Hooked on an Easing

Philly Fed Chief Charles Plosser is worried about the “unintended consequences” of QE3:

Plosser told CNBC that the U.S. was still suffering from “lasting effects” of the recession and “may never return” to its previous growth rates—and warned that policy should not bet on growth returning to previous rates, saying it could be “many, many years.”

With gross domestic product expanding at a 2.4 percent annual rate, according to the Commerce Department last Friday, Plosser said that the country was “pretty close” to its steady state growth and may never get back to where it once thought it could be. “To keep trying to think that we’re going to do that, means that we keep trying to overplay our hand in terms of policy,” he added.
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“I am very worried about the potential for unintended consequences of all this action. And it’s very difficult for us to know because we’ve never done this before,” Plosser said, adding that the curbing of this extra liquidity in the global economy would be “very challenging”.

“Sometimes if you don’t have Plan B, you don’t have a plan,” he warned.

I’ve made these two points before but they bear repeating.

The first is that our “new normal” of low growth and high underemployment is being purchased at the cost of anywhere from $600,000,000,000 to $1,000,000,000,000 a year in deficit spending and a further $900,000,000,000 to $1,020,000,000,000 a year in quantitative easing. We long ago reached the point of diminishing returns on easy money.

The second is what happens when the Fed needs to unwind its $4,100,000,000,000 (and growing) balance sheet.

To remove the excess liquidity it pumped into the economy, the Fed will have to sell its Treasuries at a discount, since they were “twisted” into lower-interest bonds, and will be competing on the bond market with higher-interest new debt being issued by the Treasury to cover our continued deficit spending. Further discounting might be required if there simply isn’t enough of a bond market to buy all that old debt on top of all the new debt and on top of all the debt refinancing Washington has to do since the Treasury deals mostly short-term notes.

(Whew — that was a sentence, eh? But if you think the description was something, wait until we see this stuff in action.)

So by this time next year the Fed might need to start pulling, say, $5,000,000,000,000 back out of the economy. But due to heavy discounting, bond buyers only put $4,000,000,000,000 back into the Fed’s coffers. That’s an awful lot of funny money floating around, competing with your not-so-funny money. But how does Washington spell relief? I-N-F-L-A-T-I-O-N.

And keep in mind, the better the economy is doing when the Fed begins its Hoover Damn Project, the higher interest rates will be — and the heavier the Fed will have to discount. That of course means even more leftover funny money and higher inflation.

But the joke’s on them, since the Washington behemoth now sits so heavily on our economy that robust growth, as Plosser was just saying, is unlikely to return.

So it’s quantitative easing today, quantitative easing tomorrow, quantitative easing forever!