The View From 1776

The following quote is from Memo to Fed: Take a Vacation
Instituting another round of quantitative easing at this point will only be pushing on a string and could have many unintended consequences.

In its statement released Sept. 21, the Federal Open Market Committee revealed its concern that deflation is now a greater concern than inflation. Further, the statement said the FOMC would “provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.”

This additional accommodation would probably come in the form of another round of quantitative easing. The Fed would most likely buy a substantial amount of long-dated debt, which would further push interest rates down in the short term and add liquidity to the financial system.

The markets have interpreted this language as the Fed having provided a put option. The equity market has gone one further along this path and believes that if the economy recovers on its own, then stocks will go up. Conversely, if the economy slows, investors believe the Fed will institute another round of quantitative easing and the additional liquidity will then push stocks up. This action creates a moral hazard that we believe sets a bad precedent.

The Fed should stop punishing savers who are already earning meager returns on their investments. By instituting policies to keep long-term rates at these low levels, the government is already indirectly subsidizing the banks and keeping housing prices at levels that are higher than they would otherwise be if interest rates were higher. Furthermore, when inflation does return, fixed-income investors in longer-dated securities will be harmed as the duration of their low-coupon debt is longer, resulting in a greater decline in the value of their investments. By keeping rates at such low levels, the Fed effectively deters savings and pushes investors toward riskier assets in the search for additional yield. Savers are further impaired by the decline in the dollar. Since the FOMC statement was released, the dollar has fallen 3.5%, according to the DXY dollar index, with a 4.5% decline versus the euro and a 2.2% decline versus the yen (which is especially troubling as the Japanese government is in its own process of trying to drive down the yen).