War Room 27 Sept 2012

QE3: The League of Extraordinary Central Bankers

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QE3: The League of Extraordinary Central Bankers

I. How does QE Work?

II. Historical – How has past QE fared?

III. Threat of Inflation?

IV. QE3 Scenarios

HiddenLevers

HOW DOES QUANTITATIVE EASING WORK?

Background: Fed Mandate Fed – 3 part mandate

1. Maximum employment

2. Stable prices

3. Moderate long term interest rates

Interest Rates Mandate:

PCE inflation < CPI

This gives Fed wiggle room

Background: Fed Mandate

Employment Mandate:

Above target 6% region

Unemployment still ugly8.1%

Interest Rates Mandate:

Record low rates

No problems here

Source: HiddenLevers

Source: HiddenLevers

Fed + Money Supply

Conventional Wisdom:

Most people believe that printing money leads to inflation

Fed + Velocity of Money

Money Velocity How often a dollar changes hands (annual)

Money moving slower = No inflation from printing

GDPMoney supply

XVelocity of money

QE3: Where Does the Money Come From?

1. Fed's balance sheet assets and liabilities: Assets: US treasuries, mortgage-backed securities,

bank loans, TARP investments Liabilities: Federal Reserve Notes

2. Federal Reserve Note = United States Dollar

3. True Quantitative Easing (not Twist): Fed buys assets using newly created USD No borrowing, no increase in US debt

HISTORICAL:HOW HAS PAST QE FARED?

HiddenLevers

Historical QE – Post World War II USA

1941- 1950 Fed + US Treasury collaboration

Fed directly purchased treasuries

1. Monetized Debt

2. Directly injected into economy

QE did help spark extraordinary growth

QE did inject money directly into Treasury

QE did NOT contain inflation

GDP upInflation punishing

Historical QE – Japan Lost Decade(s)1999 - presentClose to 0% interest rates since 1999

BOJ tried to promote lending by giving banks excess liquidity

1. Government bond purchases

2. Asset-backed securities + equities purchases

3. Commercial paper purchases

QE did prop up Japanese banking system

QE did NOT improve economy

QE did NOT end deflationary expectations

QE begins

WTC attacks

Source: HiddenLevers

Source: Economist

Historical QE – QE1 + QE22009-2011Post US financial crisis

Fed purchased the kitchen sink

1. Shot and Long Term Treasuries

2. AIG

3. Fannie + Freddie bailout

4. Bank bailouts - TARP

QE did prop up US banking system

QE did drive up markets

QE did NOT end resolve unemployment

Both up

QE3: THREAT OF INFLATION?HiddenLevers

Source: HiddenLevers

Inflation Threat – CPI + PPI

Not even close

Inflation Threat – Oil + Gold since QE

End of QE2

QE begins

Inflation Threat – Agriculture + Food

Agricultural commodities have had extraordinary rise

2009 - 2010: Inflation rising

Jul 2012 – present: Droughts in USA breadbasket

Fundamentals story

QE3: SCENARIOSHiddenLevers

QE3: Fed + Critics Views

Banks + Financial Institutions

Federal Reserve

Real Economy Commodities

$40B/month

Bernanke’s View

1. Fed buys MBS from banks2. Banks lend to real economy and buy assets3. Wealth effect + lending combine to help economy

Critics’ View

1. Fed buys MBS from banks2. Banks park money at Fed or buy assets3. Money ends up in commodities, driving inflation, not growth

QE3: So What Do We Got?

What it is

1. It is $40 billion per month in mortgage-related securities purchases

2. It is an attempt to inflate asset prices, and induce wealth effect

3. It is one of the few tools Fed has left at 0% interest rates

What it is NOT

1. It does NOT add to federal debt

2. It is NOT a direct way to kick start hiring

3. It is NOT a guaranteed way to ignite growth – Fed can give banks and institutions money, but can’t make them lend it or spend it.

QE3: Inflation or Liquidity Trap?

Guidance

1. Follow QE1 formula of rapidly rising equity market

2. Wealth effect causes small pop (GDP + employment)

3. Commodities price increases offset most real economic gains

4. Inflation rises as underlying commodity inflation metastasizes

Guidance

1. On our way to becoming Japan – zombie banks that cannot + will not lend

2. Velocity of money continues to trend lower

3. QE money sits in banks + corporate balance sheets

4. Stagflation possible if QE funds flow into commodities

BOTH SCENARIOS: QE3 cannot boost job growth directly

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