Ending QE has the potential to become a nightmare


The financial world seems to have some rules it is taking as Truth that are far from it. The first is that surging global stock markets mean the global economy is recovering and we are out of the woods. That may be true but surging stock markets are not the evidence. Market lore has it that stock markets lead the economy. Well, sometimes this is true and sometimes it’s not. Stock investors’ crystal ball is no clearer than economists’. Stock markets can rally on bad assumptions and false assumptions, just like any other market. A really good example is Chinese data showing broad recovery. What happened to worries about the teetering banking system and questions about the accuracy of Chinese data? Europe is, formally, in recession, and unless Mr. Abe succeeds, Japan may be headed there.

The one economy that is recovering is the US, and that’s a modest recovery at best; it’s also at threat of default over the debt ceiling and spending cut gridlock between Congress and the White House. In fact, it’s a tribute to the underlying sanity of economic actors that the economy is recovering (and declining to panic over the government being shut down). Still, corporations are sitting on some $2.5-3.25 trillion on cash. That’s never good.

The second Truth is that central banks are an unending source of cheap money with which to frolic in financial securities of all stripes. Mr. Bernanke is partly at fault by devising first QE1, then QE2 and now QE3, and pushing out the end of accommodation for years on end. One analyst jokes that we have QE8. The WSJ writes today that “The market is primed for words of reassurance from Federal Reserve chairman Bernanke, who speaks later today at the University of Michigan, that U.S. quantitative easing won't end prematurely.”

What is “prematurely?” Nobody knows but use of the word implies the market considers QE the normal state of affairs and ending it a matter of the Fed inflicting unnecessary pain. Chicago Fed Pres Evans said it’s when job creation reaches 200,000 jobs per month for several months. Since workers are being created at a rate of about 150,000 per month, that means only 50,000 jobs.

The real truth is that unemployment is, probably, becoming structural. All those factory workers whose jobs went to Asia will never be re-trained to become IT guys. Demand for labor is further reduced by advances in automation, including robots. The TV show “60 Minutes” showed some of the clever new robots being invented and used in the US and elsewhere, with each robot replacing three workers and costing about $3.40/hour, far under minimum wage (and about what a Chinese worker gets). Robots may allow production to return to the US, but won’t create jobs.

A third Truth is that the Fed’s balance has tripled but we are safe from inflation because bank lending, the vector of multiplication, is still sluggish and the consumer is not getting wages commensurate with productivity gains. But as the WSJ points out, some Feds (and Pimco’s Bill Gross) worry about inflation. Data this week is likely to be okay. “The consumer-price index is seen up by 1.8% in December versus a year earlier, well below the Fed's projected threshold of 2.5%.” But Fed Pres Plosser and new Fed Pres George last week started talking about the Fed risking credibility on inflation and the ending of QE risking financial market destabilization.

Ending QE has the potential to become a nightmare. It will be interesting to see if Mr. Bernanke says anything about it in today’s speech. The Fed hardly ever talks about the dollar, which is supposedly the Treasury’s business, but it’s obvious that a strong dollar is a dandy antidote to inflation. Everyone imagines that new TreasSec Lew, assuming he is confirmed, will repeat the Rubin mantra of “a strong dollar is in the US’ best interests.” The mantra was always silly, because the US never takes any actions to implement it. For broad economic purposes, in practice, it’s a weak dollar that’s in the US’ best interest and everyone knows it. But for fighting inflation, a strong dollar is a good thing. These are classic conflicts that governments have struggled with for centuries. In recent years, US governments tend not to address the currency valuation conflicts directly because that way only lies trouble, but it’s time for the rest of us to start thinking about it.

In the meanwhile, the risk-on/risk-off paradigm will almost certainly hold, and the euro’s latest halo is so far untarnished by inconvenient little things like a massive drop in industrial production. The data this week should affirm that the US economy is making the world safe for risk. The big events are Dec retail sales (tomorrow), CPI (Wednesday) and the Philly Fed (Thursday). We get corporate earnings this week (banks plus MNC’s like GE), and the preliminary University of Michigan consumer sentiment. We also have a ton of Fed speeches (ahead of the next FOMC on Jan 29-30), including Bernanke and Lockhart today, Plosser, Rosengren and Kocherlakota tomorrow. Wednesday its Fisher and Kocherlakota again, and Kocherlakota the next day, too.

With the euro nearing the scary round number 1.3500, we should probably expect consolidative jitters for the first few days of the week.

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