With QE3 the Federal Reserve has initiated another massive round of money printing, buying $40 billion worth of mortgage securities while continuing to reinvest its income from the securities purchased during QE1 and QE2. In addition the Fed has changed the emphasis of its mandate, from targeting price stability to making itself responsible for employment, promising that money printing will continue until the Fed succeeds in bringing down unemployment. Other central banks are pursuing similar strategies. The ECB has unleashed its own round of unlimited money printing while the Bank of Japan recently announced that it is to buy another $126 billion of bonds, bringing the total accumulated so far in its battle against deflation to approximately 20 percent of Japanese GDP. Most tea leaf readers are also predicting another round of money printing from the Bank of England.
Against all this is the backdrop of a slowing world economy. Make no mistake. The Fed is running scared knowing that the cumulative effect of both QE1 and QE2 was barely sufficient to hold deflation at bay. The problem, as we have noted previously, is that the Fed is basing its actions on a mechanistic view of the economy (both Monetarist and Keynesian) which does not take sufficient account of the unintended consequences of human action.
Borrowers are impaired from too much debt which affects their repayment ability, as well as from a cautious deflationary psychology which makes them reluctant to borrow money and invest in assets which may fall in price. However, lenders are also impaired both from the deflationary psychology which makes for stricter regulatory oversight and more cautious lending, as well as from ultra-low interest rates. Lenders will not lend if they cannot obtain a return greater than the overheads they incur in making a loan. This is why Bank of America and other leading banks are cutting overheads and laying off so many employees, not despite low yields, but because of them.
Consequently, despite the inflationary intentions behind the Fed’s actions the unintended consequences are deflationary as financial institutions are forced to tighten up on lending and credit, which, until 2008 have been the driving forces behind the growth of the economy. Market volatility will continue as asset prices veer back and forth between the effects of monetary stimulus and the deflationary forces unleashed by a generational deleveraging event. Ultimately, either the Fed will win or the market will win. Personally, I’m not looking forward to either outcome.
“The Law of unintended consequences holds that almost all human actions have at least one unintended consequence. Unintended consequences are a common phenomenon, due to the complexity of the world and human over-confidence.” – Author Unknown