Don’t worry, be happy.
That’s the message we are receiving from our central bankers and government officials.
Didn’t you know that an iPad II costs less to buy than an iPad I?
But does the Fed and the Administration know that you can’t use an iPad to fill your gas tank or feed your family?
The evidence that the US faces a bumpy economic road ahead as early as this summer becomes more compelling by the day. But our nation’s leaders seem frozen in indecision or wedded to dubious policies; none more dubious than the Fed’s policy of Quantitative Easing II (QE II) implemented by the Fed in November 2010.
The $600 billion initiative was designed to keep interest rates low, provide cheap credit to induce business expansion and prevent a slide into deflation, nascent signs of which appeared on the Fed’s radar in 2010.
But as it turns out, QE II was a solution in search of a problem.
The actual challenge was not the availability of sufficient reserves for market liquidity to promote business expansion – companies had socked away more than $1 trillion since the 2008 meltdown and downsizing that resulted.
No, the problem was government, business and consumer debt.
But in launching QE II, the Fed chose to ignore the underlying cause of business reticence and provide and alternate source of capital, which turned out to be distorting force on a number of levels.
For those who already held US debt – some $8 trillion – QE II fundamentally challenged the preceived asset value of their investment, creating the specter of future maturities would be eaten away by underlying inflation of the dollar.
This in turn, forced a rise in selected interest rates.
For instance, look at mortgage interest rates before and after the launch of QE II.
According to Feddie Mac, the average 30 year fixed mortgage in October 2010, just before QE II was launched, was 4.2%. In February the rate had increased to 4.95%.
In addition, by flooding the market with currency, the Fed not only debased the value of the dollar, which has been declining ever since, and is flirting with historic lows, but as a result has inversely increased the cost of commodities that are pegged to the dollar; food and oil.
Here we have an unvirtuous spiral in operation.
The flood of dollars into the market makes commodities more expensive as the expansion of the currency requires more dollars to purchase a unit of the commodity.
Consider that in light of information from the US Energy Information Administration which shows that the week that QE II was launched, oil was at $81 a barrel. Today, oil contracts are at $112 and climbing.
Certainly part of this increase has to do with the current political uncertainty in the Middle East, as well as oil consumption by emerging powers, India and China.
But those developments alone cannot explain a 28% price rise in five months. Indeed, OPEC has slashed oil production by 800,000 barrels because of current over-production, repudiating the case that the price increase in entirely demand driven.
The Fed’s policy must bear responsibility.
And that has real world impact for American consumers.
With gas prices nationally standing at $3.60 per gallon – $4.51 in Hawaii – US consumers are now devoting 6% of their personal consumption expenditures to gas. In addition, keep in mind that fuel prices have an indirect, value-added impact throughout the supply chain, that causes increased prices.
In addition, food prices have increased 6.5% since January.
Overall, food and energy now eat up roughly 15% of consumer spending at today’s prices.
Of course, the impact is relative to income, with working class Americans bearing the worst of the impact and feeling particularly stressed.
Anecdotal evidence includes a spike in AAA emergency calls for consumers who have run out of gas.
In an ominous sign for the economy overall, according to Customer Growth Partners, of the six US recessions since 1970, all but the “9-11 recession have been linked to if not triggered by energy prices that crossed the 6% of personal consumption mark.
Supporting that concern, large trading houses and economists have assembled their estimates for US growth in the first quarter based on trade and other statistics. Those estimates slashed expected US GDP growth to between 1.5-1.7%. This is considerably off from the 3.1% GDP growth of Q4 2010, which itself increased from 2.6% in 2010 Q3.
The official estimate will be released on April 28th.
Of course, none of this run-up in commodities has taken into account the impact beyond America’s shore. It’s our policy, but because commodities are pegged to the dollar, the price increase has been steep and dramatic in developing countries where the percentage of income dedicated to food and fuel can be ten times that of average Americans.
According to the World Bank food prices alone have increased 36% in developing countries. There are a number of analyses that tie the unrest in Egypt in part to the spiral of food prices, indirectly linking QE II to Middle East revolutions.
Those impacts aside, there is one area where QE II has had a profound, ostensibly positive impact – the stock market.
The Dow Jones was at 11,000 when QE II was announced. It closed at 12,505 before the Easter holiday, gaining ten percent in value in just five months.
This, despite a sovereign debt crisis in Europe, a tsunami and nuclear disaster in Japan, regime change in Tunisia and Egypt, civil war and NATO military intervention in Libya and protests throughout the rest of the Islamic world, including Saudi Arabia.
The normally event-sensitive Dow shrugged it all off and simply kept climbing, in large part that excess capital from QE II has few places to go to earn a decent return.
QE II thus distorted the Dow into a financial market that defies the laws of gravity.
This would be great for Wall Street, but QE II is set to end on June 30th.
What happens to the asset bubble that the Fed has created on Wall Street when the laws of financial physics are restored as QE II goes away?
In sum, QE II has failed to achieve any of its goals, save for an artificial wealth creation effect on Wall Street.
Initial currency inflation from the swell of dollars in the system has spiked the cost of dollar pegged essential commodities, has eroded the value of dollar denominated savings and investment, reduced economic growth and spiked interest rates in core lending tools, such as mortgages.
Designed as a catalyst for economic growth, QE II is little more delaying measure to prop up an otherwise unsustainable economic paradigm.
Yet for all its failings, QE II’s end could compound its shortcomings by virtue of the timing of its termination.
Standard and Poors has just issued a warning that unless the US gets its public finances in order, it will downgrade the benchmark Triple A rating that allows the US to borrow at the best rates.
Such action would not only immediately increase the interest the US would need to pay to borrow, exacerbating the short term impact on the budget deficit, but would have a profound impact on the international financial system where the dollar remains the reserve currency of choice and the safest investment.
This occurs against the backdrop of a statement by the Chinese government over the weekend that it plans on capping its holdings in US Treasuries as part of a larger plan to deal with its $3 trillion in foreign reserves, complicating US strategies to borrow internationally to finance its current account deficit.
In addition, Q1 GDP will be released in days, most likely showing a slowing in the US economy that will impact government revenues and unemployment. That in turn, could create a perceptions problem for financial markets with regard to the monstrous US debt that must be floated to fill our $1.6 trillion budget deficit.
This is compounded by the political gridlock in Washington regarding deficits and debt, and the open question as to whether Congress will vote to increase the debt limit, which must be addressed by July 8th, before the US must begin defaulting on its outstanding debt – creating a calamitous cascade impact around the globe.
There are 41 days between the Q1 GDP report and the Treasury’s self imposed deadline where it must begin defaulting on the debt. In between, QE II will end, likely impacting – negatively – the one sector of the economy that has been responsive to the program, Wall Street.
A significant drop in the Dow will have a substantial psychological impact on the overall view of the economy.
Additionally, with commodity prices vaporizing any gains from the partial payroll tax holiday approved by the lame duck Congress, consumer spending is likely to follow consumer sentiment with regard to economic prospects, creating a domino impact on GDP growth in Q2 where consumer spending represents 70% of the economy.
By focusing on liquidity instead of debt, the Fed simply extended and exacerbated an already untenable situation.
A reckoning is on the horizon.