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Monday, September 17, 2012

Quantitative Easing 3 (QE3) - Another Bad Move by The Fed

I'm sure by now you've heard the about the announcement by the Federal Reserve to start what it calls Quantitative Easing - Round 3. If you haven't, here is the an article from Bloomberg online that sums it up: Ron Paul supporters should be up in arms about this, and quite frankly, I am, too.

For my take, I will try my best to keep my thoughts simple. But first, I will attempt to explain this (who knows how this will go) with an analogy:

Have you ever had an issue with drafty windows in your house? It's a pain in the rear, isn't it? Have you ever tried to fix the issue by simply starting fires in your living room? Probably not. If you started a fire in the living room, sure, you'd be warm, but the draft would still exist, and most importantly, you'd have a new problem to worry about. As rough as this analogy is, it applies to QE3. The US has a problem (well, we have many problems). The economy is not recovering quickly enough, and too many Americans are out of work. So what does the Fed do? It creates another problem! It starts another fire for what it thinks will be a fix to the "drafty window" problem. It's bad policy, bad economics, and its potential benefit is certainly not worth the potential drawbacks. Let's get to some "technicals."

To sum up what the Fed is doing, Bloomberg online writes: "Federal Reserve said it will expand its holdings of long-term securities with open-ended purchases of $40 billion of mortgage debt a month in a third round of quantitative easing as it seeks to boost growth and reduce unemployment." - Yup... that pretty much sums up the actions it will take. It sounds simple enough, right? This will, in theory, "drive down mortgage rates and put downward pressure on mortgage rates and create more demand for homes and more refinancing.” While I highlight "in theory," it should work in accomplishing this goal. This accomplished result of this move is the "you'd be warm" part of my analogy. 

So what does that get us? Well, for this part of QE3 (and how it works):

- The Fed buys a ton of mortgage-backed securities* (what it is buying is relatively irrelevant... what is important is who it is buying it from; for QE3, the objective is to put more money into banks' hands, and to do that, it must buy something banks hold: MBS).
- When the Fed physically buys these MBSs, it floods the economy with money (if I came to you and bought all your furniture, I would flood your wallet with money :-) ).
- This excess money will pile up in banks' reserves, and the banks will want to use the excess money to make more money via loans (the bank would rather loan it out at say 3.25% interest via a home mortgage loan than to have it sit around it its coffers). 
- In simple economic terms, the supply of money to loan (the excess bank cash) will increase because of the Fed's MBS purchases, and when the supply of something increases, the price/value of that something decreases. In this case, the "price" of a loan (the interest rate) will decrease. If banks have so much money to lend, giving borrowers many, many choices of whom they would like to borrow from, in order to attract any borrower, the banks MUST lower their interest rates. If a bank doesn't, it will just sit on its excess cash while its competitors make loans. 
- Interest rates will fall, and with that, again, in theory, more loans will be made (take mortgages, for example... the assumption here is that with lower mortgage rates, home buyers would be more inclined to purchase a home and other big ticket purchases like homes, autos, etc., and these purchases could help jump-start the economy). 

This seems great, right? Cheaper loans for everyone! Interest rates are low, more homes are purchased, credit card rates drop, people buy more stuff, and the economy kicks up again, and off we go!

Splash! <----- That's the ridiculously cold quintessential bucket of cold water. Let's get on to the "new problem" part of my original analogy. 

Problem 1: Inflation - this should hit people, economists and non-economists alike, like a swift slap in the face. This is the most obvious problem with QE3. In fact, the issue is actually mentioned in the "solution" part above... did you catch it? Here:

     - "and when the supply of something increases, the price/value of that something decreases."

In this case, when referring to "price," the price of money is the value it holds. As stated, the Fed is going to increase the supply of money in our economy. If the supply of something increases, the value of that something decreases. It's pretty simple. Diamonds are rare, and therefore are valuable. Leaves are not rare, and will never be valuable. If more money exists, people will value it less. When you go to buy a loaf of $1.00 bread from the local bakery, with an influx of money into the market, the baker might say, "ehhh, I want $2.00... your money isn't worth as much." (I'm not trying to be a facetious jerk, and I'm not trying to imply people don't understand these issues, I'm just trying to keep it simple so that any reader of any economic understanding can comprehend. Please don't take this "simple talk" as an insult.). The problem of inflation cannot be ignored when discussing the ins and outs of QE3. I hope Americans are ready for everything to become more expensive. While it seems wonderful that loans would get cheaper, everything else would get more expensive.

To look at another example of how this would hurt the country, take a look at senior citizens. Most seniors rely on savings and debt instruments (bonds) to fund their retirements. Anyone with a large stash of money in savings accounts, money market accounts, bond funds, etc. will now see their returns drop as the interest rate (basically, the payout) of these instruments will fall. Additionally, the money they receive in payouts, the very income they use for sustenance, would be worth less, and senior citizens would not be able to purchase all the goods and services they would need. I could go on for hours about the macroeconomic problems with inflation, but this post can only be so long.

Problem 2a: Power - You read it correctly. POWER. This isn't an economic concept; it's a "Fed-is-getting-too-much-power" concept. When you hit the pause button to think, doesn't it strike you as funny that we are all at the mercy of the Fed to hinder or help our economic activity? It's truly a scary notion.

Problem 2b: More power - The Federal Reserve is supposed to be apolitical. It isn't supposed to have an agenda. Well, throw that all out the window. This might rile conspiracy theorists, but my argument is apolitical. It isn't a republican or democrat issue; it's an issue of who is controlling the power. Yes, as I said, the Fed is supposed to be apolitical, but doesn't the timing of this raise some serious questions? Of course, with no proof to back this, it's merely speculation. There will be many that will say, "the Obama administration pressured the Fed to do this." Again, it must be restated, there is no proof behind that... but that doesn't mean it couldn't happen. The mere fact that such an allegation could exist, ultimately killing the public's trust in our government and the Fed should be notion enough to question its moves and legitimacy.

Problem 3: What's the definition of insanity? - The Fed is about to embark on QE3... 3, as in the third one?! Did the first two have fabulous results? If it was so easy to accomplish what the Fed wants to accomplish, shouldn't this have been done already? Shouldn't this have worked? How many times must we repeat the same inflation-causing mistakes?

I hope I'm not forgetting anything, but with the enormity of problems that exist with this move, I'm sure I am. If they come to light, I will update this post ASAP. Please be sure to share your take below. Am I wrong in my analysis/opinions? Do you have other "problems" you'd like to share. Any and all thoughts are welcome. Thank you.



    Paul 2012!

  2. The theory itself seems flawed. I'm no economics guy and I'd be a liar if I said I understood the Fed but the theory seems to be built around the understanding that, if money is available, people will borrow it. I think that is a fundamental flaw. Regardless of the rates, banks still will not lend, at reasonable rates, to those who are unemployed, underemployed, newly employed or have negative marks on their credit scores (which many many people likely have). Banks are looking for those who offer stability. In addition, as a result of this mortgage mess we're in, people have become wary of taking on the financial obligation of a house (or any large purchase for that matter) and thus are reluctant to participate in the borrowing process. Without the confidence of the people, the economy will take some time to bounce back. The only thing the Fed could really do is to start giving money away. The only people who will generally use that money the Fed freed up are investors who are generally wealthy folks. I don't see how this creates jobs or does anything but keep rates low and I'm not sure how much of a positive effect that will have on the economy. With high unemployment and low confidence in job security, the general public will not participate which is probably why the first two rounds of QE didn't go so well.

    That's what I think I think anyway! :)

    Here's a link to an interview with RP shortly after the Fed action was announced.

  3. Good points. EIther way, we are screwed.

  4. Short on time today, but quick swing by to say that I'm on the same page here, LME. :)

    Good write-up breaking down the issue as well.