The topic du jour is the softening economy and QE3. While the consensus still favors no additional quantitative easing, those in the minority are gaining traction. Let’s define quantitative easing and then I’ll tell you how this is going to play out. Quantitative easing is the purchasing of assets by the Federal Reserve.
Here’s what monetary policy can do for you:
This is a 10-year chart of the Change from the Prior Year, in Billions of Dollars, of Money Stock–specifically M1 and M2. In an age of deleveraging, M2 is growing. The average rate of increase in M2–over the course of the last 10 years–fluctuates between $400 and $500 billion; M2 is exactly in that range today. In order to achieve that, M1 is at historical highs. This is the first reason there will be no QE3 (as defined above). While the current Velocity of M1 is negative-trending and at levels not seen since 1998, that dynamic could quickly change course. In other words, inflation is not an issue at the moment (i.e. transitory), but could be a serious problem in the not-too-distant future.
The Fed has done its job; and monetary policy has run its course. However, the economy is still soft and requires additional support–that is, more fiscal stimulus. The budget proposal in which every dollar the debt ceiling is raised, there will be as much or more cut from future spending, seems rather appropriate. It allows for the continued near-term support the economy needs, yet addresses the long-term structural issues. This is the only measure that will be helpful to today’s economy. But depending on the resolution of this issue, the Federal Reserve, in an act of desperation, may attempt to replace the lack of fiscal response. This may include an extended-extended Fed Funds Rate or some other plan that has not yet been laid out. It is very unlikely additional monetary measures will be effective. The economy requires an extremely long time to heal and tough choices need to be made at inopportune times.
What everyone agrees to is this: the sooner the Federal Reserve can raise their Fed Funds Rate, the better off the economy will be. The disagreement, and the risk, lies in how you define the acceptable conditions in order to make that happen.