QE3 Will Be More Effective Than Previous Versions – Here's Why

The analysis of current Fed policy has included the usual parade of mistaken pundits [whose views have] been obscured by… an agenda based upon their politics or their business models [and then there]…are the correct answers which are pretty obvious to anyone with any training in economics. Here is that reality. Words: 734

So says Jeff Miller in an article* on his site (http://oldprof.typepad.com) under the title QE3 Misconceptions and How to Profit.

Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!) and www.FinancialArticleSummariesToday.com (A site for sore eyes and inquisitive minds) has edited the article below for length and clarity – see Editor’s Note at the bottom of the page. This paragraph must be included in any article re-posting to avoid copyright infringement.

Miller goes on to say, in part:

1. The basic objective is to change behavior on the part of borrowers and lenders. The stock market is only one method for evaluating the impact and the “wealth” effect is only a minor transmission mechanism.
2. The key to understanding QE3 is to think about marginal effects, not the all-or-nothing, “light-switch” thinking of those without economic education. If you lower the price of something, it has a marginal effect. Lower interest rates encourage more borrowers, qualify more borrowers, and increase the size of qualified loans. The price changes affect (marginally) the interest rates on all related bonds. The increased Fed balance sheet creates more excess reserves for banks and nudges them toward more lending. Lower rates make business investments slightly more attractive. This all takes place at the margin. This is the incentive for risk that Bernanke talks about. None of it has anything to do with pushing the average investor into risk assets, the popular pundit theme.
3. The Fed is not monetizing debt if the purchases of securities are temporary.The concept of “printing money” should relate to an increase in the money supply — M2 or MZM. These increases have been modest — too low in fact. The hyper-inflationistas have been wrong for a decade or so, but that does not stop their chorus.
4. Reversing course depends upon the demand for US debt, both Treasuries and Agency securities. Readers should note that those who have questioned this theme in the past, asking who will buy our debt at the end of prior QE’s have been completely wrong. I do not understand why Bill Gross could be so mistaken, but he was. He does not seem to distinguish between the total volume of US Treasury trading and the net issuance. Or maybe he has his own agenda. Meanwhile, the average investor does not understand the total volume of Treasury trading. (See this piece for an illustration.)

Quantifying the Effects

There are some solid econometric efforts to quantify the QE3 effects. Here is a Bloomberg article that is helpful by sharing some results:

In a model-driven assessment based on the past impact of QE1 and QE2, Deutsche Bank Securities chief economist Peter Hooper says this is what the Federal Reserve printing another $800 billion – slightly less than the gross domestic product of Australia – will do:

1. Reduce the 10-year Treasury yield by 51 bps
2. Raise the level of real GDP by 0.64%
3. Lower the unemployment rate by 0.32 percentage points
4. Increase house prices by 1.82%
5. Boost the S&P 500 by 3.06%, and
6. Raise inflation expectations by 0.25%”

…The Deutsche Bank conclusion is correct. The general direction and order of magnitude of these effects makes sense given past QE policies.

A Deeper Look

In fact, I expect the current QE round to be more effective than the past versions. Why? The focus on changing expectations.

In the past, any good economic news was greeted with the notion that the Fed would step back. The current policy changes this. The Fed is committed to economic stimulation, even if it pushes inflation somewhat above the 2% target level.

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For those who don’t like the the Fed inflation measurement methods, you can just multiply by ten or apply whatever other silly adjustment you think is right. Meanwhile — learn to live with it! This is the new policy.

Investment Implications

The basic conclusion is that:

• The business cycle is going to be extended significantly. We are in the third inning or so.
• It is a good time for tech stocks and deep cyclicals.
• Financial stocks will enjoy a nice yield spread.
• Europe will be helped.
• The timing is a bit different from past QE’s. Since everyone is busy misinterpreting the policy, bashing the Fed, and politicizing the decision, the immediate market impact has been muted.
• This time the real test will come via the actual economy, not the speculative commodity buying of the those with a simplistic view of Fed policy.
• The upside catalyst will come when we see some stronger economic reports, as we [have seen in the latest] ISM numbers.

*http://oldprof.typepad.com/a_dash_of_insight/

Editor’s Note: The above post may have been edited ([ ]), abridged (…), and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.

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