The Federal Reserve’s formal QE2 announcement will arrive at 2:15 p.m. EST next Wednesday, the most-telegraphed punch in the history of punching.
Hence, a QE2 Q-and-A.
Monetary "easing" is a central bank’s standard antidote to recession, tried and effective hundreds of times here and elsewhere. The central bank cuts its cost of money and "injects" reserves into banks by buying Treasurys from them with invented money. These operations ignite lending and borrowing, and we recover.
In this Great Recession, the Fed began to ease early, in 2007, and then massively post-Lehman, in September 2008. Without effect … no response at all. Banks were and are incapable of providing credit: capital exhausted; crippled by brainless demands by government that they raise more; fear of new losses; and fewer borrowers.
A controlling equation: "M multiplied by V equals GDP(p)." More simply: The quantity of money ("M") times its rate of turnover (velocity, or "V") equals gross domestic product. That "(p)" notation refers to prices. If you get MV going too fast, you get big GDP and inflation; if too slow, deflation.
"V" rises in good times, with credit creation, and slows in bad; in extreme cases (bank runs), "M" disappears altogether. In "quantitative easing," the central bank bypasses broken banks completely and buys Treasurys in the open market, sustaining "M." Done right, it’s price-neutral printing!
For three solid years we have been in asset deflation (you live in one of those), not general-price deflation; however, core measures of inflation are falling this year below 1 percent. The Fed engaged in QE from January 2009 through March 2010, and many think it stopped too early, contributing to economic and price deceleration. Thus, QE2 — the new Fed injection.
Doesn’t printing money guarantee future inflation? The Fed hopes so! But only to get the Consumer Price Index back in the 2 percent range, and the economy is so slack ("excess capacity") and so much money has effectively gone to mattresses that all inflation tinder is soaking wet.
But, once printed, the money is still there! The easiest of all central bank jobs is to make money disappear. If the Fed overdoes QE, if banks suddenly snort to wakefulness and make loans, all the Fed must do is to sell Treasurys that it bought.
Market rates will rise and the cash will go back into the Fed’s mattress. Coming out of this, expect high volatility in start-stop-start "draining," but the Fed will not allow the aftermath to go to inflation.
Why bother? Why not just leave well enough alone? The Fed did contribute to the predicament, and is hardly infallible, but its errors were omission, especially allowing a credit bubble to inflate (and no, rates were not "too low" from 2002-04 — underwriting was too easy).
Since 2007, the Fed has been the only government institution to rise to the crisis, and a major lesson of the crisis is the need for an active Fed to regulate terms and supply of credit, and cautiously to intervene in asset bubbles.
What of that Hoenig fellow (Thomas M. Hoenig, president of the Federal Reserve Bank of Kansas City, who has objected to QE2) and his cry for stability? The captain of the RMS Titanic felt that a straight course and steady speed were the proper policies — all this zigging and zagging, slowing and speeding were just silly responses to low-probability risks.
How will we know if QE2 works? That’s why Wednesday is such a big deal. The Fed has not said what indicators it will watch itself. QE1 was "shock and awe," a pre-announced 18-month $1.7 trillion print. With QE2, the Fed is likely to revert to normal behavior: It will give a broad outline, but will not tell us what it’s watching because the Fed wants to watch markets react to QE2, not markets watching the Fed.
Hunches. (Remind me when they go wrong.) The Fed intends to drive down intermediate Treasury rates (for those Treasurys ranging from 3 to 10 years, "caving-in the shoulder of the yield curve"), and in turn drive down other longish rates. Perhaps mortgage rates will be in the 3 percent range. In further turn, those lower rates will support asset values (houses if the Fed is lucky, stocks and gold if not).
As assets stabilize, maybe even rise in value, defaults will wane and the world will become safe for bankers to lend. Last, the Fed’s intent is domestic, not to "drive the dollar down," although it would be pleased if other central banks were forced to follow, giving global support to "M" and adding pressure to currency manipulators.
I hope to hell it works. There is no Plan B.
