Originally published on The Agonist
It took a while, but the financial markets are starting to realize that Quantitative Easing will end next month, possibly once and for all. The unprecedented amount of monetary stimulus being pumped into the global economy by the Federal Reserve will come to a sudden halt. Commodity markets have enjoyed a bubbly expansion since the QE2 program was announced, and they were the first to crumble when the Fed began removing the monetary supports. Stock markets are now slowly beginning to follow suit.
One reason the markets took the news sanguinely was because the Fed engineered it that way. After the May meeting of the Fed Open Market Committee, at which it was decided not to renew QE2 when it expires in June, Ben Bernanke gave a first-ever press conference by a Fed Chairman following an FOMC meeting. The media thought it was a masterful performance – which it was, but not for the reasons cited in the press. Bernanke made it sound as if the end of Quantitative Easing was the most natural thing in the world, and that all the voting members of the FOMC agreed with him. The fact is, the FOMC decision was a defeat for Bernanke and his allies, which included the two other officers of the FOMC, Janet Yellen (Vice Chair of the Fed Board) and William Dudley (NY Fed President). Dudley, just a week before the meeting, had gone public with his desire to have a QE3 program standing by, ready to aid a struggling economy.
Bernanke Loses Control of the Fed
Bernanke is the creator of the QE programs. He is the so-called “expert on the 1930s Depression” who has decided the Depression was made much worse by the Fed’s refusal to add liquidity at the time. Bernanke is determined not to make that mistake, and there is no denying he has poured trillions of dollars into the economy since the crash in 2008. He has spoken highly of the success of the QE programs, and hinted that another round of easing would be forthcoming if it was deemed necessary.
His problem is that an easy case could be made that QE3 is necessary immediately. Most economic forecasters in the US expected real GDP growth in 2011 to average around 4%, but the first quarter has come in at 1.8% and the second quarter looks weaker still. This is exactly what happened in 2010 when the first QE1 program ended, except then the weakening occurred after the program ended, making it appear as if the US economy was completely dependent on Quantitative Easing for growth to occur. This time the second program hasn’t even ended and weakness has already set in. What is the culprit now?
The Fed is blaming the earthquake in Japan for disrupting first quarter global growth, plus droughts and other natural disasters which didn’t help. The problem for Bernanke and his allies on the Fed is that hardly anyone is buying this argument. Most financial analysts, economists, and CEOs are blaming inflation for the global slowdown, and specifically, the high price of food and energy. This is the same set of circumstances that undermined the economic recovery in 2008 and brought about the financial crisis.
Bernanke has been touting the slow growth in “core inflation”, a Fed construct that removes food and energy from the price and deflator indexes. Bernanke also lauds the nearly 100% increase in the stock markets since March 2009, something he says was a deliberate outcome of Quantitative Easing. Wall Street has certainly benefited from this engineered stock market rally, as have fine art auctions, luxury auto sales, and mergers and acquisitions. Unfortunately, most everyone else in the global economy is suffering. Wal-Mart’s CEO has said that his customers are “broke” at the end of every month, leading to eight consecutive monthly declines in store sales. The high price of food and energy is eating away at Wal-Mart’s margins, and margin compression has now spread throughout the retail sector and is beginning to affect many other consumer sectors.
The explosion in commodity prices can be traced directly to the announcement in July last year of the QE2 program – to the day, in fact. The financial and commodity markets from the outset did not trust this program to perform as promised, since the first one didn’t keep interest rates down as was the intention. Many traders feared the inflationary if not hyper-inflationary consequences of so much monetary easing, and whether they brought about the inflation by buying up commodities as protection against future price increases doesn’t really matter. Inflation was the result.
Global inflation has hurt countries all around the globe. China has complained bitterly about it, and there is good evidence that the upheavals in the Middle East have been ignited by high food and energy prices. The press was at first questioning the wisdom of Bernanke’s policy, and then began to blame him directly for problems that were arising everywhere. The six other governors on the Federal Reserve Board, and the 12 presidents of the regional Fed banks, noticed as well. One after another of them, starting late last year, began to complain publicly about inflation. Several of them called for an immediate end to QE2, and refused to endorse any extension of the program into QE3.
By May of this year, Bernanke and his allies were on the defensive, and QE3 was on the ropes. At the FOMC meeting last month, what had been a unanimous board vote to initiate QE2 became a unanimous vote to end it and not renew it. Whether this was a crushing defeat for Bernanke or just a defeat is hard to say, but to avoid embarrassment, he joined with the majority in voting to end Quantitative Easing once and for all. The Fed Chairman, after all, always has to vote with the majority in order to appear in control.
Can Bernanke Recover?
How much control of the Fed has Ben Bernanke lost? We have never had a Fed board in living memory that has been so fractious in public. The Fed has always had a party line and governors and presidents are expected to have all speeches cleared in advance to ensure the party line is followed. With this Fed, so many FOMC members have come out in opposition to official policy that you have to wonder if there is a party line left any more. To the extent it revolves around Quantitative Easing, it is in a shambles.
One other sacred tenet of Bernanke’s tenure has been the assertion that core inflation remains under control and inflation expectations are tame. Bernanke has repeated this statement over and over, and it is not that it is untrue. The problem is the statement is irrelevant. People and businesses don’t deal with core inflation – they deal with real inflation, which is hurting almost everybody and appears to be out of control, or at least out of control until inflation so damages the real economy that prices peak and begin to fall (which may now be happening).
Anyone who has lived through the 1970’s bout of inflation remembers that the Fed had a similar core inflation concept that blinded them to the effects of real inflation until it was too late to control it. The obvious move would be for the Fed to abandon the whole ludicrous idea of core inflation, and this past week one Fed president – James Bullard of the St. Louis Fed – made exactly that argument. He represents a voice of reason at the Fed, but more important, a direct challenge to Ben Bernanke and his way of running things. Yet again, we are watching the Fed Chairman be outflanked by his own board members.
With this background, we have to deal with the question of whether Bernanke can recover. He is certainly adept enough politically to remake himself into an inflation hawk as if Quantitative Easing never existed. But time may be on his side and make this transformation unnecessary. The US economy is heading into the summer months on a very weak footing, and possibly flirting with recession once QE2 ends. If recession returns, and if it becomes severe or prolonged, the political pressure on the Fed is going to mount to revive the economy. The Congress, or at least the Democrats in the Congress, are going to want a strong economy heading into the 2012 elections, as certainly will Barack Obama. The Fed has always accommodated the White House in revving up the economy during a national election year (hence the four year “presidential cycle” evident in the stock market).
We may assume, therefore, that in such a circumstance the pressure on the Fed will be intense. Will it be enough for Bernanke to reestablish his dominance and bring about QE3? He certainly will feel the pressure – he is the public face of the Fed. The rest of the governors and regional presidents work in relative obscurity, making speeches occasionally to local business groups. If they are convinced that another round of Quantitative Easing will be yet another miserable failure, causing higher interest rates and even worse inflation, they might easily stand up to Bernanke and hold their ground.
They would be joined in this regard by the Republicans in Congress, some of whom are already deeply suspicious of the Fed and its money printing ways, and a few of whom want the Fed abolished altogether. The Republicans have every political reason to allow the economy to sink into a recession or worse by 2012, as long as it happens naturally, and they cannot be blamed for causing it. Doing nothing, which means passing the minimum amount of funding legislation as possible, and keeping the Fed out of the Quantitative Easing game, would be the perfect circumstances for Republicans anxious to drape the next recession around Obama’s neck.
Finally, there are the markets themselves. Establishment of QE3 might lead to an initial burst of optimism for the economy, and a concomitant replay of QE2, where stock markets rise, the dollar sinks, and commodities rally. Equally, the markets could take this to a panicky extreme on the grounds that QE3 is an inflationary bridge too far. There could be an immediate bubble in safe assets, including gold, but possibly also the dollar in the form of cash, and hard assets like commodities, art, etc. The stock market could collapse under the weight of hyper-inflationary expectations. Markets never repeat themselves exactly, so QE3 is a very high gamble for Bernanke and the Fed, as well as a very dangerous ploy for the global economy and financial markets.
The Not Very Mighty Fed
Oddly, the easiest way out for the Fed would be to do what it should have done in the first place: declare its impotence. Maybe this is no longer possible, since the Fed has spent decades building up its reputation as the mighty mover of the economy. The reality is that the Fed under normal circumstances is the very limited mover of short term interest rates. Of course, it could have done a much better job of monitoring and regulating the banks, but don’t expect that much honesty from the Fed. What it could say is: “We tried everything possible, including extraordinary steps like Quantitative Easing. We have reached the bottom of our tool kit. It is now up to Congress to do what it can to stimulate economic growth.”
For the ultimate in candor, the Fed could simply say that there is too much debt in the American economy – with the federal government, with state and local governments, with corporations, and with consumers. Until this debt is liquidated, which means massive defaults and possibly depressionary conditions, the economy will not recover.
The problem is everyone in the Fed knows who that sounds like: Andrew W. Mellon, Secretary of the Treasury under President Herbert Hoover at the time of the Depression. Mellon advised Hoover to:
"Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.
We all know that Andrew Mellon was wrong; all the experts tell us so. Just ask Ben Bernanke.