How can QE2 help the economy?

In anticipation of the QE2, the stock market and the bond market have been rising since late August when the Fed chairman Ben Bernanke revealed his intention.

When the actual plan was announced on Nov.3, the market didn't move much either way. The amount of asset purchase ($600 billion in about 8 months) was in line with expectations. The trillions of paper wealth gained since August is now solidified. Could it translate into more spending power? If so then QE2 would be looking good.

There are other likely channels where QE can work. Bernanke published an op-ed piece on Washington Post today, which lays out clearly what he thinks how QE can help spur economic growth:

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

Housing market is in disarray. Home sales are at the rock bottom. Can lower rates help much? We'll have to see. One way to look for clue is again in the home building sector. Home builder stocks are moving up. So perhaps investors are buying into the QE2 story.

Lower corporate bond rates looks like are supporting new issuance. Bloomberg reports that

Corporate bond sales surged to $15.9 billion, the busiest day in almost two months, as the Federal Reserve’s move to stimulate the economy ignited a rush of issuers tapping credit markets at record-low interest rates.

Many big corporations are taking advantage of the lower rates. Will the cheap money then find its way into more hiring and more production? It's likely, but we'll have to see over the next few quarters.

It's quite interesting that he writes "And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending." Anyone with a 401k account would certainly understand the implications. One can argue about how likely the increased financial wealth can help consumer spending, given the skewed distribution of stock ownership, and the hard-to-establish relationship between financial wealth and consumption.

I think one likely group of consumers who will be able to borrow and spend more are the credit-worthy and asset-rich households. Their spending powers are likely to show up in luxuary good sales and other highend consumptions. We should be looking for evidence in those sales figures.

If the wealth effect kicks in, depneding on how strong it'll be, it can help increase GDP and income, thereby generate more hiring.

Contrary to all the Fed bashing out there, the rationale in Bernanke's QE move doesn't seem so hard to see. How effective it'll be is the real question. But given the observation that the fiscal side is at a deadend in terms of creating more supports to the economy, the Fed's latest effort is probably the only game in town.

What do you think?

Election day, so what?

Republicans may take over the House. Gridlock.

Government stimulus no more. The economy sinks some more. So says some of the economists on the left.

The heavy lifting would be on the Fed's shoulders. And tomorrow, the widely expected QE2 will be announced. Asset purchase should help, mostly via the wealth effect (lower risk premium, higher asset prices, HOPEFULLY more spending from those who have), and inflationary expections (higher inflation in the future makes businesses and consumers more likely to spend today).

Value investor Jeremy Grantham lists 18 points why QE2 is a bad idea. He is generally against the Fed's meddling.

On the right, economist/columnist Paul Krugman has been sure that only more spending will restore the American economy (see for example a good analysis). But I think he is too sure to be believable.

The American people are fed up. They're looking for solutions to improve lives. No one has a clue what the solution or solutions are. We're in a deep hole, and the hole is getting deeper. No clarity should be expected out of the mid-term election and the Fed action. Get used to the muddiness. But I like the view here.

China should return more wealth to its people

As G20 finance ministers gather in South Korea today, the central issue is around exchange policies and avoiding the outbreak of a global trade war.

China is under intense pressure from the U.S. and other emerging markets to revalue its currency, which is pegged to the US dollar and widely believed to be undervalued by 20-40%.

China has resisted such pressure by pointing out to potential disruption to its export-led economy and its recent efforts in stimulating domestic consumption. The central bank PBOC has recently raised benchmark interest rates by a quarter point, the first time since the onset of the 2008 financial crisis, despite signs of cooling economic growth. This may be the beginning of a series of interest rate hikes to rein in inflation.

Much of China's recent growth has been fueled by injecting loose credit into the banking system, which may have caused excessive domestic inflation, especially in the property sector.

These are happening in an environment that developed nations are trying to continue or enhance their loose monetary policies in a bid to spur growth, or at least to avoid Janpanese-style deflation.

Recent discussions (e.g. by Li, Dongrong) out of the PBOC make it very clear that Chinese officals are very aware of the international financial environment and the challenge facing China.

Leaving it at the status quo, China may face a greater risk of hot money chasing after higher returns. The flood of easy money, through various channels such as private equity, may contribute to rising asset inflation and consumption-good inflation.

Inflation, while necessary for growth if it's moderate, chips away citizens' purchasing power and helps to increase economic inequality and social unrests.

On the surface, China has become a rich country. Commentators often point to its ballooning exchange reserve (about $2.6 trillions). But much of this money cannot be used to help ordinary citizens; instead it's financing the U.S. government which in turn help to lower the already-low interest rates. In terms of GDP per capita, ordinary Chinese are still quite poor. China should return some of the wealth to its people, by appreciating its currency more and bringing down actual inflation and inflation expectations.

Raising intereat rate and the Yuan may actually go hand-in-hand in a gradual fashion, to power both domestic and international consumption. Higher interest rate puts more moeny in the hands of savers, and a more valuable currency obviously puts more purchasing power to any Yuan holder.

And, a lower inflation gives ordinary people a much needed break in the race to save enough for purchasing an apartment.

American kids are lazy and distracted?

There are real fears that America as a country has lost its touch, and the American as a people have become less competitive and too dependent on government largesee.

We don't really know if that's true. But there is that fear. In this new survey about American Dream, the middle class is in general still optimistic about the future and the access to opportunities. What's shocking to me though, is this:

Nearly half (49%) thought that countries like China and India are so far ahead of America that the United States won’t be able to catch up.

I think that's largely a reflection of economic growth rates. I doubt this impression is created by comparing per capita consumption or production.

What about the next generation and education?

Here it is very interesting to note a discussion by the CEO of the privately held SAS Institute:

His discussion about education in America was the most disconcerting. American students are not entering the fields of science, engineering, statistics, and math. These are the areas that would help America grow, invent and discover. He thinks American kids are too distracted by Twitter, Facebook, the Internet, Playstation, TV, iPhones, iPads and cell phones to do the hard work that is required in these fields. We have become a lazy distracted society. Our best colleges are educating foreign students who take that knowledge to their own countries.

There is a lot of truth in this observation. But this type of distraction has always been there, although the new technology has made it more pervaisive and compelling.

I remember growing up in China back in the late 70s and early 80s, the biggest distraction from school work was Kungfu novels and movies. Kids could spend all day reading and watching them for entertainment and excitment. The way to deal with the distraction is the same: keep a great distance and have great control over time. It's a struggle, as it has always been.

How do kids spend their time is an investment problem. Ideally we want them entertained, but we also want them to focus more on the production side rather than the consumption side.

When watching video games, for instance, I would like my kids to think about how to make these games instead of just playing them. I believe it makes a crucial difference.

High inflation, low inflation

China's central bank just announced a surprise increase of interest rates to help rein in the inflationary pressure.

It said it was raising benchmark rates by 25 basis points, taking one-year deposit rates to 2.5 percent and one-year lending rates to 5.56 percent.

Consumer-price inflation has already crossed above Beijing's 3% target for 2010. In August, the annualized rate was 3.5%.

Over here in the U.S., the opposite has been the case. The core consumer inflation rate is hovering around 1%, and maybe heading lower. In the face of slow growth, deleveraging, and high unemployment rate, this is alarming. Because the economy may be headed for deflation, when prices for goods and services are trending lower in general.

In other words, the economy is too "cold" in the U.S. and too "hot" in China. And higher interest rates in China may serve to attract even more hot money. On the other hand, the Fed's easy money policy would potentially add more liquidity to the world economy, much of which would find its way into China's asset markets, causing more inflationary pressure.

China has so far been quite successful in controlling credit expansion and contraction using adminstrative means, in order to maintain its currency peg to the US dollar. It's perhaps time to change that practice to help balance the world economy. A stronger yuan can help China take on more leadership role.

How can QE help the economy?

The Federal Reserve chairman Ben Benanke's latest speech has made it clear that both the current high unemployment rate around 10% and low inflation rate are inconsistent with the Fed's dual mandate. Therefore further action is appropriate.

Another round of "quantitative easing" (QE) is now widely expected by the market. How much and exactly in what form remain to be seen.

Has QE been successful? How does it help create jobs? Why do we need more large-scale asset purchase by the central bank? Should the Fed be even more aggressive?

Here is an old paper by Joseph Gagnon at the Peterson Institute for International Economics that helps answer some of these timely questions.

QE and global liquidity probblem

The sluggish recovery in the U.S. economy is prompting the Fed to refocus on "quantitative easing" (i.e., buying more long-maturity securities to lower the borrowing costs). That may serve to flood the financial system with even more liquidity. Professor Joseph Stiglitz talks about the potential consequences:




The Fed’s move towards more quantitative easing, conveyed in its recent policy statement issued in September, follows Japanese intervention to weaken the yen and Swiss National Bank actions aimed at its currency.

Increasing exports by weakening the dollar is one channel by which the easing could boost the US economy. But it is impossible for every country to weaken its currency and export its way to higher growth at the same time. So we're looking at the competitive devaluation scenario of global currencies. This is one of the most strong supports for gold prices. More QE would mean even higher gold prices, unless we enter into another recession.

The Fed is facing another major conundrum, not unlike the one faced by Mr. Greenspan back in 2005. Back then, the global "savings glut" was seeking outlets in the U.S., pushing the yields ever lower for the long-term assets. The liquidity found its way to private equities and the real estate market, which led to the financial meltdown of 2007-2009.

The money supply has never gone away. And the Fed is adding to it.

More easing may do very little as the rates are already very low and there aren't many credit-worthy borrowers. On the other hand, there isn't any other option for the Fed to counter deflation risk in the face of high unemployment and consumer deleveraging.

The economy is sick, and drinking more liquid may not help.