"QE 2 - A Boon to the Economy or Asset Inflation?"

Sydney M. Williams

Thought of the Day

“QE 2 – A Boon to the Economy or Asset Inflation?”

November 2, 2010

While the election will be getting all the attention tonight and tomorrow morning, the meeting that will have the bigger and more immediate impact on our market will be the report from the Federal Reserves Open Market Committee, which meets today and tomorrow. The report, which will surely keep Fed Funds at 0.0 to 0.25%, is expected to recommend a second round of quantitative easing. General expectations place the total amount between half a trillion and one trillion dollars. Their decision will be rendered Wednesday afternoon at 2:15PM.

While stocks and commodities have rallied strongly since the Fed first hinted at the move back in August, bonds, the more direct beneficiary of quantitative easing, have fared less well. The S&P 500 is up 13.2% since the end of August. In contrast, the yield on the Thirty-Year has risen from 3.53% at the end of August to 3.96% today, indicating lower Treasury prices. LQD, the I-Shares for Investment Grade Corporates, is flat. On the other hand, HYG, the I-Shares for High Yield Corporates is up 3.6%. What the market is suggesting is that QE2 will aid speculation, which explains Wall Street’s endorsement. Cheap funding is positive for asset speculation, but it can lead to inflated asset prices, as any home owner who bought in 2005-2006 can well attest.

Arguing, as the Fed appears to be doing, that lower interest rates will stimulate the economy seems questionable to this observer. On the other hand, government assisted lower rates will continue what Jeremy Grantham refers to as the “pernicious practice” of engineering asset prices upward. That we have seen. Besides stock and junk bonds, since the end of August, silver prices are up 27%; lumber and wheat are up 29% and 63% respectively. Obviously, interest rates are not the only reason for the commodity price increases, but they sure have not inhibited the rise.

Fed funds have been at 0.0 to 0.25% since January 28, 2009, yet the economy feebly stumbles along. Despite five quarters of positive GDP growth, the economy is producing below where it was in the fourth quarter of 2007 and unemployment remains just under 10%. Thirty year mortgage rates are at forty year lows, yet housing starts are at the lowest level in fifty years. In 1975, with thirty-year mortgage rates at 9.05%, housing starts were in 1.032 million. Ten years later, in 1985, mortgage rates had moved up to 12.4% and housing starts were 1.71 million. Currently the thirty year mortgage rate is 4.35% and housing starts are expected to come in at 560 thousand units. The Financial Forecast Center is projecting an increase in the thirty-year mortgage rate to 4.86% by May 2011. Our housing analyst, Jeremy Pinchot, is projecting housing starts for 2011 of 750 to 850 thousand units. It does not appear that interest rates alone have much of an impact on housing starts. Jobs and confidence are the necessary (and missing) components.

There are those who argue that the government should increase spending when private industry does not. The notion is that this is the quickest way to get the economy moving. We have done that over the past two years with little effect thus far. But taking on more government debt when corporate cash is so high appears a misallocation of stimulus options. Corporations are generally in good financial shape. Reflecting improved corporate balance sheets, Investor’s Dealers Digest, S&P downgraded 94 corporate issuers and upgraded 124 in third-quarter 2010, bringing the global downgrade ratio, or downgrades as a proportion of total rating actions, to 43%. That ties with the second quarter of 2007 for the lowest downgrade ratio of the decade. Government should consider options that encourage corporate investment – a lower corporate tax rate, less cumbersome regulation and direct incentives for investment. There is no one who disagrees that the road to recovery lies with increasing economic growth; disagreements have to do with the best way to achieve it.

Paul Krugman, in Monday’s New York Times, writes of moralizers “mugging” his preferred way of exiting the debt quandary. He writes: “government should be promoting widespread debt relief; reducing obligations to levels the debtors can handle is the fastest way to eliminate the debt overhang.” “Moralizers”, he writes dismissively are “calling it a reward for the undeserving.” It may in fact be a moral issue, but far more important, it is an economic issue. For every loan there is a borrower and a lender. Much of the debt in this country is held either directly or indirectly by elderly, retired individuals. (If all the debt were held by the Chinese, the decision might be easier, but deciding to walk would still have consequences.) Artificially keeping rates low, as the Fed is doing, promotes asset speculation, produces inflation and impairs the income of the old and the thrifty. Making it easier to skip out on one’s obligations, as Mr. Krugman recommends, raises rates for future borrowers and makes credit less available.

I am not an economist, which I am sure is obvious to anyone who is, but I don’t understand the need for lower interest rates. I do, however, recognize the necessity of bringing back jobs and restoring confidence. I recently read a refreshing article by Virginia Postrel, entitled “In Praise of Irrational Exuberance”. She quoted John V.C. Nye who teaches at George Mason University: Mr. Nye argues that “countries become economically stagnant when their business people become too mature and rational.” A government which provides regulation and tax rules that promote confidence in the future will do far more for economic growth and jobs than by artificially pressuring interest rates lower.