In order to stimulate economic growth in the US, the Federal Open Market Committee (FOMC) or ‘Fed’ reduced borrowing costs to record lows near zero, and proceeded to introduce a number of additional rounds of stimulus known widely as Quantitative Easing and Operation Twist. Both programs consist of the purchase of long-term maturity treasury securities with the intention of forcing interest rates as low as possible for as long as possible to create the incentive to purchase ‘big ticket’ items such as real estate and automobiles. Essentially the difference in the two aforementioned programs is the source of the capital that is used to purchase these treasury bonds. In the two rounds of Quantitative Easing (QE) new capital was printed, while Operation Twist (OT) funded the purchase of long-term treasury bonds through the sale of shorter-term (maturity) bonds. The various forms of stimulus including QE I & II as well as OT were implemented as follows:
One may argue that the first round of stimulus known as QE I was certainly justified and did help the US economy recover off of extremely significant lows achieved in late 2008’ & early 2009’. Notice during QE I how the Gross Domestic Product (GDP) and Consumer Price Index (CPI) did enjoy a significant move to the upside where specifically the GDP line exceeded the CPI illustrating how businesses improved at a faster rate than the prices paid for goods and services. On the chart below the white line represents the difference between the GDP calculated on a Quarter-over-Quarter basis and the CPI measured on a Year- over-Year basis. The GDP-CPI (white) line rises when the GDP rises at a faster rate than the CPI, essentially highlighting those periods of times when economic growth exceeds inflation. Simply put, the consumer has more buying power when that individual earns more money, which is able to purchase goods and services at a smaller cost. Furthermore notice during QE II how the GDP-CPI line actually fell into negative territory when GDP declined at a faster rate than the CPI. This chart helps illustrate how the rising prices (CPI) during QE II may have deceived many into believing the economy was in a stronger state (measured by GDP) than it actually was.
Perhaps one reason why the CPI data rose during QE II while the GDP fell is due to the very nature of the funding of the purchase of the long-term treasuries during QE II. Specifically the Fed purchased $600 billion of Treasury securities as new capital was printed, which increased the money supply by a very significant extent, which in turn led to surges in commodity prices as there was simply a greater amount of money in the economy competing for the same finite amount of commodities. For example, the chart below illustrates the surge in the price of Crude Oil that occurred specifically during QE II.
With the behavior of Crude Oil during QE II in mind, we may once again consider the GDP-CPI ‘spread’ shown in the chart below. While GDP declined gradually during QE II, the CPI (greatly influenced by the price of fuel) surged to the upside. This period of time was considered quite difficult for the average consumer as our personal incomes suffered during QE II while our purchasing power also declined as the CPI achieved nearly pre-recession highs. Again, during ‘more normal’ economic conditions we may logically expect the GDP and CPI to rise together, and the GDP will at least maintain pace and hopefully outperform inflation (CPI) so the average consumer will maintain their purchasing power as the economy continues to progress. However we can see that during QE II this was not the case as the negative effects (CPI outperforming GDP) may have actually outweighed the benefits as the GDP actually failed to make upward progress at all during this period of time.
Finally looking forward we can see that the current GDP-CPI spread actually remains just below zero, as the latest GDP (Quarterly) estimates in July, 2012’ were reported at 1.5%, while the CPI (YoY) was released at 1.7%. This perhaps tells us that at least at the moment, the current round of Operation Twist is not accomplishing what many hope it will.
Putting this all-together, fundamental analysis may logically forecast higher interest rates as prices and inflation rise, but only when that inflation is the result of improving economic conditions, and not simply as a result of the increase in money supply. Ultimately the anticipation of higher interest rates justified by a true economic recovery can occur alongside a strengthening local currency, and when we pair that strong currency against another relatively weaker one, we isolate the next potential long-term directional trend in the Forex market. One benefit in trading the Forex market is that the economic calendar provides us with another piece to puzzle nearly every trading day, that in turn can help us better understand the economic conditions that currently exist and what is most likely to occur in the near-term future. We wish you the best of luck in all your trading endeavors.