QE3 Is Still Coming

NEW YORK (Real Money) -- A few days ago, I shared that it was nonsensical for market participants to think that the members of the Federal Open Market Committee (FOMC) would discuss the need for another round of quantitative easing at their March 13 meeting.

That doesn't mean that there won't be another round of easing. It's just that the March 13 meeting was not the time to discuss it. In fact, I continue to believe there will be more easing, both quantitatively and through duration extension of the fed's balance sheet; and that ultimately this will require the Fed to double its balance sheet again from the current level of about $2.6 trillion.

To date, the Fed's balance sheet has nearly tripled from where it was (around $850 billion) before the subprime crisis ensued. In the process, the Federal Reserve also expanded the kinds of assets it carries on its balance sheet from being almost exclusively Treasury debt to include government-sponsored enterprise (GSE) debt and mortgages, as well as non-GSE mortgages and mortgage-backed securities.

This process provided the banks with liquidity and prevented the banking and mortgage markets from seizing. It also gave the federal government access to funds through the banks, which it used to meet fiscal stimulus objectives by selling Treasury notes.

In the process, the Fed provided a capital bridge to the banks and the federal government. The federal government was supposed to use the funds made available through the issuance of new Treasury securities to stimulate economic activity that would provide a multiplier to the private economy that would be in excess of the government's spending.

Simultaneously, the banks were supposed to use this bridge to repair their balance sheets, raise private sector equity capital if necessary, and expand their lending to productive enterprises. The goal was to create income for the banks that would allow for the absorption of the known losses that needed to be taken on their real-estate related assets and allow for the unwinding of the repurchase agreements entered into with the Fed in swap for the illiquid mortgages.

While this was going on, the legislative and executive branches were supposed to be engineering a path for the economy to absorb the losses related to the real estate bubble collapse so that housing would stabilize. This would have helped to increase consumers' and investors' confidence.

To date, almost none of this has happened to the extent necessary for the economy to grow. The banks and the federal government have used the funds afforded by way of an expanded Fed balance sheet to punt the structural issues facing the banks and the economy into the future. Apparently, the expectation is that eventually the housing crisis and associated losses would be absorbed naturally by the economy and without concerted effort.

Chairman Bernanke is now aware that, in essence, he and the FOMC members have been duped by the banks, the White House and Congress. Instead of working to stabilize the economy by stabilizing housing, they have done the opposite, and for the most part, ignored the issue.

This leaves the Fed in a precarious situation today. Housing is continuing to languish. There will probably be another trillion dollars in losses yet to be incurred just by way of contracting value to the physical collateral. And another trillion of losses will likely be associated with the mortgage supported by that collateral.

Actually, the losses on both fronts could be much larger than that. Historically, the duration and amplitude of a real estate correction corresponds inversely to that of the expansion that preceded it. If that holds true for this cycle, housing, on a national average basis, will decline in price by another 10% -- maybe more -- in nominal terms before.

The Fed, in such a situation, will be left having to consider whether or not to continue to provide the banks with the monetary stimulus necessary to absorb such action. In reality though, this is no longer a choice for the Fed. Its own solvency is now threatened by these same losses, which it incurred from having already accepted illiquid loans. This leaves the Fed in a "damned if I do, damned if I don't" predicament, with Chairman Bernanke specifically being made the fall guy if his actions do not unilaterally prevent another crisis.

Last September, before Operation Twist was announced, I wrote that should the Fed implement a duration extension program, it would try to avoid the shoulder of the yield curve. When the next round of easing is required I expect that the Fed will do the opposite and focus all of its resources directly into the shoulder in an explicit attempt to drive down loan rates with the least amount of balance-sheet expansion as possible.

Roger Arnold is the chief economist for ALM Advisors, a Pasadena, Calif.-based money management firm specializing in income-generating portfolios. Concurrent with his other business responsibilities, Arnold was a radio talk show host for 15 years. He focuses on behavioral economics and chaos theory, better known as the "butterfly effect." He explains the relationships between political, economic and social systems, and how they are all reflected in the financial markets -- stocks, bonds, commodities, currencies and real estate.

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