QE3? Not So Fast. Let's Debate the Merits of QE2 First
The Fed’s second round of monetary stimulus, the $600 billion QE2, ended on June 30. Since then, financial markets have rallied on news of another Greek bailout, and then fallen on weakening jobs and economic news from the U.S. The Dow is basically back to where it was when QE2 ended on June 30. So the world hasn’t ended, and yet there are those who think we need a third round. The minutes of the latest meeting of Federal Reserve officials, released Tuesday, show them divided on whether to implement a third round of monetary stimulus. Before we get ahead of ourselves, let’s first assess QE2. For that, we turn to two of our regular contributors, Justin Wolfers, and James Altucher.
Justin Wolfers is a professor of economics at the University of Pennsylvania and a visiting fellow at the Brookings Institution, with wide-ranging interests across labor, macro, social and behavioral economics.
QE2 Was an Economic Success, and a Public Relations Disaster
Let’s begin with the economic success story. QE2 was the Fed doing what it normally does: adjusting interest rates. It does this by buying and selling government securities. In normal times, it does this in the Fed Funds market, and the effect is to change the short-term interest rate. But right now, the short-term interest is nearly 0%, and can’t go any lower. So something else is required. That something else is extremely similar: the Fed has been buying government securities with an eye to reducing longer-term interest rates. It’s as simple as that. The best research on this—by Kellogg’s Arvind Krishnamurthy and Annette Vissing-Jorgensen—suggests that the Fed was reasonably effective at reducing longer-term interest rates, although much less effective at reducing interest rates on corporate debt. Many different factors buffeted the economy during the past year, so it’s impossible to tease out the specific effects of these lower rates, versus other factors. But most economists believe that lower interest rates spur investment, and in this case, helped avert the threat of deflation.
If you really understand quantitative easing, you’ll understand that this is all pretty much business as usual: The Fed shifting interest rates, in order to kick-start a faltering recovery. There’s nothing controversial here.
But instead, we have a public relations disaster. Instead of the usual boring language about changing interest rates, the Fed talked about “Quantitative Easing,” and $600 billion of purchases. In a world where bankers have been saved with billions of government money, we naturally feel suspicious when pin-striped central bankers are talking about devoting billions of dollars to anything. And we were suspicious. Economic policy discussions usually focus on costs, and so naturally many people believe that QE2 somehow cost us $600 billion. It didn’t. It probably cost us nothing. It’s also too easy for people to confuse this $600 billion with the $787 billion fiscal stimulus. Yet buying bonds (which have value) is a totally different proposition than building bridges. Yes, the Fed was printing money, but it always does this.
The Fed’s public relations disaster was compounded by the fact that it makes policy in a world full of political and financial opportunists. The gold bugs and their sponsors told us that currency can’t be trusted, and we should buy gold; wing-nuts exchanged their predictions of hyperinflation—which hasn’t happened—for valuable airtime to voice their lunatic theories; and people who should know better suggest a return to the gold standard. Hucksters abound, crowding out the boring truth. And the Fed invited all of this.
Here’s my suggestion to the Fed: Be more boring. Stop talking in terms of quantities. It’s confusing. Instead, announce a target for a particular interest rate—say, a five-year bond—and do what you’ve always done, buy and sell securities so that you hit that target. Right now, unemployment is high, and inflation is expected to remain low. Do what you always do in a situation like this: reduce interest rates.
And shhhh, don’t tell anyone that you do this through buying billions of dollars of bonds. I won’t tell anyone if you don’t.
We Didn’t Need QE2, and We Haven’t Even Felt Its Full Effects Yet
QE2 is the greatest thing to happen to bubble aficionados (such as myself) since Alan Greenspan cranked up the printing press in anticipation of the world shutting down for Y2K. In other words, you tell the gimp in the basement cellar of Goldman Sachs to start buying Treasuries, bonds, mortgage-backed securities (MBS), stocks– whatever he can get his hands on from the fluorescent Bloomberg screen in his cage only when you think the world is going to end.
Here’s the problem: the world didn’t end with Y2K. And the world is not ending now. In fact, we’re about to experience our eighth consecutive quarter of GDP growth. And, trivia note: this is the first recession ever where American corporate cash actually increased every quarter without a decline. Because we were so quick to cut tens of millions of jobs and/or outsource them abroad, corporate America was able to maintain and increase its already enormous profit margins. Will this continue? No, but it won’t decline so fast either. We are in a new paradigm now where American companies have become more globalized than ever, and it’s largely going to remain that way. Will we ever see 5% unemployment rates again? Maybe, but probably not for a very long time, if ever.
So what does happen with QE2 and why did its “end” not bring about the end of civilization as many people thought (or still think) it will.
QE2 buys treasuries, MBS, longer term bonds, whatever they want. They do this so that the supply of all these assets go down, and the prices go up. When bond prices increase, interest rates go down. When interest rates go down, two things happen:
– banks begin to lend
– stock prices go up.
Here’s the problem: banks have already been lending. Everyone on TV says, “The banks aren’t lending!” But commercial lending to small and medium businesses (the largest suppliers of jobs in America) has gone up for 7 straight months. And stock prices are up despite the current jobs malaise. At the end of the first half of the year, the Dow was up 7%. Will that end? Nope. Here’s why:
– Even though QE2 is “over” the Fed is still going to be reinvesting the interest they get on the bonds they bought. That’s tens of billions of dollars. And they can invest in anything they want to.
– Large cap stocks are at their cheapest levels relative to earnings ever. Ever. Apple trades for 12 times forward earnings not counting the $65 billion in cash it has in the bank. This is hard to fathom. Apple grew earnings by 92% last year. So it’s not unreasonable for Apple to trade for 92 times earnings (many companies trade at a multiple equal to their growth rate). Apple has the iPhone 5, the iPad 3, the iCloud, and heck, the iPhone 10 coming down the road. Earnings are not going down. Revenues are not going down. We are an innovation economy and Apple, Google, and hundreds of biotech companies are continuing to innovate regardless of how many jobs get outsourced to China.
– With $2 trillion in cash sitting in the coffers of corporate America and interest rates close to zero, companies are finally starting to do what they should with their money: buying stuff. Stock buybacks are at an all time high. M&A is creeping up every quarter. Again, when you reduce the supply of shares on the market and demand remains the same or goes up, stock prices go up. And when stock prices go up, companies raise more money from the public and it becomes a virtuous cycle. This was already happening without QE2.
Are there inflation worries? Of course not. Government inflation numbers use rent, not housing prices, because rent is less volatile. Your house has gone down in value for the past 5 years. It’s flat with last year (for the first time in five years) but it hasn’t gone up. Guess what? That’s your No. 1 purchase. And it’s been deflating. We have no inflation issues. When oil was at $150 we had a housing crisis and a financial crisis. Now we have neither and oil is less than $100. So inflation is in a galaxy far, far, away, no matter what gold says. I don’t buy gold. But every morning I buy a cup of coffee for 75 cents. Just like I did ten years ago.
So what’s the ugly? Well, we never really needed QE2 in the first place. The world wasn’t ending. The economy was improving. Eventually, not this year, but perhaps 2012 or 2013, the multiplier effect will kick in. That’s when the bank lending fully kicks in and they lend to company A, who buys from Company B, who resells to Company C, who pays person D, all with the same $2 bill. Every dollar of stimulus multiplies through the economy and that’s how bubbles start.
Fortunately, we are a long way from there. So forget being an economist for a second. Forget all about economics. We’re humans who feed families. How do we benefit? We buy stocks, which benefit from bubble behavior. We’re on the right side of a bubble that is pre-fueled by QE2. Buy to your heart’s content on every dip. Don’t worry about the media headlines. Greece is a beach resort the size of Connecticut. The IMF is a useless country club. Obama has zero say in fiscal policy. Everything is already in motion. Facebook will go public and the frenzy will begin from that point on for at least a year. Buy now, and precisely one year after Facebook goes public, quietly go to cash and stuff the money under your mattress. Send me the thank you letter in 2015.