- The Wall Street Journal – Ben Bernanke’s Impossible Dream
Federal Reserve Chairman Ben Bernanke may be an excellent economist, but he is not a very good bond salesman. Since his Aug. 27 speech at an annual Fed symposium in Jackson Hole, Wyo., he’s been telling us that he thinks inflation is too low and long-term interest rates are too high. In a quixotic effort to “maximize employment,” he’s begun purchasing up to $600 billion worth of long-term Treasury obligations to push inflation up and bond yields down. If it worked as planned, this would flatten the yield curve, meaning it would narrow the spread between short-term and long-term interest rates. Since banks make money by borrowing short and lending long, the effect would be to discourage bank lending. That seems an unpromising way to stimulate the economy. But the whole notion of simultaneously raising inflation and lowering bond yields presumes bond buyers are docile fools.
Jim Bianco was on CNBC yesterday discussing QE2 and how it affects the person making $75k/year. If you missed the interview click on the picture above. To view any of our interviews click here.
Here are our assumptions and what we found:
- Headline inflation has increased at an annualized rate of 2.69% over the last three months. Yes Federal Reserve apologists will say the FOMC cannot control food and energy which is why they exclude it (core up 0.78% over the same period). But, in this case, food and energy (aka commodities) are rising, in part, because of QE2. So, these prices should be included because QE2 affects them. If we assume that a person with $50k in disposal income has a 5% savings rate, they spend 95% of their paycheck. If they spend it in proportions similar to the CPI weightings (which is how they arrive at these weightings), this person’s prices rose 2.69% annualized over the last three months. That works out to an extra $258 in higher costs.
- Mortgage interest rates, using the Bank Rate National Average for Conforming Loans, have dropped from 4.57% to 4.21% in the last three months. If we assume a $300k mortgage and the ability to refinance using these rates, this person saves $192.24 every three months. This is less than their added costs due to inflation.
- Investments – This is a tricky component of this study. What has this person gained because of QE2? What has he lost? Here we have to make assumptions about this person’s investments. We know from the mutual fund flows that a typical $75k/year investor is not investing any new money in stocks, choosing instead to hide in bonds. QE2 lowers interest rates paid, which hurts him, but helps what is left of his stock portfolio. So far I think it has done nothing for his home price. Since we are guessing here, I would have to call this a wash or no effect.
Will There Be A Wealth Effect?
In the last part of the interview Ethan Harris of Bank of America disagreed without view. He was not arguing against our math, but rather he believed that the “indirect effect” of more stock market wealth would boost the economy. As we noted last week, we believe this is the basic definition of a stock market bubble:
To be clear, manipulating stock prices higher in hopes that stock prices alone will change beliefs (confidence) and behavior (spending) is a bubble. Bernanke [in last Thursday’s Washington Post Op-Ed] did not say he is trying to ramp the economy higher which would in turn support higher valuations. This would not be a bubble.
For a wealth effect to take hold, two things must happen:
- A person needs to see his wealth make a new all-time high. Reducing losses, which is what is now happening, does not lead to a wealth effect. Once the DJIA exceeds the October 2007 all-time high of 14,700, then the discussion of a wealth effect can begin.
- A person needs to believe equity market gains are permanent. If one thinks DJIA 10,000 will never happen again (first happened 11 years ago, last happened three months ago) then they might spend reduced losses. Who thinks we will never again see DJIA 10,000 (especially among the $75/year crowd)? We would guess virtually no one, which is why no wealth effect occurs with a move to 12,000.
Ethan disagreed, arguing that none of the academic research suggests a new high is necessary. If we had time, we would have said that the academic research says wealth must be perceived to have been created and right now the perception is loss reduction is happening, not wealth creation. No one spends loss reduction.
QE2′s effectiveness could ultimately come down to this concept of the wealth effect. We do not believe that higher stock prices will spur a wealth effect and more economic activity. Instead, it will push stocks higher relative to their underlying value and thus create a bubble.