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Richard Koo Explains Why An Unwind Of QE2, With Nothing To Replace It, Could Lead To The Biggest Depression Yet

Richard Koo Explains Why An Unwind Of QE2, With Nothing To Replace It, Could Lead To The Biggest Depression Yet

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Published by mrwonkish
QE2 was Bernanke’s big gamble

When the situation is viewed in this light, we come to the realization that Mr. Bernanke’s QE2 was in fact a major gamble. It was a gamble in the sense that the Fed tried to raise share prices with QE2. If the wealth effect resulting from those higher prices led to improvements in the economy, the higher asset prices would ultimately be supported by higher real demand, thereby demonstrating that prices were not in a bubble.

However, I cannot help but feel that the portfolio rebalancing argument was putting the cart before the horse, in the sense that it is ordinarily a stronger real economy that leads to higher asset prices, and not the other way around.

It might be possible to sustain the portfolio rebalancing effect for some time if conditions were such that investors were totally oblivious to DCF values. But with market participants paying close attention to DCF values, any delay in the economic recovery will naturally bring about a correction in market prices, thereby causing the portfolio rebalancing effect to disappear.
QE2 was Bernanke’s big gamble

When the situation is viewed in this light, we come to the realization that Mr. Bernanke’s QE2 was in fact a major gamble. It was a gamble in the sense that the Fed tried to raise share prices with QE2. If the wealth effect resulting from those higher prices led to improvements in the economy, the higher asset prices would ultimately be supported by higher real demand, thereby demonstrating that prices were not in a bubble.

However, I cannot help but feel that the portfolio rebalancing argument was putting the cart before the horse, in the sense that it is ordinarily a stronger real economy that leads to higher asset prices, and not the other way around.

It might be possible to sustain the portfolio rebalancing effect for some time if conditions were such that investors were totally oblivious to DCF values. But with market participants paying close attention to DCF values, any delay in the economic recovery will naturally bring about a correction in market prices, thereby causing the portfolio rebalancing effect to disappear.

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Published by: mrwonkish on May 19, 2011
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Richard Koo
 
EQUITY RESEARCH
May 17, 2011
QE2 has transformed commodity markets into liquidity-drivenmarkets
As I spoke with investors in London and Geneva last week, markets were rocked by aresurgence of fiscal problems in Greece and a steep drop in the price of silver andother commodities.In London there was talk in the market that the drop in commodity prices had left ahandful of investors facing serious losses. If true, it suggests that the preceding rise incommodity prices was driven by speculation and not by real demand.Another frequent topic of discussion was QE2, indicating that many investorsestablished large positions based on the availability of substantial amounts of liquidityunder this program.All these factors suggest that a number of markets have been transformed intoliquidity-driven markets, and that asset prices in those markets may have risen to levelsthat cannot be justified by the real economy.
Two problems with QE2
In the debate surrounding these issues, I was struck by (1) the misconceptions of QE2held by some market participants and (2) the fundamental problems inherent in QE2. Inthis report I would like to touch on both of these questions.Turning first to the market’s misconceptions regarding QE2, many investors believethat the large-scale quantitative easing programs implemented by the Federal Reserveand the Bank of England have left the markets awash in money, and that this money isproviding substantial support for the real economy and markets.The Fed’s balance sheet is now three times its pre-crisis size, and the Bank of Englandhas taken similar measures. This balance sheet expansion has been the focus of muchattention in the markets.When a central bank triples the size of its balance sheet, the amount of liquidity beingsupplied to the market is also tripled. Under ordinary conditions, that would result in atripling of the money supply, the key indicator of the money available for use by theprivate sector.A tripling of the money available for consumption and investment by the private sector puts strong upward pressure on GDP and prices, including asset prices. That is whyinvestors had such high expectations of quantitative easing.
How money supply grows under ordinary conditions
In reality, however, the money supply has betrayed market expectations inasmuch as ithas increased only modestly in response to quantitative easing, if at all. To understandthe significance of this, we need to understand the relationship between the moneysupply and central bank-supplied liquidity.
Richard Koo is chief economist at Nomura Research Institute. This is his personal view.
Richard Koo
r-koo@nri.co.jp
 
See Appendix A-1 for importantdisclosures. Analysts employedby non US affiliates are notregistered or qualified asresearch analysts with FINRA inhe US.
 
Nomura | JPNRichard Koo May 17, 2011 
When a central bank provides liquidity to the market, it buys government debt or other securities in exchange for cash. Theprevious owners of those securities, typically financial institutions, take that money and attempt to turn a profit by loaning it out.If borrowers use the money to buy goods and services, the providers of those goods and services will take the money
they 
 receive and deposit it at their banks, leading to an increase in private-sector deposits.Banks receiving those new deposits will increase their lending accordingly. If the new borrowers also use the borrowed moneyto buy goods and services, the providers will again take the proceeds and deposit them in a bank account, driving further growthin private-sector deposits.Both private-sector deposits and lending continue to increase as this process is repeated. However, banks cannot lend out theentire amount of new deposits because a portion must be set aside as statutory reserves. This creates a leakage in the cycle of increasing deposits and lending equal to the increase in statutory reserves.Consequently, the process of deposit growth will continue until the entire amount of liquidity supplied by the central bank is setaside as reserves. If the statutory reserve ratio is 10%, the deposit growth process will end once the liquidity injected by thecentral bank has been transformed into deposits worth 10 times the initial amount.The money supply data, composed mostly of bank deposits*, are closely watched by market participants because of their closerelationship to GDP and price levels. The numerical relationship between the money supply and the initial liquidity injected bythe central bank is called the money multiplier. In the previous example, the multiplier would be 10.
*Strictly speaking, the money supply includes bank deposits, currency, and coins.
Money supply has shown little change despite sharp increase in liquidity
What actually happened, however, is quite different. Market liquidity in the US and the UK almost tripled. But the money supply,which represents funds actually available for use by the private sector, has increased little if at all since the financial crisis in2008.Figure 1 shows the US monetary base (ie liquidity) along with the money supply and commercial bank loans and leasesoutstanding (ie private-sector credit), rebased so that August 2008 = 100. The graph confirms that these three indicators movedin unison, as the textbooks predict, until the Lehman-inspired financial crisis. Since then, however, liquidity has surged to nearly300, yet the money supply stands at 115.As explained above, growth in the money supply should entail a corresponding increase in bank lending under ordinaryconditions. Yet lending had fallen to 90 by April 2011.In other words, the money supply—which supports consumption and investment—has exhibited little growth during this period.We cannot expect an expansion of the economy or an acceleration of inflation without an increase in the money supply. There isno reason why inflation—apart from imported inflation—should increase at a time when the money supply is not growing.The inflation currently being reported around the world is of the imported variety, typically involving oil and food. “Home-grown”inflation, like the core deflator for personal consumption expenditures shown in the bottom portion of Exhibit 1, remainssubdued.
 
Nomura | JPNRichard Koo May 17, 2011 
Fig. 1: Relationship between monetary indicators breaks down during balance sheet recession (1): US
Note: Commercial bank loans and leases, adjustments for discontinuities made by Nomura Research Institute.Sources: Board of Governors of the Federal Reserve System, US Department of Commerce
Quantitative easing has had no effect in UK, either 
An almost identical set of conditions can be observed in the UK. As Exhibit 2 shows, the UK money supply increased from 100in August 2008 to just 103 in March 2011 despite a near tripling of the liquidity supplied by the Bank of England. Bank lendingfell sharply over the same period, from 100 to 86.When the Bank of England announced a bold program of quantitative easing in the spring of 2009, bank officials proclaimed thatthey would revive the British economy by drastically expanding the money supply and avoiding the policy missteps of Japan.Yet two years later, the BOE’s policies have had no such impact.The pound has also fallen to historic lows on a real effective exchange rate basis, which is leading to higher prices via importedinflation. Home-grown inflation, meanwhile, remains muted, as in the US.
80100120140160180200220240260280300(08/8 = 100, seasonally adjusted)Monetary baseMoney supply (M2)Loans and leases in bank credit
Down22%
0.51.01.52.02.53.008/108/408/708/1009/109/409/709/1010/110/410/710/1011/111/4% y-y)(yy/m)Consumer spending deflator (core)

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