The Fed’s announcement of $600 billion of intermediate and long Treasury purchase, informally dubbed QE2, teed off a peppy rally in stocks, and led to further weakening of the dollar. These trends were already well in motion thanks to the central bank’s winks and nods that it was going to embark on another round of bond purchases.
This move looks to be bad economics, or at least bad at achieving the Fed’s stated aim of lowering unemployment and promoting growth. The first round of QE did not arrest falling housing prices (although they have stabilized in some markets, there is still a large overhang of shadow inventory, both of delinquent borrowers where the bank has not yet seized the house, as well as owners who would like to sell, and will try to do so if the housing market in their area were to improve (and note some of these potential sellers will relent if they perceive prices are not going to rise any time in the foreseeable future). Nor did it help unemployment (one month of improved hiring was not sufficient to budge unemployment levels). As one wag remarked, “The Fed has found another string on which to push.”
Some have argued that QE2 is another sop to the banks, but that does not make sense. Moving out the yield curve in bond purchase will lower the interest rate differential between the banks’ super low borrowing costs and the interest they earn by parking the proceeds in Treasuries. If the aim were to help banks rebuild their balance sheets, the central bank would want to create a steep yield curve, one with a considerable difference between short and long-term interest rates, as Greenspan did in the wake of the savings & loan crisis. So the aim of “flattening” the yield curve is not to help banks earn easy spread income. It instead appears designed ot encourage investors to take “risk on” trades, in the cheery assumption that real economic activity will follow.
But this logic is spurious. Lower cost funds or investment capital will not lead entrepreneurs to gin up new projects. Business opportunities develop out of opportunities in the real economy; the cost of funds can operate as a constraint, but with interest rates low as it is, it seems highly dubious that a further discount on the cost of money is going to make much difference to businessmen (and it’s also worth noting that lower the rate on Treasuries does not necessarily improve availability of credit to small businesspeople).
However, one clear and immediate effect of QE2 has been to sour relationships with our major trade partners. The Fed announcement produced swift denunciations from foreign finance authorities, who correctly anticipate that a further round of Fed easing will fuel a dollar carry trade, with destablizing hot money inflows chasing the highest returns in foreign markets. China, Brazil, and Germany were quick to attack the program and some emerging markets have started restricting currency inflows. Charles Dumas of Lombard Street points out that the impact on China will be particularly acute:
In this dollar economy, China is heavily undervalued (though nobody can assess by how much) and the US is overvalued. The Fed’s newly created liquidity could in effect “flow downhill” to the undervalued portion of the dollar economy. Already overheated, inflationary China will get a much larger dose of cost-push inflation in food and energy than the US.
Food is one third of China’s CPI, versus 14 per cent in America. This makes the recent 20 per cent rise in food commodity prices more important. Meanwhile, China’s competitive leg-up vis-à-vis Japan, Korea, Germany and others will be exacerbated by a further 5 per cent trade-weighted devaluation (in line with the dollar) – a currency impact that is likely to take effect much more quickly than any benefit from devaluation to the US. So higher Chinese inflation arising from QE2 is a double-whammy: demand-pull as well as cost-push.
Food inflation is a charged political issue in China, and the officialdom is particularly sensitive to any foreign measures that might undermine their legitimacy at home.
The bizarre element of this move is its timing. The QE2 launch will hopelessly undermine the US position at the G20 meetings this weekend. Geithner had been pushing for the idea of having an agreement that countries running overly large trade surpluses seek to rein them in; no less that the Financial Times’ Martin Wolf thought it was a sound idea. We were skeptical because even though this sounds good as an international trade motherhood and apple pie statement, without any real penalties, it’s mere showmanship. However, the plan had a few wrinkles that make it seem a tad more substantive. For instance, 4% of GDP was proposed as the limit of reasonable trade imbalances; persistent results above or below that range would trigger negotiations on how to bring it back into line.
What is going on here? Bernanke, Geithner, and Paulson famously worked fist in glove throughout the crisis, but they seem badly out of sync now. The ill timed Fed move means that QE, and not any US initiative, will be the focus of the G20 sessions. China is using it as an excuse to torpedo the Geithner proposal:
Cui Tiankai, a deputy foreign minister and one of China’s lead negotiators at the G20, said on Friday that the US plan for limiting current account surpluses and deficits to 4 per cent of gross domestic product harked back “to the days of planned economies”.
“We believe a discussion about a current account target misses the whole point,” he added, in the first official comment by a senior Chinese official on the subject. “If you look at the global economy, there are many issues that merit more attention – for example, the question of quantitative easing.”
China’s opposition to the proposal, which had made some progress at a G20 finance ministers’ meeting last month, came amid a continuing rumble of protest from around the world at the US Federal Reserve’s plan to pump an extra $600bn into financial markets.
It’s a bit disingenuous for China, which has a pegged currency and currency controls and more than a few state owned banks, to lecture the US about a planned economy, but America has made such a botch of this situation that China doesn’t need to make a credible argument to win allies.
The US has managed to isolate itself, and for no good reason. Geithner peculiarly tried to negotiate with China bilaterally over its peg against the dollar, when many other emerging markets were also suffering as a result of China’s peg. QE2 has flipped a situation where China could have credibly been depicted as the bad actor to one where the US is the troublemaker.