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Why Bernanke Is Gambling

by Comstock Partners

In starting a second round of quantitative easing (QE2), the Fed is gambling on a program that has little potential upside and a substantial amount of risk. In the first round (QE1) the Fed bought $1.7 trillion of mortgage and Treasury bonds (beginning in March 2009) and dropped short-term rates to between zero and 0.25%. It was also preceded or accompanied by massive fiscal intervention in the form of TARP, the stimulus plan, cash-for-clunkers, homebuyer tax credits, tax cuts, mortgage modifications and extended unemployment insurance. For all of their efforts the authorities did help prevent a global financial collapse, but achieved only an extremely sluggish economic recovery that was almost completely dependent on an inventory turnaround and government transfer payments. Now, even this halting recovery is showing signs of petering out with debilitating Japanese-style deflation an increasing threat. Without further help the current economic expansion is unsustainable.

We believe that QE2 will have minimal direct effect on boosting the economy and that Bernanke knows it. This seems obvious upon reading his op-ed article in today’s Washington Post, in which he states that this approach eased financial conditions in the past, and specifically mentions that stock prices rose in anticipation of the recent action. In fact he mentions higher stock prices twice in the same paragraph, as if to indicate the real reason for implementing QE2. In his own words, Bernanke says, "higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending."

To be sure, the Chairman also states that lower mortgage rates will make housing more affordable and that lower corporate bond rates will encourage investment. However, according to the Fed, the planned Treasury purchases are almost all in the two-to-ten year range. We note that the two-year rate is already at 0.37% and the ten-year at 2.62%. If these historically low levels can’t spur spending, we doubt that another 20 or 30 basis points will make much difference. Corporations base their capital spending decisions on overall demand for their products and services far more than on the level of interest rates, and, in any event, are already sitting on piles of cash that they aren’t using. And don’t forget that mortgage rates are already at record lows. That virtually leaves mainly stock prices as the Fed’s real target for QE2, and Bernanke is saying that bluntly in today’s column.

We doubt that the stock market will get the boost that Bernanke and the "street" widely expect. The market reacted coolly following the FOMC announcement on Wednesday, but burst upward today on the Chairman’s unprecedented column. After all, when the Fed explicitly announces its intentions of jolting the stock market—-a thought previously expressed only by conspiracy theorists—-investors take notice. The bulls point out that stocks rose substantially during QE1, and believe that they will do so again under QE2. However, the market is in a far different position today than it was in March 2009, when QE1 began. At that time the market had declined by a whopping 57%, the S&P 500 sold at only 11 times trendline reported earnings and bears outnumbered bulls by 45% to 32%. In contrast, the market has climbed 83% since then and sells at an elevated 18.8 times smoothed reported earnings, while bulls outnumber bears by almost 2-to-1. At that time fear of a global financial collapse was rampant while now optimism is widespread as is apparent from watching the cheerleader mentality on financial TV today.

In addition to the limited upside, QE2 carries a substantial amount of risk. It has already led to a plunging dollar and far higher commodity prices on anticipation alone. Actual implementation will exacerbate these trends with potentially serious side effects. This raises costs for many American companies that buy significant amounts of commodities including energy, food and cotton. These companies would very much like to pass these increased costs along to consumers, but feel constrained by lack of demand as a result of high unemployment, limited wage increases, weakness in housing and tight credit. Already, a few companies have blamed 3rd quarter disappointments in revenues or earnings on rising commodity prices, and this tendency could snowball in coming quarters. Furthermore, to the extent that consumers have to pay higher prices for some necessities they will have no choice but to cut back on discretionary expenditures and big ticket items.

In addition, lower U.S. interest rates and a declining dollar will cause capital to flow to emerging nations, increasing the value of their currencies and hurting their economies. A number of emerging nations are taking measures to protect their exports and limit imports, possibly leading to a global trade conflict that results in less overall trade and declining economies.

Given the limited upside and potentially serious risks, why is the Fed taking this unconventional gamble? If conditions are as rosy as the stock market seems to imply, what is so dire about the economy and financial conditions that the Fed feels it necessary to take such a bold and unconventional step? Although the overall situation is exceedingly complex, the answer to this question is relatively simple. The Fed has a mandate to maintain full employment and low inflation. As it has repeatedly stated through its FOMC meeting statements and numerous speeches by Fed members, a majority of the Fed believes that the economy is growing below "stall speed" with another recession possible. It also believes that without another boost, either from monetary or fiscal policy, unemployment will remain stubbornly high, preventing a sustainable economic recovery with outright deflation a distinct threat.  Bernanke also knows that the Fed has already used all of its conventional monetary weapons and that concern about increased budget deficits has all but ruled out any further help from fiscal policy. He also believes that the Fed is now the only game in town and cannot just sit there and do nothing while the economy fizzles.

As Chairmen of the Fed he also has to pretend that all of this will work and that if it doesn’t he has even more weapons to trot out. However, the last paragraph of his op-ed column shows that he knows the desperation of the measures he is undertaking. In a statement that can only be interpreted as a plea for help he says, "The Federal reserve cannot solve all the economy’s problems on is own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector". Given the current political standoff such help is not likely. It is also likely, therefore that the strong market rally is based on false assumptions, as were the runs to the tops of early 2000 and late 2007.

About 

Comstock Partners, Inc. analyzes economic and financial conditions from a long-term macro-economic perspective and makes adjustments based on cyclical and shorter-term considerations. In pursuit of its goals, the firm invests in various asset classes including domestic and foreign stocks, bonds, currencies and derivatives including indices and options. For the Capital Value Fund, Comstock Partners can buy or sell short and make use of leverage in order to maximize returns under various market conditions. In effect, we believe our operation resembles a modern-day hedge fund in its scope of activities.

6 Comments

  1. Rick Clark says:

    Ah, the age of bubble-blowing. They’re trapped- they can’t NOT do it anymore. Now they MUST blow asset bubbles. It is too, too predictable. And pathetic. But hey, if that’s the game, I’ll play it.

  2. ds says:

    The post argues that the potential for the stock market to rise in response to QE2 is limited since stocks have already risen so much. Later the post argues that the risk of QE2 is that it will lead to a rise in commodity prices, which will drive up costs to businesses and thus reduce output. But stock prices and commodity prices are moving more or less in lock-step, so why does the author think that the stock market has run its course while at the same time feel that commodities have significant upside?

    The channel where rising commodity prices raise costs and deter output in my mind is pretty weak. Our economy is not as dependent on commodities as many people think, and in areas such as agriculture, rising commodity prices are positive. If QE is pushing up commodity prices, eventually the increased economic activity in the commodity producing nations will rise to a point where our export sector becomes more attractive. This is all in addition to the fact that lower rates motivate investment relative to higher rates.

    Ultimately the stock and commodities markets are being run by speculative forces largely beyond the Fed’s control. With sufficiently high interest rates, the Fed could check run-ups in these markets, but the collateral damage would be severe.

    • History is a useless degree says:

      ds, the price of oil will also be driven up, impacting corporations significantly [and it will cripple whatever is left of spending]

  3. Jackrabbit says:

    Why do you ignore the effect on the TBTF banks?

    Why would the Fed engage in a policy with substantial risks for little economic benefit? Because the in addition to whatever economic benefit there is for main street, the TBTF banks get a boost. They have huge excess reserves that are invested in Treasuries and they act as the middleman for Fed purchases.

    Yet the worst part of QE2 may be that it gives Congress an excuse not to act. In fact, the new Congress may take austerity measures that counter whatever benefit QE2 may provide. Does that lead to QE3? When does the Fed take the punchbowl away?

  4. Anonymous Comment says:

    I get it now. One little concept that has always eluded me – you helped me understand. A weaker dollar supposedly helps the exporters, but we as Americans mostly buy imports. Isn’t it ironic?

    The higher cost in raw materials will be concealed by the vendors for as long as possible, of course. Duh. [Lightbulb comes on overhead] So it goes to figure than when the follow-through prices jump up, it will be more than most people expect because the companies are doing their darnedest not to pass on those follow-through costs, and will therefore be playing catch-up at that time. So they cut corners: A few ounces less in the package, a few hours less for Sally. And then, boom [opening mail]: “What?! Jim, take a look at this bill! We have to find a new vendor.”

    Gambling, indeed.