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Craig Allen: Will QE3 Make a Difference for Our Economy?

With threat of double-dip recession looming, Fed easing might provide at least short-term relief

Markets reacted favorably last week to speculation that central banks across the globe would provide more liquidity to spur economic expansion. Here at home, a third round of quantitative easing may be on the near-term horizon, but will it be enough to reverse the building economic weakness?

To date, we have had two rounds of quantitative easing, or QE, in which the Federal Reserve essentially pumps cash into the economy by expanding its balance sheet, buying long-term securities from banks. This action increases the reserves of banks and also lowers long-term interest rates. The hope is that banks flush with more cash will make more loans, thus expanding the economy. Lower interest rates on the longer end of the curve also help make these loans cheaper, which helps to expand the economy, since more individuals and companies can afford to borrow.

The potential problems with QE are significant. First, printing money to buy securities can be inflationary because it can reduce the value of the currency — the U.S. dollar in our case. As the value of the currency falls, the number of dollars needed to buy goods increases. As prices increase, it costs consumers increasingly more to buy the same goods and services. Inflation can be devastating to an economy, and can eventually result in hyperinflation when the currency implodes and then collapses. Many countries have experienced this, including Germany and even the United States during the Civil War.

Second, there is no direct cause and effect for the Fed. In other words, the Fed can conduct QE operations but there is no way for it to directly make banks lend. While the Fed hopes that providing more cash to banks will result in more loans, there is no guarantee that banks will, in fact, make more loans. This has, unfortunately, been the outcome from the first two rounds of QE; interest rates have been at historic lows for many months, and, after two rounds of QE, loans are still very difficult for both consumers and businesses to obtain.

Third, the law of diminishing returns is certainly a concern. Each successive round of QE is certain to result in a reduced impact on the economy. There is plenty of cash on bank balance sheets already and interest rates across the yield curve are at historic lows. Short-term rates are essentially at zero percent and the 10-Year Treasury Note is yielding 1.57 percent. The potential for any measurable impact on lending resulting from driving rates even lower is limited at best and very likely to be nonexistent from these levels.

Finally, what happens if the Fed conducts a third round of QE and it doesn’t work? The Fed has already exhausted its traditional monetary policy tools — short rates are already at zero percent. It has already conducted extensive QE and this will be its third round, pumping literally trillions of dollars into the economy.

Current data on the U.S. economy indicates that economic growth, which was already tepid, is slowing. Some economists are calling for a second recession in the first half of 2013 — a double-dip recession. The last double-dip we had was in the early 1980s and the results were very hard on U.S. consumers.

Some economists believe we actually need to have a more severe recession before we can have a true recovery. The double-dip recession of 1980 and 1981-1982 was devastating. The economy fell into recession from January 1980 to July 1980, shrinking at an 8 percent annual rate from April to June 1980. Basically, during the late 1970s, inflation became a major concern (warranted or not) and when Paul Volcker took over as Fed chairman under President Jimmy Carter, he pushed rates sky high to combat inflation. Between the summer of 1979 and December 980, the prime rate rose to 21.5 percent from 12 percent. This spike in rates caused an immediate and severe contraction of the U.S. economy.

The economy then entered a quick period of growth, and in the first three months of 1981 grew at an 8.4 percent annual rate. In the second dip, which officially began in the summer of 1981 and ended late in 1982, unemployment rose past 10 percent. As the Federal Reserve under Volcker continued to raise interest rates to fight inflation, the economy dipped back into recession (hence, the “double dip”) from July 1981 to November 1982. The economy then entered a period of mostly robust growth for the rest of the decade. The Fed didn’t move the discount rate below 5 percent until the 1990s.

The recessions of the early 1980s resulted in major changes to consumer behavior and preferences. In some ways, those changes were appropriate and good for the economy in the long term, while other changes resulted in permanent losses to some industries and to employment.

Just as inflation was the key driver of the early 1980s recessions, the massive amount of QE already undertaken by the Fed and the possibility of even more QE to come, could result is significant inflation that eventually could force the Fed to raise interest rates dramatically. There is no doubt that rates, especially on the long end of the yield curve will immediately rise once it is clear that the Fed will stop injecting cash into the economy. (If the Fed conducts QE 3, this will undoubtedly be the last round in this economic cycle.) From that point, rates should continue to rise on the long end, especially once the Fed begins to raise short-term rates, which it will be forced to do at some point in the near future to avoid letting inflation get out of control.

Most economists agree (and the Fed has already indicated) that the Fed will begin raising short-term rates by 2014, if not sooner. I believe it will start raising rates in the second half of 2013 (or sooner). I believe the Fed is much more concerned about inflation than anything else, including maintaining employment and economic growth. The Fed will attempt to maintain a balance between combating inflation and supporting economic and employment growth. This is a tall order. If it begins raising rates sooner rather than later, I believe the Fed will have a slightly better chance of achieving both inflation control and growth. It will not be easy, however. A slower pace of rising rates will be easier for the economy to absorb, but rising rates will still have a negative impact on real estate prices and consumer and business borrowing.

We should know whether the Fed will implement QE 3 very shortly. While I do not believe it will be a long-term positive for the economy, it should help both the economy and the financial markets in the short and intermediate term. Consumers, business owners and investors should anticipate the implications of QE 3, especially with regard to borrowing and the impact a rising interest rate environment will have on fixed-income securities and incorporate these facts into their long-term strategies.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.

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