Wednesday, October 22, 2014

The inevitability of QE

A swan dive in commodity prices followed by the latest stock market correction has investors talking about the “D word” once again.  References to deflation abound in the news while economists seriously discuss the possibility of a global economic recession.  What, they ask, will it take to arrest the slowdown in the euro zone and China and prevent its coming to U.S. shores?  Why central bank intervention, of course!

One of the dominant themes of 2014 has been the unwinding of the U.S. Federal Reserve’s QE stimulus measure.  After purchasing as much as $85 billion worth of long-term Treasuries and mortgage-backed securities per month in 2013, the Fed was scheduled to end asset purchases this month.  With the revival of deflation fears, however, there has been some talk among Fed members that perhaps it would be wise to delay the end of QE.  Considering that the QE tapering process has clearly had a negative impact on stocks and commodities, as well as the real estate market, the suggestion to extend QE further is being seriously considered.

While there have been many negative headline events this month that have been blamed on the September-October stock market decline – ranging from overseas economic concerns to unrest in Hong Kong and Ukraine to Ebola – the real reason for investors’ worries can be boiled down to one major concern, namely liquidity.  (Remember the old Wall Street mantra: when it comes to the stock market it’s all about “liquidity, liquidity, liquidity”). 

The selling panic started just as the Fed was putting the final touches on phasing out QE.  While economists were convinced the market would be able to stand on its own two feet without the benefit of QE, investors were far less certain.  Adding to the concerns of U.S. investors were recent actions (or inactions) by the heads of Europe’s and China’s central banks which suggested that both regions weren’t committed to pursuing further monetary stimulus.  Those concerns have recently been allayed by statements by central bank chiefs in the last couple of days. 

Last week, James Bullard, head of the St. Louis Fed, said the Federal Reserve should continue with asset purchases and thus extend QE until the U.S. economy shows more strength.  “We can go on pause on the taper at this juncture and wait until we see how the data shakes out into December,” Bullard told Bloomberg Television.  “Delaying the taper is something we could do right now that could buy us a little time.”

Not everyone at the Fed agrees with Bullard, however.  Boston Fed President Eric Rosengren suggested that when the Fed meets for its Oct. 28-29 policy meeting it likely will maintain its original intention of ending QE at that time.  “The [QE3] program was really designed that once we made substantial progress on the unemployment rate and labor markets more generally that that program would end.  If it looks like we're not going to get that kind of progress now and going forward then we’d have to reconsider it, but I would be surprised if in the next two weeks we get enough data to make us change our mind on that,” he told CNBC.

Despite Rosengren’s hawkish comments, other central bank members share Bullard’s dovish tone.  European Central Bank executive member Benoit Coeure said that ECB purchases of asset-backed securities are set to begin within days, while Bank of England Chief Economist Andy Haldane stated that recent economic data “speaks in favor of delaying the BoE’s first rate hike,” according to 

Bullard also made an even more revealing statement.  “Inflation expectations are dropping in the U.S. and that is something that a central bank cannot abide,” he said.  There you have in a nutshell the entire philosophy of the Fed these last six years.  The actions of central banks, especially the Fed, are governed by the idea that a little inflation is a good thing and that inflation should even be created where it doesn’t exist.  Instead of letting prices take their natural course according to the demands of the free market, the meddlesome Fed is constantly intervening to prevent the natural cycles from doing their job and keeping the economy healthy.  This intervention does more harm than good since it tends to create artificial asset price bubbles followed by their subsequent deflation. 

The trend of retail prices on the consumer level since the credit crash is a case in point.  What should have been a bonanza for consumers with money in savings turned out to be burdensome as retail prices were artificially high from about 2010 and beyond.  Only in recent weeks have consumers finally seen some relief in the form of collapsing fuel and commodity prices.  But of course the Fed won’t allow this break to consumers to carry on for very long since the bank is intent on stoking the fires of inflation.  With any luck, though, consumers may get to enjoy at least a few months of lower retail prices before the next round of QE starts up. 

Wall Street is also keen on seeing the Fed reinstitute some form of QE.  Since money managers have gotten used to the easy stock market gains fueled by the loose money and corporate share buybacks of recent years, they’re understandably in no hurry to see it end.  They’ll no doubt push the Fed to keep its foot on the monetary accelerator in the near term despite calls from the hawks to completely end the stimulus and raise interest rates. 

The important thing for now is that investors are apparently satisfied that central banks are at least showing an awareness of the risks confronting the global economy and won’t be as quick to tighten monetary policy (which would no doubt be bad for stocks).  A recent report suggested that China may replace the current head of the country’s central bank with someone more dovish.  China’s currently tight monetary policy is one reason for its diminished gold and commodities demand.  A loosening of monetary policy strictures would surely set the wheels in motion for higher stock and commodity prices. 

Central bankers may even heed the calls of the doves and loosen monetary policy (which would be bullish for stocks, at least in the interim).  Thus the September-October stock market correction was arrested by nothing more than the reassurance that central banks stand ready to do “whatever it takes” to keep the financial system liquid. 

Global investors still aren’t completely convinced of the Fed’s intention to maintain liquidity at all costs, however.  The distrust of investors both foreign and domestic can be seen in the strength of the U.S. dollar, which has become the safe haven du jour since this past spring.  Indeed, the dollar index (above) has been in a sustained uptrend during the final descent of the long-term deflationary cycle and is stubbornly remaining near its highs.  Only when a concerted central bank monetary stimulus becomes a reality again will the dollar lose its allure.