Queasing over Quantitative Easing

The world’s largest hedge fund, the Federal Reserve, is trying to decide whether it should expand its operations.  Unlike most hedge funds, the Federal Reserve has a big advantage in that it can fund itself cheaply, and for the most part, at its own discretion.

  • Unlike most hedge funds, it issues 0-day 0% Commercial Paper, which is accepted almost everywhere as a means of completing transactions.
  • Banks affiliated with them must place reserves with the Fed, on which they earn interest of around 0.25%
  • The affiliated banks, not finding as many opportunities as they would like to lend privately on a risk-adjusted basis, leave more money than they have to at the Fed, again earning about 0.25%.

What a cheap funding base.  They can buy almost any asset and make money, so long as equity/credit risk is limited, and so long as the yield curve doesn’t hit new records for steepness.  Given that the Fed does not have to mark most of its positions to market, and does not have to worry about margin calls in the conventional sense of the term, they make money year after year, and hand most of the profits over to the US Treasury, which keeps accounts for the Fed’s main owner, the US Congress.

Life is tough when you have to serve multiple conflicting interests.

  • They demand that you create conditions for full employment, something beyond your control.
  • They ask that you restrain inflation, which is possible.
  • They ask that you lend, because the banks affiliated with you are not lending, and an increase in lending is always a good thing, right?

So, like Keynes, the fools that think that a lower rate of interest is always better urge that the Federal Reserve should expand its balance sheet and buy up more Treasuries, Agencies and Agency MBS, forcing rates lower.  What good can come from forcing high-quality long rates lower?

My answer is, not much.  Existing debts if non-callable, will be worth more.  If debtors are solvent, and can refinance, they  can lower their debt service costs, though that is a minority of borrowers.  Beyond that, it will lead the favored debtors to borrow more — Treasury, Fannie, Freddie, etc.  We need more borrowing, right?

But a greater effect can be the speculative frenzy engendered by dropping the rate that savers earn to such a low level, leading them to invest more aggressively to meet their income targets.  As with any other sort of speculation, the game is over when people rely on the occurence of capital gains.

I think quantitative easing is a mistake; I also think it does not help matters much.  It transfers resources from creditors to debtors in a funky way.  That is not the right way to go if you want a country to grow.  (Which, contrary to the received wisdom, would mean that raising short term rates would be better for the US and Japanese economies than engaging in quantitative easing.  There would be short-term pain, but there will be pain regardless of how this policy is conducted.)

If the Fed makes a bow in the direction of quantitative easing on Tuesday, such as reinvesting the proceeds of MBS in more MBS, the markets will rally, but I would fade it, because it will have no long-term beneficial  impact on the economy.

There is no free lunch.  Any action that seems to cost nothing on the part of the Fed or the Federal Government will have no long-term effect on the economy.  Quantitative easing is one of those comforting fairy tales that is a fraud, whether intentionally so, or not.