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Friday, September 21, 2012

Why Analysts are Scratching Their Heads Over QE 3

QE 3.  Open ended.  Fed has arrows in its quiver.  Buy mortgage securities and Treasuries until employment picks up.  Sounds like a plan!

When the Fed buys securities like mortgage securities and Treasuries, it takes its checkbook and creates money out of thin air.  When banks get the deposit, they can create money out of thin air by lending because of our fractional reserve  monetary system.  As it continues, the money supply increases by a multiple amount.

It's pretty clear that this should be the cure for what ails a very sick economy. Or maybe not.

This chart is the monetary base - currency + reserves- i.e. what is referred to as "high powered money." The monetary base is the raw material from which money is created.

 Uh... a lack of raw material does not seem to be the problem!

Maybe the banks are loaded with excess reserves, but interest rates are too high.  Yeah!  That's got to be it.  Let's look at the yield on the constant maturity 10-year U.S. Treasury note:

Hmm...the yield on the 10-year Treasury note started the century over 6% and now is below 2%!

Maybe the problem isn't rates.  Maybe the problem isn't a liquidity problem at all but, instead, is an on-going solvency problem.  Maybe banks have forgotten how to lend if they can't readily sell the loans to be securitized by Wall Street.

Maybe we have gone to the opposite extreme of moral hazard, where bank execs are overly cautious in their lending as they see that some high fliers (not Franklin Raines or James A. Johnson by the way, in case you're wondering) in the housing bubble actually had their lives ruined by greed.

One thing to be clear on is that the Fed, in our fiat money system, will never run out of arrows. Bernanke can literally walk down the street and write $50,000 checks to every homeowner if he wanted (I hope FOMC members aren't reading this; I'd hate to be the one to give them the idea).

Anyway, some analysts will continue to scratch their heads as they look at the charts and some will even wonder how the Fed (whomever is in charge at that point) will reverse Bernanke's actions.

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