Fed is banking on phony wealth effect

By J Saft
October 7, 2010

The Federal Reserve is committed to enticing Americans into doing once again what worked out so badly in the last decade: spending the phony paper gains engineered by overly loose monetary policy.

That, at least, is the very strong impression given by a speech by Brian Sack, the markets chief of the New York Federal Reserve, a man whose job it will be to implement the second round of large-scale quantitative easing coming after the elections in November.

A round of speeches from key Fed officials has given the clear view that, faced with deteriorating conditions and trapped by the lower bound of zero in its monetary policy, the Fed is preparing to once again buy up large amounts of Treasuries, perhaps even more than the government is issuing on an ongoing basis, in an attempt to drive down market interest rates and stimulate the economy.

Will that do any good, given that people generally do not want to borrow and the banking system is impaired?

“Balance sheet policy can still lower longer-term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be,” Sack said in a speech in Newport Beach, California on Monday.

“It seems highly unlikely that the economy is completely insensitive to borrowing costs and wealth, or to other changes in broad financial conditions.”

So, there you have it: pump up asset prices and hope that people spend some of the ephemeral gains. The idea that people will spend more if their houses and other assets rise in value is called the wealth effect, but this policy creates only pretend wealth.

In fact, many people in the U.S. now face diminished retirements and generally straitened circumstances precisely because they mistook the rising prices of their house and Internet stocks for wealth and spent or borrowed against it. Is the U.S. actually so desperate for economic activity that this is the best it can do? Apparently so.

“When will these guys ever learn that maybe, just maybe, these Fed policies aimed at targeting asset prices at levels above their intrinsic values is probably not in the best interests of the nation?” Dave Rosenberg, chief economist and strategist at Gluskin, Sheff wrote in a note to clients.


So, now that the strategy is clear the question is will it work? So far, the promise of QE seems to be affecting the term premium in debt markets, reducing longer-term funding costs, and stock market traders also seem to think it will be good for equities.

The reality of QE when it arrives may be a bit different: debt markets are less dislocated than last time and so the value of the balm will be less, while stocks are far more richly priced.

A more interesting question is how households and businesses react to the paper wealth if the Fed is successful in creating it. Businesses may use their newly rich equity prices to go and buy other businesses, especially ones with actual resources attached, such as mining companies. They will be less interested in investing in new production unless they see strong signs from households that they are interested in buying more again.

For households, you have to wonder if there is a sort of Ricardian equivalence that applies to manufactured asset price inflation caused by QE or otherwise loose monetary policy. Ricardian equivalence is the controversial idea that consumers realise the fiscal constraints of their governments and will, for example, not spend a tax rebate if they know it means a tax rise down the road. Would they similarly not spend asset gains they see as false?

Clearly this idea did not apply to the interplay of policy, asset prices and consumption in the last decade. People spent some of the paper wealth that was created by loose policy under Alan Greenspan. That, however, was before they were burned by the housing crash, and Greenspan had the good sense to effectively conceal his experiment from his subjects. Now that the Federal Reserve has come out and said it is trying to ramp up asset markets, the feel-good factor from a rising stock market may be lacking.

If QE will work it will work as the big gun in the currency war, driving down the value of the dollar. In doing that,  though, the Federal Reserve takes considerable risks; that investors lose confidence in the dollar and in the U.S.’s commitment to its lasting value, and that they react by pulling back from dollar investments. This cannot be good for U.S. consumption, other than it might cause people to buy things now rather than later in diminished dollars.

Perhaps the real beneficiaries of QE will be commodities, or, whisper it not, gold.


We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

This web site truly has all of the information and facts I wanted about this subject and didn’t know who to ask.

I am curious to find out what blog platform you’re using? I’m experiencing some minor security problems with my latest site and I’d like to find something more secure. Do you have any solutions?|

Very good article. I’m going through many of these issues as well..

I am truly thankful to the owner of this web page who has shared this wonderful piece of writing at here.|

Simply want to say your article is as surprising. The clearness on your publish is simply great and i could think you’re knowledgeable on this subject. Well with your permission allow me to clutch your feed to keep up to date with imminent post. Thank you one million and please carry on the gratifying work.|

Your style is very unique in comparison to other folks I have read stuff from. Thanks for posting when you’ve got the opportunity, Guess I’ll just book mark this blog.|

great issues altogether, you simply received a logo new reader. What would you recommend in regards to your submit that you made some days in the past? Any sure?|

What’s up, all the time i used to check webpage posts here early in the break of day, for the reason that i like to find out more and more.|

You have made some decent points there. I looked on the net for more information about the issue and found most people will go along with your views on this website.

I absolutely love your blog.. Excellent colors & theme. Did you build this site yourself? Please reply back as I’m looking to create my own blog and would love to find out where you got this from or what the theme is called. Many thanks!

I used to be able to find good information from your blog posts.|

Posted by best seo companies | Report as abusive

Good web site you’ve got here.. It’s hard to find high-quality writing like yours these days. I seriously appreciate people like you! Take care!!

This piece of writing will help the internet visitors for creating new website or even a weblog from start to end.|

It’s going to be end of mine day, except before end I am reading this wonderful post to increase my knowledge.|

Posted by seo agency | Report as abusive

You’re so cool! I don’t think I have read a single thing like that before. So nice to discover someone with original thoughts on this issue. Really.. thanks for starting this up. This site is something that’s needed on the web, someone with some originality!

hello!,I really like your writing so much! share we keep in touch extra about your post on AOL? I require an expert in this house to solve my problem. Maybe that’s you! Looking ahead to peer you. |

I was recommended this web site through my cousin. I’m no longer sure whether this submit is written by means of him as no one else realize such specific approximately my trouble. You are incredible! Thank you!|