Dr. Frank Shostak, an Austrian theory economist who works for MF Global, and who writes for Mises.org on economics, came out with an article this week on what will happen when the Fed freezes its balance sheet in June, as they have said they will do. I very much enjoy Shostak’s writing and have followed his ideas for years.
In this article he says:
We suggest that once Fed policy makers freeze the balance sheet of the US central bank it will slow down the growth momentum of the Fed’s balance sheet. Consequently, this is going to exert downward pressure on the growth momentum of the money supply. Note that ultimately it is fluctuations in the growth momentum of the money supply that set in motion fluctuations in the pace of formations of bubble activities. As a result, various bubble activities that emerged on the back of the rising growth momentum of the money supply will come under pressure — an economic bust will be set into motion.
Obviously it is possible to have a situation where commercial banks’ expansion of lending “out of thin air” counters the freezing of the Fed’s balance sheet. It remains to be seen whether this is going to be the case in the months ahead. For the time being, the Fed’s balance sheet continues to expand at a rapid pace. …
Now, we suspect that the difficulty the Fed has had in meaningfully “reviving” the economy so far could indicate that the state of the pool of real savings or the pool of real funding is in trouble. This means that even if the growth momentum of lending does currently show some strengthening (see chart) it is highly unlikely that, with the weakening of bubble activities on account of the Fed’s freezing its balance sheet, commercial banks will pursue an aggressive expansion of credit out of thin air. Also, it is quite likely that with the freezing of the balance sheet, Treasuries will come under pressure, and the growth momentum of banks’ holdings of Treasuries will weaken. This in turn will exert downward pressure on the growth momentum of total bank lending, which includes lending to the government. …
He predicts that CPI growth will reach 5% by year-end.
We suggest that once Fed policy makers freeze the balance sheet of the US central bank, the growth momentum of the money supply will slow down. As a result various bubble activities that emerged on the back of the rising growth momentum of the money supply will come under pressure. A visible strengthening in the growth momentum of the CPI may prevent Fed officials from introducing QE3 as suggested by some experts.
There are several aspects of this conclusion that I wonder about. The basic issue is whether or not the Fed will let their balance sheet “freeze” at its current $2.75 trillion level or will the Fed be eventually encouraged to undertake QE3.
I agree with everything he says about the bubble consequences of the money supply expansion. The vast amount of liquidity the Fed pumped into its primary dealers have fueled the stock markets and the current M&A splurge. It has also provided liquidity to the corporate markets which makes borrowing cheap. That is why you see companies like cash rich Google ($35 billion in the till) borrow $3 billion on the bond market at an average of 2.33%.
It makes sense that when the growth momentum of quantitative easing stops, that this will eventually affect the markets, usually 6 to 9 months later.
Shostak sees that this will put downward pressure on credit expansion by banks and thus the money supply will shrink. I think that is correct as well. We have seen some growth in lending activity recently and, as I have written lately on this, it is likely that this will stagnate.
But there are two factors which lead me to believe that it is more likely that we will see more quantitative easing.
While Shostak concludes that the Fed is wary of price inflation (that they are causing) and that this will deter another round of money pumping, I think the primary motivation behind QE is unemployment, not price inflation.
The consequence of taking their foot off the money pedal will lead to higher unemployment and I do not think this is politically acceptable to the Fed or to the Administration. I think they will institute a new round of quantitative easing (QE3) because politicians will demand that the Fed “do something.” Which is, of course, the worst thing they could do. It will lead to more “bubble” activities and higher price inflation.
I believe the Fed and the Administration will be willing to tolerate a higher level of price inflation and for a much longer period of time, despite the inflation hawks’ warnings. I think this new money stimulus will occur no later than during the start of the presidential election period (January, 2012), and will continue until the winner is sworn in. I think Dr. Bernanke will be fired thereafter.
This would also cast a different light on Treasurys. If I am correct, then the Treasury market would, post-QE3 remain as it is today. It is likely though, that between June and when the new QE round occurs, the freezing of their balance sheet will take some pressure off the Treasury market as Shostak suggests.
Assume that I am incorrect, and the Fed doesn’t embark on a new round of QE. Where will money go? I believe there is sufficient demand from institutional and foreign sovereign buyers to keep the market up and keep yields low, despite growing price inflation. It is likely that eurozone problems will continue for quite some time in the future, at least two more years if I were to guess, and that institutional and sovereign investors will continue to park money in Treasurys, despite what China, Russia, and other Brics may say. China has no real alternative. It is conceivable that Japan will reduce its Treasury holdings, and possibly be forced to borrow on the international market in order to fund its reconstruction. But the PIIG problem will continue to drive money into Treasurys.
The Fed is serious about freezing its balance sheet starting in June. They will continue to buy Treasurys as issues mature and are replaced. But, as Shostak points out, the momentum of money growth will slow down and that is the key to understanding what will then happen. If Treasury rates do not take off, then my assumption about domestic and foreign demand for Treasurys will be correct. If they do take off, it will be an indication of a shrinking money supply as Shostak points out which will lead to economic stagnation or even a market bust. On the other hand, I don’t believe the Fed will play “chicken” during an election year, and when things turn ugly they will announce QE3 and that will kick the can down the inflationary road. QE3 may be the last installment of this monetary madness.
I agree that QE 3 will happen incrementally until the next election. The inflation and unemployment is less of a political liability than the cut backs that would have to happen otherwise.
If QE3 does not commence this summer and we continue to be fiscally hamstrung due to a lack of political leadership, why would other countries step up their buying of Treasuries?
(This whole article reminds me of the Russian Roulette scene from The Deer Hunter.)
Great article Jeff. These are the questions to be asking and trying to answer (of course it’s impossible to model or predict the behavior of irrational megalomaniacs like the men who run the system).
Larry: With the JPY possibly about to blow up, and the EUR seemingly in the process, wealth will move out of these dollar derivatives and into the genuine dollar. Of course, from an individual’s perspective the place to go is gold and silver. But the dollar system is a closed loop. Where do the holders of dollars go? Treasurys, especially of the USD is gaining vs. other paper currencies, and especially if it is gaining vs commodities and stocks are rolling over. I think we will see new all-time lows for interest rates in the 10- and 30-year…
yes, great article Jeff.
nuclear reactor aside (and this is a serious incremental event), the JPY and EUR have been on the road to ruin for some time now. so i can’t imagine people wanting to move into dollars now than they did 6 months ago, and furthermore, the dollar is also a disaster. i’m not sure where that leaves me …
Keith: i think you make a good point, it seems very sensible and intuitive, and i know you have made it before. you may be right, i wish i knew. the only thing that i get stuck on is, as Larry S said, is there enough incremental demand post-Fed pullback? maybe, there always has been in the past, but that begs the question: where are these incremental buyers putting their capital now while the Fed gorges itself? and what will compel them to move back into Treasurys?
When QE2 stops, the dollar will strengthen, the market will fall because of $ fleeing to treasuries. This will also cause an economic slow down because of costs to other countries for our exports(stronger dollar) and people will watch their retirement account fall with the market causing less consumer spending. Unemployment will rise and I still don’t think the $ going to the treasuries will be enough to make up for the almost 70% of buying that the Fed has done in QE2 to make the interest rates remain low. With the combination of higher rates and a slowing economy, Mr. Bernanke will have to turn on the digital presses again so the gov. can keep its current level of spending. No politician wants to cut spending with elections next year and even if they did, that would slow the economy as well since gov. spending is part of the GDP. I’m betting on QE3,4,5,etc., and I’m buying gold and silver. Just my 2 cents. But what do I know I’m only 30.
[...] QE III Is on the Way – Daily Capitalist [...]
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The fundamental argument about the inevitability of inflation made in the article is based on a top down assumption that in turn is based on a flawed reading of monetary theory, Austrian or otherwise. Inflation is not the necessary outcome of an increase in the raw amount of “money” in circulation. Inflation is, at it’s core, the result of too much money chasing too few goods over a defined period of time. A secondary driver of inflation are individual and business expectations of rising prices. The “money” or liquidity created by the Fed has, for the most part, not been circulating. If you use a twenty first century definition of mone8y supply that includes credit the ability to purchase — to buy goods and services – has declined dramatically and is doing so monthly. On the supply side, there is not shortage of anything anywhere except certain commodities. Unless you believe speculation is driving commodity prices — I do not, speculators may be adding an increment to demand – the current rise in commodity prices is the result of demographics and the emergence of previously moribound economies. Further, commodities may be visible, i.e. gasoline, but contribute very little to inflation in developed nations. The Fed policy, aimed at pushing up asset prices, has been a “net” failure – the stock market is roughly where it was before the post Lehman crash, the value of housing in the US is roughly 35%-40% below where it was four years ago.
My arguments against this piece are based on facts, not top down theories. Monetarist theory, and all its variants from Chicago to Vienna, is based on a world of fixed exchange rates, the gold standard, little or no consumer credit, trade barriers that inhibited the ability of goods to come to market when demand grew and a world where it took time to build new manufacturing capacity to meet demand. The world is awash with industrial capacity and industrial workers. I love reading Schumpeter, I love reading Friedman, but they were then, this is now. Articles and arguments should begin with facts first, theory second. There was a fellow in Scotland by the name of Adam Smith who took this approach….
Try reading a little Mises.
If by “Vienna” you mean Austrian theory, then you are wrong to simply lump it in with Keynes and Friendman. Austrian theory shares nothing with those two jokers.
For example, your aside about “inflation” (i.e. rising prices, which itself is the wrong definition) being partly a function of expectations. Really? At what rate of rising prices would you be tempted to by extra refrigerators, cars, books, computers, etc. that you don’t need? The reason why people don’t buy more stuff that they don’t need is due to declining marginal utility of stuff. Something I don’t think Keynes or Friedman wrote about, but which is central to Austrian school thinking, is the idea that the next unit of whatever good is worth less to you than the previous. What is the 2nd car worth (if you are alone) or the 3rd or 8th? Computer? Etc. Even if one expects the value of money to fall, it falls less than the value of an extra PC!
You are describing what most people call hyperinflation or what Mises called the Crack-Up Boom, when people are in such a desperate rush to get rid of rapidly-falling paper that they will buy whatever they can get. It is a mini boom but totally unsustainable and once the store shelves are bare, it’s over.
The 2011 trade deficit will be around $500 billion dollars. The budget deficit is about $1.5 trillion. The foreign countries can buy is up to $500 billion of Treasirues if they do not buy anything else with their dollars. Someone else needs to buy the rest of $1 trillion to finance the bufget deficit. That one is Ben Bernanke’s Fed. The goverment needs to spend otherwise we will see deflation. No one else has money to spend. The customer is dead in the water, with no jobs and lower wages. If the govermnet does not spend like a drunken sailor, Benny and Obammy will sell hamburgers on the street.
“QE3 may be the last installment of this monetary madness.”
It wont!
And we all know it…
As an outsider hearing scantly from outside,Americans have no other worst option than forget their previous frivolity and over-consumption of almost everything consumable.
Let the system fail…it’s only going to get worse from here folks! I just returned home from America today and there are plenty of problems I could see from being there on a holiday.
For now just invest in gold and silver and sit back and let Mr B and the fed print your own financial success. The more the US$ drops the price of gold silver oil increases due to it’s purchasing power, it’s as simple as that.
[...] Journal) responding to my article on the inevitability of QE3 (which originally appeared here). The writer of the letter criticized me for being foolishly naive and ignorant of the TBC [...]
[...] also means that my forecast of the likelihood of QE3 is still [...]