the speculation in the stock market, particularly in small cap stocks, while denying any culpability for the commodity hoarding and dollar weakness that predictably results from driving real short-term interest rates to negative levels.

In our view, quantitative easing has been a reckless policy, not only because it has fueled what Dallas Fed president Richard Fisher calls "extraordinary speculative activity," but because aside from a burst of short-term optimism, the historical evidence is clear that fluctuations in stock prices have very little impact on real spending (the so-called wealth effect is on the order of 0.03-0.05% for every 1% change in stock prices). People consume off of perceived permanent income, not off of fluctuations in the prices of volatile assets. Now, it's true that QE2 has probably been good for a fraction of 1% in additional GDP, which should be sustained over a period of a year or two, and though we haven't observed real activity or actual industrial production that matches the optimism of survey-based measures such as the ISM indices, it's clear that some pent-up demand was released. Still, the links between monetary base expansion, stock values, and GDP growth are tenuous at best. The most predictable outcome was commodity hoarding, where our expectations have been fully realized, with awful consequences for the world's poor, not to mention for geopolitical stability.

So for our part, we'd be happy to see the termination of QE simply because it is misguided, reckless policy. In contrast, most of the Fed officials pulling back on their enthusiasm for QE argue along the lines that "the economy is strong enough now to do without it," which is unfortunate because it leaves the door open to continue this sort of lunacy should the economy weaken again.


The belief that low real interest rates are helpful is the result of confusing the demand curve with equilibrium itself. Yes, strictly from the demand curve, lower real interest rates are associated with greater demand for capital investment and so forth. But if we want growth, then what we really desire is a persistent outward shift in the demand curve. We want increased desire for real investment and employment at every level of real interest rates. Meanwhile, on the supply side, higher real interest rates help to induce a shift from consumption toward savings that can be directed to finance that new investment. In equilibrium, then, what generally precedes strong economic growth is an upward movement in real rates. Trying to engineer low real rates, which is what the Fed seems to want, is an attempt to move along the existing demand curve, which can never, in itself, be the source of sustained growth, and harms savers at the same time (as the Fed's Richard Fisher observed last week, it only works to "continue the injustice against the virtuous.")