Wrapping up QE2
(July 7, 2011)
Dear Subscribers and Readers,
As the European Central Bank prepares to hike its policy rate by 25 basis points later this morning, the Fed has finally wrapped up its “QE2” policy of purchasing an additional net $600 billion of Treasuries as articulated in its November 3, 2010 press release. Combined with China's surprise 25 bps rate hike yesterday, the whole world is now officially in tightening mode. While we believe that the ECB's hike is misguided given the simmering European sovereign debt crisis, we agree with the Fed to let it quantitative easing policy expire. We believe that a “QE3” policy would do more damage than help, as it will surely reignite the rally in commodity prices—causing further deterioration in the current account and the balance sheets of lower-income U.S. households. From late June to mid-November last year, the size of the Fed's balance sheet (the amount of securities outstanding) remained steady in the $2.04 to $2.07 trillion range. Since the implementation of the Fed's “QE2” easing policy in mid-November, securities outstanding on the Fed's balance sheet has rocketed higher by $588 billion by June 29, 2011—a record high. As shown on the following charts, the Fed had been purchasing more Treasuries as its agency debt and agency MBS holdings matured over the last 12 months:
As mentioned, any further asset purchases by the Fed will likely do more damage, as U.S. monetary policy is already highly misaligned—i.e. there's no need for further quantitative easing as the U.S. financial system is no longer in “crisis mode.” Such purchases will likely cause further erosion in the US$, resulting in further deterioration in the current account and commodity inflation. Just as important, a “zero interest-rate” policy, combined with quantitative easing, will result in a gross misallocation of capital in the long-run (it not only “short circuits” Joseph Schumpeter's “creative destruction” forces; but also allows the U.S. government to spend even more money that it doesn't have). Make no mistake: The Fed will and should not implement a “QE3” policy.
Let's now look at the Fed's weekly purchases up to June 29, 2011:
Since mid-November, the Fed has purchased a net average of $17.5 billion of securities on a weekly basis. While the amount of agency securities (which includes debt + MBS) outstanding has declined by $171 billion, this is more than offset by $759 billion in Treasuries purchases over the same period. More important, the size of the Fed's balance sheet has rocketed higher by nearly $588 billion in the last 7 1/2 months—to a whopping $2.64 trillion. At this point, QE2 will add little to global liquidity, although this is not a bad thing if commodity prices follow to the downside.
On the other side of the Pacific, the Bank of Japan is also tightening somewhat after opening the liquidity spigots in the wake of the March 11th earthquake. This is somewhat disappointing given the much-needed rebuilding in Japan. From the end of May to the end of June 2011, the year-over-year increase in the Japanese monetary base increased slightly from 16.2% to 17.0%, although it is still down significantly from 23.9% at the end of April. The pullback in liquidity creation is evident in the following chart:
Upon the publication of the April numbers, we reminded our subscribers that while the increase was highly encouraging, we should note that the Bank of Japan has historically tightened liquidity quickly after any exogenous shock. This is again coming true, given the latest decline in the Bank of Japan's monetary base. Given all-around global tightening, subscribers should continue to be cautious.
Henry To, CFA, CAIA