I’ve often cited comments by Hoisington in the past with regards to monetary policy (one of the few outfits that seems to “get it”) so I think these comments from their most recent commentary are particularly pertinent. In short, monetary policy remains a blunt instrument in a balance sheet recession:
“Operations by the Federal Reserve, including the start of the second round of quantitative easing (QE2), have increased bank reserves by approximately $1 trillion since the latter part of 2008. Virtually all of this gain is held in excess reserves at the Federal Reserve Banks earning very close to 10 basis points. In other words, the Fed has provided substantial new reserves to the banks and they have, in turn, deposited the funds back with the Fed.
Reserves are not money unless banks turn them into loans and deposits. Loans are made based on bank capital, which continues to erode because of loan write-offs due to increasing delinquency and default. The bulk of the problem loans are in the residential and commercial real estate. Additionally, the private sector does not have the balance sheet capacity to increase borrowings because their debt ratios are at or near record levels.
Many consider QE policy to be on a successful path because the psychology of its orchestration has boosted the stock market, thereby creating a wealth effect. However, QE has also set in motion unintended consequences. The same factors that have boosted equities have also lifted commodity prices and mortgage rates, both of which are damaging to economic activity.
Commodity loans can be financed at 1% or less. This encourages speculative buying of commodities for inventory, thereby causing food and fuel price increases. For household’s of average means, funds for discretionary purchases are quickly drained. This is especially evident since the pump price is now at or above $3 a gallon. A 30-year mortgage rate approaching 5% only serves to accelerate the downward pressure on home prices – the main source of household wealth. In short, higher stock and commodity prices are not a net gain in current circumstances.
In the past twelve months M2 has risen 3.1% versus the 110 year average growth of 6.6%. If the velocity of money is unchanged in the next year, nominal GDP will rise by 3%. If inflation stays at the less than 1% pace, then real growth will be a paltry 2% in 2011. In the aftermath of failed financial innovation and private sector deleveraging, velocity of money has historically declined. Thus, real GDP may rise less than 2% next year. Either way, the unemployment rate will continue to rise. Fiscal policy influences GDP through the velocity of money. Thus, the new tax compromise may serve to stabilize velocity, but if it passes it will provide limited stimulus to the economy since most of the package is just an extension of existing tax rates, not a reduction in tax rates from current levels.”