On September 13, 2012 the Federal Reserve (Fed) announced a third round of money printing, or Quantitative Easing 3 (QE3).  This round of money printing has a dramatically different twist and message attached to it, as it has no expiration date or limits.  Clearly, the Fed’s stated objective of a sound currency is now taking a back seat to stimulating the economy.  Today, the question remains whether or not this latest attempt to stimulate the economy will work, or will it be remembered as just another desperate attempt by the Fed to save a broken system.

The outlined plan of QE3 states that the Fed will purchase at least $40 billion worth of mortgage-backed-securities each month until unemployment numbers are satisfactory.  It is interesting that they have not defined what a satisfactory level of unemployment is, but based on historical statements released by the Fed, they are likely looking for levels somewhere between 5% and 7%.  Many are calling this QE program, QEternity due to the lack of end date and limits on the program.

Open-ended money printing could be considered positive from the perspective of stock markets, since the message delivered by the Fed is clear that they will do whatever necessary to prop markets up, and continue the illusion of recovery. Interestingly enough however, markets to this point have actually seen declines since the announcement.  Major US indices are down between 6 and 8% in the two months following the announcement, despite prior consensus that prices would rise like they did following QE1 and QE2.  The effect of QE programs are losing their marginal effectiveness, and require larger injections, only to see lower marginal returns each time.  As you can see on the following chart of the S&P500, QE programs 1 & 2 have resulted in diminishing returns. The Feds are clearly aware of this troubling pattern and as a result implemented QE3, which is the most significant version of their stimulus to date. Unlike QE1 and QE2, the 3^rd edition is infinite with no end-date yet established, but this time the program is being conducted in co-ordination with existing Operation Twist plan. Operation Twist was rolled out to lower long-term interest rates via the Feds swapping long dated bonds for short-term bonds.  Clearly Chairman Bernanke and the Federal Reserve do not think that Operation Twist and the two prior QE programs were effective as they had hoped.  So what will the end results of the Federal Reserve latest attempt to jumpstart the U.S. economy?

It is probably too early to analyze whether or not QE3 will have any real effect on pushing up stocks and positively impacting the economy, but early signs have not been positive.  Markets appear be trading more on macro issues like the U.S. Fiscal Cliff which could take out more than   $1 trillion from the U.S. economy starting January 1, 2013.  This “fiscal cliff” would include tax increases and government spending cuts, and would have an extremely negative effect on economic activity.  In addition to this major challenge, U.S. corporate results for the 3^rd quarter have been very disappointing, with poor guidance and expectations for the 4^th quarter.  Clearly weak world economies are translating into weak earnings and revenues for companies, and it appears that at this point, no amount of stimulus will convince investors otherwise. The overall effect of such conditions leaves the prospect of a recovery in the near future, bleak at best.  Market forces appear bigger than any stimulus plan that the Federal Reserve can inject into the system.  Unfortunately it is apparent that their policies have resulted in greater disparities in the U.S. and only deferred a natural process that the economy must go through – de-leveraging of excessive debt.

The current strategy of the Fed appears to be based on a hope that at some point, the U.S. economy will strengthen to an acceptable level, at which time the excessive money printing can end, and things can return to normal, but this ‘kick the can down the road’ strategy will likely not end well.  It has been 4 years since the first QE program was enacted and the U.S. continues to struggle economically, despite the paramount risks added to the system through the more than $2 trillion and counting of money printing. Another major risk is that creditors could start to selloff US treasuries should they have concerns that the US dollar is at risk of further sharp devaluation given their inability to fix fiscal and monetary challenges.  There is also a risk of the rating agencies downgrading US debt once again, potentially increasing the interest cost of future borrowing.  One other significant risk is that all the monetary intervention by the Fed has created a risk of inflation as money printing continues to dilute the value of the U.S. dollar.  Given these risks, what would happen to the U.S economy should interest rates be forced up by 3 or 4 percent? Interest on American debt would spiral out of control, and the country could find itself in economic ruin. This ongoing monetary intervention poses risks that cannot be ignored.

A devalued U.S. dollar has and will continue to result in a decrease in living standard of all Americans.  The Fed appears to have made a decision to devalue the dollar in order to enhance the export sector, and indirectly lower the value of its sovereign debt (i.e. U.S. debt owed based on a lower a U.S. dollar goes down relative to other currencies, precious metals and commodity assets). 

Money printing stimulates economies in the short-term, preventing dramatic economic declines.  It is important to understand that the underlying goal of the Fed appears to be to keep the bubble economy afloat and expanding, rather than the alternative, a deflationary depression. In such a case asset prices plunge, stocks and real estate markets crash, unemployment soars, and overall economies weaken dramatically.  Given this, one might say they understand why the Fed has taken the approach they have.  The problem is that they are not helping resolve the underlying problems of fiscal stability and solvency.  Is a market system not intended to cleanse out the weak players and allow strong businesses to flourish? Unfortunately the Feds intervention has allowed weak businesses and industries to survive at the expense of the mass population and more effective business models.

Another major concern for the Fed is the declining velocity of money.  This is the frequency at which a unit of money flows through the economy via spending on new goods and services.  It is arguably a better indicator of economic activity than GDP or the stock market.  In a healthy economy, a dollar is used many times over and over.   To put this in perspective the level of velocity peaked in 1982 at 22. In a weak economy, the velocity of money shrinks.  In the great depression, velocity shrunk to around 7, with this level actually falling below that level today.  This is an extremely dangerous phenomena and something the Fed must closely watch.  Velocity is probably one of the reasons they have committed to unlimited QE until employment is restored, since it is apparent that the stimulus is not reaching the market as fast as they may have anticipated. 

The problem here is that if the economy does improve and velocity of money increases, the risk of very high inflation is real.  Inflation is a major bubble killer and the U.S. debt and bond market are huge bubbles waiting to burst. In the end this will negatively impact their goal of economic and employment growth.  Market economies must be driven by real stimulus – savings, production and profit, not artificial mechanisms that the Fed has created from thin air.  It does appear that a growing number of investors are becoming more concerned about inflation as we have seen inflation protected bonds demand increase.  We have also seen Central Banks demand for gold bullion increase, and prices of gold and silver rise amidst the announcement of QE 3.  This is generally seen as a negative view towards the U.S. dollar and a movement to hard currencies.

Some policy makers and economists have argued that inflation is not a major concern, as major inflation indicators have not been overly apparent thus far. One of the problems with this argument is that there have been revisions to the way that inflation is calculated over the years.  If inflation rates were calculated with the same methods used in 1990 (including food & energy) inflation levels today would actually be over 5%, not the official 2% rate reported by the Bureau of Labor Statistics. 

There are those who believe that the printed money is being absorbed by the banks and deposited back with the Fed rather than being lent out into the broader economy.  This has likely been the case with much of the over $2 trillion created by the Fed to date, as the amount of reserves being held by banks in Federal Reserve accounts are near all time high levels.  Since the financial crisis, consumer revolving credit (credit cards, lines of credit etc.) has fallen by 16%, even though more than $2 trillion has flooded the market by the Feds.  Banks receive 0.25% interest on reserves that they leave on account with the Fed.  This return may sound low, but when we are talking about trillions of dollars of reserves, these banks are still able to bring in millions of dollars of guaranteed revenues, while average Americans have struggled to stay above water.  Also Federal funds rate was recently as low as 0.13%, so the interest paid to banks is nearly double this yield.

Debt As you can see from the following charts, U.S. household debt has exponential grown since around 1970, around the time Nixon officially removed the U.S. dollar from the gold standard.  Not only has debt excelled, but household income has only modestly increased. This has put severe strains on individual`s budgets and the problem has become exacerbated by weakening economic conditions including high unemployment, and slowing growth since the financial crisis began. 

In 2008, debt and derivative growth resulted in a real estate and stock market crash.  Personal balance sheets were dramatically devalued, and bank balance sheets became fraught with toxic assets.  Fed policies have bailed out the banks through direct financial injections and by substituting new cash for risky mortgage securities.  These clearly were mortgages and debt that should not have been underwritten in the first place.  This is once again the focus and strategy of QE3, as the Feds are committed to purchasing a minimum of $40 billion per month.  They want to encourage more lending from the banking system as well as further clean up the balance sheets of banks, by purchasing their lower quality bonds and mortgage securities. One of the mandates of QE is to stimulate the real estate sector, a sector that is critical for job growth both directly and indirectly.  A healthy real estate market is needed for the U.S. to return to stable economic growth, and the Fed believes by stimulating the mortgage market, it will boost the entire economy. Short-term this strategy may help, but the economy and financial system of the developed world are in need of fundamental structural adjustments, not short-term fixes.

 Unlimited and unending QE has now put the Feds in a position where there is no turning back.  Monetary policy is so entrenched in the U.S. fiscal environment that Washington could not survive without it.  This will be the challenge moving forward – can we get back to where true market forces drive the economy, not artificial monetary ones?  Numerous bubbles have been created by Fed policies and unfortunately, they clearly have not learned from their mistakes.  A currency war is under way as all worldwide exporting countries want their currency to fall in order to make them more competitive.  The U.S. also would like to see their dollar fall to lower the debt value relative to other currencies.  Unfortunately, they are taking massive risks, with the potential of a government debt bubble exploding.  They were primarily responsible for the financial and housing bubbles and now we will probably be adding sovereign debt to that list.  Sooner or later you have to pay for your mistakes – this time the result may be much larger than previous ones as prior bubbles with current ones will compound together.  The Feds actions are proven very dangerous to all Americans.

About the Author: Mr. Sammut is on the Board of Directors of the Financial Policy Council and he is the President of Fortrus Financial Inc., an investment education and strategy firm. He specializes in creating investment strategies including all asset and currency classes. His firm designs strategic plans without the conflict of interest of managing the assets and writes strategic financial newsletters. Mr. Sammut can be contacted at the website: www.fortrusfinancial.com

Sources:

• Wall Street Journal, Al Lewis, Q & A on QE3, September 15, 2012
• Forbes, mark Hendrickson, The Wages of Bernanke, Winners and Losers from QE3, September 19, 2012
• Reuters, Ben Berkowitz, Forceful QE3 needed to aid economy:  Feds Rosengren, September 20, 2012
• Barrons, Alan Abelson, Two Cheers for QE3, September 15, 2012
• Bob Wiedemer – Financial Intelligence Report October 2012
• James Dale Davidson – Ahead of the Curve October 2012
• Natsuko Waki, Central Banks and the Next Bubble article Feb 21, 2012
• Tyler Durden, The Global Central Bank Put In All Its Visual Glory Sept (Zero Hedge) 7, 2012
• John Schoen, How does Feb inject money into the system NBC News August 12, 2007
• Brad Plumer, Washington Post Sept 13, 2012 QE3:  What is quantitative easing and will it help the economy
• Wall Street Journal, How Quantitative Easing Works Sept 14, 2012
• The Guardian UK – James K Galbraith Sept 20, 2012 Quantitative easing isn’t magic
• The New York Times Oct 4, 2012 Quantitative Easing
• Bob Prechter, Elliott Wave International, June 2012
• Mike Dolan, Reuters, Analysis: Endless QE? $6 trillion and counting, June 20, 2012