The actions by the US Federal Reserve have indicated an "all in" approach to monetary policy in the drive to arrest a plunge in prices emanating from a collapsed economy. Both the WSJ (op-ed) and Pimco's McCauley (on CNBC) have used this term.
The extraordinary actions to cut rates and to indicate that they would use all means necessary including buying US Treasuries had an immediate salutary effect on equities. It also had an immediate adverse effect on the US dollar.
These competing visions of the future tell us everything we need to know about the risks the US Federal Reserve is embarking upon by embracing quantitative easing. The equity markets are betting that the massive injections of money into the system will reflate the economy and flow through to businesses that need them. LOIS spreads (Libor-OIS) narrowed and indicate that the credit markets believe the actions will aid in reducing risk for banks to lend.
The rate reductions and statement about buying US Treasuries have driven down interest rates including the Fannie Mae benchmark yield to 2.757%. This will translate into much cheaper mortgages and refi rates for consumers. It should encourage home buying and bolster consumer confidence.
The flip-side is that the greenback had its worst day in a long time against most major currencies. This follows the direction that was set after the US NFP day when the US equities had a major reversal going from down over 200 points to rallying over 300 points with the US dollar losing value in the process. The Fed had indicated that it was analyzing the QE approach several weeks ago and was one of the reasons we had advised clients to hedge US dollar exposure for Q1 2009. The move yesterday in the currency markets was the rush to cover risk of a potential massive infusion of money into the US financial system.
However, there may also be a rush out of the US dollar due to a disbelief that the US central bank can manage the risks of their QE program. After all the last time the Fed embarked on a serious monetary stimulus program, it created a massive bubble in the US housing market. Let's face it, the Fed doesn't deserve much credibility when it comes to turning off the monetary spigot.
The other group that has a worse record for spending control is Congress. Can anyone believe that a government that spends its time creating new programs and new constituencies from those programs to pull back when the economy stabilizes? Won't there always been an additional risk that mandates a continuation of a program to ensure no "backsliding" into the abyss? Is there a politician alive that will give up their ability to send $$ back to their home state?
This is the potential scenario for the future in the United States. We return to an economy that is structured similar to the one in the 1970s: 1/3 private, 1/3 government, and 1/3 regulated/mandated by the government. Yes, the short term pop to the economy is needed. The long term consequences are not needed or desired as the economy will lose its top end GDP potential from these splits. Or worse, there could be a massive run on the dollar in 2009 as markets gets skittish over the ability of the US to fund their fiscal deficit.
Until we see what rules or economic conditions the Federal Reserve, the US Treasury, and the Congress use to determine when to end the fiscal and monetary programs, we should all be very skeptical of these "all in" approaches as the consequences may be to get cashed out. Short term gain equals long term pain.