Sometimes I wonder if financial journalists know what they are talking about – the FED printing money, really?

 

Do you believe that the FEDis the only institution that evolves in a closed world separate from real economic data and without expertise? Do you believe that Ben Bernanke is not as smart as a 5th grader? When you read the financial news, I start to believe that journalists think so!

 

I’ve read numerous articles about the fact that the FEDis printing money like there is no tomorrow through their set of Quantitative Easing measures (aka QE1, QE2 and QE3). At the end of summer 2012, the FEDannounced a third round of QE by buying $40B of mortgage back assets on a monthly basis (read more on QE3). Bernanke was accused by many of printing more money and eventually pushing the States into an uncontrollable inflation spiral. When you think about it: The FED is injecting $40B per month into the markets. Where do they find the money if they don’t print it? At first glance, it seems that Bernanke is not smarter than a 5th grader after all… but, thank God!, the reality is more complex.

 

How Quantitative Easing Measures Work In theREALWorld

 

In the real world (this is what matters, right?), theFEDis not depositing $40B into someone’s bank account each month. It’s not “real money” but rather a way of playing with accounting books to facilitate liquidity (read; more credit facilities for consumers) and add pressure to long term bonds (which results in pressure on mortgage rates to stay low). As you can see in the chart below, this part of the system works well:

30 yr treasure rates vs QEIOU System

 

As I mentioned earlier, QE is not real cash in a bank account. It’s working like an IOU system:

 

#1 The FED buys mortgage back assets from a bank. Therefore, in the books, the bank can release its weight as it doesn’t hold the illiquid (and most probably under water) mortgage assets on its books.

 

#2 In exchange, the bank doesn’t receive cash.  The money from the mortgage backed asset sale is deposited at the FED. This allows the bank to switch an illiquid asset from their books to solid cash. The interest in theFED bank account is paying more than regular money market. This is why the bank will keep it there.

 

#3 The Bank now shows an improved balance sheet. With the mortgage backed assets gone, the bank shows a stronger balance sheet and is able to lend more money at better rates to consumers. It’s like capitalizing banks without “real” money.

 

#4 The money in the market is coming from banks to consumers. So theFED is not printing money, its only facilitating the banking industry to provide credit to its consumers. Since 70% of the USGDP comes from internal consumption, it is crucial to help US consumers to continue to buy goods.

 

There is No Printing Money but there is a lot of Burning Money

 

Another factor that most people tend to forget is the fact that we are currently burning a lot of money in the US at the moment. How can we burn money? Here’s how it works:

 

In a “normal” situation, you have a mortgage on a house that’s worth more than its debt. So you buy a house at 100K with a mortgage of 80K. Each time you make a mortgage payment; you drop your debt and automatically create equity in your house. Therefore, the day that your mortgage is paid down to 70K, you can still borrow back the 10K equity you’ve built on your house. If you are lucky, the house now worth 110K and you have 20k equity ready to be used (or abused ;-) ).

 

But right now the situation is different. You bought a house at 100K with a mortgage at 80K. Housing market has been so bad that your house now worth 50K. So even if you have paid 10K on your mortgage, you are still “under water”. Your balance sheet is showing a 50K asset with a 70K debt attached to it. You are still in “negative equity”. So each time you are paying down your mortgage, you are taking away this money from the system as you are not creating equity. This is what we call money burning.

 

Since there are millions of mortgages in this situation, there are millions being burned at the moment? So creating liquidity on the banks’ balance sheet in this situation is not that bad!

 

Monetary Mass is Relatively Stable

 

Everything you read here could be confirmed or destroyed by someone else like any other theory. But I think I’m pointing in the right direction since there is a key metric that doesn’t lie: theUSmonetary mass.

 

The monetary mass is the sum of all US dollars that “exists”. When we look at the money supply, we can see that it’s increasing but not like there is no tomorrow either:

 

monetary base

For this reason, I’m not too pessimistic about hyperinflation. As long as the monetary mass is stable, we shouldn’t have to fear inflation.

 

What Truly Concerns Me is Obama

 

I’m not American, I didn’t vote and this blog is not about politics. In fact, I don’t really mind if Obama or Romney is the President. What concerns me is the fiscal cliff that is looming ahead and while the President is a democrat, the congress belongs to the republicans. With a neutral opinion, I just don’t think it’s a good fit since both parties have a very different way of seeing the economy right now.

 

The fiscal cliff is arrives in January 2013 when several spending cuts and tax increases are going to happen (including taxing dividends!) if a solution is not found. So the problem is not being a democrat or a republican at this stage. The problem is that both parties will have to walk hand-in-hand towards in the same direction to find a solution. This is where I see the problem happening. They do not seem to get along very well at the moment.

 

My concern is the following: while both parties argue on which way to turn, do you fear that we will jump in the cliff before they decide to avoid it?

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7 Comments   |  

7 Comments

Michel
November 12, 2012, 7:41 am

When I discuss with americans here in Florida this winter, I find that most of them think that a solution will be found before year end. There is no choice. Look at the alternative! The question is, Will it be the Great Solution? probably not…just enough to keep going for a while. I’m staying put…no foolish trades.

RICHARD
November 12, 2012, 1:57 pm

It doesn’t matter if the cliff was in January 2012.
But it will matter if it is in Jan 2013.

A typo Mike.

November 12, 2012, 1:59 pm

I’m from the US and I can’t stand the lack of compromise in politics. I think they will do like they do with most things and wait until the last minute to avoid the fiscal cliff. Even then their solution will most likely be to kick the can down the road a bit and we will have this same conversation a year or two from now.

Steve
November 12, 2012, 6:39 pm

I have a hard time understanding why the Fed, or any other “correct” (as opposed to right) thinking institution would buy mortgage backed securities which are under water. Great deal for the F/I’s – sucks to be a US tax payer. I understand in the US you can walk away – with no lender recourse to you – from an underwater property. So, if you have a house, which is underwater why would you not walk away. Imagine if you could buy stocks on full margin. Your fifty thousand dollar investment is worth twenty five grand. If you could just give the stock back to your broker and walk away cleanly – why wouldn’t you. Lots of individuals won as the housing bubble inflated. A whole set of other people are carrying the can when the balloon popped. Until the housing issue gets “fixed” I fear the USA is in a world of hurt.

Mike
November 12, 2012, 9:19 pm

oops! Thx Richard!

@Michel & Dividend Growth,
I also think they will come out with a solution that will simply report the problem at a later date. We seriously lack of “political courage” these days (from both sides of the frontiers!).

@Steve,
It’s definitely not a great deal but it’s the only deal on the table. They don’t really have the choice of “sponsoring” banks if they want banks to continue lending…

Saberjim
November 19, 2012, 3:57 pm

I am US. Watched politics long enough to know that congress will do the following:

1. Kick the can down the road as much as possible.

2. Sneak in personal goodies as bargaining chips.

3. Do everything to keep the lobbyist money flowing.

4. Call the result something like, “21st Century Economic Savior Act”.

November 21, 2012, 10:41 am

[...] Forget About What You Read – This article is located over at The Dividend Guy Blog.  It addresses the concern of quantitative easing and the effects on inflation.  While Dividend Guy isn’t concerned about hyperinflation, he is concerned about the upcoming fiscal cliff and the lack of cooperation going on in Washington to try and fix the problem. [...]

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