Not only did the Fed announce its controversial $600 billion QE2 program today, but Ben Bernanke felt compelled to defend it in a Washington Post op-ed tonight. For the normally oracular Fed to feel it has to sell its program in a non-financial media outlet says Bernanke must recognize that he is staking on thin ice. The problem is he appears to believe the problem is at most one of perception, when it is in fact practical, that QE2 is unlikely to work, and if anything is more likely to produce collateral damage than achieve its intended aims.
And no one less than the co-CEO of Pimco, a bond fund and hence presumed fan of QE@ (bonds ought to benefit from Fed intervention) expressed his considerable doubts in an op ed at the Financial Times.
First to Bernanke, and the guts of his argument at the Post. After explaining why low inflation and the risk of deflation are reasons to act, he explains the presumed benefits of QE2:
This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
The Fed chair is so disengaged from reality it isn’t funny. This is the classic wealth effect argument, that if you goose asset values, people will feel richer and spend more. The problem is it was an abysmal failure the first it was put into effect as a policy idea, in Japan in the later 1980s. The result was rampant asset speculation followed by a twenty year bust.
And the assertion that QE1 was a success of any sort is a canard. Unemployment is still stuck at just shy of 10%, with job additions still too low to absorb workforce increases. Housing appears to have bottomed in some markets, but that’s only as a result of repricing so as to be more in line with long term relationships with income and rentals. The fact that Bernanke is worrying about deflation says it didn’t do much to create expectations of price increases (or more accurately, consumers most certainly do expect price increases, but in select but important areas like food and energy prices, which are not well suited to the sort of anticipatory purchases that help increase general price levels). The uncertainty over foreclosures and the reality of shadow housing inventory (delinquent borrowers banks have not evicted yet, plus people who would like to sell but are unduly optimistic re a near term housing recovery) means that any prod to demand from super low rates is offset by concerns about supply pressures on housing prices (as in consumers are correctly concerned that they still face downside risk).
In addition, even if it worked, the low mortgage rate inducement is a con. The Fed hopes to create inflation. That means higher interest rates. If the Fed succeeds in its goal of achieving modest inflation (2-4%), the increase in funding costs for homebuyers would cycle back into less affordabilty. Anyone who understands that dynamic is again not going to want to gamble on the possibility that the Fed succeeds.
And as for consumer stock prices boosting confidence, experts are not certain which way the causality runs. As a Fidelity report noted:
There is a relationship between confidence and stock market movements, although it is not clear which factor has a larger influence on the other (survey respondents may report lower sentiment as a reaction
to a decline in the stock market as opposed to a prediction of future weakness).
And the idea that a Fed induced rally will fool anyone into opening their wallet is spurious. Trading volumes are weak, the opposite of what you’d expect with a bona fide market rally. Retail investors increasingly are withdrawing from stocks, perceiving the market as manipulated. And many pros stress that equities are now driven by technical rather than fundamental factors.
El-Erain criticizes the Fed’s program for its risk of adverse consequences. The headline is blunt, “QE2 blunderbuss likely to backfire“:
Other government agencies are paralysed by real and perceived constraints, seemingly happy to retreat to the sidelines and let the Fed do all the heavy lifting. But liquidity injections and financial engineering are insufficient to deal with the challenges that the US faces. Without meaningful structural reforms, part of the Fed’s liquidity injection will leak right out of the US and result in yet another surge of capital flows to other countries.
The rest of the world does not need this extra liquidity, and this is where the second problem emerges. Several emerging economies, such as Brazil and China, are already close to overheating; and the eurozone and Japan can ill afford further appreciation in their currencies.
Despite polite rhetoric to the contrary in the lead up to the Group of 20 leading economies summit in Korea this month, other countries are likely to counter what they view as an unnecessarily disruptive surge in capital flows caused by inappropriate and short-sighted American policy. The result will be renewed currency tensions and a higher risk of capital controls and trade protectionism.
The third issue relates to the gradual erosion of America’s central role in the global economy – including as the provider of both the world’s reserve currency and its deepest and most predictable financial markets. No other country or multilateral institution can displace the US, but a combination of alternatives can serve to erode its influence over time. No wonder commodity prices surged higher and the dollar weakened markedly in anticipation of QE2, pointing to increased input costs for American companies and unwelcome pressures on their earnings.
The unfortunate conclusion is that QE2 will be of limited success in sustaining high growth and job creation in the US, and will complicate life for many other countries. With domestic outcomes again falling short of policy expectations, it is just a matter of time until the Fed will be expected to do even more. And this means Wednesday’s QE2 announcement is unlikely to be the end of unusual Fed policy activism.
I am not certain that the Fed will be anywhere near as free to experiment as it was in the past. The Fed is a particular hobbyhorse of libertarians, and with Tea Partiers taking ground in the Congressional elections, the Audit the Fed movement might gain renewed energy. More aggressive intervention would be tantamount to waving a flag in front of these bulls. The Fed risks intrusive oversight if it goes too far down the policy activism path.