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Analysis
As QE2 prepares to sail, scepticism surrounds Fed’s plan

As QE2 prepares to sail, scepticism surrounds Fed’s plan

Iceberg of botched mortgage documentation could turn monetary vessel into the Titanic

by Darrell Delamaide

Thu 21 Oct 2010

The second round of quantitative easing to stimulate the economy planned by the US Federal Reserve is generally referred to as QE2, a name reminiscent of the British luxury cruise vessel. Many economists believe the exercise is like using an ocean liner as a tugboat. And some fear that QE2 may be heading, Titanic-like, towards the icebergs.

Critics say the massive injection of central bank money is a much less efficient way to stimulate demand than a more concentrated package of fiscal measures. The Fed’s plan to expand purchase of government securities – analysts are expecting additional buying of around $500bn – will simply add to bank reserves and will not be available for on-lending to borrowers. Banks already have plenty of reserves and in any case, as the private sector deleverages, there is no great borrowing demand.

One top Fed official acknowledged this week that the US central bank is counting on QE2 to stimulate the economy in other ways that simply through the credit mechanism. ‘A second possible channel is called the portfolio balance effect,’ Dennis Lockhart, president of the Atlanta Federal Reserve Bank said. ‘If the Fed buys a significant portion of available Treasury securities, for instance, investors may feel the need to migrate their holdings to other assets that carry more risk, such as corporate bonds and equities. The buying pressure in these asset classes could push up values and generally improve the atmosphere that supports risk taking and spending.’

According to this variant of wishful thinking, not only will consumers start to feel better and spend more, but companies may find the returns on capital so low that they will be tempted to invest in new capacity and create new jobs.

That’s the benign view. Many economists remain doubtful. David Rosenberg, strategist at Canadian investment management firm Gluskin Sheff, says Ben Bernanke is well aware of prevailing scepticism – but wants, all the same, to take the risk of more easing.

The Fed chairman ‘knows that there is a chance that QE2 will only be met with limited success - monetary policy, even in a non-conventional form, is a very blunt tool to use to reverse a secular uptrend in the savings rate, redress chronic unemployment or induce people to spend rather than correct their debt-laden balance sheets,’ Rosenberg said in a note to clients this week.

The problem can be put in a nutshell: fiscal policy is what is needed to stimulate the US economy, but the Obama administration’s too-timid approach last year has closed that off as an option for the foreseeable future because of the political backlash.

Only jobs and income will stimulate spending, says Randall Wray, an economics professor at the University of Missouri at Kansas City (UMKC), and monetary policy cannot supply these. ‘If we really wanted to use our central bank to resolve this economic crisis,’ Wray wrote this week, ‘it would be far better to have it directly buy houses and create jobs for the unemployed. But it makes far more sense to use our fiscal authorities for that.’

This isn’t going to happen, Wray acknowledges. He sees QE2 going the way of the Titanic, underwater.

The Atlanta Fed’s Lockhart said that another way in which quantitative easing will boost the economy is to stimulate exports with a weaker dollar. This point, of course, has not been lost on Brazilian finance minister Guido Mantega and other emerging market officials who see the move as part of the skirmishing in a developing currency war.

The US government had one other opportunity to help the economy with its loan modification programme for mortgages. Delinquent mortgages and foreclosures continue to push down housing prices and are a major drag on economic recovery. But here, too, the administration’s action fell well short of what was desired. Its loan modification programme failed to provide proper incentives and helped very few homeowners.

Now there is a new crisis over foreclosure documentation. Bad enough in itself, it may be the tip of an iceberg, as suspicions grow that much of the original mortgage documentation is faulty or fraudulent. Investors sent Bank of America shares into a tailspin this week as holders of mortgage-backed securities, including the New York Fed, began insisting that BofA buy back securities with insufficiently documented mortgages.

The White House is belatedly calling a top-level meeting this week to examine the documentation issue. There is so much at stake that even some of the sceptics may secretly be pleased to be proven wrong this time. For if UMKC economist Wray is right and the Fed’s QE2 becomes the Titanic, then a lot more than one leaky monetary vessel packed full of hopes will be sinking into the sea.

Darrell Delamaide is a member of the OMFIF Board of Contributing Editors

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