Best of the Week
Most Popular
1.Spain Ignores Scotland Lesson as Catalan Independence Referendum Could Spark Civil War - Nadeem_Walayat
2.Used Car Buying From UK Dealer Top Tips, CarMotion.co.uk Real Customer Experience - N_Walayat
3.Spanish New Civil War Begins as Madrid Regime Storm Troopers Quell Catalan Independence Rebellion - Nadeem_Walayat
4.Virgin Media Broadband Down, Catastrophic UK Wide Failure! - Nadeem_Walayat
5.Are the US Markets setting up for an Early October Surprise? - Chris_Vermeulen
6.The Pension Storm Is Coming To Europe—It May Be The End Of Europe As We Know It -John_Mauldin
7.Stock Market Crash 2018; Will it Prove to be Another Buying Opportunity - Sol_Palha
8.The Profoundly Personal Impact Of The National Debt On Our Retirements - Dan_Amerman
9.Stock Market as Good as it Gets; Like 2000 With a Twist -Gary_Tanashian
10.1987 Stock Market Crash 30th Anniversary Greatest Investing Lesson Learned - Nadeem_Walayat
Last 7 days
Debt-Driven Consumer Economy Breaking Down - 23rd Oct 17
Next Wall Street Stock Market Crash Looms? Lessons On Anniversary Of 1987 Crash - 23rd Oct 17
This Super Metal Is Set To Soar By 300% - 23rd Oct 17
More New Record Highs As S&P 500 Gets Closer To 2,600 Mark - 23rd Oct 17
Another Minor Stock Market Top? - 23rd Oct 17
Bitcoin Hits $6,000, $100 Billion Market Cap As Helicopter Ben and Jamie Demon Warn The End Is Near! - 22nd Oct 17
Time for Caution in Gold Miners - 22nd Oct 17
“Great Rotation” Ahead; Will it Be Inflationary or Deflationary? - 21st Oct 17
The Trigger for Volatility, Rates and the Next Crisis - 21st Oct 17
Perks to Consider an Agent for Auto Insurance - 21st Oct 17
Emerging Megatrends Hurting Consumers - 21st Oct 17
A Catalyst of the Stock Market Bubble Bust - 21st Oct 17
Silver Stocks Comatose - 21st Oct 17
Stock Investors Ignore What May Be The Biggest Policy Error In History - 20th Oct 17
Gold Up 74% Since Last Stock Market Peak 10 Years Ago - 20th Oct 17
Labour Sheffield City Council Employs Army of Spy's to Track Down Tree Campaigners / Felling's Watchers - 20th Oct 17
Stock Market Calm Before The Storm - 20th Oct 17
GOLD Price Creates Bullish Higher Low - 20th Oct 17
Here’s the US’s Biggest Vulnerability in NAFTA Negotiations - 20th Oct 17
The Greatest Investing Lesson Learned from the 1987 Stock Market Crash - 20th Oct 17
Stock Market Time to Go All-in. Short, That Is - 19th Oct 17
How Gold Bullion Protects From Conflict And War - 19th Oct 17
Stock Market Super Cycle Wave C May Have Started - 19th Oct 17
Negative Expectations, Will the Stock Market Correct? - 19th Oct 17
Knowing the Factors Affect your Car Insurance Premium - 19th Oct 17
Getting Your Feet Wet In Crypto Currencies - 19th Oct 17
10 Years Ago Today a Stocks Bear Market Started - 19th Oct 17
1987 Stock Market Crash 30th Anniversary Greatest Investing Lesson Learned - 19th Oct 17
Virgin Media Broadband Down, Catastrophic UK Wide Failure! - 19th Oct 17
The Passive Investing Bubble May Trigger A Massive Exodus from Stocks - 18th Oct 17
Gold Is In A Dangerous Spot - 18th Oct 17
History Says Global Debt Levels Will Lead to Another Crisis - 18th Oct 17
Deflation Basics Series: The Quantity Theory of Money - 18th Oct 17
Attractive European Countries for Foreign Investors - 18th Oct 17
Financial Transcription Services – What investors should know about them - 18th Oct 17
Brexit UK Vulnerable As Gold Bar Exports Distort UK Trade Figures - 18th Oct 17
Surge in UK Race Hate Crimes, Micro-Racism, Sheffield, Millhouses Park, Black on Asian - 18th Oct 17
Comfortably Numb: Surviving the Assault on Silver - 17th Oct 17
Are Amey Street Tree Felling's Devaluing Sheffield House Prices? - 17th Oct 17
12 Real-Life Techniques That Will Make You a Better Trader Now - 17th Oct 17
Warren Buffett Predicting Dow One Million - Being Bold Or Overly Cautious? - 17th Oct 17
Globalization is Poverty - 17th Oct 17
Boomers Are Not Saving Enough for Retirement, Neither Is the Government - 16th Oct 17
Stock Market Trading Dow Theory - 16th Oct 17
Stocks Slightly Higher as They Set New Record Highs - 16th Oct 17
Why is Big Data is so Important for Casino Player Acquisition and Retention - 16th Oct 17
How Investors Can Play The Bitcoin Boom - 16th Oct 17
Who Will Be the Next Fed Chief - And Why It Matters  - 16th Oct 17
Stock Market Only Minor Top Ahead - 16th Oct 17
Precious Metals Sector is on Major Buy Signal - 16th Oct 17
Really Bad Ideas - The Fed Should Have And Defend An Inflation Target - 16th Oct 17
The Bullish Chartology for Gold - 15th Oct 17
Wikileaks Mocking US Government Over Bitcoin Shows Why There Is No Stopping Bitcoin - 15th Oct 17
How to Wipe Out Puerto Rico's Debt Without Hurting Bondholders - 15th Oct 17
Gold And Silver – Think Prices Are Manipulated? Look In The Mirror! - 15th Oct 17

Market Oracle FREE Newsletter

3 Videos + 8 Charts = Opportunities You Need to See - Free

Fed’s Bullard Defence of QE2 is Full of Contradictions

Interest-Rates / Quantitative Easing Dec 22, 2010 - 07:19 AM GMT

By: Dian_L_Chu

Interest-Rates

Best Financial Markets Analysis ArticleJames Bullard, President of the Federal Reserve Bank of St. Louis was on CNBC Monday, December 20, 2010 mostly defending the Fed’s controversial $600 billion Treasury purchasing program (QE2) announced in Nov.

What struck me as totally self-contradictory were Bullard’s statements regarding the QE2, treasury yield, inflation expectations, and inflation, which I will outline and rebuff below.


Bullard – Higher Treasury Yield = QE2 Success

During the interview, aside from the usual Fed PR spin that QE2 has been 'modestly successful so far', he also states:

“People who see the rise in Treasury yields as a sign the Fed's purchases were not having their desired effect should look at other measures, especially the improvement in the economic outlook and the rise in inflation expectations in the market for Treasury Inflation-Protected Securities (TIPS). These are the ultimate goals of the Fed's policy.”

Bullard – QE2 Unrelated to Rising Commodity Prices

But when Fred Smith, Chairman, President and CEO of FedEx asked whether QE2 was related to the run-up in commodity prices, fuel prices in particular, which has been up 15% in the last 90 days and acted as a tax on American consumers, Bullard had this to say:

“…Is there some independent effect coming from monetary policy other than supply and demand conditions globally…I haven’t seen very much evidence of that, but would like to keep an eye on that.”

So, basically Bullard touts QE2 as building up inflation expectations, driving up treasury yields (thus averting a potential deflationary cycle), which was the goal of the Fed QE2 initiative.  Furthermore, Bullard contends that global demand and supply factors are behind the record high prices across almost all commodities, which he believes is unrelated to QE2.

Higher Treasury Yields– Kills Housing et al

First of all, the ultimate goal of the Fed’s securities purchases (QE2), as outlined by Chairman Bernanke in his speech at Frankfurt, Germany on Nov. 19, is to “lower interest rates on securities of longer maturities” to support household and business spending.

On that measure, QE2 has failed miserably. Interest rates, instead of declining, are rising rapidly driven by the bond markets and the bond vigilantes. The 10-year yield was at a low for the year of 2.4% in early October, and has shot up to a seven-month high of 3.56% the week of Dec. 12, before easing back to around 3.34% on Monday Dec. 20. (Fig. 1)

The yield on the U.S. Treasury is used as a benchmark to set interest rates on many kinds of loans including mortgages, and business borrowing rates in the capital market. So, the sharp rise in yields on Treasurys since the QE2 announcement in early November not only kills any flickering recovery sparks in the housing and other related sectors, but also raises the borrowing costs and interest payments of Uncle Sam.

Higher Borrowing Costs for Uncle Sam

The Congressional Budget Office (CBO) on Dec. 14 projects that under current law, debt held by the public will exceed $16 trillion by 2020, reaching nearly 70% of GDP. The CBO also projects the combination of rising debt and rising interest rates to cause net interest payments to balloon to nearly $800 billion, or 3.4% of GDP, by 2020 (Fig. 2).


U.S. Debt Downgrade - More Than a Warning

Now, the U.S. is at a stage where the downgrade of U.S. sovereign debt rating seems closer to reality than ever before. Although most have dismissed the downgrade initiated by China’s Dagong Credit Agency back in July, CNBC reported that this time around the U.S. Treasury Dept. is going to meet with Moody’s and other agencies in January, 2011 to make its case to prevent a downgrade from the current AAA status.

CBO’s debt and interest payment projection assumes that US borrowing cost will remain reasonable. However, a credit downgrade and/or further loose monetary policies along with continued over-spending will only prompt bond markets and bond vigilantes to demand even higher interest rates resulting in much higher interest payment than the current projections, reminiscent of the 80’s when bond yields were in double-digit.

Expectation Drives Inflation

When it comes to inflation expectations, I’m actually in agreement with Bullard that the Fed has been successful in driving it up, which is reflected in the TIPS yield as well as the steepening yield curve (Fig. 3). However, as Bernanke himself puts it:

“The state of inflation expectations greatly influences actual inflation and thus the central bank's ability to achieve price stability.”

Since the Fed hinted at QE2, commodity price inflation has surged at a record pace during the past six months (Fig. 4)  The manifestation of inflation is a combination of many factors including but not limited to expectations, which drives behavior, as well as supply and demand factors.



So, for Bullard to “take credit” for driving up inflation expectations, but ignore its inflationary effect on commodity prices is illogical as well as self-contradictory.

QEs Not Flowing Where It’s Needed Most

The bottom line is this: Unlike China where its central government can mandate banks to actually lend to business and individuals, Fed’s two rounds of QE liquidity did not go to where it’s intended; it is instead trapped on banks, and corporations’ balance sheets.

U.S. banks have been holding about $1 trillion of excess reserves for the last two years, while American corporations are flush with $3 trillion in cash.

What do they use this money for? Banks and institutions with access to the Fed’s cheap money are pumping up commodities and stocks to make their quarters, while corporations, facing higher input costs in the form of runaway commodity prices, are busy engaging in M&A’s (which typically means “job rationalization”), and share buybacks to juice up earnings per share.

Meanwhile, stagnant wage and hiring trends failing to keep pace with skyrocketing food and energy costs for consumers, coupled with higher input costs, such as fuel, hitting companies' bottomline, will only further cut into growth prospects, and the purchasing power of consumers and even their overall standard of living.

QEs = Wealth Redistribution

The concern of deflation is entirely overblown (thanks to Bullard’s research paper warning of a Japanese-style deflation in the U.S.) and the Fed jumped the gun. In a way, the Fed’s QEs are a form of wealth redistribution from taxpayers to banks, institutions and corporations.

The liquidity has created an artificial financial market where a disproportionate minority is benefitting through higher stock and commodity prices (without producing much output and benefit to the real economy); while the majority suffers higher input costs for essential items like food and energy. 

Food and energy are some of the things that affect every consumer's daily life and pocket book, but are excluded from the core inflation calculation, a key measure on Fed's watch list.  This bias would only further misrepresent true inflation pressures, misguiding Fed's future policies, and result in a net loss for the economy over the long haul.

Dian L. Chu, M.B.A., C.P.M. and Chartered Economist, is a market analyst and financial writer regularly contributing to Seeking Alpha, Zero Hedge, and other major investment websites. Ms. Chu has been syndicated to Reuters, USA Today, NPR, and BusinessWeek. She blogs at Economic Forecasts & Opinions.

© 2010 Copyright Dian L. Chu - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2017 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Catching a Falling Financial Knife