The Major Political Implications Of QE2

Published January 14, 2011

As the media look for signs the economy is heating up — and whether a recovery will be in place when President Obama runs for re-election — it’s a good time to consider the likely effects of the latest initiative from the Federal Reserve, called quantitative easing (QE2), on top of the administration’s other economic policies. It’s not a pretty picture.

The Fed initiative involves the central bank’s buying $600 billion in government bonds from the Treasury over eight months starting in November 2010.

The intent is to avoid deflation and create just 2% inflation as measured by the consumer price index (CPI).

Chairman Ben Bernanke has promised that if inflation shows signs of exceeding 2%, the Fed will take countervailing action. The personal consumption expenditure index of inflation is now below 1% and could be 0% within a year, according to Marc Sumerlin, former deputy director of the National Economic Council under President George W. Bush.

Time And Money

A point to be appreciated is that the CPI is a historic measure, not a market outcome.

Market measures indicate a greater rate of future inflation. For example, long-term interest rates, which reflect anticipated inflation, are rising. Commodity prices are rising. Gold, silver, copper and oil prices are near record highs and have been rising sharply in the past year.

The yield curve for gold futures on the Comex also indicates future rates of inflation in excess of the Fed’s 2% goal.

The Fed has been encouraging foreign currencies, especially the Chinese yuan, to appreciate while the U.S. dollar declines. This is designed to reduce imports to America and increase exports. This has upset many countries and raises the prospect of a competitive series of currency devaluations.

This is reminiscent of the 1930s, when the Smoot-Hawley tariff in the U.S. spread the Great Depression throughout the world.

Another international activity that has a similar effect is the agreement among the Group of 20 developed countries calling for an increase of bank reserves from 2% to 7% on what are deemed risky assets. This will make lending more difficult in a recession period, when virtually all projects are risky.

The move is similar to the Fed’s doubling of the bank reserve requirement in 1936 that, according to the late Milton Friedman and Anna Schwartz, was largely responsible for the sharp downturn of 1937-38. The higher reserve requirement makes bank credit less available to businesses.

On the Dec. 5 broadcast of “60 Minutes,” Bernanke claimed there has been no increase in currency, the basic component of the money supply.

An examination of the Fed’s data, however, shows the annualized rate of increase for the three months ended in October 2010 was a substantial 9.5%.

Later, four-month data that include a projection for November show an annualized rate of 9.6%.

These data indicate the currency component of the money supply is increasing at an increasing rate.
These rapid rates cannot be ascribed to an increase in demand for money. The growth rate in gross domestic product is just half of the increase in currency and one-quarter of the rate for the larger M1 money supply.

Thus we have inflation measures higher for the future than in the present. This reflects the fact that there is a lag between an injection of money by the Fed and the subsequent appearance of inflation.
In his 1991 book, “Monetary Mischief,” Friedman concludes from his lifelong study of monetary policy that there is a pattern in the lags.

Six to nine months after an injection to the money supply, there is a short-term increase in economic activity. After 24 months, inflation appears and is persistent until money growth is slowed, another recession occurs, and 24 months pass before the inflation is abated.

If these lags are superimposed on the nation’s political calendar, there is a disturbing conclusion.
A short-term increase in economic activity will occur before the 2012 presidential election, and a virulent inflation will occur after the votes are in.

Here Comes Texan Paul

The Republican takeover of the U.S. House of Representatives this month has brought Rep. Ron Paul, R-Texas, to the chair of the subcommittee that oversees the Federal Reserve. Bernanke has warned that if Congress increases its oversight of the central bank, the Fed’s independence from political influence will be impaired.

But the political influence appears to be already present, either by accident or intention. Although Paul’s oversight may not reverse the political influence, it could reduce it. That would be a good outcome, not a dangerous one.

Johnston is an economic adviser to the Heartland Institute.