Friday, October 29, 2010

Now What?

Well, the numbers are out, and things still seem a little gloomy. The U.S. economy grew at a less-than-stellar 2% in the third quarter. For the optimists in the crowd, that's better than the 1.7% growth for the second quarter. For the rest of us, U.S. average quarterly growth from 1947 to 2010 was 3.31% (tradingeconomics.com).

What does this all mean? There's almost certainly going to be another round of quantitative easing (QE2), probably after the midterm elections. The Fed has already purchased $1,725bn of assets during the crisis, and the extent of this next spree is up for debate.

Let's start with the simple fact that QE has only happened once before (during the crisis). QE is when the Fed buys long-term assets in order to push down long-term interest rates. This can only occur when the short-term rate is near 0%, which it is right now. Why am I so certain that QE will happen? As alluded to earlier, 2% growth is not wholly encouraging (in fact, it may be downright discouraging), and it's probably not going to change our 9.6% unemployment rate at all. Also, inflation is still sluggish (CPI is up 0.8% on the year).

Lastly, remember that it's expectations that count. So far, there actually may be some good news there. The difference between 10-yr Treasury bills and inflation protected Treasury bills (TIPS) is about 0.5%. This shows that people expect the Fed's QE will have an tangible effect on prices. These things tend to be self-fulfilling prophesies. The Taylor Rule does, after all, take into effect expected inflation, however, it does feel like we're working backwards now. Instead of expecting high inflation and lowering interest rates, we lowered interest rates and hoped for higher inflation. Christ, my head's starting to hurt...

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