Perpetual QE - The Stock is the Flow

Jim Rickards continues to illustrate that he is one of the truly brilliant and original thinkers in today’s financial world. Jim’s latest piece exclusively for the King World News blog is a must read. Here Jim discusses the Fed and the ongoing debate surrounding QE, “As we approach the end of the Fed’s quantitative easing program many are prepared to shout, “QE is dead!” Few realize the old royal salute is more appropriate – “QE is dead, long live QE!” Because an heir to the throne is here and will be with us for a long time. QE has now become a permanent part of the financial landscape of the United States.”
March 11, 2011

Perpetual QE - The Stock is the Flow
By James G. Rickards

March 11 (King World News) - As a child, I was confused by shouts of “The King is dead, long live the King!” I understood the declaration about the deceased king but didn’t understand why you would then wish long life to a dead King. Only later did I come to understand the distinction between the King who had just passed and the heir who had just ascended to the throne. Then it all made sense.

As we approach the end of the Fed’s quantitative easing program many are prepared to shout, “QE is dead!” Few realize the old royal salute is more appropriate – “QE is dead, long live QE!” Because an heir to the throne is here and will be with us for a long time. QE has now become a permanent part of the financial landscape of the United States.

The reason is that the size of the Fed’s balance sheet is now so vast that the reinvestment of principal payments from the existing assets will be enough to monetize a large portion of the Federal deficit without having to increase the total size of the balance sheet. The Fed’s balance sheet is to the bond market as Thomas Hobbes’ Leviathan was to society – a monarch beyond the capacity of its subjects to change. Apart from the obfuscation of words like “stocks and flows” coming from Brian Sack at the New York Fed and Ben Bernanke, there’s nothing hidden going on, it’s just a matter of math. The key fact is that while the Fed will not expand the balance sheet, they will not let it shrink either. Keeping the balance sheet unchanged means reinvesting the entire maturing principal on the existing assets. And when the assets are big enough, that reinvestment becomes enormous. This is what is behind the talk of “stocks and flows.” When the stock is large enough, it is the flow.

The Fed said last November that QE2 would last until June 30, 2011 but reserved the right to “adjust the program as needed” in light of “incoming information.” So they have laid a foundation to continue QE2 if they wish. The negative impact of rising oil prices on the economy might give the FOMC a reason to continue QE2. However, there is not much time to decide. There are only three FOMC meetings before the end of June. These are March 15th, April 26th and June 21st. The Fed might make a formal announcement on June 21st, however, they will want to make a firm decision and leak it sooner in order to guide the market in advance and avoid surprise. Recall that when QE2 was decided the Fed made a formal announcement in November but began leaking their intentions in August, three months earlier. So it seems likely the Fed will reach a tentative decision on March 15th, begin leaking the announcement immediately and confirm this with a formal announcement in June.

The criticism of QE2 has been intense from Republican circles, Tea Party adherents and international trading partners such as China, South Korea, Brazil and others who are suffering the effects of inflation caused by QE generally. The Fed may have pushed this program to the limit. For political reasons, more so than economic, the Fed will end QE2 in June and will make its intentions known. But is this the end of QE? The answer is no.

Recall that QE2 was not really $600 billion but was $900 billion if you add the $300 billion of reinvested principal payments on the original $1.5 trillion of mortgage-backed securities from QE. Since this $300 billion of principal paid out in a seven-month period from November 2010 to June 2011, it’s reasonable to assign a principal payment run rate of $500 billion per year for the next two years on that portion of the Fed’s portfolio. Treasury securities are different because they don’t amortize the same way mortgages do, but the Fed still has about $1.3 trillion of Treasury notes and bonds on its balance sheet today and will likely have $300 billion more by the end of June as a result of new purchases under QE2. So, $1.6 Trillion seems like a reasonable estimate of the amount of Treasury notes and bonds the Fed will own on June 30, 2011.

It is difficult to know the exact maturity structure of all of the notes and bonds on the Fed’s balance sheet, however, the New York Fed has been transparent about the composition of the $600 billion of purchases under QE2. These have been made in all maturities from 2 years to 30 years, however, the purchases are concentrated in the 2-to-10 year sector with a weighted average maturity of about 6 years. Assuming the Fed’s entire portfolio has the same weighted average maturity, this means that approximately $250 billion of securities mature each year. Combining the $500 billion annual principal payments on QE mortgage backed securities with $250 billion of maturing principal payments on the remainder of the Fed’s portfolio gives the Fed about $750 billion per year of buying power without expanding the balance sheet.

The projected U.S. deficit for fiscal 2011 is $1.645 trillion. This will be funded by new issuance of Treasury securities over and above the amount needed to refinance maturing debt plus interest payments on existing debt. About 60% of outstanding Treasury issuance is in the 2-to-10 year maturity range. If we assign the 60% weight to the $1.645 trillion of new debt, we get $987 billion of new 2-to-10 year maturity Treasury notes issued in fiscal 2011 to finance the deficit. Therefore, the Fed’s buying power of $750 billion per year can monetize over 75% of the new 2-to10 year note issuance needed to fund ongoing U.S. budget deficits for the next two years without expanding the balance sheet.

The Fed is now like a 400-pound man who can eat 5,000 calories per day without gaining weight because his morbidly obese metabolism requires it to function. The discussion of QE, QE2 and QE3 has become irrelevant. What we have is permanent QE until such time as the Fed decides to tighten financial conditions. This is unlikely to happen until mid-2012 at the earliest, perhaps later in view of the housing double-dip and increasing oil prices. In any case, QE will be with us for an “extended period” no matter what the Fed announces.