Christopher Mahoney of Seeking Alpha has written this thoughtful and scholarly analysis piece on Federal Reserve policy and its anticipated effect on economic growth, reproduced in its entirety here for your enjoyment.

 quantitative easing

Assuming that the Fed implements QE3 as announced recently, I expect to see the Dow around 15,000 next Christmas. This is because the Fed’s balance sheet should grow by $1 trillion next year, a 36% increase over where it is now. By year end, I expect nominal GDP growth to have accelerated from its current 4% to a level closer to 5%. I am therefore bullish about both economic growth and equity prices.

The quantity theory of money holds that nominal GDP growth is a function of money growth, and that money growth is a function of the size of the central bank’s balance sheet. Therefore, the central bank is able to control the level and growth rate of nominal GDP.

However, these are not constant relationships. As interest rates decline, so does monetary velocity, such that it takes proportionately greater increases in the money supply to produce comparable GDP growth. Similarly, the relationship between the central bank’s balance sheet and the money supply is also not linear, particularly as interest rates approach the zero bound. Keynes called these phenomena the liquidity trap in which monetary policy loses its power as the central bank “pushes on a string”.

While monetarist economists concede that these relationships are not linear, they do not accept that a central bank can ever lose its power to grow nominal GDP. It is a bit ironic that the same voices that argue that monetary policy has lost its efficacy also argue that quantitative easing will lead to inflation. They argue that monetary policy is (1) powerless; and (2) powerful. They are wrong on both counts: monetary policy never loses its efficacy, and the current program of expansion will not lead to high inflation (just as the prior rounds of QE did not, despite dire warnings from the hawks).

No one can reasonably argue that a central bank cannot inflate its currency such that nominal GDP will grow. We have witnessed this phenomenon many times since the invention of fiat money in 17th century France. The central banks of Zimbabwe and Ukraine have been poster children for the power of the printing press, and have both succeeded handily in greatly expanding the size of nominal GDP.

helicopter-bigAs Bernanke argued to the Japanese, in extremis, there is nothing to stop the central bank from dropping money on the citizenry from the air. In 1933, when FDR decided to inflate the currency, he began to raise the dollar price of gold by arbitrary daily increments until he saw the overall price level begin to rise. He didn’t know very much about monetary policy, but he understood that by printing money he could cause inflation.

Now let’s look at the facts today. Since the crash, the Fed has engaged in two rounds of balance sheet expansion. (Note: I am using the Fed’s balance sheet and the monetary base interchangeably; they are very close in dollars.) In QE1, the monetary base grew by about $1 trillion. In QE2, the base grew by another $700 billion. In QE3, the Fed plans to grow the base by additional $1 trillion. Overall, the monetary base will have grown from $800 billion pre-crash to around $3.6 trillion by next Christmas (while inflation has remained subdued).

The money supply (M2) has grown by almost $3 trillion since the crash, for a total growth of 40%. Since the crash, nominal GDP has grown from $14 trillion to $16 trillion, an increase of 14%. The Fed’s plan is that by growing the monetary base by about a third in 2013, nominal growth will accelerate to a level that would allow unemployment to decline to from its current 7.8% to a targeted 6.5%.

Since the immediate recovery period after the crash, NGDP has been growing steadily at a subpar 4%. This third round of monetary expansion, if pursued, should lift that rate to a level above 5%, which is still less than robust but closer to potential [NAIRU].

If the Fed pursues QE3 as announced, inflationary expectations should rise next year as bond prices fall. This should be bullish for equities as returns from the “risk off” trade decline. With cash yielding zero and falling bond prices, equity inflows should rebound.

The equity risk premium today is still attractive at over 4% (earnings yield minus bond yield) and appears to be in solid value territory in a historical context. As the appeal of bonds diminishes, equity valuations should rise and the risk premium should decline.

My advice for next year is: Don’t fight the Fed.