Bernanke goes to war armed with QE3


U.S. Federal Reserve Chairman Ben Bernanke addresses U.S. monetary policy with reporters at the Federal Reserve in Washington September 13, 2012. The Federal Reserve launched another aggressive stimulus program on Thursday, saying it will buy $40 billion of mortgage-related debt per month until the outlook for jobs improves substantially as long as inflation remains contained.

Article Highlights

  • The Fed's commitment to supporting growth signals that it’s willing to tolerate higher inflation & currency depreciation.

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  • QE3's open-ended commitment is Bernanke's version of Draghi's "whatever it takes."

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  • A central bank intervention of QE3's magnitude constitutes a declaration of war on the price of the dollar.

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The Fed's move into QE3 marked a sharp change in tone from Chairman Ben Bernanke and the FOMC. While markets were pleased by the move, Bernanke's strategy may be something we soon come to regret.

No longer content to hold the line against deflation, Bernanke seeks to shoot down fears about tepid growth and elevated unemployment. Bernanke's attack mode means unsterilized expansion of the monetary base in a manner that will anger his international central bank counterparts and put upward pressure on U.S. prices.

"Bernanke's attack mode means unsterilized expansion of the monetary base in a manner that will anger his international central bank counterparts and put upward pressure on prices in the US." -Daniel HansonThe Fed's purchases of $40 billion a month will be modest stimulus by recent central bank standards, at least in the short run. If QE2 was the Fed turning on the money spigot by buying $600 billion over eight months, QE1 was a fire hydrant blast, as nearly $1.5 trillion was added to the Fed's balance sheet.The Fed's open-ended commitment to supporting growth signals that it's willing to tolerate higher inflation and currency depreciation through asset purchases that could dwarf prior QE by the time the economy recovers.

Consider the timeline over which the Fed expects to keep interest rates extremely low. If it buys $40 billion of mortgage-backed securities every month until the third quarter of 2015, its purchases would total more than $1.3 trillion. Combine this with low interest rates and the Fed's continued twisting of the yield curve, and the intervention looks crisis-sized at a time when economic growth is still positive.

While the Fed's realistic time horizon for these moves is likely much shorter, reasonable observers will conclude this open-ended commitment is Bernanke's version of Mario Draghi's "whatever it takes" and a stark reversal of decades of Volcker-style inflation-fighting.

The downward pressure this large-scale intervention might have on the dollar should not be underestimated. A central bank intervention of this magnitude - which we might call "currency manipulation" if it was done by China - constitutes a declaration of war on the price of the dollar.

Bernanke's hope is to drive investors out of cash and into risk, to produce a wealth effect that spurs employment, and to rekindle the flames of growth in manufacturing.  In order to accomplish these ends, the dollar will have to fall against other major currencies.

When the US closed the gold window in 1971, Treasury Secretary John Connally faced sharp criticism from his G-7 counterparts over the instant wealth loss produced in the move, but when Connally offered a 20 percent instant devaluation of the dollar to realign it with market prices, foreign leaders balked. 

A devaluation of that magnitude from a major production engine like the US would have bankrupted other exporters who would see the relative prices of their goods skyrocket with sudden increase in the price of their currency.  The eventual devaluation of 8 percent produced a mini-boom in the US from 1971-74 wherein real GDP expanded by about 11 percent.

While no one expects QE-3 to produce the sustained debasement of the 70s, major exporters like Germany should be concerned.  Not only will US inflation erode the value of foreign-held US financial assets, it will cause the already-rising price of German goods to rise faster. 

Given the ECB's recent promise to buy more bonds, the German economy may soon find itself in the midst of a large export contraction while faced with rising inflation and slowing growth.

Such conditions in Europe will renew calls for the ECB to intervene in markets to promote more competition. Peripheral countries, with high interest rates, face substantial carry trade from the U.S., wherein borrowing in U.S. currency against low interest rates and lending at high interest rates in indebted countries further devalues the dollar. 

Furthermore, European exporters, with their fixed exchange rates, have free capital flows but have thus far not been willing to be passive about the money supply.  Simply put, either the currency price is endogenous or the quantity of money is endogenous, and the quantity of money that will clear the markets in Europe - particular as the dollar price falls - is clearly not the quantity currently being printed by the ECB.

Bernanke's move forces exporters such as Germany and China to either bear the cost of U.S. expansion or choose to go to war. At a time of anemic global growth, a return to the "beggar-thy-neighbor" currency policies and trade wars of the Depression seems like a bad idea. A currency war means higher inflation, less trade and more pain for consumers. None of these is a recipe for sustained growth.

The Fed has acted decisively.  Bernanke has declared war.  Americans better hope he wins.

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