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Economists, politicians, and taxidermists have been all a-twitter over the past couple weeks with talk about Ben Bernanke's latest gambit to kick-start the U.S. economy, QE2. The general consensus is that Ben Bernanke is out of his mind, blindly driving the U.S. economy off a cliff.
But on the release date of the latest installment of the Harry Potter film series, let's suspend disbelief for a moment, and consider that Dr. Benjamin Bernanke (that's right, he has a Ph.D. in this stuff) isn't an evil monetary magician, bent on completely destroying the American dollar and American life as we know it.
It's a mess
Let's imagine for a second that Dr. Bernanke is actually doing his darndest to get the American economy back on track. An economy, by the way, that relies on consumer spending for a vast majority of its oomph.
Well, consumer spending won't happen when people feel they don't have any money. A 9.6% unemployment rate (and that number is low, if you consider the declining labor-force participation rate) and collapsed housing prices have people concerned about their overleveraged lifestyles. This has pushed the savings rate up to 5.5%, a level we haven't consistently seen since 1998.
So if you've got people (aka consumers) scared about losing their jobs and homes, how can you expect them to go out and spend? You can't. But what is a Federal Reserve chairman to do?
The Fed's mandate is to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." But it only has three tools to manage this: open market operations, adjusting the discount rate (the rate at which it lends to banks), and reserve requirements. These essentially boil down to monkeying with interest rates to increase or decrease the amount of money in the economy.
I may be missing something, but I didn't see anything in that list about mailing money to people so they can go buy stuff (which eventually leads to more jobs, which leads to more buying).
So Bernanke has to work within confines of the financial system to get money to the people. That means boosting liquidity by lowering reserve requirements, so banks have more money to lend, and dropping interest rates, so businesses are better able to borrow. But as my colleague Morgan Housel pointed out a few months back, all the liquidity in the system won't do any good until people are buying, giving businesses a reason to hire and invest in growth.
Outside the box
Enter quantitative easing. Through this mechanism, the Federal Reserve buys assets from banks to infuse more money into the system. These assets have generally been U.S. government debt and mortgage-backed securities, which has artificially increased demand for these assets, resulting in lower interest and mortgage rates (something that should make it easier to borrow for businesses and homeowners).
However, lower interest rates also make fixed-income securities less attractive to investors, so they pour their money into equities and commodities. This flood of liquidity is one of the reasons we saw the S&P 500 rocket up 80% from its low in March 2009 to its recent high in April 2010.
This boost to investor equity portfolios had what is referred to as a wealth effect -- people feel more wealthy (i.e. they have more money) when their nest eggs look like they were laid by an eagle rather than a hummingbird (never mind they once looked ostrich-like).
When people feel more wealthy, they feel more like shopping. Looking at the results from high-end retailers like Saks (NYSE: SKS ) and Nordstrom (NYSE: JWN ) , we can see that something has opened up the wallets of the wealthy. Both companies have reported monthly same-store sales growth since last December, and Nordstrom even achieved third-quarter sales greater than those seen in the same quarter of 2007. For those who have succeeded in erasing their short-term investing memories, that was before everything hit the fan.
Just listen to what Saks CEO Stephen Sadove had to say about the company's third-quarter performance: "With improvement in the financial markets, we have experienced a more stable and predictable operating environment this year, and we feel much better about the overall tone of business and the way our customers are responding to our initiatives."
Notice how he relates rising financial markets with his company's fortunes? Now, look at what the hint of QE2, which first crossed the bearded lips of Dr. Bernanke during a speech in Jackson Hole, Wyo., on Aug. 27, has done for markets. The S&P 500 is up 12.4% in the three months since then, effectively extending the market rally started by the first round of quantitative easing that had stalled out in late spring. And just in time for the holidays, the most wonderful (retail) time of the year.
How long will it take?
As can be expected, there is a lag between when the market expects a liquidity boost (and rises) and when it translates into higher spending. And because most people with investment portfolios are upper-middle class and above, not everyone has been able to share equally in the quantitative easing bonanza. Just looking at Wal-Mart's (NYSE: WMT ) third-quarter results tells us it hasn't worked its way through the system as quickly as officials would like.
The world's largest retailer reported its sixth straight quarter of declining same-store sales in the U.S., and Mike Duke, president and CEO, said, "Financial uncertainty still weighs heavily on everyday Americans, including many of our core customers. The paycheck cycle is still pronounced for these customers."
Until we stop seeing comments like these, no one will declare quantitative easing a success, and I am sympathetic to those voices that want to know how much longer we have to give this strategy before calling it a failure. I would argue, however, that we already know it isn't a failure -- it did what it was intended to do, reflate asset markets.
But that is just step one, a stopgap if you will. Ben Bernanke, as powerful a wizard as he may be, is only one man, and monetary policy is only one branch of our country's economic plan. We need a concerted effort between fiscal and monetary officials. Bernanke's latest round (hopefully the last) was an effort to buy time for Congress and the administration to get its act together on getting our financial house in order (most importantly by clearing up uncertainty around tax changes, so that small-business owners can figure out what is in store for them).
In itself, QE2 is not a solution. It's like Advil. It doesn't actually make the pain go away; it blocks your sensors so you can get the job in front of you done. Now it's time for Congress to get the job in front of it done, and done quickly. Like any magic, quantitative easing can easily turn on its user, and there are limited marginal returns with each round. Pushing it too far will definitely lead to dire consequences.
But I don't think we've crossed that line yet. There's still time to
defeat Voldemort turn the U.S. economy around. But time is running out.