Fed risks inflation with talk of QE3

With the eurozone crisis threatening to pull down the US economy, some members of the Federal Reserve are discussing another round of quantitative easing.

By Anthony Mirhaydari Jan 11, 2012 2:57PM

Image: Inflation (© Nick Koudis/Getty Images)We've got problems. A number of structural issues -- from Europe's woes to the federal debt problem to stagnant job growth and still-falling home prices -- will likely push the American economy dangerously close to a new recession in 2012.


Much of Europe and Asia are already there. Indeed, a coalition of Europe's major economic institutions said Wednesday that the eurozone is already in a recession.

 

It's probably not surprising, then, given the activist nature of our central bank, that the Federal Reserve -- which is already in the midst of Operation Twist to pull down long-term interest rates and has committed to holding short-term rates near zero through 2013 -- is starting to fidget. A chorus of officials have hit the speaking circuit over the past week, talking up the potential for more policy easing.

 

In simple terms: The Fed is laying the groundwork for another round of unmitigated money printing, also known as quantitative easing -- or QE3, as it would be the third iteration of the strategy. If carried out, it would not only be a political blunder in an election year but it would do further damage to the economy.

 

Backing up a minute, there is evidence that, all else equal, quantitative easing is effective in bringing down interest rates and stimulating growth when the economy is on the ropes and inflation is fully at bay. This has a lot to do with the surprise factor or novelty effect.

 

Thus the success of the original QE1, which started back in late 2008 with the Fed's announcement that it would buy $600 billion worth of mortgage securities and mortgage debt. This was expanded in March 2009 to include U.S. government debt. 

 

The second iteration, teased in late 2010 and launched that November, was decidedly less successful despite Wall Street's excitement over Fed chief Ben Bernanke's overt goal of pushing up the stock market as a way to boost economic growth despite the risks of higher inflation and dollar devaluation.

 

It didn't work.

 You can see this in the chart above. GDP growth peaked just before the Fed teased QE2 and plunged afterward as inflation spiked. The Fed's preferred core measure of inflation, which filters out fuel and food prices, jumped from nearly 0.5% to more than 2% in a smooth, steady upward trajectory.

 

Headline inflation, which includes food and fuel, increased from 1% to nearly 4% a few months ago before pulling back slightly.

 

If this isn't an example of the "significant increases in inflation" Bernanke derided his critics for warning of in his November 2010 opinion piece in the Washington Post, I don't know what is.

 

What's more, inflation pressure looks to be bubbling again as crude oil pushes over $100 a barrel on Iranian saber rattling and Wall Street shenanigans.

 

These pressures are translating into gas price increases at the pump. And they are sure to show up in fourth-quarter inflation reports due next week. With inflation so high, it'll be hard for the Fed to justify another round of QE. It'll also give the Fed's political opponents in the Republican Party added fodder to attack Bernanke and his pals as assisting President Barack Obama's re-election chances.

 

That's not stopping them from trying anyway over the past week:

  • Chicago Fed president Charles Evans said Wednesday that more needs to be done to support housing, that the banks need to make more loans, and that, if needed, the Fed could provide another $600 billion worth of quantitative easing.
  • Atlanta Fed president Dennis Lockhart, while somewhat skeptical of its effectiveness, would not rule out QE3.
  • San Francisco Fed president John Williams said there is a case to be made for using QE3 to purchase additional mortgage securities.
  • Fed governor Sarah Raskin said the Fed's use of unconventional policy tools, including QE1 and QE2, has been appropriate.
  • Fed governor Elizabeth Duke said there is too much slack in the economy to create inflation.
  • Boston Fed president Eric Rosengren said that the Fed still needs to support the recovery and that the purchase of mortgage securities could do the trick, since inflation is likely to remain below 2% for several years.
  • New York Fed president William Dudley said it would be appropriate to consider additional easing measures to assist the housing market.

I think you get the idea.

 

It's very possible that the Fed will decide to launch QE3 as the temporary tailwinds boosting the U.S. economy -- consumer savings draw-downs and the now-disappearing drop in gas prices -- end just as the eurozone crisis kicks up a few notches.

 

The script after that would look something like this: Stocks rally on Fed largess and another flood of cheap cash, speculators dump said cash into commodity speculation, prices for energy, precious metals and foodstuffs swell, inflation measures increase, consumer spending and consumer confidence drop, the economy weakens further, and stocks drop.

 

I don't know about you, but all of this just feels like a bad dream. For the brave, silver looks to be the best way to bet on QE3, with the iShares Silver (SLV) breaking up and out of a long downturn.

 

I found SLV with the help of technical screens developed with Fidelity's Wealth Lab Pro back-testing tools, which you can find here. (Fidelity sponsors the Investor Pro section on MSN Money.)

 


Check out Anthony's investment advisory service The Edge. A two-week free trial has been extended to MSN Money readers. Click here to sign up.


The author can be contacted at anthony@edgeletter.c​om and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.

13Comments
Jan 11, 2012 5:24PM
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I don't know about you, but all of this just feels like a bad dream.

Let me interpret this bad dream for you. The value of the dollar is not based on gold, or productivity, or anything tangible. It’s based on trust, whatever trust means. For as long as the dollar is perceived as a safe haven, the Fed has the latitude to stretch that trust and cheapen the dollar and the trust associated with it.

 

The Fed has to do this because it has to finance the government while keeping its mandate: maintaining inflation at a reasonable rate with employment. Inflation is the hidden tax with which it finances government. For as long as government keeps spending money it doesn’t have and the dollars is viewed as a safe currency, be assured  that there will be QE3, QE4…QE500.

 

The real nightmare is when we lose the faith of the public, here and abroad. Then we will have a war. If we win it, we press the Reset button and we start all over. If we lose it, we'll lose all our assets, we will have to learn another language and another national anthem.

Jan 11, 2012 6:17PM
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There are diminishing returns economically each time Ben loads up his helicopter. Always it is punitive for the middle class. It is time to rethink the federal reserve.
Jan 12, 2012 10:03AM
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I think Bernanke wants to make sure he keeps his job. He will do anything to help Obama get re-elected even at the cost of screwing the American people. The market manipulation needs to stop. We need to deal with our debt and get leaders in Washington who want to lead and fix the mess this country is in.
Jan 11, 2012 8:16PM
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As much as I have degraded Anthony and his opinions in the past. He has finally seen the light. I still do not think he nor 80% of americans get the big picture. There isn't much "hope" out there, but there will be a lot of "change". Sheeple continue to criticize those that claim everything is doom and gloom. How do you paint a rosy picture here? Europe is our example, we can have hyperinflation and paper over everything, then have a dollar collapse soon, or raise taxes and Austerity, and tighten our government spending. Either way its gonna hurt. What do you think this government is going to do? I am all in support of Ron Paul and his ideas, but what major laws are getting through the house or the senate right now. I hate to be the bearer of bad news folks but Gold and Silver really are the only alternative. And no Anthony the paper silver market is not the answer. Physical is the only way to go. Go ask an Argentinean what we are in for! 
Jan 12, 2012 12:58PM
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Only Ron Paul has shown any interest in stopping these bastards from robbing us blind. The press is so stupid it's frightening. This means NBC and Fox too. Change is available you freakin' zombies, wake up and grasp the chance to live free.
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 For as long as government keeps spending money it doesn’t have and the dollars is viewed as a safe currency, be assured  that there will be QE3, QE4…QE500.
Yes Buzz Bernanke saying is "prints monies to infinity and beyond"
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Geithner (the tax evader who should be in jail not running the IRS) is in China trying to keep the US from going under this year. The Chinese are selling the US t-bills to build apartments and manufacturing buildings in China and they have forged trade in yuan with all the major players Brazail,Canada,South Korea,Japan,Great Britain, Australia. They are getting ready to decouple from the US dollar by 2014 or not sooner. 

Pretty much it's game over for the US
Jan 11, 2012 11:37PM
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Bull Rider has the feeling that everybody has.

 

I have it a lot.

 

I just finished reading "Retirement Heist" by Ellen Schultz.

 

So . . . maybe we should stop fighting it and start running for office.  The only way out?

 

ConfusedConfusedConfused ConfusedConfusedConfused ConfusedConfusedConfused ConfusedConfusedConfused ConfusedConfusedConfused ConfusedConfusedConfused ConfusedConfusedConfused ConfusedConfusedConfused

 

 

 

 

Jan 12, 2012 4:03PM
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I don't know about you, but all of this just feels like a bad dream. For the brave, silver looks to be the best way to bet on QE3, with the iShares Silver (SLV) breaking up and out of a long downturn.

I'd advise sitting back and waiting there.

 

A) QE3 hasn't happened yet.

B) The hard support line is not where you have it drawn at. You have to go by daily close level. The hard resistance was at 28.5-29.5. Not below where you have it drawn (in a way to make it look at though it didn't break it, which it did).

C) It spent *1 week* below the support line. That is a break. Not a snap back. 28.5-29.5 is now acting as resistance. Even though you are calling a break out above the downtrend, it's really not....

D) The chart is moving sideways, that is not breaking out. It's at the same level today that it was at on January 3.

E) The 50-day MA is at 30.58. Offering *another line* of resistance even after this level.

 

I wouldn't buy that looking for a range 29.22 to 30.58. 5% gain? That's your target?

F) http://finance.yahoo.com/echarts?s=SLV+Interactive#chart14:symbol=slv;range=20100927,20120111;indicator=sma(50,200)+bollinger+volume;charttype=line;crosshair=on;ohlcvalues=0;logsca​le=on

 

Look at a longer term chart. Slv made a top Dec2010/Jan2011, from which it traded down and broke below 50day MA creating a bottom around 26.30.

 

The 28.50-29.50 level was key dating back to then and it was taken out just a few weeks ago. It also bounced at 26.27. The level it rallied from in late January 2011.

 

26.30 is the lower side resistance line, and there is *huge* upside resistance all thruout the area it is in now 28.50-29.50 and 30-30.50. Wrong time to buy. 10% downside risk is much more likely than the 5% upside you are currently proposing.

 

It would be better to wait and see here, if it breaks thru the 50-day MA and doesn't do an immediate pull back, there's a lot more upside potential there. The next upside target would be 35. At that point I'd consider pulling the trigger. You'd also have more clarity on QE3.

Jan 12, 2012 3:39PM
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You can see this in the chart above. GDP growth peaked just before the Fed teased QE2 and plunged afterward as inflation spiked. The Fed's preferred core measure of inflation, which filters out fuel and food prices, jumped from nearly 0.5% to more than 2% in a smooth, steady upward trajectory.

That's a real loose interpretation Anthony.

 

While GDP was going down, inflation was still sub 1%. In fact, the times don't even line up. GDP peak in Summer 2010, inflation starting back up in Fall 2010.

 

Headline inflation, which includes food and fuel, increased from 1% to nearly 4% a few months ago before pulling back slightly.
If this isn't an example of the "significant increases in inflation" Bernanke derided his critics for warning of in his November 2010 opinion piece in the Washington Post, I don't know what is.

Reasoning in a vacuum.

 

The QE programs had an indirect impact.

 

What really matters is simply that the global economy started moving again after 2008. Should be pretty obvious. Oil popped back up after being down, and the global economy continued to grow which meant the US was going to be tapped for food supplies.

 

Also, you seem to be completely ignoring that oil spike in early 2011 from a variety of issues unrelated to QE2. Like the Arab Spring. Also on food, US food exports are at an all time high. Global economy.

 

Most of the money printing these days simply doesn't hit the mainstreet economy and cause inflation like you'd think.

Jan 13, 2012 2:12PM
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Saying the Fed shouldn't print money is like saying the sun shouldn't come up in the morning.

 

The US is insolvent.  There is no way we can pay our debts.  Printing money is the only way out.

 

Yes we are headed for hyperinflation but there is nothing that can be done about it.

Jan 11, 2012 5:18PM
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Well, look on the bright side.  They finally took those creepy looking people off of the Schwab log on page.

 

I hope there will be a new E-Trade baby commercial during the Superbowl.

 

Can we send some stealth Navy seal commando team to Europe to start the meldown?  I'm tired of waiting.       Sleepy

 

 

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