Quantitative easing… is supposed to stimulate the economy by increasing share prices, leading to higher household wealth and therefore to increased consumer spending. Fed Chairman Ben Bernanke has described this as the “portfolio-balance” effect of the Fed’s purchase of long-term government securities instead of the traditional open-market operations that were restricted to buying and selling short-term government obligations. Here’s how it is supposed to work. When the Fed buys long-term government bonds and mortgage-backed securities, private investors are no longer able to buy those long-term assets. Investors who want long-term securities therefore have to buy equities. That drives up the price of equities, leading to more consumer spending….
[T]o be fair one more time, he is accurately characterizing Ben Bernanke’s explanation…. [But] the portfolio balance rationale for QE misrepresents the mechanism whereby QE can have any effect. That mechanism is primarily by preventing inflation expectations from dropping…. I explained the underlying theory in my paper "The Fisher Effect under Deflationary Expectations", which also provided supporting empirical evidence showing of a strong positive correlation since 2008 between inflation expectations as measured by the TIPS spread and stock prices, a correlation not predicted by conventional theory and not observed in the data until 2008….
Feldstein continues to attack a strawman, albeit one presented to him by Ben Bernanke…. Feldstein’s closing comment reminded me of a piece that he wrote two and a half years ago in the Financial Times entitled “QE2 is risky and should be limited.” Here are the first and last paragraphs of the FT contribution.
The Federal Reserve’s proposed policy of quantitative easing is a dangerous gamble with only a small potential upside benefit and substantial risks of creating asset bubbles that could destabilise the global economy. Although the US economy is weak and the outlook uncertain, QE is not the right remedy.
The truth is there is little more that the Fed can do to raise economic activity. What is required is action by the president and Congress: to help homeowners with negative equity and businesses that cannot get credit, to remove the threat of higher tax rates, and reduce the out-year fiscal deficits. Any QE should be limited and temporary.
I was not yet blogging in 2010, but I was annoyed enough by Feldstein to write this letter to the editor.
Sir, Arguing against quantitative easing, Martin Feldstein (“QE2 is risky and should be limited“, Comment, November 3) asserts that Federal Reserve signals that it would engage in QE, having depressed long-term interest rates, are fuelling asset and commodities bubbles that will burst once interest rates return to normal levels.
In fact, since Ben Bernanke made known his intent to ease monetary policy on August 29, longer-term rates have edged up. So rising asset and commodities prices are due not to falling long-term rates, but to expectations of rising future revenue streams. Investors, evidently, anticipate either rising output, rising prices or, most likely, some of both.
Why Mr Feldstein considers the recent modest rise in commodities and asset prices (the S&P is still more than 20 per cent below its 2007 all-time high) to be a bubble is not clear. Does he believe that with 15m US workers unemployed, expectations of increased output are irrational? Or does he believe the Fed incapable of causing the price level to increase? It would be odd if it were the latter, because Mr Feldstein goes on to insist that QE is dangerous because it may cause an “unwanted rise in inflation”?
Perhaps Mr Feldstein thinks that expectations of rising prices and rising output are inconsistent with expectations that interest rates will not rise sharply in the future, so that asset prices must take a hit when interest rates finally do rise. But he acknowledges that expectations of future inflation may allow real rates to fall into negative territory to reflect the current dismal economic climate. Since August 29, rates on inflation-adjusted Tips bonds have fallen below zero. Rising asset prices indicate the expectation of QE is inducing investors to shift out of cash into real assets, presaging increased real investment and a pick-up in recovery.
Why then is inflation “unwanted”? Mr Feldstein maintains that it would jeopardise the credibility of the Fed’s long-term inflation strategy. But it is not clear why Fed credibility would be jeopardised more by a temporary increase, than by a temporary decrease, in inflation, or, indeed, why credibility would be jeopardised at all by a short-term increase in inflation to compensate for a prior short-term decrease? The inflexible conception of inflation targeting espoused by Mr Feldstein, painfully articulated in Federal Open Market Committee minutes, led the Fed into a disastrous tightening of monetary policy between March and October 2008, while the US economy was falling into a deepening recession because of a misplaced concern that rising oil and food prices would cause inflation expectations to run out of control.
Two years later, Mr Feldstein, having learnt nothing and forgotten nothing, is urging the Fed to persist in its earlier mistake because of a neurotic concern that inflation expectations may soar amid massive unemployment and idle resources.
Well, that’s my story and I’m sticking to it.