The Fed's plan for quantitative easing was innovative and therefore unprecedented. No one could know for sure what to expect, so there was abundant speculation.
That speculation has created an atmosphere of confusion and misinformation.
Even after months of the program there is little clarity about the effects. The problem is that many things are changing at the same time. What caused what? There was an economic soft patch last year related to European issues. That coincided with the end of QE I. The launch of QE II came just as other things were also happening, including significant improvement in economic data. Most observers dismissed a double-dip recession and corporate earnings were strong. Despite this background, some insisted on a Fed-based explanation for the market rally.
I have provided comprehensive QE II analysis, which you can easily review. Understanding the Fed has certainly helped my investment decisions over the last year, and I hope some readers also found the stories useful.
Measuring the Effect of QE II
A precise measurement is impossible, since we do not know what would have happened in the absence of QE II. Many pundits take advantage of this uncertainty by attributing anything that happened since Labor Day to QE II. I showed why this was wrong by explaining the Super Powers of Ben Bernanke.
In fact, the effects of QE II are quite modest. To demonstrate this I really need a chalkboard. Failing that, I am trying an experiment by producing a little video. It shows how what you learned in school can actually be applied to your investment advantage.
Video Credit: "Basic Supply and Demand" from the Wolfram Demonstrations Project http://demonstrations.wolfram.com/BasicSupplyAndDemand/ Contributed by: Mark Gillis
I hope you don't mind the little refresher.
Those who need volume data on the bond market can download and review data, as I did. It is important not to confuse the daily volume, which is most relevant for price determination, with data about the eventual holders of the securities, the size of the daily Fed auction, or the banks participating. None of these factors is relevant to the market price which is determined by -- drumroll -- the market!
Once you understand that the direct interest rate effects of QE II are on the order of 20 bps, you are better prepared to deal with outlandish claims.
- The idea that "no one will buy our bonds" is silly. A small change in interest rates will attract many buyers. Who will this be? Out of the $500 billion in trades it would basically be the last marginal buyer.
- QE II was not (directly) responsible for speculation in either commodities or stocks. The 20 bps effect might nudge a few players into a different asset, but it could not be the source of the monster rally in commodities. The Fed explanations of quantitative easing discussed the concept of making other asset classes more attractive. Some observers seized upon this directional language and inferred effects far beyond what could have been expected from small interest rate moves.
- QE II did not cause the decline in the dollar. The interest rate effects were too small. The dollar is responding to the trade deficit, along with many other factors.
- The buying in QE II has ended, but the effects will continue until there is a reduction in the balance sheet.
- The alleged and mistaken "end" of QE II will have little immediate effect. It will not take long for this to be recognized.
If QE II did not directly cause big moves in asset prices, and if the correlation analysis is bogus, what is the real explanation for what has happened?
The best analysis I have seen comes from Mike Konczai's interview of Joe Gagnon, a visiting director at the Fed and now working at a prestigious think tank.
MK: So did QE2 work? And if so, how can you tell?
JG: It did work. I think QE2 had two elements. One element was of moderate importance, one element was of minor importance. The moderate one is that QE2 convinced markets that the Federal Reserve would not allow deflation or a double dip recession to happen. This is good because it inspired confidence and kept inflation expectations from falling any further. That was the most important step, because it convinced financial markets that the United States wouldn’t turn into Japan, which they were worried about. The element of minor importance was that it lowered long-term bond rates a little bit. It takes a lot of purchases to move these interest rates even a little bit, and QE2 wasn’t big enough to move them dramatically. It’s not nothing, but it is small in the scheme of things.
There is plenty more analysis in the interview, including speculation about what an (unlikely) QE III would include.
As I wrote yesterday, the biggest effects are psychological, not a direct policy consequence.