Are hopes for a QE2-driven recovery already drifting off course?
Goldman is on record saying the first round of quantitative easing won't be nearly big enough to fill in the massive hole that has developed in U.S. demand for goods and services. And with QE2 coming under attack from Republicans in Congress and politicians overseas, the Fed may not have the leeway to open the monetary spigot as wide as Fed chief Ben Bernanke might like -- increasing the chance a rickety recovery will run aground.
"The backlash against the Fed's policy probably does raise the hurdle for substantial further purchases beyond June," economist Jan Hatzius wrote in the weekly U.S. Economics Analyst, released Friday.
Goldman continues to see expansive asset purchases as an appropriate response to an economy characterized by massive debt loads and corresponding private-sector belt-tightening. Hatzius notes that private households and businesses are currently running a financial surplus equivalent to 7% of annual U.S. economic output -- which is about 5 percentage points above the historical norm.
This is the problem for the high-income economies in a nutshell, and it's not one that's about to go away any time soon.
"Because the private sector is trying to pay down debt, its financial balance -- i.e., the gap between its total income and total spending -- has risen to a level that needs to be offset by larger government deficits than the public is willing to tolerate over anything but the very short term," Hatzuis writes. "This means that the economy as a whole suffers from insufficient aggregate demand during the private sector deleveraging episode; in effect, the different sectors of the economy, when taken together, are trying to spend less than they earn, which is a recipe for economic weakness."
One remedy is for the Fed to buy assets to push down long-term interest rates and boost asset prices. Every $1 trillion in Fed purchases can help create perhaps 400,000 jobs, Goldman estimates. Admittedly, that is a drop in a bucket overflowing with 15 million unemployed workers, but at least "it's a start," Hatzius writes.
While even a full-fledged QE2 "is unlikely to turn the economy around," it can serve its purpose by keeping the economy from slipping into a spiral of falling prices and rising real debt burdens known as deflation, the firm says.
Goldman expects the Fed to end up buying something like $2 trillion of assets by the time all is said and done, and it sees even that shocking and awful number as a half-measure. The firm has estimated the central bank would need to buy twice that much to plug a yawning demand gap in a deleveraging economy.
Yet with skeptics from German Finance Minister Wolfgang Schaeuble to Sarah Palin decrying QE's weakening effect on the dollar, the odds that the Federal Open Market Committee will extend asset purchases beyond the initial $600 billion plan are falling.
"Combined with the better data of recent weeks," Hatzuis says, the backlash "has increased the risk that Fed officials will ultimately stop short of our estimate of $2 trillion in cumulative QE2."
Indeed, Hatzius points to the recent rise in government bond yields (see chart, right) not as a failure of Fed policy itself, but as a sign that Fed chief Ben Bernanke won't be able to prevail on his colleagues on the FOMC to loosen policy as much as he might prefer.
And if a smaller QE2 means a weaker recovery, the central bank's already tarnished reputation could soon take another hit.
"If the recovery continues to disappoint, QE2 will undoubtedly be viewed as a failure, even if it in fact helped matters at the margin," Hatzius writes. "There is some risk to the Fed's prestige if QE2 isn't followed by a visible improvement in the economy and the labor market."
Say what you will about Bernanke. But at a time when the rest of Washington shows precious little interest in fixing the economy, another hit to the Fed is most certainly not what the doctor ordered.