QE2: Captain, your ship is sinking

So imagine the corn crop report comes out and it surprises on the upside at up 30%
What happens? The price of corn probably starts to fall. Commercial buyers back off, farmers rush to hedge, and, overall, players of all ilks try to reduce positions, get short, etc.

A few weeks later it’s further confirmed that the farmers are producing a massive bumper crop.

What happens? The same adjustments continue.

But what if that crop report was wrong? What if, in actual fact, there had been a crop failure? And market participants never do get that information?

What happens? Prices go down for a while as described above, but at some point they reverse, as sellers dry up, and as consumption overtakes actual supply price work their way higher, and then accelerate higher, even if no one ever actually figures out there was a crop failure.

QE is, in fact, a ‘crop failure’ for the dollar. The Fed’s shifting of securities out of the economy and replacing them with clearing balances removes interest income. And the lower rates from Fed policy also reduces interest paid to the economy by the US Treasury, which is a net payer of interest.

But the global markets mistakenly believed QE was producing a bumper crop for the dollar. They all believed, and some to the of panic, that the Fed was ‘printing money’ and flooding the world with dollars.

So what happened? The tripped overthemselves to rid them selves of dollars in every possible manner. Buying gold, silver, and the other commodities, buying stocks, selling dollars for most every other currency, selling tsy securities, etc. etc. etc. in what was, in most ways, all the same trade.

This went on for months, continually reinforced by the pervasive rhetoric that QE was ‘money printing’, and that the Fed was playing with fire and risking hyperinflation, with the US on the verge of suddenly/instantly becoming the next Greece and getting its funding cut off.

Not to mention Congress with it’s deficit reduction phobia.

So what’s happening now? While everyone still believes QE is a bumper crop phenomena, QE (and 0 rate policy in general) is none the less an ongoing crop failure, continuously removing $US net financial assets from the economy.

And so now that the speculators and portfolio shifters have run up prices of all they tripped over each other to buy, the anticipated growth in spending power-underlying aggregate demand growth needed to support those prices- isn’t there. And, to throw more water on the fire, the higher prices triggered supply side repsonse that have increased net supply along with a bit of ‘demand destruction’ as well.

Last week I suggested that higher crude prices were the last thing holding down the dollar, and that as crude started to fall I suggested its was all starting to reverse.

It’s now looking like it’s underway in earnest.

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25 Responses to QE2: Captain, your ship is sinking

  1. Ivan says:

    Simple question: other than changing reserve requirements, reserve operations, discount window lending etc, what legal means does the Fed have at its disposal to induce inflation? In reality, isn’t the “too many dollars chasing too few goods” phenomenon almost entirely a fiscal issue?



    in reality it’s almost entirely fiscal.


    Ivan Reply:

    Then Friedman’s “inflation is always and everywhere a monetary phenomenon” is completely off base. The growth of monetary aggregates can be directly tied to fiscal policy? Have there been any instances in our history where monetary aggregates were growing while we were running surpluses?




    not sure he meant ‘monetary policy’ phenomenon as you suggest?

  2. Hi Warren,

    I’ve followed your blog casually for a number of years, it really opened my eyes after a traditional economics education at Wharton (where by the way, I was first introduced to your ideas in a job interview with Cliff Viner – you guys even flew me down to Boca to see the place but I’m an engineer at heart and ended up becoming a tech entrepreneur).

    I forwarded your Reuters videos to a listserv of friends who are mostly finance professionals, and one of them had the following response to your views on QE2 being ineffective:

    “the second video, where he argues that QE2 and lower interest rates aren’t stimulative or inflationary, I find to be wrong. he focuses on changes in “interest income” but the recipients of interest aren’t all american
    and someone, even if it is the gov’t, is paying the interest
    yes, my point is non govt interest income goes down with qe

    and could spend the savings elsewhere.
    true, remembering this discussion is about dollar interest income going down.

    which means qe could reduce dollar interest income of non residents, which makes dollars ‘harder to get’ for them.

    the more impt effect of lowering interest rates is to discourage saving and encourage consumption/investment.

    Yes, that’s the mainstream theory. And that end result may be correct. But it ignores the reduced interest income from qe.

    So yes, interest rates are a bit lower, but so is interest income. So which is more important? Any bank loan officer will tell you a drop in income trumps a decline in rates. And rates for borrowers didn’t fall all that much as bank net interest margins widened.

    that is clearly stimulative. by increasing liquidity in the economy (exchanging cash for treasury bills) it is inflationary. a shift in the LM curve, if you will.

    ISLM is fixed exchange rate analysis not applicable to non convertible/floating fx regimes, where lending is not constrained by ‘loanable funds’ as it is with fixed fx.

    the fed put out a report on how QE works, but basically the idea is to reduce the term premium of medium-dated bonds by affecting their supply/demand balance. this filters into higher asset prices across the board/lower costs of capital…

    Yes, it shifts indifference levels/term structure of rates a bit.

    and this is stimulative and inflationary.

    That’s the theory, but does it hold?

    Again, in the private sector for every dollar borrowed there’s a dollar saved, and the govt is a net payer of interest
    So lowering the term structure of rates lowers interest income via the ‘fiscal channel’ (bernanke, sachs, reinhart 2004)
    So what’s more important- rates a bit lower or less income?

    it’s also good in that it reestablished inflation expectations, which had been trending dangerously close to zero. this means that though nominal interest rates rose, real interest rates didn’t

    Not particularly applicable with a tax driven currency where the state is the monopoly issuer of the currency.

    I’d also note that QE has worked in terms of increasing inflation expectations as baked into the TIPS breakeven spread to treasuries.”

    True, and my point exactly!

    All qe did is frighten players out of the dollar, mistakenly believing there was a bumper crop

    When in fact qe is a crop failure that instead drains dollar net financial assets

    hope that helps!


  3. Panayotis says:


    The interest income channel is overrated if you realize that LT rates are barely declining from the QE2 net of other factors and that the excanged reserves are placed with carry trade in foreign securities fetching interest income!



    It also needs to be adjusted for propensities to consume, etc. etc.

    But Fed ‘profits’ are what they are, and the tsy’s duration is maybe 3 or 4 years, so higher coupons keep running off and are getting replaced by lower ones.

    And bank net interest margins widened and remain there, last I saw, as savers higher coupons roll down as well.


  4. Hello warren, and totally agree with you on this one.
    One question though. By this logic, if ever an european state woudl default (not my scenario, but I am quite lonely to dare think that nowadays…), that would also take euros out of the system, and push it even higher vs the Us $?
    And if an offical wider bailout is confrimed, and the short term greek bonds (and else) quoting 70/80 are paid at par, that would flush the sytem with unanticipated (to say the least) money, and would push the euro lower?
    Best Regards



    Good questions! Depends on what the market is already discounting


  5. sw says:

    This is a powerful framework for currency analysis over the longer term, but if reserve allocators decide to diversify even fractionally more aggressively than earlier – and none of them seem to fundamentally understand QE – then it is dangerous to call a medium-term bottom in the USD just yet. Non-USD, non-managed currencies seem at risk to deviate even further from fair value.





  6. Mario says:

    Warren and all else

    you have to read this article…it is all about the EU and the real issues going on there.

    This article was written by a Finnish political leader and published in the WSJ…but then the WSJ “edited” the piece and re-released it after they “tinkered” with it.

    Here is the real full article and it shows what was edited. Guys…this is serious shit man…the corruption is so rampant it really is getting scary.


    300-500 years ago the USA was a land of hope and refuge and opportunity away from the corruption of the Old World…where can freedom-and-truth lovers go now in this wide world?


    Robert Kelly Reply:

    Randy Wray touched on this with his recent article about Ireland. If Ireland chooses to default, a lot of the fraud and shenanigans will come to light in court, if it goes there.


    art Reply:


    You act like being the smartest person in the room is a bad thing! :)

    BTW, I hear Crete might go up for sale soon. Too bad we don’t have a fat credit line w/ Goldman et al…so we could do more of “God’s work”…



    art Reply:


    On a more serious note, and speaking as someone who edits for a part-time living, I don’t see much of a conspiracy in what was removed. Am I missing something?


    jason m Reply:

    I agree, I think the edits made the piece better, not worse.


  7. Tom says:

    So would it be a good thing then, that they all believe what they believe about QE2…if the dollar rises, that is?



    if you’re long dollars…


  8. John Derpanopoulos says:

    I don’t see how you say “the Fed is replacing one asset with another.” While that is the official propaganda line, it is a fact that the gov. is running a $150-200B monthly deficit which the Fed finances with freshly minted fiat. That they are buying existing bonds rather than the newly issued ones (which even that is true only in theory as they are also buying newly isssued bonds within hours of their auction) does not change the arithmetic: The current deficit spending is being financed by high-powered money. High powered money is increasing while other securities are not concurrently decreasing – which is what your argument rests on.

    What is the danger to that? That at some point foreign dollar holders (and even US ones) might take flight leading to a sharp fall in the dollar’s value and a terminally weak dollar. People might stop accepting dollars for payment. How would it feel if the US gov. had to issue a bond denominated in Euros to purchase oil instead of simply writing a dollar check? And what would that do to its current standing as the global superpower?



    yes, we all know deficit spending adds to net financial assets, and yes, fx rates fluctuate, but no, I don’t think the dollar goes to 0.

    now start reading the ‘mandatory readings’ and ‘the 7 deadly innocent frauds’ on this website


    PJ Pierre Reply:

    @John Derpanopoulos, By your account, the Govt. is net crediting non Govt. bank accounts by $150-200B a month, witch the non Govt. sector exchanges for Treasuries, one Govt. liability for another. QE simply provides the non Govt. sector with incentive to swap back.


  9. rvm says:

    Warren, did you position yourself in an appropriate way to take advantage of the situation?
    I read somewhere about Soros’ strategy based on riding bubbles inflated by market participant’s misunderstanding and leaving before the burst.



    my trading’s been ok but not much capital to trade with so not making a whole lot in absolute terms


  10. peterc says:

    Terrific analogy.


    rvm Reply:

    Agree 100 per cent !

    Hope you doing well, Peter.


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