QE 2: not just another giant ocean liner

I remember several years ago, before they decided to dismantle her in Dubai, when the Queen Elizabeth II arrived in San Francisco to much fan fare. People lined the bay all the way from the Golden Gate Bridge to her berth over by Pier 29. I happened to be crossing the Bay Bridge after she had berthed and caught a glimpse of her transom. It was massive. It almost dwarfed the impressive west-looking view of the San Francisco skyline. But that was the old QE 2. The new QE 2, even bigger and more impressive than the last, was christened in Southampton earlier this month. Ironically, this is happening at the same time that the markets are widely speculating that the Fed will announce the details of its own version of QE 2 at the conclusion of their meeting on 3-NOV. 

WASHINGTON (MarketWatch) — The Federal Reserve could make $2 trillion in government bond buys, according to a research note from Goldman Sachs that was making an impact on the market on Monday.

The Fed is widely expected to announce a new program of asset purchases, or quantitative easing, at the conclusion of its next policy meeting which wraps up on Nov. 3.
A Goldman Sachs research note from Jan Hatzius and Sven Jari Stehn published Friday night said the Fed may announce $500 billion in purchases at the conclusion of the meeting, or perhaps slightly more, over a period of 6 months. The Fed could announce monthly buys of $100 billion, the analysts said.

 If correct, the Fed intends to increase the size of the balance sheet another $2 trillion from its current size of $2.3 trillion which would put it north of $4 trillion. That's pretty incredible considering just 2 years ago it was around $850 billion. (This snappy graph from the WSJ puts things in perspective.) The first $500 billion round of quantitative easing is the equivalent of reducing the fed funds rate by 75 basis points which is impossible since FF rate target is already at zero.

Bernanke is trying to stimulate the economy by increasing the money supply and stoking inflation. This week the bond market suggested that there's not much worry of inflation over the next 2 years, but inflation could begin to gain traction as we approach the 5 year horizon. Tuesday the Fed auctioned $35bil in 2 year notes (not inflation protected) with a yield of 40 basis points. The day prior, they auctioned off $10bil of 5 year TIPS (inflation protected) with a negative yield of .055%.

This suggests investors are so terrified of inflation that they’re willing to pay the government money every year to buy insurance against it.
As with everything in the Treasury market, it’s a little more complicated than that. The negative yield owes partly to the fact that plain-vanilla five-year Treasurys yield just 1.16%, which is barely higher than consumer price inflation for the past year.
The spread between the regular Treasury yield and the negative TIPS yield gets you what investors expect inflation to be in the next five years, and that’s a not-horrifying 1.68%.

Not-horrifying, but worth paying attention to what future TIPS auctions yield. It's also worth remembering that TIPS are indexed to the CPI, which history has shown to be vulnerable to political manipulation regardless of who is in the White House. Steak too expensive? Replace it with hamburger in the the basket of goods that helps make up the CPI. If I can no longer afford to buy steak and must eat hamburger instead, is that not indicative of inflation?  Food and energy too volatile to be included in the CPI? Carve them out and what remains is the "core CPI" even though food and energy prices represent the largest monthly expenditures for the average household, etc. It is not a stretch of the imagination to speculate that if the government is not seeing the intended results of their current fiscal stimulus plan, they'll simply massage the data until it fits their template. The other problem is that once you let the inflation genie out of the bottle, it's hard to stuff him back in. And it's impossible to imagine inflation really taking off with the housing market still moribund and billions (trillions?) of dollars of inventory tied up on bank's balance sheets for the foreseeable future. Let's not forget that if we say hello to inflation we can say good bye to record low mortgage rates...

Clearly our nation is in uncharted financial straits. Rule number one of back country travel is if you are lost, it is best to go back to the spot where you lost your bearings. Rule number two is if that is not possible, stay put and wait for help, even if that means waiting for Spring to come. The one thing you should never do is keep bumbling down the path, wasting resources hoping you'll stumble back out onto the highway.