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Sanity Zone 2-4-2011 QE2

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Posted 02-05-2011 at 11:44 AM by xan

Sanity Zone 2-4-2011 The QE2

No, the QE2 is not a boat. It stands for Quantitative Easing 2, which is fancy econo-speak for “printing money and dumping it into the currency markets.” One might wonder what all the fuss is about, as the Federal Reserve increases the money supply regularly. Well, all things equal, I can understand how this might be confusing, but this can be simple to understand with a few graphs.

The Situation:
The US economy is currently growing at an annualized rate of 2.8%. The broadest measure of unemployment shows that there are 16 million people unemployed but willing to work, or 12.8% of the broadest measure of the labor force. Consumer inflation is at 1.2% on an annualized basis. The risk free interest rate is at 0.23% for AAA rated 3 month commercial paper and the 30 year Treasury Bond is 4.22%.

As of August, M2 (the broad measure of currency in markets) was about $8.7 Trillion growing at about 2.8% year over year. It is ok that currency levels increase over time; if we held currency constant, it would limit the capability of the economy to grow because money has “velocity” in that it changes hands about 5 times during the year. The more money (within reason) the easier the economy will grow. Increasing the M2 will also devalue all the previously deployed dollars. That’s known as monetary based inflation. Should the Fed increase the money supply by too great a rate for an extended period of time, people’s expectations about the value of the dollar will change, and prices will rise to reflect its lower value.

The Policy Initiative:

The Fed is going to buy $600 Billion of outstanding US Treasury debt instruments (mostly bonds). By doing so, they will push that amount of additional currency into the capital and currency markets. Buying or selling debt instruments is a normal activity of the Fed, but this program is unusual in its size. QE1 was over $1 Trillion back in 2008/2009. This newest round of bond purchases, QE2, while smaller, is supposed to complement the effects of QE1.


As I described, it is easy to see what will happen by looking at the following charts.

The first thing that will happen is in chart (c) where the increase in the quantity of dollars available will cause the exchange rate relative to other currencies to fall, making the dollar cheaper, and thus increasing our exports.

The second implication is that when there is an increase in exports, which means that capital has to flow out of the US. This capital outflow is a result of foreign buyers of US goods/services needs for dollars to purchase those goods, so they sell US based securities in order to fund their purchases. See chart (b).

Finally, the increased number of dollars in circulation devalues all the dollars, causing inflation. This inflation, coupled with a firmness in the Federal Reserve’s position on nominal interest rates makes the real interest rate decline (real interest = nominal interest – inflation). This reduces demand for US based Investment, accentuating the flow of capital out of the US. See chart (a).


Quantitative Easing as a policy initiative is a short run horizon tool that can have a damaging long run impact.
When deployed correctly, the magnitude of the cash infusion should be just enough to stimulate demand (and therefore production) by foreign buyers. This increased production will hire additional workers, which should stimulate domestic demand, bringing a cascade of higher production and higher prices. Firms’ profitability should improve, and that should increase domestic savings and potentially stimulate investment in new opportunities for growth.

The downside scenario is that the capital outflow is so large due to the reduced rate of return for investing in US based growth that projects designed to increase growth in the economy aren’t funded. It takes several years for that effect to detract measurably the GDP and thus employment situation.

The capital flight we experienced in 2006-8 is being felt today. The large depletion of loanable funds has caused many companies to rely on internally generated cash flow to fund growth. This is the slowest form of growth, as it tends to be the most risk averse use of capital. There are numerous instances in history that correspond to weakened/negative growth subsequent to instances of capital flight. The extent and duration of the flight is correlated to increased lending activities. Unfortunately, the case today offers a crippled banking industry not predisposed to adding risk to an already set of shaky balance sheets.

Worse yet, it does not include what other countries are trying to do with their currencies. The Chinese have pegged the Renminbe at below reset rates. This makes Chinese goods more favorably priced. It also makes wages in China more favorably priced relative to wages elsewhere. This policy enables the Chinese economy to grow at its target of 10% per year. By deflating the US currency, one could argue that in order to keep stability, the Chinese must buy up all the excess dollars, or risk letting the dollar fall against the Euro or TRIB averages, which would reduce demand for Chinese goods and increase demand for US goods. In ironic circular fashion, the Chinese use those scooped up dollars to buy US treasuries, which fund the deficit and the QE’s. It seems to be a colossal game of chicken. If the Chinese unpeg their currency, they will experience much slower growth, the rest of the world will begin to accrete more manufacturing jobs, and capital will flow more normally. If they do reset, it will also reduce demand for dollars, depreciating it significantly, causing a significant monetary based inflation.
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