The world's three dominant central banks -- the Bank of Japan, the U.S. Federal Reserve and the European Central Bank -- are all moving toward similar stimulative monetary policies. Japan began overt quantitative easing about 10 years ago, the U.S. started it three years ago, and Europe is on the brink of beginning.
Quantitative easing is the policy of increasing the quantity of capital available to be used in the economy, after the cost of that capital has been brought down to zero. So far, though, QE has failed to stop the deflationary forces in either Japan or the U.S.
As a result, the Federal Reserve is now considering advancing the policy to the next level by targeting nominal GDP. That means concentrating on what the economic results are of the increase in the money available to the banks, rather than just the cost or quantity.
The two most germane questions for investors to consider at this juncture are 1.) Why has traditional monetary policy failed, and 2.) What are the limits of non-traditional monetary policy, if any?
Traditional and non-traditional QE monetary policy have failed to spur and increase real economic activity in Japan and the U.S, for very different reasons.
The general consensus concerning Japan is that the policy was instituted too long after the equity markets had collapsed. Because it waited 10 years after the Nikkei collapsed before aggressively pursuing QE, the Bank of Japan lost the opportunity to prevent people's perception of stocks' inherent risk from changing permanently.
So even though the Bank of Japan has been increasing its QE, the capital has been flowing outside of Japan and its financial markets in what is called the "yen carry trade" -- borrow in yen at low rates, and invest in other countries with higher rates. This process has been promoted by the aging demographic profile of Japan.
As the financial crisis of 2008 unfolded in the U.S., the Federal Reserve knew that if it did not move to make money available to the banks, which could in turn put the money into the stock market, the U.S. faced the possibility of following the Japanese situation. But because the Fed did intervene quickly and aggressively, U.S. equities have rebounded strongly from their March 2009 lows.
However, the real economy has still not rebounded. The housing market is continuing to contract, and banks have so far refused to lend any of the new capital.
It's good that the capital markets have been sustained, but in order for monetary policy to be successful, the economy must grow, and that requires bank to make loans.
This is also where things begin to get very dicey for the Federal Reserve, should it either extend the QE measures or advance them to nominal GDP targeting.
The risks are best understood by reviewing the stagflation of the 1970s -- i.e., rising prices coupled with decreasing economic activity. The Arab oil embargo caused prices to rise from about $5 to $30 per barrel -- a price shock. This raised manufacturers' costs of producing goods and lowered consumers' willingness to accommodate those price increases.
To address the shock, the Federal Reserve chose to manage monetary policy to increase economic activity, rather than reduce production costs by maintaining a "cheap money" stance. And this gave rise to the hyperinflationary environment of the late 1970s.
Today, oil prices are at $100 a barrel, and other commodity prices also rising. Much of this can be directly attributed to the "cheap money" monetary policies of the Bank of Japan, the Fed and the ECB. This is the greatest limitation facing monetary policy right now, and it will become a major issue in 2012.
The conundrum is how to get banks to lend and real economic activity to increase without causing oil prices and other raw-material inputs to increase.
This requires legislative incentives or disincentives to either promote lending or punish commodity speculation, with the goal of steering money to where it best promotes economic activity and risk-taking, rather than asset-parking or rent-seeking.
The legislative action necessary to facilitate such will require the U.S. Congress and executive branch to pursue policies that are contrary to the financial interests of energy traders and speculators. The Dodd-Frank legislation requires this, and the Commodity Futures Trading Commission began implementing increased restrictions on commodity speculation about two months ago.
However, as global monetary policies become even more stimulative in 2012, even more action will be required to prevent this new money from distorting the commodity markets.