Catch QE-II Meets Operation Leap Frog
Joseph Heller did not write the script for the Fed’s latest move, but he might have. Ben Bernanke is pursuing a policy that can only work if people suspend disbelief. In Heller’s famous book, Catch-22, the pivotal idea was that while insanity could get you out of military service requesting discharge for the reason of insanity was proof that you were sane after all. That was ‘catch-22.’ In this case there is also a ‘catch’ but if the Fed can get you to stop thinking about the details and to suspend some logistical disbelief, its policy can be effective. Will it?
As the G-20 meet and about 19 out of the 20 members are hostile to the current US policy this is an ever-pressing question.
The problem, or ‘catch’, with QE-II is that mechanically it just is not working. The Fed already has tried reserve injections and banks still are sitting on billions of excess reserves. As any ‘Money and Banking 100’ student knows, if the reserves are not lent by banks (as loans to the public) then the money multiplier is thwarted. So the jump start ability of QE-II is dead in the water from the start since this process is not underway. To see this version QE-II work now, you must suspend disbelief.
But any reserve injection process has two sides to its scissor. Asking which blade of the scissor cuts the paper misses the point. The ‘other blade’ in this case is the Fed’s asset purchase program which enables the reserve injection. But it is hard to believe that a $600bln asset purchase program could have the effect the Fed wants given the huge stock of treasury securities in the world. Again, to see this policy as effective, you must suspend disbelief, or play leap frog...
The Fed and Operation leap frog
Interestingly, the Fed’s policy is unnerving the foreign exchange market. Interestingly, the nations of the G-20 are worried about the impact. What the Fed appears to be successful in doing is in convincing markets that QE-II can leap frog over the broken mechanisms that give the policy teeth and affect market performance anyway. Its scissors are broken, but the Fed is talking with such conviction that its goal has become ‘credible.’ This is an amazing twist of logic and made more amazing since it seems to be working. Future historians looking back at this - if it works – will take it as evidence of cognitive dissonance on a grand scale (this can’t work…but it is working!).
Read the Fed’s last policy statement. It expunged from that statement nearly all forward-looking negative thoughts about the economy. No more forecast that growth will be ‘modest’ or inflation ‘too low.’ The Fed eliminated this sentence for its September 21 policy statement when it issued a new one in November:
“With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.”
It also eliminated this one:
”The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term”
It is as though the Fed thinks that through the sheer force of its will and rhetoric it can get the results sought by QE by pretending that QE-II can work. Hence I call it Operation Leap Frog.
Interestingly, the Fed has left in its policy statement the reference to rates being kept low for an extended period of time. But there is no longer a low inflation or growth statement to support that tilt. The Fed is engaged in Open Mouth Operations instead of Open Market Operations to do its will. If it can project the force of its will onto the market and if the market believes that the Fed can have an impact on inflation expectations (raising them) then the Fed can make real interest seem lower than they really are and make current policy more stimulative to the economy.
This is a game. We know the important central role expectations have come to have in modern economics. But, of course, it takes credibility to alter expectations. It takes a ‘policy will’ and ‘mechanical ability’ to do achieve what that will is focused upon. The Fed seems to be succeeding with only one of the prerequisites in place. How is that possible?
Maybe the Fed’s timing is right. Like the Druid priest that warned his people that God will swallow the sun he has no power to make this happen but knows there is an eclipse coming. The Fed has timed its policy move to coincide with the economy actually doing better, and with the US elections that have been cathartic. People have a taste for change. For once they want to believe. They are acting even though it is illogical. Cognitive dissonance rears its helpful head. This is also like the period in the financial crisis when the bank ‘stress tests’ were run as mark-to-market rule were suspended. When banks stocks rebounded the Fed/Treasury argued it was the stress tests that convinced people that banks were safer, when in fact it was the suspension of mark to market rules that had been so destabilizing. Bait and switch can make good policy even if it’s devious. In this case the Fed seems to have channeled some careful timing and a delicate alignment of all the stars. To the G-20’s chagrin QE-II seems to be working. But maybe QE-II is a good thing for its members too.
Bernanke after pushing for $800 billion for TARP for another strangely esoteric ‘reverse auction’ rescue of banks in the depths of the financial crisis may have stumbled or craftily maneuvered (you decide) into anther esoteric rescue scheme. This one may work… but for all the wrong reasons. It will be interesting to see how history will judge him for his various innovations some of which worked some of which did not even get started. But this one will be his crowning achievement – if it works.
This is no ordinary QE.