Thursday, March 5, 2009

Quantitative Easing Today, A $50 Cup of Coffee Tomorrow

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

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This morning, the Bank of England (BOE) lowered interest rates (already at 300 year lows) to 0.5% and the European Central Bank (ECB) lowered them to 1.5%. Like the U.S. Fed, both central banks are worried about deflation, which is like someone in the Amazon worrying about the next blizzard. The Bank of England even announced it was embarking on a quantitative easing program (as if this is something new) that would purchase $106 billion of commercial paper and government bonds. British gilts soared on the news (interest rates went down) and inexplicably the pound rose and then more logically fell. Why someone would buy a currency, just after the issuing government announces it's embarking on a currency debasing program is something to ponder.

Quantitative easing is the creation of money out of thin air by a central bank, followed by its injection into the country's banking system. Central banks can accomplish this by using the new money to buy government bonds in the open market, lending the money to banks, or buying assets from banks in exchange for currency. It is not the only form of new money creation, just the most extreme. Quantitative easing causes government bond rates to go down. It should also lower the value of a country's currency.

The U.S Fed has effectively been using quantitative easing since late 2007. Note that government bond interest rates have gone down substantially during this time (and the U.S. dollar had a massive sell off from the fall of 2007 until spring of 2008). Records also indicate that only 20% of U.S. treasuries are in private hands. The rest are held by the Fed, its subsidiaries and foreign central banks. The U.S. government has essentially been printing money and then buying its own bonds with this newly printed money. According to many economic experts, including noble prize winners, this is somehow not going to lead to inflation.

The thinking (or lack thereof) of central bank heads on the deflation issue was demonstrated clearly in the rate cut announcements this morning. Both the ECB and BOE are worried about inflation rates falling below 2%. Trichet the ECB head, admitted that the a sharp drop in commodity prices was the cause of this 'deflation' (although official inflation rates in the Eurozone are still above 1%) and apparently he thinks commodity prices can continue falling below the cost of production and there won't be any reduction in supply (did he take economics 101?). This argument is used by the U.S. as well, along with the 'inflation can only happen if wages are rising' line of reasoning. That argument is false as well and is based on the interpretation of the mechanism of the course of inflation in the U.S. in the 1970s. Even if this wage rate argument was true, revised figures came out this morning showing U.S. wages actually rose sharply in Q4 2008, instead of falling as had originally been 'mistakenly' reported by the government.

Ultimately, inflation comes down to whether of not the value of a country's currency is maintained and all other issues are secondary. When countries issue money faster than justified by economic growth, whether in the form of actually printing it as hyperinflationary superstar Zimbabwe has done or by using the more sophisticated tricks of the U.S Fed, the value of that country's currency declines against hard assets and consumer prices rise. Only if the money does not flow into the greater economy because it gets stuck in banking system because you have continual recession/depression, can you avoid inflation. Either way you lose.

NEXT: U.S. Unemployment reaches 15%

Daryl Montgomery
Organizer,New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

1 comment:

Faraz Qureshi said...

Good post Daryl. It is incredible that our elected officials can't see past the immediate future and see the huge wave of inflation that is going to hit us.

I think for many people (myself included), it is difficult to understand how quantitative easing works. Or how the Fed actually creates money. This is a mental block that is not easy to get your head around. But once you do, you realize there will be ramifications for all this money printing.

I thought this was a good resource for learning how the Fed creates money:

Quoting: "When you or I write a check, there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which that check is drawn. When the Federal Reserve writes a check, it is creating money."

Thanks for writing about these important topics,