The great Bernanke QE2 debate continues to heat up. In the run-up to the G-20 meetings, China, Russia, Germany, and others are all coming out against the Federal Reserve’s quantitative-easing agenda. They don’t want hot-money excess dollars to flow into their higher-yielding currencies.
The assault against Bernanke’s easy money has reached such a fever pitch that President Obama felt it necessary to defend the $600 billion in new-money printing in a news conference in India.
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Meanwhile, World Bank president Robert Zoellick has actually called for putting gold back into global money, in order to use it as an international reference point to measure market expectations over inflation or deflation. The former Treasury and State Department official wants a successor to Bretton Woods. To my way of thinking, Zoellick is dead-on right.
And then there’s Kevin Warsh’s opus op-ed in Monday’s Wall Street Journal. I have written about Warsh in the past, and his sound-thinking views. Taking a bit of a shot at Bernanke’s QE2, the Fed board member basically says: Look, you want better growth, reform the tax code and stop regulating. “The Federal Reserve is not a repair shop for broken fiscal, trade, or regulatory policies,” he writes.
But in the key part of his op-ed, Warsh calls for a strictly limited QE2, not an open-ended commitment. He describes it as “necessarily limited, circumscribed, and subject to regular review.” And he goes on to say that if the dollar decline and run-up of commodity prices continues, these inflation signals should stop QE2, regardless of the unemployment rate.
It’s noteworthy that both Zoellick and Warsh are using gold, commodities, and the dollar as alarm signals — market-based alarm signals — that would warn the Fed if it’s too loose.
Since Bernanke first hinted at quantitative easing in late August, commodity indexes have jumped nearly 20 percent, gold has hit a new record high over $1,400 an ounce, and the dollar has fallen nearly 10 percent against the euro. And riding the crest of easy-money expectations, stocks have increased just less than 20 percent. But is it real? Is it sustainable?
Markets are presently agonizing over QE2, wondering what Chairman Bernanke is thinking. After all, what can $600 billion in purchases of long term treasuries over the next 3 quarters possibly do to stimulate the economy? The reason for the confusion is that the market is pondering the wrong question. QE2 is a convenient disguise for what is really going on.
We all know the Fed is mandated to stimulate economic growth and increase employment. All true, but it answers first to an even higher calling. The Fed is owned by the banks and is run first and foremost, in their interest. When the financial crisis left banks insolvent, the Treasury stepped in with the TARP program to take care of the immediate capital shortfall. It was the Fed, however, which provided the longer term solution, a rebuilding of the banks’ capital base through internal growth and to provide the earnings needed to offset additional unrecognized mortgage foreclosure losses.
The Fed’s solution was to drop its short term lending rate to near zero, thereby allowing banks to borrow at this rate and invest the proceeds in long term treasuries paying 3% to 4%. Leverage that 5 or 10 times and you get a 20% to 30% rate of return with zero credit risk (this is what is referred to as the carry trade.)
The problem with this Fed solution is that banks saw no reason to make commercial loans where they had credit risk and had to actually work for their money. Better to put their loan officers to work cleaning up those bad mortgage loans already on the books.
The greatest risk in the carry trade, however, is a sudden increase in long term interest rates. It’s fine to collect 20% a year’s worth of carry trade interest, but not if long term rates suddenly move up. A 2% rise at 10 times leverage would result in a 33% capital loss, or more precisely, a wipeout. A year ago this carry trade looked to be about $500 billion and I suspect it has grown since then. What made this carry trade bet look risk-free was the Fed promise is wouldn’t change the short term borrowing rate for some time and then only with plenty of advanced warning. The more important signal, however, is the rise in long term rates; rates over which the Fed has only limited influence.
Those who play the carry trade game look for the first signs of a long term rate rise. When they see it, they will rapidly de-leverage their holdings to avoid the rate spike that can occur when everyone sees what’s coming and tries to bail out at the same time. And what better first signs can you have than for the Fed Chairman to announce he wants to see more inflation combined with the market surge in gold and commodity prices?
The problem with the carry trade unraveling is that you suddenly have an unbalanced market where everyone wants to sell their long term treasuries and there is a dearth of buyers. The Fed will have to step up to fill the void, but at what price level? To forestall the uncertainty and head off a selling surge, the Fed announces it will become the buyer of last resort for these treasuries at current market levels over the next 3 quarters, but calls it QE2. I believe this is Bernanke’s way of telling his banker friends it’s time to unwind their carry trade positions and get back to the business of lending to the private sector. Yes that means taking credit risk, but it also means making loans tied to the prime rate and therefore, loans which adjust with the coming inflation.
Now God forbid the Fed should tell us this is what is going on, it will only be perceived as another bank bailout (which it is.) Better to keep us guessing to slow down the market reactions and to avoid those unintended consequences. And what are those unintended consequences? I don’t know, but they are usually bad. While I agree that the Fed has to buy up these treasuries to slow down the inevitable rise in long term rates, it is the consequence of an equally bad policy of encouraging the engagement in the carry trade at the expense of savers in the first place. I’m not sure Chairman Bernanke anticipated all the fallout and misunderstanding so far, but he sure can play a mean game of monopoly.
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