QE2 is damaging the economy and reducing GDP growth
This post is a guest contribution by Dian Chu, market analyst, trader and author of the EconMatters blog.
QE2 is going to go down as one of the worst monetary policy initiatives in the history of the modern Federal Reserve era. On almost any metric applied, QE2 ends up not only falling well short of its proposed goals, but actually turns certain metrics like GDP growth negative compared with the prior quarter, and heading in the wrong direction.
Costs Eat into Corporate Profits = No Hiring
A weak dollar (Fig. 1) to a point can help exports, but an extremely weak dollar which in combination with QE2 liquidity juicing up commodities even further, turns out to be a net negative on the economy, and risks sending the economy into another recession.
The reason for this is if businesses are having to eat higher input costs, and start to have lower margins, guess what? They start cutting costs again, and that means either stagnant employment practices or workforce cuts in the future. This would start sending the employment figures in the opposite direction, and negate much of the recent progress made over the last year.
Increase Cost of Living = Consumer Pullback
And since the US is largely a consuming nation, if the consumer pulls back, then businesses are going to pull back as well. This linkage of events does not bode well for employment growth, and this shows how rising input costs not only hurt one of the fed`s mandates for price stability, but can also have a negative impact on their other mandate which is to increase employment.
Increase Consumer Debt…& Defaults
This means that the recent gains of consumers paying off their debts, and having more money to spend at retailers over the past year will start to reverse as consumers pay a higher percentage of their monthly budget in finance costs. The real damage starts to add up as consumers start to default on their credit cards as the high food and energy costs continue to be financed on credit cards until the consumer hits the breaking point, and just defaults.
We saw a lot of this in 2008, and this is where we are heading again unless commodity prices start to come down in a rapid fashion. There are a large group of consumers whose monthly budget doesn`t allow for a 30% increase in gasoline prices at the pump, or a 10% rise in food costs at the grocery store. So they just pile up debt until they max out their credit cards.
Dominos to Credit Card Issuers
These increases in credit card defaults hurt businesses like banks and credit card firms as they have to write off more accounts, and thus their margins start to get squeezed. This means additional contractionary effects as they respond by cutting costs, and you can readily see how this starts to become a vicious deflationary cycle.
Deflation by High Commodity Prices
This is why high commodity prices are actually deflationary in the long run. Something the fed should think about the next time they embark on a dollar weakening campaign, whether intended or not QE2 has been a dollar weakening campaign.
And for those of you who still do not understand the chain of events, and how the Federal Reserve is responsible in large part for higher commodity prices here is the chain of events.
Currency Crisis Looming
A lot of countries and investors rely on the dollar as a store of value for their assets because it has the Reserve Currency Status. It can be weak, but if global investors start to have legitimate doubts about the safety of their assets parked and backed by the US Dollar, then we have a much bigger problem than just a slow recovery. We could end up in a currency crisis that takes down the entire global economy, thus sending us right back to where we were in the depths of the financial crisis.
Silver Market Signals Irrational Investing
The time to buy Physical Silver was when the Fed Funds Rate was 5.25%, and the time to sell Physical Silver is now during the last vestiges of an equivalent Zero Fed Funds Rate. This irrational investing in the Silver Market, based upon concerns regarding the long term stability and security of the US Dollar, is one of the unintended consequences of the QE2 Initiative, and from a macro standpoint should raise a few eyebrows within the Federal Reserve.
Micro & Macro Effects
However, the more practical concern for the Fed is this–If they leave QE2 to finish out on course, and attach some dovish language to boot, investors will add another 50 cents to the price of gasoline at the pump, food prices will go up another 3 to 4%. After all, they have to pass on higher transportation costs to consumers. Businesses can expect higher commodity input costs for the next two months. The US Dollar will get even weaker, and GDP will be affected even more, as two additional months of damage will be pushing through the US Economy and Supply Chains. So this could result in the third quarter GDP be even more significantly revised down by economists.
Benefits of Ending QE2 Early
In essence, the ending of QE2 this month, serves to jumpstart GDP Growth for the remaining two months of the 2nd quarter, which will then build some momentum going into the third quarter, and should boost 3rd quarter GDP growth, and set the stage for a robust 4th quarter GDP number.
Significant Two Months
The choice is obvious when asking the question regarding would the economy be better off without QE2 for the next two months? It is a resounding yes! Why this is even an issue at this stage seems more to do with the Federal Reserve saving face, than based upon any sound economic analysis of the facts at hand.
Give Consumers a Break
In summation, if President Obama wants cheaper gas prices for consumers over the next two months, then all he has to do is make a call over to the Federal Reserve. I hear they are having a meeting this week and are deliberating over the future of QE2.
Source: Dian Chu, EconMatters, April 25, 2011.
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