Brewster's Trillions And The Week Ahead
Well, at long last the week we have been waiting for has arrived, and with it we can expect a degree of volatility that has recently been somewhat rare. Monday's range on the S&P, for instance, was a smidge more than 18 points. Since the beginning of September, there have been only three days with a range more than 20 points (one of those was the 31.58-point range seen in the launch off the bottom on 9/1), so we are already seeing volatility which, though far from extreme, is more life-like than what we have recently seen. To be sure, both stocks and bonds closed near-unchanged, but there are definitely some volatile undercurrents. Investors by now should have their positions squared away for the election, FOMC meeting, and Employment, but some of these investors will discover that their positions are wrong.
I admit that I am surprised that the squaring-away of positions didn't seem to involve much selling. Certainly most indications are that investors are quite long stocks as well as bonds, but apparently the risk of not being long enough heading into this week was taken to be greater than the risk of being too long. Investor and analyst surveys both show very high levels of bullishness and low levels of caution; while the VIX has risen to 22.3 (the highest since September), in the context of the event calendar that doesn't seem to signal much nervousness to me.
I, for one, am nervous about a lot of things. I am not particularly nervous about the general outcomes. It seems clear that the Republicans are on pace to secure major victories in the House and Senate, although they will probably fall short of taking control of the Senate (considering that 40 seats held by Democrats were not even up for reelection in this cycle, that's not terribly surprising. Democrats would have to lose 28 out of 37 races to cede control of the senior body, and occasionally incumbents do, you know, win). It seems clear that the Fed will announce some form of QE2; although "how much" and "when" remains in doubt, the market seems to be generally discounting "a lot" and "soon", and will have some trouble being measurably surprised. The Payrolls number on Friday should be up in the ballpark of 50-75k; how much we care about a miss will be determined by the first two events and the market reactions thereto.
There is considerable resistance to the notion of QE2. I am pleased to have the company of such august market observers as Bill Gross of PIMCO and Jeremy Grantham of GMO. We all seem to dislike QE for different reasons.
Gross in his latest monthly letter describes QE as a "brazen" "Ponzi scheme." I don't agree with many of the things Mr. Gross says in this letter, but he surely isn't far off in that description.
I agree with much more of what Jeremy Grantham says in his quarterly note that has the classic title "Night of the Living Fed" and a cover page that is already a classic. Grantham is a great strategist, even if he gets a little wacky with the whole global warming/climate change thing. His conclusion is basically that "Fed policy [is] a large net negative to the production of a healthy, stable economy with strong employment." And he argues it extremely well. Readers of that piece will see some arguments similar to ones I have made in this space. Another useful summary as QE pertains to inflation:
"Thus, the Fed falls back on its last resort - quantitative easing. This has been used so rarely that its outcome is generally recognized as uncertain. Perhaps the most certain, or least uncertain, is that the eventual outcome will be inflationary or, at best, that it will be inflationary unless precise and timely countersteps are taken."
My own objections to QE2 are less strident; I simply believe it will be ineffective and is therefore a waste of time. I am much more animated by the wasting of taxpayer dollars by the ridiculous fiscal policies we have pursued for several years now (like, 20). Damage done by quantitative easing can in principle be reversed, but now that the IRS has grabbed our legs and shaken us upside down to get at our loose change, so that the Congress and Administration can incinerate it faster than Richard Pryor in "Brewster's Millions" (about 4 times as fast, come to think about it. Brewster had to spend $30mm in 30 days and have nothing to show for it; we've spent $3 trillion in 2 years with almost nothing to show for it), I doubt very much that we will ever see that money again.
Here is a quick summary of my own arguments about QE2:
- Further quantitative easing is likely to have little effect. The quantitative easing of 2008-09 went almost entirely into excess reserves, because the Federal Reserve paid banks to keep excess reserves. While the Fed continues to incentivize the carrying of excess reserves, quantitative easing is likely to go largely into excess reserves. The FOMC does not want to eliminate interest on excess reserves (IOER), or to make it negative, because they feel - probably correctly - that letting short rates go negative would decimate the money fund industry. This is probably true, but if they were really worried about the economy then presumably they would choose the economy over the money fund industry. The latter is easier to rebuild.
- If I am wrong, and QE2 gets into M2 quickly, then its main effect is likely to be on prices, not growth. For additional money in the economy to result in growth, there needs to be substantial money illusion. That is, consumers need to react to the additional money that flows into their salaries and in the value of their investments as if it is true wealth that is increasing and not just a slipping lower in the unit of account. (See my more-elaborate comments on the topic here) I think that such a reaction is more likely when the increase in circulating money is a surprise, rather than being trumpeted for several months in every major news outlet. Therefore, to the extent QE2 "works," it will work mostly to push prices higher rather than growth.
- It also isn't particularly clear that any such stimulus is even necessary. The economy is sickly, but sometimes economies are sickly. Prices ex-shelter over the last year or two have risen at a 2-3% rate, so the "deflation" argument only makes sense if you are trying to prevent a bubble from deflating (which may be the case, but is not in the Fed's mandate) and so are focusing on core inflation including housing.
- While QE2 is likely to be ineffective, and the Fed probably knows it, they may have no choice politically. The beginning of 2011 will see substantial fiscal drag unless (a) the Republicans win the House and Senate, (b) the House and Senate repeal the Health Care Bill and so make serious progress in dismantling and reversing the recent growth of government, (c) with these savings, they manage to maintain the Bush-era tax rates, or something close to them, and (d) the Administration realizes that the mood of the country will not allow it to block these moves. I think this collection of events is supremely unlikely, which makes it highly likely that substantial fiscal drag is coming our way. In that context, the Fed cannot simply sit idly by lest it be accused of "fiddling while Rome burns." Appearing to be doing something is necessary politically.
- The main effect of QE2 on real rates (down 50bps or so since Bernanke's speech in August) and expected inflation (up by a like amount since then) has probably already been mostly felt. Moreover, the money supply is already accelerating, even without M2 (see Chart below). The 6-month rate of change is 7.2%, which is plenty high enough to support an economy growing at a suitable long-term rate. (Indeed, it is a bit too high, but since deleveraging continues and there is considerably economic slack to be taken up before the economy reaches its limit, this is probably acceptable.
Don't really need QE2 when M2 is recovering so well.
In summary, I think QE2 is going to happen, and I don't think it will do much; if I am wrong, I believe I am mostly in agreement with Grantham when I say I think the errors will all be on the side of higher inflation. We have waited patiently for this week, but that doesn't mean we have waited anxiously for it. Are we better off than we were two years ago? Three-quarters of the country in a recent poll said that things are going badly in the country, the highest such proportion in a few decades. But the poignant question will soon be "are we better off now than we were last week?" Let's hope we can say so, but I have my doubts.