Wednesday, June 20, 2012

Diminishing returns on monetary easing

With everybody closely watching the FOMC on whether they re-institute another round of QE and/or Operation Twist, I think it's instructive to examine the frequency of easing.  QE 1 was launched in March 2009 to stem the collapse on Wall Street.  QE 2 was launched in November 2010 (the Fed announced it in August 2010).  Operation Twist was initiated in October 2011.

edit:  As I type this, Operation Twist has been extended from June 30 to December 31, 2012. Short-term interest rates will also continue to be pinned to 0% until 2014.

Based on the timeline of monetary easing (i.e. money printing), the law of diminishing returns is in full effect--and that includes its effect on propping up asset markets.  The period between QE 1 and QE 2 was 20 months, and the period between QE 2 and Operation Twist 1 was 11 months.  The period between Operation Twist 1 and Operation Twist is 8 months.  It appears markets need more sugar, more frequently to maintain its highs.

Previous announcements of easing caused markets to rally sharply.  With the latest announcement, it appears markets have already priced it in.  Printing money out of thin air seems to be dampening the wealth effect--or at least is becoming less and less effective.

Of course, the counter argument is that the economy is stronger now and doesn't need more sugar--it just needs an extension of current monetary policies.  I believe this view is Polyannish, as the world economy is still teetering on the verge of another financial collapse.

The Fed also downplays the desired outcome of elevating markets, but that easing is more intended to cap interest rates to stimulate the economy.  Given rates are already at historical lows, this justification seems flimsy.  The Fed is pushing on a string.

My views are debatable, but what is intractable is the balance sheet of the US continues to balloon.  This does not bode well for the financial condition of the US, especially if inflation ends its apparent dormancy.  At that point, a rising interest rate environment would be a death knell for the US economy.

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