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.

CALLING DR RICARDO

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.

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