Wringing of Hands: QE2, Gold, and the Dollar

QE2. What to make of it? On a stand alone basis, I don’t make that much of it. More of the same ineffective policy. Must it lead to a debasement of the dollar and hyperinflation? Nah. That’s just the current undies-in-a-bunch worry that has everyone’s attention.

I agree with Alan Blinder’s recent OpEd in the Wall Street Journal—if the Fed wants to stimulate the economy, it doesn’t need to create more dollars. It can start by charging banks to hold funds in reserve at the Fed, instead of paying them to hold cash in reserve.

I find it funny, however, that it’s getting so much criticism—so where were you people when QE1 was going on? QE1 was three times greater than QE2. The President and Fed Chair have conspired to effectively move the metaphorical printing press into the White House. The Government creates a recklessly large deficit that must be financed through the issuance of Treasuries, which are bought up by the Fed. To buy these Treasuries, the Fed creates money ex nihilo. The Fed collects the interest from the Treasury and gives it back to the Government. Rather incestuous, don’t you think?  We haven’t yet fully monetized the debt, but we’re getting close.

So why has the creation of over one trillion new dollars done nothing to help the economy? Because only a fraction has made it into the public’s hands. To this point, most of the dollars have been held in reserve by member banks that have little lending they can do, and capital positions that are improved by large reserve balances.

With Quantitative Easing (QE), the Fed buys bonds from member banks and dealers, who then keep their cash proceeds in reserve at the Fed. And since the Fed pays the bank for the reserves, there’s an incentive for the bank to keep the funds there, where, oh by the way, the cash can be counted towards necessary capital thresholds.

We’re still in a credit crunch: lending standards have been lifted at the same time borrower quality has fallen. Harangue the banks for not lending all you want, but beware of the irony of chastising them for not taking on enough risk.

Below is a chart of the dollar growth in the aggregate monetary base over the last two and a half years. This measures the broad money controlled by the Fed. You’ll see that it grew by 160%, from $850 billion to $2.2 trillion.

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Now, look at M2 – a measure of money actually in the public hands – over that same period. Just 12% growth.

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Or another way to put it is that of the $1.2 trillion the Fed’s created since late 2008, only $100 billion made it’s way into the public area—less than 10 cents on the dollar. That’s why it’s having no discernible effect on economic growth—or for that matter inflation.

Now of course if that money does make its way out the front door of the bank, there is a risk of inflation—and potentially extreme inflation. Some have accepted it as fait accompli. They suggest that the only possible explanation for gold’s hyperbolic ascension is that’s a presage of inflation.

While it’s possible that we get hyperinflation and therefore a debased currency, there are a couple of things to keep in mind. For starters, the bond market doesn’t buy the hyperinflation argument. Take a look at the 10-year yields for Treasuries and TIPS (Treasury Inflation Protected bonds).

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The TIP spread measures implied annualized inflation, and is measured as the difference between Treasury yield and the TIP yield. As you can see, it’s 2.13% over the next 10 years–nothing close to “hyper.”

Some say gold’s ascension is surely a sign that hyperinflation lurks around the corner. I don’t agree. Gold is going up because gold is going up. It’s the one notably strong asset of late, and everyone knows it. Think of all the commercials there are for gold. Here’s what I know: by the time everyone from Glenn Beck to Mr. T are touting gold, you’ve missed it.

We recently sold our gold—I’d rather be long the US Dollar (because no one else sees how it can recover). Currencies adjust. The cheaper the dollar gets, the more our exports become competitive, which puts pressure on the dollar as demand for our goods go up. Higher (eventual) interest rates will also put pressure on the dollar, as foreigners will need to buy it to invest here.

At any given time—good times, bad times, and every time in between—investors have their undies-in-a-bunch over something. Most of the time, these somethings never amount to anything. Looking back, I think we will add QE2 to that list.