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QEnull – What’s The Point?

I feel guilty when I have not much to add atop someone else’s words, but for the second time in a fairly short period of time, that humble explanation applies to an article that Stephen Stanley, chief economist at Pierpont Securities, wrote in response to an article in the Wall Street Journal today by Jon Hilsenrath that discussed a ‘new option’ that the Fed could conceivably deploy when QE3 takes place. While Wall Street was actually quite preoccupied today with cutting risks down ahead of the Greek invocation of the collective action clause (CACs) tomorrow – which seems far and away the most-likely event, since some 58% or so of Greek bond holders have come out in favor of the tender while enough have been opposed to ensure that the 95% hurdle for non-invocation will not be reached – there was plenty of discussion about this article, especially in inflation circles.

The article concerns the actions that the Fed could conceivably take if they decide to implement a third Quantitative Easing program (QE3). Recently, there has been little suggestion that any such possibility was forefront in the minds of Fed officials, but the appearance of such an article from Hilsenrath constitutes a “running it up the flagpole” event since he is the columnist assumed to be most-associated with “official leaks” these days (justified or not).

The article noted a third approach the Fed could conceivably take towards QE3:

Under the third approach, the Fed would create new money as it buys long-term bonds. But then it would effectively lock up the money rather than letting it loose in the broader economy. The Fed would do this by borrowing the money back from investors for short periods—say, 28 days—in exchange for some low interest rate it would pay investors.

Now, at some level there is nothing new about this. For decades, the Fed’s Open Market Desk has done reverse repos when it needed to temporarily drain reserves from the system. What is new is that this would be conducted on an extremely large scale, so that the Fed can buy longer-term securities (which adds reserves) and then ‘immunize’ them by draining the liquidity from the market at the same time. My initial reactions were “big deal – this isn’t new,” but Stephen Stanley’s take was much more insightful and I recommend that you read it in full.  But at least, you can read these two snippets, which by themselves are devastating observations:

Do we need stimulus or not? The first and most obvious objection to “sterilized QE” is to ask why it needs to be sterilized. Does the economy need stimulus or not? If it does, just do QE3. If it doesn’t, then, for goodness sake, put the shovel down and stop digging.

That’s so insightful that I am embarrassed that it didn’t occur to me when I first read the Hilsenrath article. But golly, it’s right. We’ve become so accustomed to the idea of massive QE that doesn’t lead immediately to inflation because the added funds are sequestered on the central bank’s balance sheet (as happened with QE1, QE2, LTRO1, and it appears LTRO2), that I didn’t think to ask why you’d target that outcome! I believe I correctly asked that question leading up to QE2: why do QE2 when QE1 was still sitting in reserves? But my thought process has obviously been co-opted as well, embarrassingly. Here is another Stanley snippet:

In the article, the sources that Hilsenrath cites go to great pains to argue that Fed officials (at least the majority of them) think that these concerns about inflation are entirely misguided. The implication is that sterilizing QE is really about placating the irrational inflation fearers, not because there is a true need to protect against a future acceleration in price hikes. This is unbelievably weak. Either there is an inflation threat or there isn’t…If these inflation fearers are as misinformed as Fed officials seem to suggest, then they should be easily disabused of their erroneous inflation fears by some reasoned discourse from Chairman Bernanke and others on the FOMC.

Again, Stanley nails the hypocrisy here in a way I simply missed the first time around. Stephen Stanley is the first economist I think I have ever cited twice at length. The fundamental points he raises are devastating because they are so simple: either QE is needed or not; if it is needed, then there’s no reason to sterilize, if it’s not then there’s no reason to do it, q.e.d..

What’s amazing it that this topic even comes up while the stock market is near 4-year highs, bond yields are near all-time lows, and economic data have been consistently surprising on the positive side (according to the Citi Economic Surprise Index) since October. No, I’m not a bull on the economy, and yes I think Greece’s invocation of CACs will precede by only a short time the exit from the Eurozone of Greece and Portugal at least, but … I’m also not the one sitting around saying that everything is working, and I’m extensively on record as pointing out that monetary policy only works in the presence of money illusion and its main effect is to raise price levels. So why is Hilsenrath even penning this column?

Incredibly, I think the right answer is that the Fed feels it needs to be doing something, and at some level may fear for the future of the institution if a conservative government is put in place in November. I don’t think that the Fed would really be dissolved (it’s always easier to shout about change from the back bench than to actually implement it), but there’s no question that the Fed has all of its chips in the ‘interventionist’ camp right now so doubling-down may not be a crazy strategy from an institutional-imperative standpoint. As amazing, and discouraging, as that is to write…

On Thursday, you can fairly ignore Initial Claims (Consensus: unchanged at 351k) with Employment on Friday and, more importantly, the deadline for the PSI tender at 10pm Athens time (3pm ET). We may not know the official result of the tender until after the close, and will probably not hear about the CAC invocation until Friday. And then, as they say, the real game begins.

Whether we skate past the March 20th deadline or not is currently the market’s preoccupation. It is likely that on Thursday we will find out that enough tenders exist to allow the PSI to proceed with CAC-invocation, which will probably be perceived as a positive. Some chance exists of a complete failure, but most likely now is that there will merely be a technical default and some wrangling to get Greece past March 20th. All that really does, in my view, is give the country time to prepare for the inevitable withdrawal from currency union in a more-graceful way, but the markets may well regard this as a wonderful development – and worth selling into, frankly. Good luck.

  1. Lee
    March 8, 2012 at 12:06 pm

    Greece has gotten too confusing to keep straight for me . Will the CDS pay out if the CAC is invoked?

    • March 8, 2012 at 1:10 pm

      It would need to be adjudicated by the ISDA committee tasked with that decision, but it seems there is broad unanimity that this would almost certainly represent a Credit Event as defined by standard CDS documentation.

  2. Morgan
    March 8, 2012 at 1:06 pm

    You need to lose the parochial viewpoint which is keeping you from appreciating the current State of Play.
    Stop thinking of the Fed in the context of a US central bank and instead realize they are a CB to the world. Let your mind soar.
    Inevitable result of globalization which was itself inevitable.
    Think for a minute of the Final Destination of QE.
    Think about how US ZIRP impacts rates in the EM’s.
    Reflect on how important the feeding and watering of those potted plants the EM’s has become to the world credit system, especially since China is so recalcitrant.

    I feel sure that Stanley’s analysis on the impact of sterilized QE on Repo Rates was masterful, but I confess I did not understand his conclusions.
    I did think his commentary was enlivened by his dark reflections on the probable sanity of the Fed. Very entertaining.

    BTW- Realize these are very unoriginal thoughts for FX traders which is why they have so much fun snickering at the rest of us.

    • March 8, 2012 at 1:12 pm

      I think really his main conclusion was this: if QE is needed (either here or globally), then do QE. If you don’t need to do QE, then don’t do QE. But doing QE and ‘sterilizing’ it is silly…unless, of course, you intend at some point to stop rolling the repo and unsterilizing it. Frankly I’m not sure the Fed even knows what it is trying to do any more.

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