Are the Fed’s QE measures misdirected?

Now that the Federal Reserve has finally made a decision on the scope, size and length of its QE2 actions, the markets should breathe a sigh of relief.

Fortunately, market participants are oft times independent minded. And now that they have paused to scrutinise the possible long term effects from this third round of easing, equity markets are no longer exhibiting sheer jubilation.

The Fed’s aim in using these unconventional measures is to obtain a similar effect as a reduction in short term interest rates, or the Fed Funds rate as it is more popularly known. But with short term rates truncated at near zero percent, Fed chairman Bernanke and his team have had to resort to alternative and unprecedented measures.

The additional $600 billion repurchasing of Treasuries and Mortgage Backed securities is essentially designed to lower longer term rates. Businesses are then expected to borrow at these low rates, increasing the attractiveness of investment projects while discouraging savings. It is also designed to boost asset prices, lower the exchange rate and increase investor confidence. Considering the $1.7 trillion spent since the start of the crisis to accomplish these same goals, why should investors believe this round of easing will be any more effective than the previous ones?

To be fair, since the Fed enacted quantitative easing measures in March 2008, asset prices have seen moderate growth. The exchange rate, already facing a longer term decline, has also had a moderate impact. But when you consider that US Imports contribute 15 per cent to GDP, the changes in exchange rates will need to be significant in order to impact net exports and the broad economy at large. As for asset prices, Capital Economics reports that for every $1 increase in housing wealth, consumption will increase by less than 10 cents. With unemployment at such elevated levels, modest or no income growth and significant loss of household wealth, this consumption estimate may even be a tad bit overstated. With these two factors potentially having so little impact in driving economic activity, a reduction in longer term rates and consumer confidence are the two remaining catalyst to drive meaningful economic growth.

Few would argue that longer term rates which make cheap money available can boost domestic demand. But are the issues facing businesses and investors the lack of cheap money?

Moody’s Inc reported that non-financial US companies have cash piled almost $943B in cash/cash equivalents as of June 2010. In the most recent Senior Loan officer Federal Reserve survey, the number of bank loans has also decreased. With increasing uncertainty surrounding future tax obligations, financial regulation and healthcare costs, businesses appear reluctant to borrow and financial companies reluctant to lend.

The consumer on the other hand does not fare as well. With almost 20 per cent of homeowners now under water in their mortgages, many are unable to afford the 20 per cent home equity requirement to refinance their mortgages.

A proven way to stimulate business and consumer spending in a domestically driven economy is to significantly improve confidence. But is expanding the Fed’s balance sheet by hundreds of billions more the way to achieve this?

If history be our guide, QE1 resulted in little or no change for the markets. While equities and other risk assets saw a nice rebound in prices, this was short-lived only to sputter towards the start of summer.  Bond markets fared the same. The 10 Yr US Treasury tightened following the announcement, only to revert back to 4 per cent close to the end of the easing cycle. And following the announcement of QE2 in mid October, yields on the 10 year bond actually increased from 2.42 per cent to 2.93 per cent, as of this writing.

The underlying issues now facing our policymakers and admittedly, is quite difficult to resolve; is how to address the lack of confidence that has rattled investors globally. Until our officials are able to effectively restore confidence amongst investors, we may witness a slew of measures that will only prove futile in driving our economy back on the path to sustainable growth.

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited.  The Bank accepts no liability for errors or actions taken on the basis of this information.