QE Infinity Won’t Work, But Here’s What Will

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Dallas Federal Reserve President Richard Fisher recently offered a stunning assessment about our policymaking central bankers down in Washington.

 By Keith Fitz-Gerald, Chief Investment Strategist, Money Morning

Dallas Federal Reserve President Richard Fisher recently offered a stunning assessment about our policymaking central bankers down in Washington.

They’re winging it.

In a talk before a Harvard Club audience, Fisher presented a candid assessment about all the levers the Fed has been pulling in the aftermath of the 2008 financial crisis. And that includes the recently announced QE3.

“Nobody really knows what will work to get the economy back on course. And nobody-in fact, no central bank anywhere on the planet-has the experience of successfully navigating a return home from the place in which we now find ourselves. No central bank-not, at least, the Federal Reserve-has ever been on this cruise before.”

I don’t know about you, but the idea that four years and trillions of dollars into this quantitative easing voyage we’re still sailing without a compass isn’t just appalling.

It’s terrifying.

Yet this ship of fools sails on.

The problem is, Fisher is right: QE3 won’t work. QE1 and QE2 didn’t fix this mess. Nor will QE4, QE5, onwards to infinity.

What’s more, there’s a cottage industry of pundits and consultants who’ll agree.

Trouble is, just like Fisher and his colleagues at the Fed, none of them can tell you why it won’t work.

That’s what we’re going to do here today.

We’ll start by giving you the lowdown on how this nation’s central bankers view “Quantitative Easing.” Then we’ll show you how the Fed thinks QE is supposed to work.

Finally, we’ll punch some (actually, many) holes in in the Fed’s hull by discussing why it’s not working.

We’ll even demonstrate what could still be done to fix this wretched mess.

Quantitative Easing (QE) is a Great Theory, But …

The latest version of QE calls for the New York Fed (the central bank’s trading arm) to buy $45 billion of U.S. Treasuries and $40 billion of mortgage- backed securities a month from dealers and banks .

The Fed then intends to “sterilize” these purchases by selling 1- to 3- year bonds through the end of the year – until it runs out of short- term paper to sell. A “sterilized” intervention is one that doesn’t increase the money supply.

But beginning in 2013, the Fed plans to continue doing the same thing – effectively continuing “Operation Twist,” but without the sterilization, because it has no more short- term paper to sell.

In plain terms, this means the Fed will monetize nearly 50% of the entire U.S. budget deficit in 2013. That will boost its balance sheet from the current $2.8 trillion to approximately $4 trillion – or 24% of U.S. GDP – by the end of the new year.

There isn’t a big list of players here. And that’s extremely important to understand.

Even the Fed’s own Website tells us there are only 21 counterparties – including U.S., Canadian, British, French, German, Japanese, and Swiss banks.

The upshot: The risks are highly concentrated – in just this list of financial institutions:

  • Bank of Nova Scotia, New York Agency.
  • Barclays Capital Inc.
  • BMO Capital Markets Corp.
  • BNP Paribas Securities Corp.
  • Cantor Fitzgerald & Co.
  • Citigroup Global Markets Inc.
  • Credit Suisse Securities (USA) LLC.
  • Daiwa Capital Markets America Inc.
  • Deutsche Bank Securities Inc.
  • Goldman, Sachs & Co.
  • HSBC Securities (USA) Inc.
  • J.P. Morgan Securities LLC.
  • Jefferies & Company Inc.
  • Merrill Lynch, Pierce, Fenner & Smith Incorporated Mizuho Securities USA Inc.
  • Morgan Stanley & Co. LLC.
  • Nomura Securities International Inc.
  • RBC Capital Markets LLC
  • RBS Securities Inc.
  • SG Americas Securities LLC
  • UBS Securities LLC.

In theory, the Fed expects these actions to push bond yields down while removing “safer” investments from the market. To be fair, Treasuries and other forms of government debt will always be available – but at higher prices because there aren’t as many offered for sale.

This is not unlike buying the last egg at the grocery store…if nobody wants it the price will be low, but if everybody wants it, you can bet you’ll have to pay a premium.

The idea is that, flush with cash and with fewer opportunities for higher returns, the banks will take on more risk and boost their lending to businesses and consumers.

With more money available – and at cheaper “prices” (lower rates) – that money will then work its way through the economy.

Businesses would use the cheap money to expand their operations, make capital purchases, produce more and hire workers to make it all happen. Firms are expected, according to the model, to build inventory in anticipation of the higher demand to come.

Then there are the consumers, who in good times account for 70% of what makes the U.S. economy go. Those folks, too, will borrow more of this abundant, cheap money to pay for products and services. That, of course, bolsters demand, boosts corporate profits, and spurs hiring. That hiring, in turn , puts additional money in consumer wallets, which accelerates spending, and starts the whole cycle anew.

Consumers are also expected to invest in housing. The Fed presumes both are the result of more or better wages ahead.

The Fed’s grand plan is also supposed to benefit the stock and bond markets. The yield-starved, zero-interest-rate environment the Fed is deliberately creating will force businesses and consumers to turn to stocks, bonds, capital purchases, and other assets in pursuit of higher returns. At least according to the Fed.

Over time, Team Bernanke hopes this will reflate everything from stocks to housing. It believes that increased demand creates jobs, stimulates new capital creation, raises housing values and leads to higher prices.

The hope is that there’s enough capital injected into the banking system to create a self-sustaining cycle of “capital creation.”

Fed Folly 1 425 QE Infinity Wont Work, But Heres What Will

It’s a great theory.

But that’s the problem.

It’s a theory.

The central bank’s master plan is constructed mostly by academics and policy wonks with a decidedly political agenda – all of whom appear to believe in the fallacy of perfect information as part of their decision making.

So what are they missing? Let’s take a look.

What the Banks Are Really Afraid Of …

A key reason the Fed can’t clear away the financial-crisis fallout is that it doesn’t understand why the banks engaged in the risky behavior that caused the crisis in the first place. As Fisher’s comments suggest, it also doesn’t understand the implications of the moves it’s making now.

Given that, it’s no surprise our central bankers are so ill-prepared to deal with the witch’s brew they’ve now created.

Let’s start with FDIC insurance. When the Glass-Steagall Act (technically the Banking Act of 1933) was repealed in 1999, the protective wall that separated the more-staid commercial banking world from its risk-taking investment-banking counterparts was demolished.

The new “bank holding companies” could now reach through the proverbial firewall and finance their high- risk trading activities using FDIC- insured deposits as the anchor.

Some would say fuel.

Then, as part of the Commodity Modernization Act of 2000, derivatives and other exotic investments were specifically exempted from reporting and public- exchange requirements in a move that further incentivized and even encouraged risk-taking.

Taken together, it was as if Washington had dumped a barrel of jet fuel on an open campfire: It started a blaze that just about burned the whole forest down.

With access to an entirely new pool of capital and an implicit government guarantee, big banks moved rapidly out on the risk curve as CEOs like Dick Fuld (Lehman Brothers), Martin J. Sullivan (AIG), Charles Prince (Citi), and James Cayne (Bear Stearns) realized that trading – and not banking – provided a direct pathway to obscene profits.

Some experts don’t believe this could have happened in private markets, where risk is directly a function of capital on hand rather than the implicit guarantee of the U.S. federal government.

I agree. Banks would have had to quintuple their capital before anybody in their right mind thought about taking on that much risk. The markets would have made that impossible.

That brings us back to the present.

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