Why QE3 Is Coming Next Week

Since the Jackson Hole Symposium, I've been thinking it is very likely that so-called "QE3" would be announced at the next FOMC meeting (Sept 12th and 13th). And after thinking about Columbia University professor Michael Woodford's paper presented at Jackson Hole, I think this round of asset purchases might be more effective than most people expect.

Notes: QE3 is shorthand for another Large Scale Asset Purchases (LSAP) program. "QE" is monetary policy, not fiscal policy (not spending).

Yesterday, Goldman Sach economist Sven Jari Stehn beat me to the punch. He wrote:

[W]e expect the Federal Open Market Committee (FOMC) to announce a return to asset purchases as well as a lengthening of the FOMC’s forward guidance for the first hike in the funds rate to mid-2015 or beyond at the September 12-13 FOMC meeting. Our baseline forecast is an open-ended purchase program, focused on agency mortgage-backed securities.

[O]ur “double punch” Fed call relates to the much-discussed study presented by Columbia University professor Michael Woodford at Jackson Hole last Friday. Woodford argues that forward guidance is a powerful tool both in theory and practice. But in his view the effect of asset purchases is largely confined to their role in conveying guidance about future monetary policy actions. ...

We fully agree with Woodford’s view that such aggressive guidance measures could be a powerful tool. However, we also believe that Fed officials are unlikely to adopt them anytime soon.

Fortunately, we are somewhat more optimistic than Woodford with regard to the impact of Fed asset purchases. ... we believe that a more moderate strengthening of the forward guidance coupled with renewed asset purchases could provide a decent amount of monetary easing next week.

From the article: “we’ll try to return inflation to 2 percent at a pace which takes into account the situation with respect to unemployment.”

By that Bernanke clearly meant that if inflation starts to run 3, 4, or 5% but the economy remains in the doldrums, he would continue to maintain the very easing posture that is causing the higher inflation rate.

QE3, as with QE1 and QE2, accomplished only one objective; it drove long-term rates to ridiculously-low levels, not only here but around the world. Ironically, even as the U.S. Treasury was successfully extending the maturity of our outstanding debt (a wise move when rates are so low), Bernanke’s Fed was undoing all of that effort and more by buying the very bonds that the Treasury was selling.

And now he sits on trillions (yes trillions, not billions) of long-maturity debt that will plunge in value if he ever tries to unwind the position. Unfortunately it will also plunge in value if inflation gets really rolling again and they don’t stop it, which is exactly what he said he wouldn’t do unless the economy picks up also. But if the economy picks up, interest rates normally rise to ration credit.

In other words the Fed is screwed, and their bond position will cost the taxpayers more than the entire banking system debacle did, and could rival the housing price debacle in the end.

Anyone who lends money long term at 1.6% (10-year rate) to 2.8% (30-year rate) to the federal gov’t in this environment is crazy. QE3 might make you some money in the short term, but, in the long term, losses of 60 to 80% in a single year are possible when this fiasco blows up.

One of the greatest challenges a Romney/Ryan administration will face is how to unwind Bernanke’s mess without crashing the debt markets, driving interest rates up significantly, and adding to the federal deficit at an even faster rate as debt paying nearly zero interest now is rolled over at much higher rates in the future.

I’ll concede that this game has taken a lot more innings to play out than I would have imagined possible, but it’s nearing the ending soon and it isn’t going to be a pretty one.

>>Interesting if 3 and 4 were even remotely close to being accurate. Rates are at all time lows and interest is less than 6% of the budget. And Opertion Twist has extended maturities out so that we have locked in extremely low long term rates on the current debt.<<

3 could very well be accurate. It was a forecast, not a comment on the historical number.

As for Operation Twist, that was the Fed BUYING all the long bonds it could. Yes, the Treasury has been issuing longer debt lately and has extended the average maturity of the debt, but what’s the point if another arm of government (the Fed) is undoing the effort by buying all the long debt back in?

Besides, of the 10 trillion or so of public debt, about 7 trillion of it will mature before Romney finishes his first term. If inflation blows up and the Fed is forced to unwind it’s ridiculous QE’s, interest on the debt will be taking up a lot more tax dollars than it now does. If rates rise to 5-7% from their current .1 to 2.8% that 6% of the budget you’re talking about could rapidly approach 15% to 20% of the budget. And if inflation gets out of control and rates really start to accelerate, the interest on the debt will wipe us out long before Medicare, Medicaid and SS, especially since those programs will be taking in higher collections due to the higher inflation rate.

It’s the debt that is going to sink the country if we don’t soon get a handle on it, and that is going to be anything but easy to do. Bernanke has created a mess that is going to be very difficult to unwind and inflation is already picking up with no economic growth to show for it.

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