In These New Times

Doug Noland

Asia Times

9th November, 2010

The late-July arrival of St Louis Federal Reserve President James Bullard’s monetary policy white paper commenced serious discussion regarding a second round of quantitative easing – or QE2 – in the United States. From August lows, the S&P500 has gained almost 18%, the S&P400 Mid-Caps 21%, and the small cap Russell 2000 25%.

Notably, many global market prices have enjoyed even more robust inflation. Gold is up 19% and silver has surged 50%. The Shanghai Composite has rallied 22%. India’s Sensex index rose 18% to a record high. Copper is up 23% from August lows. Cotton has surged 80%, sugar 82%, and corn 46%. The Goldman SachsCommodities index has gained 21% from mid-August lows.

In Bill Gross’s latest post, he posits that the Fed is “pushing on a string”. This is not the case. The current backdrop has little-to-no similarity to the 1930s; the world is definitely not today stuck in a credit collapse and deflationary quagmire. Instead, much of the globe is facing an unrelenting onslaught of financial inflows and heightened inflationary pressures. Faltering dollar confidence is the prevailing force behind troubling inflationary pressures and strengthening bubble dynamics.

Increasingly, “emerging” economy credit systems have succumbed to overheating, while key developed economies are locked into a perilous cycle of massive non-productive government debt expansion. Our unsound debt, liquidity and currency dynamics ensure that excess flourishes throughout global credit systems. Bubbles are today left to run uncontrolled and undisciplined by a market hopelessly distorted by liquidity overabundance. Fed policies seemingly ensure that global liquidity goes from extraordinary to extreme overabundance.

The Fed may today be alone in “quantitative easing” through the purchase of domestic government obligations. Our central bank, however, has considerable global company when it comes to monetization and liquidity creation. From Bloomberg’s tally we know that global central bank international reserve positions have inflated US$1.5 trillion over the past 12 months. That last thing the global financial system needs is an additional shot of liquidity and reason to believe that dollar devaluation will be accelerated.

In post-announcement analysis of the Fed’s commitment to another $600 billion of Treasury purchases, Bill Gross commented on CNBC that “the biggest risk is inflation down the road”. I again disagree with Mr Gross. The greatest risk is a destabilizing crisis of confidence for our nation’s debt obligations. Our system doubled total mortgage debt in just over six years during the mortgage/Wall Street finance bubble. Washington is now on track to double the federal debt load in just over four years. Federal Reserve policy remains instrumental in accommodating a precarious credit bubble at the heart of our monetary system.

It seems again worth highlighting a couple key sentences from European Central Bank president Jean-Claude Trichet’s July 22, 2010, op-ed piece in the Financial Times, “Stimulate no more – it is now time for all to tighten”. He wrote: “Given the magnitude of annual budget deficits and the ballooning of outstanding public debt, the standard linear economic models used to project the impact of fiscal restraint or fiscal stimuli may no longer be reliable. In extraordinary times, the economy may be close to non-linear phenomena such as a rapid deterioration of confidence among broad constituencies of households, enterprises, savers and investors.”

The Ben Bernanke Fed is playing with fire here. QE1 was implemented in an environment of deleveraging, impaired global financial systems and acute economic contraction. And, importantly, the dollar was enjoying a strong performance in the marketplace as global risk markets suffered from de-risking and general outflows. QE1 had a stabilizing influence, as it worked to accommodate financial sector de-leveraging.

The QE2 backdrop is altogether different. Global markets are these days demonstrating robust inflationary biases. Risk embracement is back in vogue – speculation is rife. The “emerging economies” and global risk markets have been on the receiving end of massive financial (“hot money”) flows. Meanwhile, the dollar has been under heavy selling pressure with heightened risk of a crisis of confidence. This week’s market activity supported my view that the environment would seem to dictate that QE2 will only exacerbate increasingly unwieldy financial flows and unstable global markets.

It has been critical to my analysis that current reflation dynamics are different in kind from those that for the past two decades provided the Federal Reserve the most potent mechanism for domestic monetary stimulus. In today’s post-mortgage finance Bubble and housing mania backdrop, the Fed has lost much of its capacity to inflate household net worth and spending. The robust inflationary biases – and fledgling bubbles – are now in global markets and economies. The “core to periphery” financial flow dynamic has become deeply embedded.

The key dynamic today is one where deep structural US impairment elicits an unprecedented monetary response from our central bank. Yet the markets anticipate that this liquidity will seek out the inflating asset classes and most robust global economies. Last week, gold climbed to a record high, crude oil to a two-year high, and copper to a 28-month high. The Shanghai Composite jumped 5.1% last week and India’s Sensex was up 4.9%. So far, indications support the view that the Fed’s move will further stimulate unfolding global booms.

Whether it is Asia or the commodities/natural resources economies, QE2 will exacerbate the already powerful financial flows and bubble fuel. The US economy is poorly structured to benefit from these new global financial flows, inflation and growth dynamics. There may be some gain from inflating US stock prices. Yet the struggling consumer sector is going to get smacked with higher food and energy prices.

In his Thursday op-ed in the Washington Post – “What the Fed did and why: supporting the recovery and sustaining price stability” – Bernanke argued that “the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability”. The dilemma for the Fed is that the financial and economic environment will dictate that their policies have minimal impact on both US employment and growth, while providing a major impetus for additional global monetary disorder. A strong case can be made that QE2 will only worsen already unprecedented global imbalances. Global policymakers must be at their wits’ end.

November 5 – Financial Times (Alan Beattie, Geoff Dyer, and Chris Giles): “‘With all due respect, US policy is clueless,’ Wolfgang Schauble, German finance minister, told reporters. ‘It’s not that the Americans haven’t pumped enough liquidity into the market,’ he said. ‘Now to say let’s pump more into the market is not going to solve their problems.'”

November 4 – Bloomberg (Arnaldo Galvao and Andre Soliani): “Brazil’s Finance Minister Guido Mantega said he’s not considering additional currency measures even as the US throws ‘money from a helicopter’ in a bid to boost economic growth. Mantega said the Federal Reserve’s decision yesterday to inject $600 billion into the economy through debt purchases won’t work and increases the risk of asset bubbles forming around the globe. He said President Luiz Inacio Lula da Silva will urge the US to change its policy next week when he attends the Group of 20 nations summit in Seoul, South Korea. It doesn’t work to throw money from a helicopter because this won’t make growth flourish,’ Mantega told reporters… ‘In Brazil, there is no risk of bubbles because we took measures that block exaggerated inflows.'”

November 5 – Bloomberg: “China said the US Federal Reserve needs to explain this week’s decision to purchase bonds to pump money into the world’s biggest economy or risk undermining the global recovery. ‘Many countries are worried about the impact of the policy on their economies,’ Vice Foreign Minister Cui Tiankai said … ‘It would be appropriate for someone to step forward and give us an explanation, otherwise international confidence in the recovery and growth of the global economy might be hurt.'”