War Room 27 Sept 2012 QE3 : The League of Extraordinary Central Bankers

War Room Monthly macro discussion Using tools in context Update on HiddenLevers Features Your feedback welcome

QE3: The League of Extraordinary Central Bankers I.How does QE Work? II.Historical – How has past QE fared? III.Threat of Inflation? IV.QE3 Scenarios

HiddenLevers HOW DOES QUANTITATIVE EASING WORK?

Background: Fed Mandate Fed – 3 part mandate 1.Maximum employment 2.Stable prices 3.Moderate long term interest rates Fed – 3 part mandate 1.Maximum employment 2.Stable prices 3.Moderate long term interest rates Interest Rates Mandate: PCE inflation < CPI This gives Fed wiggle room

Background: Fed Mandate Employment Mandate: Above target 6% region Unemployment still ugly 8.1% Interest Rates Mandate: Record low rates No problems here Source: HiddenLevers

Fed + Money Supply Conventional Wisdom: Most people believe that printing money leads to inflation

Fed + Velocity of Money Money Velocity How often a dollar changes hands (annual) Money moving slower = No inflation from printing Money Velocity How often a dollar changes hands (annual) Money moving slower = No inflation from printing GDP Money supply X Velocity of money GDP Money supply X Velocity of money

QE3: Where Does the Money Come From? 1. Fed's balance sheet assets and liabilities:  Assets: US treasuries, mortgage-backed securities, bank loans, TARP investments  Liabilities: Federal Reserve Notes 2. Federal Reserve Note = United States Dollar 3. True Quantitative Easing (not Twist):  Fed buys assets using newly created USD  No borrowing, no increase in US debt

HISTORICAL: HOW HAS PAST QE FARED? HiddenLevers

Historical QE – Post World War II USA Fed + US Treasury collaboration Fed directly purchased treasuries 1.Monetized Debt 2.Directly injected into economy QE did help spark extraordinary growth QE did inject money directly into Treasury QE did NOT contain inflation QE did help spark extraordinary growth QE did inject money directly into Treasury QE did NOT contain inflation GDP up Inflation punishing

Historical QE – Japan Lost Decade(s) present Close to 0% interest rates since 1999 BOJ tried to promote lending by giving banks excess liquidity 1.Government bond purchases 2.Asset-backed securities + equities purchases 3.Commercial paper purchases QE did prop up Japanese banking system QE did NOT improve economy QE did NOT end deflationary expectations QE did prop up Japanese banking system QE did NOT improve economy QE did NOT end deflationary expectations QE begins WTC attacks Source: HiddenLevers Source: Economist

Historical QE – QE1 + QE Post US financial crisis Fed purchased the kitchen sink 1.Shot and Long Term Treasuries 2.AIG 3.Fannie + Freddie bailout 4.Bank bailouts - TARP QE did prop up US banking system QE did drive up markets QE did NOT end resolve unemployment QE did prop up US banking system QE did drive up markets QE did NOT end resolve unemployment Both up

QE3: THREAT OF INFLATION? HiddenLevers

Source: HiddenLevers Inflation Threat – CPI + PPI Not even close

Inflation Threat – Oil + Gold since QE End of QE2 QE begins

Inflation Threat – Agriculture + Food Agricultural commodities have had extraordinary rise : Inflation rising Jul 2012 – present:Droughts in USA breadbasket Fundamentals story

QE3: SCENARIOS HiddenLevers

QE3: Fed + Critics Views Banks + Financial Institutions Federal Reserve Real Economy Commodities $40B/month Bernanke’s View 1. Fed buys MBS from banks 2. Banks lend to real economy and buy assets 3. Wealth effect + lending combine to help economy Critics’ View 1. Fed buys MBS from banks 2. Banks park money at Fed or buy assets 3. Money ends up in commodities, driving inflation, not growth

QE3: So What Do We Got? What it is 1.It is $40 billion per month in mortgage-related securities purchases 2.It is an attempt to inflate asset prices, and induce wealth effect 3.It is one of the few tools Fed has left at 0% interest rates What it is NOT 1.It does NOT add to federal debt 2.It is NOT a direct way to kick start hiring 3.It is NOT a guaranteed way to ignite growth – Fed can give banks and institutions money, but can’t make them lend it or spend it. What it is NOT 1.It does NOT add to federal debt 2.It is NOT a direct way to kick start hiring 3.It is NOT a guaranteed way to ignite growth – Fed can give banks and institutions money, but can’t make them lend it or spend it.

QE3: Inflation or Liquidity Trap? Guidance 1.Follow QE1 formula of rapidly rising equity market 2.Wealth effect causes small pop (GDP + employment) 3.Commodities price increases offset most real economic gains 4.Inflation rises as underlying commodity inflation metastasizes Guidance 1.On our way to becoming Japan – zombie banks that cannot + will not lend 2.Velocity of money continues to trend lower 3.QE money sits in banks + corporate balance sheets 4.Stagflation possible if QE funds flow into commodities BOTH SCENARIOS: QE3 cannot boost job growth directly

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