When U.S Federal Reserve Chairman Ben Bernanke strongly hinted at a press conference last week that the end of QE was on the horizon, the markets went into a tailspin.
The more than $2.5 trillion that the Fed's bond-buying program - known as quantitative easing, or QE - has pumped into the financial system is credited with fueling the current bull market.
But while you can't blame investors for getting nervous at the thought of the end of QE, there's really nothing to worry about.
In fact, the Fed's policy-setting FOMC (Federal Open Market Committee) is now caught up in a trap of its own making - something known as a "liquidity trap
." It happens when easy money policies like the Fed's zero interest rates and QE still fail to get people and businesses to spend money.The trap is that you can't reverse the policy without discouraging spending even further, threatening to push the economy into recession (and spooking the markets, as we saw last week), while continuing it will remain ineffective.
"The biggest fear of the Federal Reserve has been the deflationary pressures that have continued to depress the domestic economy," Street Talk Live radio host Lance Roberts wrote in a recent column. "Despite the trillions of dollars of interventions by the Federal Reserve the only real accomplishment has been keeping the economy from slipping back into an outright recession."
Worse still, any stimulative effect that QE has had on the U.S. economy is fading, even as it continues.
"The overriding deflationary drag on the economy is forcing the Federal Reserve to remain ultra-accommodative to support the current level of economic activity," Roberts said.
In other words, we won't see the end of QE and a zero federal funds rate for a very long time.
How Deflationary Pressure Is Preventing the End of QE
Deflation - prices going down instead of up -- sounds like a good thing, but it wreaks havoc on economies, causing people and businesses not to spend today, because their money will be worth more in the future.
The lack of spending forces businesses to cut back on employees and/or wages. Everybody loses.
While we don't have actual deflation yet, slowing economic activity is creating "deflationary pressure" - lowering inflation to the point where it's having a similar effect to deflation.
That's important to keep in mind regarding the end of QE, because the FOMC has said often (and said again last week) that it will not make a big change in policy unless unemployment gets back down to the 6.5% range and inflation goes above 2%.
Despite the Fed's optimistic economic outlook, neither appears likely anytime soon.
"There is no wage inflation and no industrial materials inflation, thus the major forces impacting production costs aren't pointing to towards even moderate inflation," Money Morning Capital Wave Strategist Shah Gilani said. "The Fed has articulated it wants a 2% inflation target to be sustained for a long enough period (at least a few quarters, but they haven't said for how long) to insure against deflation. We're nowhere near 2% inflation."
In fact, the Fed's preferred measure of inflation, the Personal Consumption Expenditures (PCE) index, has been falling, not rising, since last September, when it was 1.8%. As of April, the PCE had slipped to 1.1% -- its lowest level since 1963.
Of course, the Fed last week said it saw inflation rising along with a strengthening economy, hence the talk about the end of QE.
But the Fed has revised its own "central tendency forecast" for inflation lower several times over the past year. Right now it stands at a range of 0.8% to 1.2%, well below the FOMC's stated 2% target. The committee doesn't see inflation hitting 2% for at least two years.
Even Fed Members Don't See a Quick End of QE
Apart from the weak economic indicators, other members of the Fed followed last week's bombshell with statements that seemed to back off the idea of tapering QE this year.
One of the dovish Fed members, New York Fed President William Dudley, voiced concern about ending QE while unemployment is still high and inflation is edging lower.
"U.S. monetary policy, though aggressive by historic standards, was not sufficiently accommodative relative to the state of the economy," Dudley said.
But the surprise was that several Fed hawks also spoke out against the end of QE.
In his dissent last week, St. Louis Fed President James Bullard said the Fed "should have more strongly signaled its willingness to defend its inflation target of 2% in light of recent low inflation readings."
Dallas Fed President Richard Fisher, a leading hawk on policy, also pointed out than even a cutback in QE would be just that - a cutback.
"Even if we reach a situation this year where we dial back QE, we will still be running an accommodative policy," Fisher said in a speech in London on Monday. "I'm not in favor of going from wild turkey to cold turkey overnight."
If you want to know why the Fed said what it did about QE and what investors can do about it, read Shah Gilani's How to Play the New Normal: Spiking Volatility.
Related Articles and News:
- Money Morning:
Now What: A Q&A with Keith Fitz-Gerald - Money Morning:
Why the Fed's QE Policy is Bullish for Oil Prices - Street Talk Live:
The Fed's Real Worry - A Pick Up In Deflation - MarketWatch:
Bernanke doesn't fear deflation - but should - The Atlantic:
The Biggest Economic Mystery of 2013: What's Up With Inflation? - Reuters:
Two Fed officials downplay worries over end to stimulus
Credit: Money Morning - Only the News You Can Profit From http://moneymorning.com/2013/06/25/why-we-wont-see-the-end-of-qe-for-a-very-long-time/
