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QE2: a cost benefit analysis

Martin Feldstein, former President of NBER, argues on FT that QE2 will have limited chance of success.  Given the huge bank excess reserves in the system already, the marginal benefit of pumping another $1 trillion excess reserves is low.  Fed’s main objective is to raise people’s inflation expectations so that real interest rate can go negative, a way of simulating the economy when facing the zero lower bound of nominal interest rate.

The Fed uses standard inflation measure, core PCE.  But the excessively easy monetary policy will pop up asset prices across broad – oil, corn, cotton, gold, to name a few.  The super easy monetary policy is also likely to create asset bubbles in emerging markets, laying the seeds for global instability in the future.

Like all bubbles, these exaggerated increases can rapidly reverse when interest rates return to normal levels. The greatest danger will then be to leveraged investors, including individuals who bought these assets with borrowed money and banks that hold long-term securities. These risks should be clear after the recent crisis driven by the bursting of asset price bubbles. Although the specific asset prices that are now rising are different from last time, the possibility of damaging declines when bubbles burst is worryingly similar.

The problem now extends to emerging markets, a group not directly affected in the last crisis. The lower US interest rates are causing a substantial capital flow to those economies, creating currency volatility. The economies hurt by the increasing value of their currencies are responding with measures to protect their exports and limit their imports, measures that could lead to trade conflict.

Although its real focus is on reducing unemployment, much of the rhetoric of Ben Bernanke, the Fed chairman, is about preventing deflation because some members of the Fed’s open market committee think the Fed should focus exclusively on price stability. But there is no deflation. Core consumer prices are rising and inflation is expected to average 2 per cent over the next 10 years.

Since short-term interest rates are already near zero, some economists advocate QE to reduce the real interest rate by raising inflation temporarily while holding the nominal interest rate unchanged. A 4 per cent expected rate of inflation for the next few years would turn a 1 per cent nominal interest rate into a real rate of minus 3 per cent, thereby stimulating interest-sensitive spending. But doing that would jeopardise the credibility of the Fed’s long-term inflation strategy.

Mr Bernanke’s argument for QE is based on the “portfolio balance” theory which stresses that, when the Fed buys bonds, investors increase their demand for other assets, particularly equities, raising their price and increasing household wealth and spending. Equity prices have already risen by 10 per cent since Mr Bernanke discussed this approach. But how much further will equity prices rise and what will that do to GDP?

Neither theory nor past experience can answer the first question. Much of the share price increase induced by QE may already have occurred based on expectations. An optimistic guess would be another 10 per cent. Since households have about $7,000bn in equities, that would imply a wealth gain of $700bn, raising consumer spending by about one-quarter of one per cent of GDP, a welcome but trivially small effect on incomes and employment.

The other ways in which QE would raise GDP are also small. A 20-basis-point reduction in mortgage rates would have little effect on homebuying at a time when house prices are again falling. The increase in banks’ liquidity would do nothing since banks already have massive excess reserves. Big corporations are sitting on vast amounts of cash. Small businesses that are not spending because they cannot get credit will not be helped, because the banks on which they depend have a shortage of capital.

The main reason behind the Fed’s action is to prevent Japan-like decade-long deflation.  Given the uncertainties in forecasting, the Fed is willing to act proactively – the downside risk of deflation outweighs the risk of mild inflation, according to Jim Stock, professor at Harvard (see the video interview below).  It’s assumed that the Fed can always act by raising interest rate when inflation reaches an uncomfortable level.

But something ignored here is the divergence of core inflation measure, preferred by the Fed, and the inflation in dollar-sensitive assets, such as oil, gold and commodities in general.

As pointed out by Marty, the cost-free borrowing at the short end is likely to rekindle the speculations and re-leveraging.  Then 2003-2007 bubble just demonstrated how dangerous it can be when there is a sudden reversal of asset prices.

The mistake the Fed is committing now is their continuous ignorance of how monetary policy could fuel huge credit expansion and risk-taking, and help  generate asset bubbles, one after another.