Response to the Federal Reserve's recent round of quantitative easing, a $600 billion effort aimed at boosting demand for Treasury bills and driving down interest rates to spur growth, has been swift and impassioned. Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, called it a "bargain with the devil." "Everybody wants the U.S. economy to recover, but it does no good at all to just throw dollars from a helicopter," said Brazilian Finance Minister Guido Mantega in the Financial Times. What's more, leaders at the most recent G20 meeting expressed anger that the U.S. is effectively stimulating its exports at the expense of its international competitors.
The fact that the Fed has been so aggressive has convinced many businesses that things are going to get better for them.
The stock market, however, responded positively: On November 4, one day after the Fed's announcement, the Dow closed up 1.96%, the Nasdaq jumped 1.76%, and the S&P 500 ended the day up 1.93%.
So who's right? Those who think that the Fed's move will lead to runaway inflation, possibly sink the U.S. economy, and undermine global markets? Or those who believe this might be the beginning of the end of bad times?
Probably the second group, says Â鶹´«Ã½AV Chief Economist Dennis Jacobe. In fact, the characteristically un-exuberant Jacobe goes so far as to say this might be "the turning point" for the U.S. economy. He hastens to add, however, that there are significant risks to quantitative easing -- including higher commodity prices, inflation, and a currency war. He believes the risks pale in comparison to the potential benefits, though, especially if the U.S. focuses unwaveringly on job creation. That will take some effort, will, and optimism from consumers and the business community, as Jacobe says in the following interview.
GMJ: Depending on who you ask, QE2 -- as it's being called because it's the second round of quantitative easing in the last couple of years -- will either doom us or save us. What do you think?
Dennis Jacobe, Ph.D.: There's a lot of economic analysis that shows that it's risky, that argues it won't be effective, that suggests the first round didn't have as much impact as we may have wanted or anticipated, and that we'll get even less in the way of benefit now. When the Fed first announced it and I thought about it and talked about it, I was skeptical. But now, as I've seen its impact on expectations and behaviors, I think this really does have a chance to work.
GMJ: Why?
Dr. Jacobe: It's a psychological thing more than anything else. People on Wall Street have decided that you can't fight the Fed. If the Fed's going to keep pumping money into the system, if the Fed is going to drive up asset values, then that's what the Fed's going to do. That's why we saw a big increase in equities and the value of commodities such as oil, precious metals, and farm products since Federal Reserve Board Chairman Ben Bernanke spoke at an economic symposium in Jackson Hole, Wyoming in late August.
As a result, there's been some new optimism in the financial markets. That's because people are making money on Wall Street, U.S. exporters are seeing their competitive position improve, and international companies are seeing their earnings and profits go up. There's an increased demand for basic commodities that are a substantial part of the U.S. economy. That part of the export economy can see a good business environment going forward. The fact that the Fed has been so aggressive has convinced many businesses that things are going to get better for them. The stock market's boost has influenced them too -- not to mention the mid-term elections.
GMJ: That's a lot of play from a single Fed decision that many people don't approve of.
Dr. Jacobe: That's correct. And many people don't agree with me that the Fed's determination to increase asset values is really driving economic improvement.
You know, recently, I went to the doctor for a problem I was having with one of my eyes. The doctor gave me some experimental medicine and told me to come back in a couple of weeks. When I returned, my eye had improved. When I noted that it appeared that the medicine had worked, he responded with a "maybe." He said that my eye might just have recovered on its own given a few weeks to heal.
That's the problem with assessing the Fed's actions, particularly when you are arguing that the policy has had a major impact based on expectations and behaviors. In turn, so the argument goes, improving expectations lead to an improved economy.
GMJ: So why do you think the Fed's "experimental medicine" is working while others don't?
Dr. Jacobe: Because Â鶹´«Ã½AV's U.S. economic data, which are based on daily polling, allow us to see shifts in consumer perceptions and behaviors before they register in other, less immediate metrics. During late September and early October, Â鶹´«Ã½AV's unemployment measure surged past double digits. Our consumer spending numbers showed a decline in spending, particularly among lower and middle-income Americans. Even our small-business polling showed that small-business owners were more pessimistic in July than at any time since August 2003.
In early October, Â鶹´«Ã½AV's daily polling data suggested that the U.S. economy might be "hitting a wall" as it did in June 2010. It looked like consumers and businesses were becoming increasingly uncertain about the economy -- like they weren't willing to make decisions -- and the odds of a double-dip recession were increasing.
All that seemed to change in late October. We saw a surge in hiring that sent Â鶹´«Ã½AV's unemployment numbers plunging. We also saw a sharp improvement in consumer optimism. I attribute much of this abrupt turnaround in consumer perceptions and business behaviors to the Fed's openness during September and October about its intention to drive up asset values. Wall Street surged, and the dollar's value plummeted. Global companies in the U.S. became more competitive. Even some of the economists who complained about the Fed's efforts seemed to acknowledge they would increase U.S. economic growth in the near term, if only on the margin.
In sum, Â鶹´«Ã½AV data showed a sharp deterioration in the economy and then a strong rebound that the September and October monthly economic reports missed. If you look at traditional monthly economic trend data, you might argue that the U.S. economy has just begun to recover on its own. Â鶹´«Ã½AV's daily economic data suggest to me that a sharp reversal in expectations and optimism has taken place -- and I attribute much of it to the Fed's announced intention followed by its explicit statement that it would pursue a QE2 strategy.
Of course, I also think the mid-term elections may have played a role in changing perceptions. It seemed clear the Republicans were going to take over the House in early October. As a result, many major corporations could see that Americans were moving toward a politically divided government, which companies might perceive as posing less legislative and regulatory risk. With a divided government, there's less chance that Congress will pass aggressive actions in any area.
Based on my reading of Â鶹´«Ã½AV's attitudinal and behavioral economic data, I think the combination of the Fed's QE2 and the change in the political environment has turned the psychology of the economy around. It's the first time I've seen the economic outlook this positive for quite a while.
GMJ: But this means the government's printing more money.
Dr. Jacobe: Yes.
GMJ: And using it to buy its own bonds.
Dr. Jacobe: Yes. We call it "monetizing the debt."
GMJ: Other people call it "inflation bait."
Dr. Jacobe: Well, there are big risks associated with the Fed's experimental policy. In its essence, the rapid devaluation of the dollar means inflation will occur. Commodity prices have gone up, food prices will go up, oil prices have gone up, gas prices should go up. As food and energy prices go up, American consumers will suffer. In turn, consumers could pull back on spending -- purchase only necessities -- and that could offset some of the benefits of increasing employment that QE2 will probably bring.
Many countries are already angry, as illustrated by their leaders' reactions at the most recent G20 meeting.
Further, people don't think about what this does to older Americans, when the economy basically has negative real interest rates. Many earning assets, such as savings accounts, won't earn much interest, so older Americans who live on their investments either must take on risk or see their income go down. It's a hard time for them, and it's a hard time for banking institutions because they can't lend money at any kind of attractive interest rate.
Ultimately, what the Fed is trying to do is generate price increases and avoid deflation. Now to some degree, the increases in commodity prices have been absorbed by foreign exporters. But the way the dollar is valued by some Asian currencies means that some of those inflationary factors have not translated into higher prices for many goods imported into the U.S. economy, and this situation could easily change, leading to much higher prices over time.
GMJ: Are there other risks associated with QE2?
Dr. Jacobe: There's the real possibility of something that might be seen as a currency war or even a trade war. This could happen if other countries decide they don't like the way the U.S. is devaluing its currency and start to devalue their own currencies. Many countries are already angry, as illustrated by their leaders' reactions at the most recent G20 meeting. They say the U.S. is taking advantage of the global situation; the U.S. is increasing its global exports and pumping up the commodity part of its economy, stimulating its exports at the expense of its international competitors. And they have a point. The U.S. is becoming much more aggressive and competitive internationally.
GMJ: Aside from inflation, could increasing commodity prices create asset bubbles?
Dr. Jacobe: Absolutely they could; they may already be doing so. If QE2 works, asset values will go up and people will start spending money again. But inflation could go wild because there's so much money out there. If that happens, how will the Fed pull that money back out of the global economic system? It becomes an enormous problem. Our experience with inflation is that once it gets going, it is very, very hard to stop. If we have too much money out there, we could get very rapid inflation increases.
The other danger is that uncontrollable bubbles form in various commodities, and that becomes a real problem for consumers. Depending on how job growth is going and whether the economy is actually expanding, the biggest short-term danger is a big jump in prices. To control surging prices, the Fed then must start increasing interest rates and pull money out of the system to pop those bubbles. They might have ideas and plans about how to achieve this goal while minimizing the damage to the global economy, but we're in totally uncharted waters.
Nobody ever thought that the Fed would actually buy debt and pump money into the economy to push up asset values. It's a tremendous experiment. Fed Chairman Ben Bernanke studied the Great Depression, and you can think of this as his anti-Depression strategy. That's why the policymakers and economists are reacting so strongly, because nobody knows what will happen over time.
GMJ: So once again, why do you favor this experimental Fed policy?
Dr. Jacobe: I think people's assessment of the Fed's new policy tends to differ depending on the time frame being considered and how you assess the risks involved. If you take a longer view, you might easily conclude that QE2 is a bad idea because of its long-term risks, including inflation and asset bubbles. This is particularly the case if you see today's unemployment rates as something the U.S. economy can live with for several years to come.
In contrast, a short-term view might be that the enormous risks involved are worth it: Without the Fed's efforts, the economy could stagnate or possibly slow further. Unemployment is likely to remain in the double digits for another year or two. The odds of a double-dip recession go up.
If the Fed's grand experiment works, we get an economy that starts to advance and we get jobs created. We may also get an inflation problem, and we take on the risk that we can minimize the damage if that happens. The worst result would be that the Fed tries to pump up the economy and we get inflation but we don't get economic growth. If that happens, then we have stagflation, and that's the worst outcome.
GMJ: Stagflation is a term that brings back dreaded memories from the 1970s.
Stagflation is a worry, but the real problem right now is unemployment.
Dr. Jacobe: Stagflation is a real worry. Still, the real problem right now is unemployment. In the short term, we have to do whatever it takes to get the economy going. Until recently, I thought the odds of stagflation were fairly high. I think the risk of that has diminished because we're at an economic inflection point. I think Americans, both consumers and businesspeople, are essentially an optimistic people. We've become a lot less optimistic over the last couple of years because of the recession and the financial crisis. But when the Fed is pumping money into the system and there's optimism that asset values will increase, that jobs will be created, and in turn, there will be economic growth, then basic American optimism and entrepreneurship will take over.
I think there's a reasonable chance that the Fed's strategy will work. I feel this more strongly than I had expected to because I think it's already affecting expectations. Â鶹´«Ã½AV's most recent confidence measures are improving, and the job situation seems to be getting a little better. We're still a ways off before we can confirm that it's working, but so far, all the indications are good. The expectations built on QE2 and the change in fiscal policy associated with two-party rule are very positive.
GMJ: What will the impact be on small and medium-sized business?
Dr. Jacobe: Well, I think it's still a tough economic climate for small businesses. But we are at a turning point. If U.S. optimism continues, and if some of the bad things that can happen internationally like a currency war don't happen, and if people give this Fed policy a chance, then I think the outlook for small business and for the economy in general improves significantly, probably as soon as in the second quarter of 2011. On the other hand, if we retreat into the political and economic morass we've been in for the last couple of years, arguing about all kinds of things and not focusing on job creation, then I'm not as optimistic.
I think the correct action right now is to take whatever momentum the QE2 and the political change have generated in terms of America's expectations and optimism and build on them to create jobs. Whatever has to be done to improve the job situation is what we should be focusing on right now.
GMJ: What about fixing Social Security and deficits? Those problems are top of mind for many people right now.
Dr. Jacobe: Those are real problems and they're very important, but we don't need another dose of pessimism right now. What we need is for people to do whatever it takes to create jobs. Then after the economy gains some real positive momentum, we can talk about these serious issues in an economy that's expanding and with more people getting hired. Then we'll be in a better position to deal with inflation, deficits, Social Security, Medicare, and Medicaid. If we try to focus on those long-term problems before we take care of jobs in the short term, we'll get stagflation.
GMJ: And you thought we were getting close to that?
Dr. Jacobe: I did. Not too long ago, the situation was getting bad again. As I noted earlier, unlike many of the federal government's economic measures, Â鶹´«Ã½AV monitors economic data weekly, not just monthly. Â鶹´«Ã½AV's economic measures for late September and early October showed the economy slowing dramatically. At that time, in my view, the probabilities of the U.S. sinking back into a double-dip recession increased significantly. I was very worried about the outlook for the economy.
GMJ: Then why are so many people against QE2? Just recently, we've seen a group of Republican economists join with some Republicans in Congress to argue against this new policy and suggest that the Fed should not go through with it. In fact, House Republican Conference Chairman Mike Pence has just introduced new legislation to limit the Fed's role to controlling inflation because of QE2.
Dr. Jacobe: As we've discussed, some people think the economy is healing on its own. Others think the risks associated with such an experimental policy are just too great. Some simply argue it won't work. Further, I don't think there has been enough discussion about what happens to American society if unemployment remains in the near double digits -- and one in five or more Americans are underemployed -- for years to come. And, we continue to see global economic challenges such as the Irish debt crisis and China's efforts to combat inflation.
Most importantly, I don't think they're seeing what we're seeing with the Â鶹´«Ã½AV Daily: The Fed's experimental action is already having an effect. We see unemployment dropping and hiring picking up. I think we'll see real estate values improve because quantitative easing makes hard assets more valuable, which in turn helps commercial real estate and homeowners. We have some positive momentum, and if people in Washington will focus on dealing with out-of-control federal spending while joining businesspeople and consumers in focusing on job creation, we've got a chance to have a much better year in 2011. This is the first time I've been really optimistic about the economic outlook in quite a while. I think we're at an inflection point here, and we have our best chance in years to turn this thing around.
-- Interviewed by Jennifer Robison