The Failure of Quantitative Easing
A perfect storm brews on the economic horizon while the Fed looks the other way.
With the specter of Quantitative Easing 3 raised this week during congressional testimony from Federal Reserve Chairman Ben Bernanke, there has been renewed debate over the impact of QE2 and whether more monetary stimulus is the right prescription for our economic ills. Some warn of an impending no-growth inflation crisis much like the phenomena seen in the 1970s. Others point to the artificial formation of another asset bubble. What few are brave enough to consider is the possibility of an asset bubble forming at the same time as heavy inflationary pressures build in a low-to-no-growth environment. Signs of this perfect storm have already surfaced.
The United States is currently in a low-growth environment. The 2011 first quarter GDP has grown a weak 1.9 percent while the 2010 growth rate was only 2.9 percent. That may count as a decent performance in normal times, but it's very low growth following the steep economic decline we recently experienced. Meanwhile, wages continue to remain flat and by some measures are in decline—not surprising given an unemployment rate of 9.2 percent. More than $2.1 trillion flowing from the Fed clearly has done nothing to mend the American job market. Asset markets on the other hand are booming.
Since the Fed began its campaign, the S&P has more than doubled, the Barclays aggregate is up 8 percent, and IPO pricings are signaling the next bubble. The latest major IPO to hit the street, LinkedIn, is trading at well-over 1,000 times its earnings. Plenty more companies will soon become public with price valuations that will make even that look cheap. Inflation is also beginning to creep higher and a commodity boom threatens to rapidly accelerate price hikes.
When solid underlying fundamentals of the economy contribute to inflation and to spiking asset prices, the Fed normally has a number of options at its disposal to curb the situation. But this situation is different. Now it's the Fed itself, via its purchases, productivity gains, and abnormal speculation that has created this strange environment.
Typically commodity run-ups, inflation, and asset bubbles are associated with and partially offset by healthy economic growth, hiring, and innovation through entrepreneurism. That is not the case today. Without a strong economy corresponding with the coming confluence of inflation and bubbles, the Fed may find itself helpless to act given its current balance sheet and extended zero-interest-rate-policy (ZIRP).
Furthermore, the solution of either selling assets or raising interest rates would each run counter to the Fed's mandate to promote full-employment. (Not that it's a good mandate.)
As Chairman Bernanke has made clear, the Fed is comfortable maintaining the status quo for the time being, keeping asset prices propped up by reinvesting QE purchases as they run-off. In an effort to shirk the responsibility of acting preemptively, the Fed maintains that the slack job market is mitigating the threat of inflation and/or an asset bubble. The Fed also points to inflation expectations as keeping conditions anchored. These two factors are providing an excuse to justify further asset purchases and the continuance of ZIRP because the Fed believes asset bubbles and high inflation cannot occur in an environment with high unemployment and stagnant wages. The looming perfect storm is not even on the Fed's radar.
For the Fed to take measures counter to its current policy something would have to change in the present environment, either a wage-price spiral or an unexpected (to the Fed) shift in inflation expectations. An asset bubble factoring into current Fed policy is not even conceivable at this point. And given its success at identifying the previous two, it most likely never will be.
The central (bank) irony here is that the Fed alone is keeping expectations low through its purchases. QE2's $600 billion treasury purchases on top of the first round of quantitative easing clearly affected yields. Using them now as an indicator for future inflation is like using tech stock P/Es as an indicator for future growth in 1999. They are manipulated metrics. The Fed has artificially pushed down yields by bidding up prices, which not only skewed inflation expectations, but may also be contributing to a bond bubble. If nothing else, it has mispriced risk.
The very indicator the Fed is using to dictate a change in policy is being directly affected by its own policy. That paradox is also keeping the Fed from properly identifying pending problems in the economy.
So a perfect storm brews on the horizon while the Fed looks in the wrong direction. The crippling affects from inflationary stagnation and from the recessionary onset of a busting bubble would line-up some very difficult decisions for the Fed. If both occur simultaneously, the Fed will be helpless to defend against the two-front assault on the economy. Indeed, the Fed won't even see it coming.
James Groth is a research associate at Reason Foundation. Anthony Randazzo is director of economic research at Reason Foundation.
