Zero Chance For QE3 - The Fed's Job Is Done

Just a interesting article to get the juices flowing..

The German vote this morning, just adds another layer...

its more beneficial if they do....than the US at this point.

note: there could be a adjustment to twist but i dont see anything substantial.

Stocks have moved dramatically on the "bad is good" theory of investing in recent weeks. That theory states that more bad news will motivate the Federal Reserve to go to QE3 and inflation will be the result, driving equities and other assets higher. The flaw in that thinking is that investors simply don't understand what QE actually does and why additional QE will not have any impact.

To assume that QE3 will work to expand money supply and regenerate inflation is a flawed assumption. Investors who are basing their investment decisions on QE3 are going to be disappointed. A little refresher course on Money and Banking should help to shed some light on the matter.

The fractional banking system and QE impact on money supply:

Let's consider the Federal Reserve's purpose for initiating QE. The goal is to inject liquidity into the fractional banking system so that banks can increase lending and in so doing expand money supply. It is a misnomer to assume that the Federal Reserve can create money out of thin air as some apparently believe. What they can do is set the stage for the fractional banking system to print money.

Keynes tells us what we need to do to stimulate economic growth when we are in a recession or a depression:

" ... if Investment exceeds Saving, there will be inflation. If Saving exceeds Investment there will be recession. One implication of this is that, in the midst of an economic depression, the correct course of action should be to encourage spending and discourage saving. This runs contrary to the prevailing wisdom, which says that thrift is required in hard times. In Keynes's words, 'For the engine which drives Enterprise is not Thrift, but Profit."

The table below is revealing in that it establishes that we have done the exact opposite of what Keynes says is necessary for a recovery. What we have done since the start of the Federal Reserve's QE programs is increase savings.

Impact of QE1 and QE2 on Money Supply(trillions)

The table above shows a modest expansion in M2 during the QE years from $7.995 trillion to $9.926 trillion - an increase of 24% over the period which works out to be an annualized rate of increase of 7.7%.

By contrast, the two year period of time just prior to initiating QE1 resulted in annual increase of 6.7%. Considering the magnitude of the Fed action to inject liquidity into the banking system, an 1.1% increase in the rate of growth of M2 is insignificant.

The next number to look at is the savings portion of M2. Savings is broken out as a separate line item of the total M2 figure. According to Keynesian theory, we want savings in dollar amounts to decrease, remain flat or at least expand at a slower rate than the broader M2 number.

Here's why we want and need savings to remain at low levels. As Keynes points out, conventional wisdom suggests that you should save during times of uncertainty and economic contraction but that is the exact opposite of what we should do. From an individual perspective, this might be a wise decision but for the broader population to engage in a policy of paying off debts and saving virtually insures a continuation of the recession.

It's a rather circular process that is either working in the right direction or the wrong direction from a macro point of view. If we begin to spend at an increasing rate, the effect is an increase in the demand for goods and services. As demand increases more workers are needed. As those workers are hired, the unemployment number shrinks and more workers, now with paychecks, enter the consumer pool and begin to spend. That increases demand further requiring additional hiring to meet the demand. As the process continues, we eventually reach full employment.

The counter view is that we reduce spending, which reduces demand, which results in layoffs, which reduces the consumer pool, which reduces spending further resulting in further demand reduction and more layoffs. The result is an increasing rate of unemployment and shrinking demand, which impacts corporate profits.

The table above shows that we as a population have not reacted as we should to stimulate growth. Instead, we have taking what Keynes refers to as the "prevailing wisdom" path. We have paid down debt and increased savings. The reaction is a natural one in that we don't know when we might get a pink slip ourselves - best to prepare for it is the logic.

Savings have grown from $4.032 trillion to $6.377 trillion during the QE period - an increase of 57% versus the M2 growth increase of 24%. Savings has increased at a rate of 2.4 times the rate of increase in M2.

The last set of numbers above shows the real impact of QE - it shows the direction that spendable money has taken. To arrive at that number we subtracted the Savings portion of M2 from M2. The result is the amount of money we presume to be available for spending. Remember, as spending shrinks the economy contracts and unemployment moves higher.

The M2 less Savings number started out at the beginning of QE at $3.963 and ended at $3.589 on June 30, 2012. That is a reduction in real spendable dollars of 9.5% over the period. What we can take away from this is that the problems we are facing in our attempts to recover are in fact of our own making.

The Federal Reserve has gotten a bum rap from politicians and the public. They have done their job, which is to set the stage for a recovery. The Fed didn't create the problem in the first place but they did step in and did what they could within the scope of their powers to set the stage for a recovery. The fact that banks, politicians and U.S. citizens didn't cooperate is simply not the Fed's fault.

So what has the Fed done? The Fed has reduced interest rates all along the yield curve with rate cuts and Twist operations. Additionally they have flooded the banking system with cash. Let's take a look at how the fractional banking system really works.

The Federal Reserve operates as a guidance system for the economy by expanding or contracting money within the economy. They do that by increasing or decreasing cash reserves within the banking system.

The nation's banks must maintain a cash balance equal to 10% of liabilities, which means that they can't make loans when that cash position drops below the reserve threshold. When banks make loans, they are effectively adding cash into the economy. When loans are paid off they are effectively reducing cash in the economy.

When the Fed wants to expand money supply, it injects cash into the system by buying Treasuries that the banks own. The balance sheet impact is a reduction in Treasuries and an increase in cash on the banks' books and the exact opposite effect on the Fed's books.

Now the banks can increase the dollar amount of loans. So what has happened since QE1 and QE2? What we have done is nothing. The banks have been reluctant to loan and borrowers have been reluctant to borrow. Both groups have valid reasons for taking these positions but the impact is that we have fallen into a period of stagnation as a result and it is entirely possible that this deleveraging process coupled with self imposed austerity will continue. If that is the case, we can expect continued high employment and shrinking corporate profits.

The Feds frustration and what they will do this week

As we prepare for the announcement of additional stimulus, the Fed must be frustrated. Additional QE can accomplish nothing at this point. Here is why: All QE can do is inject additional cash into the banking system. It can't force the banks to lend it out nor can it force borrowers to borrow it.

The banking system is flooded to overflow with liquidity that is not being utilized. Further increases in that liquidity will not change a thing at this point. It would be like adding water to a glass that is already full to the brim. Adding water to the glass till it overflows will not make you drink if you are not thirsty.

The Fed is stuck in a situation where the only tool they have at their disposal is rhetoric. Actual QE is useless but since the public and in particular investors don't understand how the process works they still have the hope that the public will respond to the promise that the "Fed has their back."

Expect more of the same from the Fed this week. There will be no QE - that would be bordering on irresponsibility. There may be an extension or modification of Twist, which is designed to keep interest rates low along the yield curve. Of course, rates are already low and no one's borrowing, so that is not likely to have much impact.

As Bernanke told all those who actually paid attention in his recent Jackson Hole speech, Fed policy going forward is very limited in what it can accomplish:

"Estimates of the effects of nontraditional policies on economic activity and inflation are uncertain and the use of nontraditional policies involves costs beyond those generally associated with non-standard policies. Consequently, the bar for the use of nontraditional policies is higher than for traditional policies. In addition, in the present context, nontraditional policies share the limitations of monetary policy more generally. Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve; in particular, it cannot neutralize the fiscal and financial risks that the country faces. It certainly can't fine tune economic outcomes." Bernanke speech at Jackson Hole, August 31, 2012

Understanding "Fed speak" is not particularly easy if you don't understand the fundamental concepts of monetary policy. Hopefully after working your way through this brief explanation you now have a better understanding of how all this works. If not, I will try to translate.

What Bernanke is saying is we have done all we can do. We have flooded the banks with liquidity and flattened the yield curve like a pancake. It is now up to Congress, the president, the banks and the people to do their part.

Notwithstanding that position, the Fed will use what they refer to as "education and forward guidance" to keep our hopes alive. What we can expect from the Fed is a continuation of the current Twist program with some minor changes - probably a more open ended version of the current program. All that will do is keep interest rates down though. It won't force banks to lend or borrowers to borrow.

The Fed has primed the pump. There are massive amounts of liquidity in the banking system and large cash balances in the banks. The Fed can do no more.

Bernanke will conclude with his boiler plate remark:

"Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in the labor market conditions in a context of price stability." Bernanke speech at Jackson Hole, August 31, 2012.

http://seekingalpha.com/article/859841-zero-chance-for-qe3-the-fed-s-job-is-done

If you want another take here is another denied..  but from another angle..

and i like the top one better..but there are a few sections here which i do like.

With Friday's disappointing jobs number, the price action of stocks and precious metals, and chairman Bernanke's job security dependent on the reelection of President Obama, almost the entire investment community expects the Fed to announce a third round of quantitative easing. However, in all likelihood, bullish investors will be disappointed. Outside of the conspiratorial bent of the corruption over reality driving central bank action, there is no real reason to do more asset purchases. For why this is the case, I have broken down, the primary economic reasons why the Fed will not add more QE in the list below.

1. Food and Energy Prices Already High

Additional QE will only spur on further inflation in food and gasoline prices. Since a relatively small portion of the population owns enough stocks or commodity futures to offset the loss in discretionary income created by commodity inflation, further easing will result into a significant drag on the economy. Oil (DBO) is currently at over $96 per barrel and grains such as wheat, corn, and soybeans are at or are near all time highs. Higher grain and energy prices are not in isolation as they increase the costs products and services such as shipping of imported goods, electrical power, meats, anything that uses plastic, and capital intensive products with high energy costs. As a result, commodity inflation will spill into core inflation numbers. More QE would compound food and energy inflation to the point of transforming a stagnating economy to a stagflationary recession.

The other side of the food inflationary coin is geopolitical instability. An example of this was last year's Arab Spring. The media likes to argue that it was the aspiration of democracy was what triggered these revolutions, but the reality was that QE2 drove food prices up to the point where the lower classes in these countries got desperate enough to rebel. With food a much larger percentage of citizens budgets in the developing world versus the West, expect QE driven higher food prices to increase civil unrest and geopolitical risk globally. A more unstable world is a headwind to the global economy.

2. The Fed will Be Out of Credible Bullets, QE4 will create hyperinflation

QE3 is the Fed's last real shot at restoring the economy for those who thinks it would work. If QE3 fails to create significant real income and job growth, markets will no longer react to positively to rumors of easing. With continuous ZIRP policy, financing costs for credit worthy individuals and business are already at bare minimums. QE fails to spur lending not because of a lack of liquidity, but the combination of the lack of credit worthy borrowers and economically profitable projects give banks incentive to use funds on carry trades instead of lend. More QE would just increase dollar carry trades into Treasuries or bank reserves in foreign currencies such as the Australian dollar. If QE3, ends up being lackluster on the economy outside of stock prices (which is expected), any other attempts of further easing lack creditability and will instantly trigger higher inflation expectations.

3. QE3 will Cause Severe Questioning of the Independence of the Federal Reserve

With movements to audit the Federal Reserve already taking place within Congress, many voters and investors are starting to lose faith in the credibility of the independence of the Federal Reserve. With the US debt to GDP ratio over 100%, trillion dollar deficits, and no political will to resolve them, additional easing to buy Treasuries can easily be interpreted as a covert method of monetizing debt to finance government operations. Even before QE3, the Fed owns 19% of all Treasury debt receives 43% of interest payments on US government debt. With no politically realistic way of solving the national debt problem without money printing, additional easing creates an easy way for the Treasury to run budget deficits without having to pay them back. As a result, Investors will perceive the Fed as a mechanism of state financing rather than an independent central bank serving the best interest of the US economy.

4. QE has no track record in causing any real GDP, real income, or job growth

Despite the positive effects on stock prices, commodity prices, and inflation expectations, Fed action does little to improve the real macro-economy. The reduction of the unemployment rate is solely due to people dropping out of the workforce as job growth fails to match population growth. Record of numbers of Americans on food stamps and disability claims do not help QE's case either. Real incomes in the US have also been stagnant since the launch of QE 1 in 2009 and GDP growth has been modest.

In fact it could be argued that Fed policy has hurt long term economic growth. ZIRP limits the spending of retirees as they have limited options to collect fixed income yield. As a result, retirees lack discretionary income to spend into the economy, or lack enough interest income from assets to retire in the first place therefore preventing job growth for younger Americans.

5. The Fed owns too much of the long term Treasury market to make QE3 viable without eliminating bond market liquidity.

As seen in the charts below, the Fed owns all but $650 billion worth of long dated Treasury bonds. With QE2's size being $600 billion and investors expecting QE3 to surpass $1 trillion, there is not enough bonds out in circulation for the Fed to buy without eliminating liquidity in the bond market. As a result, diminished liquidity will result in severely higher interest rates when either a large private investor or if the Fed itself ever plans on reducing its balance sheet. QE3 would basically trap the Fed from ever raising interest rates and reversing its current path of bond buying without sever disruptions to the market.

(click to enlarge)

6. Printing Money has Never Historically Created Real Wealth

When in history has a large scale currency debasement has resulted in renewed economic prosperity. If it did, countries such as Argentina, Zimbabwe, Weimar Republic Germany, 1990's Russia, would have been the most prosperous countries of the past century. Instead these country were hyperinflationary basket cases.

It may have a new name in quantitative easing, but currency debasement is not new. Ever since the Roman's filled silver coins with base metals in the 200's AD, monetary debasement has alwayed ended in high (US in 1970's from breaking of gold standed to Volcker) to hyper inflation as in the cases mentioned previously. All this does is destroy wealth in favor of debtors and governments both historically and currently are the world's largest debtors.

7. QE has diminishing returns and may already be fully priced in by equity markets.

With the S&P 500 surpassing QE2 highs of April 2009, equities have already priced in a significant portion of quantitative easing. What else to equity investors have to be optimistic about if QE3 occurs? Economic data in the US, Europe, or Asia does not point to a rosy picture and earnings outlooks are pointing towards an earnings recession. The chart below shows the direct results during the tenures of QE1 and QE2. Equity performance diminished sharply between each of the first two rounds with hard sell offs following each one in 2010 and 2011. I do not expect more easing to break this trend. With bullish sentiment and technical indicators such as RSI on risk assets such as the Euro, US and European equity markets, gold and silver reaching severe overbought levels and the performance of the US dollar and the VIX showing extreme levels of complacency, it seems like QE3 is priced into the market. It also interesting to not that Treasury yields have diverged noticeably from risk markets.

Overall, all economic reasons point to that fact that further QE has a negative expected value to the US economy and therefore will not be pursued. The one risk to my thesis and hope for bullish investors is the corruption factor. The degree of corruption within the US government has risen substantially since 2000, and the need for politicians to preserve cushy jobs and pensions probably outweighs any concern for the American people as a whole. In addition, the federal government has no realistic way to pay off it debts other than taxation through inflation. However, as long as the Fed is truly independent, QE3 will not happen.