In recent months economic commentators and financial markets have focused almost excessively on the Federal Reserve's quantitative easing (“QE”) policy as the market's main driver. However, last month two senior economists at the Federal Reserve published a report entitled 'How Stimulating Are Large-Scale Asset Purchases' which calls this devotion into question.
The report estimated that the $600 Billion of QE2 that was pumped into the economy (which equates to about 4% of GDP) added only about 0.13% to the GDP growth rate. The report illustrates that the entire QE program has been a costly failure. Little wonder that many on the Federal Reserve's Open Market Committee have voiced support for an imminent 'tapering' of QE.
In contrast to the widely discussed benefits of QE, the report's authors conclude that “Forward Guidance” (which is the Fed's policy of clearly communicating its long term policy plans) is far more important in keeping the economy on an even keel. The report estimated that the effect of QE2 was less impactful, and more unpredictable, than a conventional temporary lowering of the Federal Funds rate by just 0.25 percent points. Conversely, the report warns that any increase in the federal funds rate will be more impactful than any tapering of QE.
However, QE seems to have taken on an importance that its creators don't want to acknowledge. The mere mention of a possibility for a diminishment of the program has sent financial markets into a tailspin. So while the Fed is trying to tell the markets that they don't need QE, the markets are screaming even louder that they do.
This is consistent with what I believe is really at the core of the current financial landscape. To an extent that is far greater than it has been in the past, the markets are dependent on confidence rather than fundamentals. Real world indicators of economic ill health are now second page news. The headlines belong to QE, which has become the central, if not singular, element in that maintenance of investor confidence. The belief that the Federal Reserve will do all that it can to keep markets afloat for as long as possible has become a necessary condition for financial success. The “Greenspan Put” has become enshrined.
In this light, the Fed's forward guidance on interest rates should be considered a far more powerful force than QE itself. However, the idea that rates can stay at near zero for perpetuity is naïve to the extreme. But that is exactly what the markets want to be told, loudly, clearly, and regularly.
How long market participants will continue to believe the fictions that it wants the Fed to tell is unknown. If the markets were to suddenly become skeptical that the Fed can effectively support asset prices even during a time of economic stagnation then a new page will be turned. An international fiat currency crisis could then ensue and possibly spread a cataclysmic economic depression in its wake.
So if we can believe that the Fed reads its own research reports, it is perhaps true that the Fed may soon try to taper down its monthly asset purchases. If this does happen, however, look for some other confidence boosting program to take its place. Is it possible that “negative interest rates” could be the next lullaby to quiet the frightened masses?
John Browne is a Senior Economic Consultant to Euro Pacific Capital. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.