September 13th: a day to remember
The day starts badly for real people. Jobless claims come in 12,000 higher than expected at 382,000. More people out of work, the jobless rate stuck stubbornly well above 8%. Over 25 million people in the US are now out of work or without a full time job. Then producer prices come in far higher than estimates. A 1.7% rise in August is blamed on higher food and fuel prices, the two things that affect the ordinary man most. Watch for consumer prices to rise over the next few months, though this is, perhaps, what the Fed wants if the later news of the day is anything to go by.
Of course the main weapon in the fight against inflation is interest rates. When inflation rises, put interest rates up to dampen demand and place pressure on prices. The trouble is the Fed can’t do that, because basically the economy is in systemic decline.
Instead, what the Fed does later in the day is announce a sustained and unprecedented never-ending release of money into the market. The much vaunted third round of quantitative easing is here: and boy how it arrived. Bernanke, having warmed us up at Jackson Hole a couple of weeks ago to the possibility of further monetary easing, announced the Fed would be buying $40 billion of mortgage backed securities every month for the foreseeable future.
Related: Which Stocks will Benefit From QE3
Why the new QE3?
In making the announcement, the Fed has admitted the massive quantitative easing program conducted to date has had no real effect on the economy. In fact, it’s so scared of the future that not only did it put in play its short dated bond buying program, but also stated that it would keep interest rates at a zero rate policy until 2015 at the earliest. This is a lengthening of the 2013 date it had set last year, and proof positive that it cares not for inflation. Inflation is rising, we are all feeling that in our pockets, but is seen as the lesser of two evils.
The Fed seems hell bent on pushing inflation up to try to boost the economy and increase jobs. That’s the whole point of QE3. As Bernanke said at Jackson Hole, QE works by “reducing the supplies of various assets available to private investors”. Assets that are in short supply will rise in price. Buying mortgage backed securities, and the longer dated bonds that the Fed also announced will be bought, will push the prices of those securities up. That will push yields and interest rates down. And when there are no more mortgage backed securities to buy, then investors will look at the next asset in the food chain. High yield bonds, and then equities, will rise in price as money flows into them.
Money becomes cheaper, house prices start to rise (as they have already done so). And when house prices rise, so too does consumer confidence. And when consumer confidence rises, so too do retail sales and this flows through to job creation. Easy, isn’t it? The Fed has resorted to attempting to manage the economy by encouraging inflation.
Storing problems for the future
The problem is that it really isn’t that easy. After more than $2 trillion of quantitative easing to date, the only real change in the economy has been an increase in inflation and an increase in joblessness. Stock markets are rising with rising company earnings, prompted in the main by huge cost cutting measures.
The Fed has bought trillions of dollars of bonds, and now will buy, buy, buy until it sees the jobless rate coming down markedly. To do so, it will print money. That money is going to recapitalize the banks, and then get stuck. When the fire of demand for credit is finally lit, this money will flood the market. Real asset prices will rocket. Commodities and real estate are not liquid markets like equities and bonds: there will be a disproportionate effect on prices. Owners of real assets like real estate and gold will be showered with profits. The ordinary man will see the value of his property rocket through the roof. It won’t matter that inflation is rising, because overall wealth is rising faster.
Then the Fed will be forced to pull the plug on easy money. Inflation will again become the focus, and interest rates will rise. Mortgage payments will rise, while the rise in the cost of living shows no sign of abating. Money will get tight, and the economy will begin to shrink again, except it will be with an even greater burden of debt on both the public and private sector.
Walking a tightrope
The Fed has embarked on a tightrope walk to push the economy to a better place. It’s not alone, of course: Europe’s ECB announced a similar course of action a week earlier. And with Japan’s economy turning rapidly south, and its interest rates at rock bottom also, it seems likely that it will do similar sooner rather than later. The perceived wisdom seems to be that if everyone prints money, then the currency depreciation that would usher in potential hyperinflation won’t happen, because all currencies would be deflated.
But when all currencies are deflated, then they must be deflated against something tangible: and that means in the short term real assets are going to do rather well.
If the Fed manages to stay on the tightrope, and see the walk through to the end, then it may be that in a decade or so the economy will be on a properly based firmer footing. Only at that time will the systemic failures of massive debt begin to be tackled.
But first, real asset prices will improve. It may take a while to see real improvement, but when it happens it will be fast and furious. The prices of gold and silver have already seen a sizeable bounce in expectation of the inflationary effects of QE3.
So, be invested in real assets now and be prepared to wait for the big rise. Then be nimble enough to get out before the next big financial crisis hits. For the real problem, of course, is that the Fed and other central banks around the world are running out of options – it’s one thing to walk a tightrope, but quite another to do it blindfolded.
Michael Barton has a career of 25 years covering global financial markets. Having worked for companies large and small, trading and advising on assets from equities to derivative products, Michael now writes about the opportunities and markets that matter to investors. He contributes content to several keenly followed investment blogs and websites.